Financial Management

Financial Management
This book is a part of the course by Jaipur National University, Jaipur.

This book contains the course content for Financial Management.
JNU, Jaipur
First Edition 2013
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content whenever the need arises, and to vary it at any time without prior notice.
Index
I. Content....................................................................... II
II. List of Figures...........................................................VI
III. List of Tables......................................................... VII
IV. Abbreviations.......................................................VIII
V. Application. ............................................................ 114
VI. Bibliography.......................................................... 117
VII. Answers to Self Assessment............................... 120
Book at a Glance
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Contents
Chapter I.......................................................................................................................................... 1
Financial Management and Planning........................................................................................... 1
Aim................................................................................................................................................... 1
Objectives......................................................................................................................................... 1
Learning outcome........................................................................................................................................... 1
1.1 Introduction to Financial Management..................................................................................................... 2
1.2 Goals of Financial Management............................................................................................................... 2
1.3 Financial Decisions................................................................................................................................... 2
1.4 Interface between Finance and Other Business Functions....................................................................... 4
1.5 Financial Planning.................................................................................................................................... 4
1.6 Capitalisations........................................................................................................................................... 5
1.6.1 Cost Theory............................................................................................................................... 5
1.6.2 Earnings Theory........................................................................................................................ 6
1.7 Over-capitalisation.................................................................................................................................... 6
1.8 Under-capitalisation.................................................................................................................................. 7
Summary........................................................................................................................................................ 8
References...................................................................................................................................................... 8
Recommended Reading................................................................................................................................ 8
Self Assessment . ........................................................................................................................................... 9
Chapter II.....................................................................................................................................................11
Time Value of Money...................................................................................................................................11
Aim................................................................................................................................................................11
Objectives......................................................................................................................................................11
Learning outcome..........................................................................................................................................11
2.1 Introduction to Time Value of Money..................................................................................................... 12
2.2 Simple Interest........................................................................................................................................ 12
2.3 Compound Interest.................................................................................................................................. 13
2.3.1 Compounding Value of a Single Amount............................................................................... 13
2.3.2 Variable Compounding Periods.............................................................................................. 13
2.4 Doubling Period...................................................................................................................................... 15
2.5 Present Value........................................................................................................................................... 16
2.6 Effective Vs Nominal Rate..................................................................................................................... 18
2.7 Sinking Fund Factor................................................................................................................................ 18
2.8 Loan Amortisation.................................................................................................................................. 19
2.9 Shorter Discounting Periods................................................................................................................... 20
Summary...................................................................................................................................................... 21
References.................................................................................................................................................... 21
Recommended Reading.............................................................................................................................. 21
Self Assessment............................................................................................................................................ 22
Chapter III................................................................................................................................................... 24
Valuation of Bonds and Shares.................................................................................................................. 24
Aim............................................................................................................................................................... 24
Objectives..................................................................................................................................................... 24
Learning outcome......................................................................................................................................... 24
3.1 Introduction to Valuation........................................................................................................................ 25
3.2 Nature of Value....................................................................................................................................... 25
3.3 Bond Valuation........................................................................................................................................ 25
3.3.1 Types of Bonds....................................................................................................................... 26
3.4 Bond Yields............................................................................................................................................. 27
3.5 Bond Value Behaviors............................................................................................................................. 29
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3.5.1 Required Rate of Return and Bond Values............................................................................. 29
3.5.2 Time to Maturity and Bond Values......................................................................................... 30
3.5.3 Relationship between Bond Value and Time to Maturity Period............................................ 31
3.6 Valuation of Shares................................................................................................................................. 31
3.6.1 Valuation of Preference Shares............................................................................................... 32
3.6.2 Valuation of Equity/Ordinary Shares...................................................................................... 32
Summary...................................................................................................................................................... 35
References.................................................................................................................................................... 35
Self Assessment............................................................................................................................................ 36
Chapter IV................................................................................................................................................... 38
Cost of Capital............................................................................................................................................. 38
Aim............................................................................................................................................................... 38
Objectives..................................................................................................................................................... 38
4.1 Introduction to Cost of Capital............................................................................................................... 39
4.2 Cost of Different Sources of Finance...................................................................................................... 40
4.2.1 Cost of Equity......................................................................................................................... 40
4.2.2 Cost of Preference Shares....................................................................................................... 41
4.2.3 Cost of Debentures.................................................................................................................. 41
4.3 Capital Asset Pricing Model Approach (CAPM).................................................................................... 42
4.4 Weighted Average Cost of Capital (WACC)........................................................................................... 43
4.4.1 Factors Affecting WACC........................................................................................................ 44
Summary...................................................................................................................................................... 45
References.................................................................................................................................................... 45
Self Assessment . ......................................................................................................................................... 46
Chapter V..................................................................................................................................................... 48
Capital Structure and Leverages............................................................................................................... 48
Aim .............................................................................................................................................................. 48
Objective....................................................................................................................................................... 48
5.1 Meaning of Capital Structure.................................................................................................................. 49
5.2 Features of an Appropriate Capital Structure.......................................................................................... 50
5.3 Determination of Capital Structure......................................................................................................... 51
5.4 Theories of Capital Structure.................................................................................................................. 51
5.4.1 Net Income Approach............................................................................................................. 51
5.4.2 Net Operating Income (NOI) Approach................................................................................. 52
5.4.3 Traditional Approach.............................................................................................................. 53
5.4.4 Miller and Modigliani Approach............................................................................................ 54
5.5 Leverages . ............................................................................................................................................ 55
5.5.1 Operating Leverage................................................................................................................. 55
5.5.2 Financial Leverage.................................................................................................................. 57
5.5.3 Combined Leverage................................................................................................................ 57
Summary...................................................................................................................................................... 59
References.................................................................................................................................................... 59
Self Assessment . ......................................................................................................................................... 60
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Chapter VI . ............................................................................................................................................ 62
Capital Budgeting....................................................................................................................................... 62
Aim............................................................................................................................................................... 62
Objectives..................................................................................................................................................... 62
6.1 Introduction............................................................................................................................................. 63
6.2 Definition of Capital Budgeting.............................................................................................................. 63
6.3 Importance of Capital Budgeting............................................................................................................ 63
6.4 Objectives of Capital Budgeting............................................................................................................. 63
6.5 Principles or Factors of Capital Budgeting Decisions............................................................................ 64
6.6 Capital Budgeting Process...................................................................................................................... 64
6.7 Types of Capital Expenditure.................................................................................................................. 64
6.8 Types of Capital Budgeting Proposals.................................................................................................... 64
6.9 Methods of Evaluating Capital Investment Proposals............................................................................ 65
6.9.1 Traditional Methods................................................................................................................ 65
6.9.2 Improvement of Traditional Approach to Pay-back Period.................................................... 67
6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method.................... 68
6.9.4 Discounted Cash Flow Method (or) Time Adjusted Method.................................................. 69
6.9.5 Net Present Value Method (NPV)........................................................................................... 69
6.9.6 Internal Rate of Return Method (IRR).................................................................................... 70
6.9.7 Profitability Index Method...................................................................................................... 71
Summary...................................................................................................................................................... 72
Reference..................................................................................................................................................... 72
Self Assessment . ......................................................................................................................................... 74
Chapter VII................................................................................................................................................. 76
Management of Working Capital.............................................................................................................. 76
Aim............................................................................................................................................................... 76
Objectives..................................................................................................................................................... 76
7.1 Introduction............................................................................................................................................. 77
7.2 Meaning and Definition of Working Capital.......................................................................................... 77
7.3 Classification of Working Capital . ........................................................................................................ 77
7.4 Components of Working Capital............................................................................................................. 79
7.5 Aspects of Working Capital Management.............................................................................................. 79
7.6 Need for Working Capital....................................................................................................................... 79
7.7 Estimation of Working Capital Requirements........................................................................................ 84
7.8 Sources of Working Capital.................................................................................................................... 84
Summary...................................................................................................................................................... 86
References.................................................................................................................................................... 86
Self Assessment............................................................................................................................................ 87
Chapter VIII . ............................................................................................................................................ 89

Inventory Management.............................................................................................................................. 89
Aim............................................................................................................................................................... 89
Objectives..................................................................................................................................................... 89
8.1 Introduction............................................................................................................................................. 90
8.2 Meaning and Definition of Inventory..................................................................................................... 90
8.3 Types of Inventory.................................................................................................................................. 90
8.4 Inventory Management Motives............................................................................................................. 91
8.5 Objectives of Inventory Management..................................................................................................... 91
8.6 Costs of Holding Inventory..................................................................................................................... 91
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8.7 Risks of Holding Inventory..................................................................................................................... 92
8.8 Benefits of Holding Inventory................................................................................................................ 93
8.9 Techniques of Inventory Control............................................................................................................ 93
8.9.1 ABC Analysis.......................................................................................................................... 93
8.9.2 Economic Order Quantity (EOQ)........................................................................................... 94
8.9.3 Order Point Problem............................................................................................................... 95
8.9.4 Just in Time (JIT).................................................................................................................... 96
Summary...................................................................................................................................................... 97
Reference..................................................................................................................................................... 97
Recommended Reading ............................................................................................................................. 97
Self Assessment............................................................................................................................................ 98
Chapter IX................................................................................................................................................. 100

Dividend Decision..................................................................................................................................... 100
Aim............................................................................................................................................................. 100
Objectives................................................................................................................................................... 100
Learning outcome....................................................................................................................................... 100
9.1 Introduction........................................................................................................................................... 101
9.1.1 Types of Dividend/ Form of Dividend.................................................................................. 101
9.2 Dividend Decision................................................................................................................................ 101
9.2.1 Irrelevance of Dividend ....................................................................................................... 102
9.2.2 Relevance of Dividend.......................................................................................................... 104
9.3 Factors Determining Dividend Policy.................................................................................................. 109
9.4 Types of Dividend Policy.......................................................................................................................110
Summary.....................................................................................................................................................111
References...................................................................................................................................................111
Recommended Reading ............................................................................................................................111
Self Assessment...........................................................................................................................................112
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List of Figures
Fig. 1.1 Financial decisions............................................................................................................................ 3
Fig. 3.1 Bond value and time to maturity..................................................................................................... 31
Fig. 5.1 Net income approach....................................................................................................................... 52
Fig. 5.2 Net operating income approach....................................................................................................... 53
Fig. 5.3 Traditional approach........................................................................................................................ 54
Fig. 7.1 Types of working capital................................................................................................................. 78
Fig. 7.2 Operating cycle................................................................................................................................ 80
Fig. 9.1 Classification of dividend theories................................................................................................ 102
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List of Tables
Table 1.1 Cost dimension................................................................................................................................ 3
Table 1.2 Merits and demerits of cost approach............................................................................................. 5
Table 1.3 Merits and demerits of earnings theory........................................................................................... 6
Table 8.1 Categorisation of Inventory.......................................................................................................... 93
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Abbreviations
a - alpha
AAI - Average Accounts Payable
AAP - Average Accounts Payable
APP - Accounts Payable Period
APR - Accounts Receivables Period
AR - Account Receivables
ARR - Accounting rate of return
BR - Bills Receivables
CAPM - Capital asset pricing model
CCC - Cash Conversion Cycle
CE - Certainty Equivalent
CFAT - Cash Flow after Tax
CV - Compound value
DCF - Discounted cash flow
DF - Discounting Factor
ECL - Economic Conversion Lot
EMV - Expected Monetary Value
EOQ - Economic Order Quantity
ERI - Effective rate of interest
FM - Financial Management
FMCG - Fast Moving Consumer Goods
FV - Future value
GDP - Gross Domestic Product
HR - Human Resource
IRR - Internal Rate of Return
JIT - Just in Time
L/C - Letter of Credit
LCL - Lower Control Limit
MAN - Materials as Needed
NI - Net income
NOI - Net operating income
NOT - Neck of Time
NPV - Net present value
OC - Operating Cycle
PI - Profitability Index
Pro - Probability
PV - Present Value
PVA - Proportional Value Analysis
PVIFA - Present Value Interest Factor of Annuity
RADR - Risk Adjusted Discount Rate
ROI - Return on investment
RP - Return Point
TD - Trade Debtors
UCL - Upper Control Limit
WACC - weighted average cost of capital
WC - Working Capital
WCL - Working Capital Leverage
YTC - Yield to call
YTM - Yield to maturity
ZIN - Zero Inventories
ZIPS - Zero Inventory Production System
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Chapter I
Financial Management and Planning
Aim
The aim of this chapter is to:
• explain the concept of financial management
• elucidate profit maximisation
• explicate financial planning
Objectives
The objectives of this chapter are to:
• explain the concept of management planning
• enlist various financial decisions
• explain the concept of capitalisations
Learning outcome
At the end of this chapter, you will be able to:
• identify the types of financial decisions- investment, financing and dividend
• understand the process, benefits, factors of financial planning
• describe the merits and demerits of cost and earnings theory
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1.1 Introduction to Financial Management

Financial management "is the operational activity of a business that is responsible for obtaining and effectively
utilising the funds necessary for efficient operations".
Financial management is concerned with three key activities namely:

• Anticipating financial needs
• Acquiring financial resources
• Allocating funds in business
Traditional approach to financial management

Traditionally, financial management was considered as a branch of knowledge with focus on the procurement of
funds. Instruments of financing, formation, merger and restructuring of firms, legal and institutional frame work
involved therein occupied the prime place in this approach.
Modern approach to financial management

Modern phase has shown the commendable development with combination of ideas from economic and statistics
that led the financial management more analytical and quantitative. The key work area of this approach is rational
matching of funds to their uses, which leads to the maximisation of shareholders' wealth.
1.2 Goals of Financial Management

Goal of financial management of a firm is maximisation of economic welfare of its shareholders. Shareholders' wealth
maximisation is reflected in the market value of the firms' shares. A firms' contribution to the society is maximised
when it maximises its value. Two widely accepted goals of financial management are:
Profit maximisation
Profit is primary motivating force for any economic activity. Firm is essentially being an economic organisation,
it has to maximise the interest of its stakeholders. To this end the firm has to earn profit from its operations. The
overall objective of business enterprise is to earn at least satisfactory return on the funds invested, consistent with
maintaining a sound financial position.
Limitations of Profit Maximisation

The term profit is vague and it doesn't clarify what exactly it means. It has different interpretations
for different people.Time value of money refers a rupee receivable today is more valuable than a
rupee, which is going to be receivable in future period. The profit maximisation goal does not help in
distinguishing between the returns receivable in different periods.The concept of profit maximisation
fails to consider the fluctuation in the profits from year to year.
Wealth maximisation:
Wealth maximisation refers to maximising the net wealth of the company's share holders. Wealth maximisation is
possible only when the company pursues policies that would increase the market value of shares of the company.
1.3 Financial Decisions

The functions performed by a finance manager are known as finance functions. In the course of following these
functions finance manager takes the following decisions:
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Financial
Decisions
Investment Financing Dividend

Decisions Decisions Decisions
Fig. 1.1 Financial decisions
Investment decisions
It begins with a determination of the total amount of assets needed to be held by the firm. It relates to the selection
of assets, on which a firm will invest funds. The required assets fall into two groups namely:
• Long-term assets: This involves huge investment and yield a return over a period of time in future. It is also
termed as 'capital budgeting' and can be defined as the firm's decision to invest its current funds most efficiently
in fixed assets with an expected flow of benefits over a series of years.
• Short-term assets: These are the current assets that can be converted into cash within a financial year without
diminution in value. Investment in current assets is termed as 'working capital management'.
Financing decisions
Financing decisions relate to the acquisition of funds at the least cost. The cost has two dimensions which have been
illustrated in the below mentioned table.
Explicit cost Implicit cost

It refers to the cost which is not visible
It refers to the cost in the form of
but it may seriously affect the company's
coupon rate, cost of floating and
operations especially when it is exposed to
issuing the securities and so on
business and financial risk
Table 1.1 Cost dimension
The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions
which would attain an optimal structure of capital.
Dividend decisions
Dividend decision is a major decision made by the finance manager on the formulation of dividend policy. Since
the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands
the managerial attention on the impact of its policy on dividend on the market value of shares. Optimum dividend
policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio
means what portion of earnings per share is given to the shareholders in the form of cash dividend.
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1.4 Interface between Finance and Other Business Functions

Financial management has relationship with almost all functional departments. But it has close relationship with
economics and accounting.
Relationship to economics
The relationship between finance and economics is studied under two prime areas of economics. They are
macroeconomics and microeconomics:
• Macroeconomics: It is the environment in which an industry operates, which is not controllable. It is important
for financial managers to understand changes in macroeconomics and their impact on the firm's operating
performance. External environment analysis helps in identifying opportunities and threats.
• Microeconomics: It is concerned with the determination of optimum operational strategies. All financial decisions
of a firm are made on the basis of marginal cost, and marginal revenue. Therefore it is necessary to understand
the relationship between finance and economics.
Relationship to accounting
Accounting and finance are closely related. For computation of return-on-investment, earnings per share of various
ratios for financial analysis, the data base will be accounting information. Without proper accounting system, an
organisation cannot administer effectively function of financial management. The purpose of accounting is to report
the financial performance of the business for the period under consideration.
Relationship to HR (Human Resource)

HR activities include recruitment, training, development, fixing compensation and so on for which we need finance.
HR managers need to consult finance managers. Finance managers take decision after studying the impact of HR
activity on organisation.
Relationship to production
Production department is another functional area that involves huge investment on fixed assets. The production
manager and the finance manager need to work closely for effective investment on plant and machinery.
Relationship to marketing
Marketing functions involves selection of distribution channel and promotion policies. These two are the primary
activities of marketing department and involves huge cash outflows. Therefore finance and marketing managers
need to work with coordination to maximise value of the firm.
1.5 Financial Planning

Financial Planning is a process by which funds required for each course of action is decided. A financial plan has
to consider capital structure, capital expenditure and cash flow. Financial planning generates financial plan which
indicates:
• The quantum of funds required to execute business plans
• Composition of debt and equity
• Formulation of polices for giving effect to the financial plans under consideration
Process of financial planning

• Projection of financial statements
• Determination of funds needed
• Forecast the availability of funds
• Establish and maintain systems of controls
• Develop procedures
• Establish performance-based compensation system
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Benefits of financial planning
• Effective utilisation of funds
• Flexibility in capital structure is given adequate consideration
• Formulation of policies and instituting procedures for elimination of all types of wastages in the process of
execution of strategic plans.
• Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for
plant and machinery and other fixed assets.
Factors affecting financial plan

• Nature of the industry
• Size of the company
• Status of the company in the industry
• Sources of finance available
• The capital structure of a company
• Matching the sources with utilisation
• Flexibility
• Government policy
1.6 Capitalisations
Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the firm.
It has two components, viz., debt and equity.
After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive
at the value at which the company has to be capitalised. The two theories of Capitalisation are:
1.6.1 Cost Theory

According to the cost theory of capitalisation, the value of a company is arrived at by adding up the cost of fixed
assets like plants, machinery patents, the capital that regularly required for the continuous operation of the company
(working capital), the cost of establishing business and expenses of promotion. The original outlays on all these
items become the basis for calculating the capitalisation of company.
Merits of cost approach Demerits of cost approach

• It helps promoters to estimate the amount • It the firm establishes its production facilities at
of capital required for various activities like inflated prices; productivity of the firm will be
incorporation of company, conducting market less than that of the industry.
surveys and so on.
• If done systematically it will lay foundation for • Net worth of a company is decided by the
successful initiation of the working of the firm. investors by the earnings of a company. Earning
capacity based net worth helps a firm to arrive
at the total capital in terms of industry specified
yardstick cost theory fails in this respect.
Table 1.2 Merits and demerits of cost approach
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1.6.2 Earnings Theory

The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise depends
upon its earnings and earning capacity. According to it, the value or capitalisation of a company is equal to the
capitalised value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and
loss account. For the first few years of its life, the sales are forecast and the manager has to depend upon his/her
experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings
of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study
the rate at which other companies in the same industry similarly situated are earning. The rate is then applied to the
estimated earnings of the company for finding out the capitalisation.
Merits of earnings theory Demerits of earnings theory

• It is superior to cost theory because there are • The major challenge that a new firm faces is in
the least chances of neither under nor over deciding on capitalisation and its division thereof
capitalisation. into various procurement sources.
• Comparison of earnings with that of cost • Arriving at capitalisation rate is equally a formidable
approach will make the management to be task because the investors' perception of established
cautious in negotiating the technology and companies cannot be really representative of what
cost of procuring and establishing the new investors perceive of the earning power of new
business. company.
Table 1.3 Merits and demerits of earnings theory
1.7 Over-capitalisation
A company is said to be overcapitalised, when its total capital exceeds the true value of its assets. The correct
indicator of overcapitalisation is the earnings capacity of the firm. If the earnings of the firm are less then that of
the market expectation, it will not be in position to pay dividends to its shareholders as per their expectations. It is
a sign of overcapitalisation.
Effects of over-capitalisation
• Decline in the earnings of the company
• Fall in dividend rates
• Market value of company's share falls, and company loses investors confidence
• Company may collapse at any time because of anemic financial conditions
Remedies for over-capitalisation

Restructuring the firm is to be executed to avoid the situation of company becoming sick. It involves the
following:
• Reduction of debt burden
• Negotiation with term lending institutions for reduction in interest obligation
• Redemption of preference shares through a scheme of capital reduction
• Reducing the face value and paid-up value of equity shares
• Initiating merger with well managed profit making companies interested in taking over ailing company
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1.8 Under-capitalisation
A company is considered to be under-capitalised when its actual capitalisation is lower than its proper capitalisation
as warranted by its earning capacity.
Causes of under-capitalisation
• Under estimation of future earnings at the time of promotion of the company
• Abnormal increase in earnings from new economic and business environment
• Under estimation of total funds requirements
• Maintaining very high efficiency through improved means of production of goods or rendering of services
• Use of low capitalisation rate
• Purchase of assets at exceptionally low prices during recession
Effects of under-capitalisation
• Encouragement to competition
• It encourages the management of the company to manipulate the company's share prices
• Higher profits will attract higher amount of taxes
• Higher profits will make the workers demanding higher wages
• High margin of profit may create among consumers an impression that the company is charging high prices
for its product
Remedies
• Splitting up of the shares- This will reduce the dividend per share
• Issue of bonus share – This will reduce both the dividend per share and earnings per share.
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Summary
• Financial management "is the operational activity of a business that is responsible for obtaining and effectively
utilising the funds necessary for efficient operations.
• Wealth maximisation refers to maximising the net wealth of the company's share holders.
• Financial Planning is a process by which funds required for each course of action is decided.
• A financial plan has to consider capital structure, capital expenditure and cash flow.
• Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the
firm. It has two components, viz., debt and equity.
• The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise
depends upon its earnings and earning capacity.
• A company is said to be overcapitalised, when its total capital exceeds the true value of its assets.
References
• Reddy, G. S., 2008. Financial Management. Himalaya publications, Mumbai.
• Correia, C., Flynn, D. K., Uliana, E. & Wormald, M., 2012. Financial Management, 6th ed., Juta and Company
Ltd.
• Financial Planning - Definition, Objectives and Importance, [Online] Available at: <http://www.
managementstudyguide.com/financial-planning.htm> [Accessed 27 May 2013].
• Masters of Business Administration Notes, [Online] Available at: <http://freemba.in/articlesread.php?artcode=
299&substcode=19&stcode=10> [Accessed 27 May 2013].
• 2008. Financial Management, [Video online] Available at: <http://www.youtube.com/watch?v=iDlFPm3fqbs>
[Accessed 27 May 2013].
• 2011. Financial Management - Lecture 01, [Video online] Available at: <http://www.youtube.com/
watch?v=iDlFPm3fqbs> [Accessed 27 May 2013].
Recommended Reading
• Brigham, E. F., 2010. Financial Management: Theory & Practice. 13th ed., South-Western College Pub.
• Shim, J. K., 2008. Financial Management (Barron’s Business Library). 3rd ed., Barron’s Educational Series.
• Brigham, E. F., 2009. Fundamentals of Financial Management. 12th ed., South-Western College Pub.
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Self Assessment
1. Wealth maximisation refers to maximising the ___________ of the company's share holders
a. profit
b. net wealth
c. assets
d. liabilities
2. A company is said to be ____________, when its total capital exceeds the true value of its assets.
a. under-capitalised
b. capitalised
c. overcapitalised
d. profit maximisation
3. Which of the following statements is false?

a. Capitalisation of a firm refers the composition of its short-term funds.
b. A financial plan has to consider Capital structure, Capital expenditure and cash flow.
c. Wealth maximisation refers to maximising the net wealth of the company's share holders
d. Goal of financial management of a firm is maximisation of economic welfare of its shareholders
4. The earnings theory of Capitalisation recognises the fact that the _________ of an enterprise depends upon its
earnings and earning capacity.
a. false value
b. total value
c. true value
d. half value
5. Which of the following cost is not visible but it may seriously affect the company's operations especially when
it is exposed to business and financial risk.
a. Explicit cost
b. Implicit cost
c. Direct cost
d. Indirect cost
6. Match the following

Concept Description
A. Explicit cost 1. A process by which funds required for each course of action is decided
2. This involves huge investment and yield a return over a period of time in
B. Financial Planning
future.
3. The current assets that can be converted into cash within a financial year
C. Long-term assets
without diminution in value
D. Short-term assets 4. The cost in the form of coupon rate, cost of floating and issuing the securities
a. A-2, B-1, C-4, D-3
b. A-4, B-3, C-1, D-2
c. A-4, B-1, C-2, D-3
d. A-1, B-2, C-3, D-4
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7. ___________ is the operational activity of a business that is responsible for obtaining and effectively utilising
the funds necessary for efficient operations.
a. Financial planning
b. Financial management
c. Asset management
d. Budget management
8. ______________is a major decision made by the finance manager on the formulation of dividend policy.
a. Investment decision
b. Financing decision
c. Dividend decision
d. Accounting decision
9. Financing decisions relate to the acquisition of funds at the _________ cost.

a. maximum
b. less
c. more
d. least
10. Which among the following is the primary goal of financial management of a firm?
a. Maximisation of economic welfare of its shareholders
b. Encouragement to competition
c. Fall in dividend rates
d. Effective utilisation of funds
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Chapter II
Time Value of Money
Aim
• explain the concept of time, value and money
• explain simple and compound interest
• elucidate variable compounding periods
Objectives
• explain the compound value of series of cash flows
• elucidate the concept of doubling period and sinking fund factor
• explicate the concept of present value
Learning outcome
• describe the sinking fund factor with its formula for calculation
• understand the concept of loan amortisation
• identify shorter discounting periods
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2.1 Introduction to Time Value of Money

One of the most fundamental concepts in finance is that money has a “time value.” That is to say that money in
hand today is worth more than money that is expected to be received in the future. This leads us to summarise the
concept of time value: “A Rupee today is worth more than a Rupee tomorrow."
Concept - Time value of money

A rupee, which is received today, is more valuable than a rupee receivable in future. The amount that is received
earlier period can be reinvested and it can earn an additional amount. Therefore, people prefer to receive the rupee
that is receivable at the earliest.
Rationale of time preference for money

Individual prefers value opportunity to receive money now rather than waiting for one or more years to receive the
same. It is referred to as an individual's time preference for money. There are three reasons that may be attributed
to the individual's time preference for money:
• Uncertainty: Future is uncertain and it involves risk. An individual is not certain about future cash inflows.
Hence, the individual would prefer to receive cash toady instead of future.
• Current consumption: Most of the people prefer to use the present money for satisfying existing present
needs.
• Possibility of investment opportunity: The reason why individuals prefer present money is due to the possibility
of investment opportunity through which they can earn additional cash.
2.2 Simple Interest

Simple interest is the interest paid on only the original amount, or principle borrowed. Simple amount is a function
of three components such as principle amount borrowed or lent, interest per annum and the number of years for
which the interest rate is calculated. Symbolically:
SI = Po (I) (n)
Where,
SI= Simple interest, Po= Principle amount at year '0', I= Interest rate per annum
n=Number of year for which interest is calculated
For instance
Mr. Dorabjee has deposited Rs.1,00,000 in a Savings bank account at 7 per cent simple interest and interest and
interested to keep the deposit for a period of 5 years. He requested you to give accumulated interest end of the
years.
Solution: SI = Po (I) (n) = Rs.1, 00,000 X 0.07 X 5 years= Rs. 35,000

If an investor wants to know his total future value at the end of 'n' years. Future value is the sum of accumulated
interest and the principal amount. Symbolically:
FVn = Po + Po (I) (n) OR SI + Po
For instance
Manish annual savings are Rs. 1000, which is invested in a bank saving fund account that pays a 5 % simple interest.
Krishna wants to know his total future value or terminal value at the end of 8 years period.
Solution: FVn = Po + Po (I) (n) OR SI + Po

FVn = Rs. 1000 + Rs. 1000 (0.05) (8) = Rs. 1,400
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2.3 Compound Interest
Here the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found,
interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the
first compounding period.
There is no difference between simple interest and compound interest when there is only one time investment yearly
compounding, and for only one year maturity. But the difference can be seen only when the investment is made for
more than two years. Compounding interest is also referred as future value (FV).
2.3.1 Compounding Value of a Single Amount

Compound value or future value on an account can be calculated by the following formula.
CV = Po (1 + I) n
Where,
CV = Compound value, Po = Principal amount, I = Interest per annum,
n = Number of years for which compound is done
(1 + I) n = CVIF I…..n or future value inter factor for interest and 'n' years.
For instance: Suppose you have Rs. 10, 00,000 today and you deposit it with a financial institute, which pay 8 %
compound interest for a period of 5 years. Show how the deposit will grow.
Solution: CV = Po (1 + I) n
CV5 = 10, 00,000(1+0.08)5
= 10, 00,000 (1.469*)
CV5 = Rs. 14, 69,000
Note: * See compound value of one rupee Table for 5 years at 8 % rate of interest.
2.3.2 Variable Compounding Periods

Generally compounding is done once in a year. In the above problem, we assumed that the compounding is done
annually. If the investor promised to pay compound interest for variable periods, compound value with variable
compound periods is determined with the following formula.
Where,
CVn = Compound value at the end of year 'n', Po = Principal amount at the year '0', I = Interest per annum,
m = Number of times per year compounding is done
n = Maturity period
For instance (Semi compounding): How much does a deposit of Rs. 40,000 grow to at the end of 10 year at the rate
of 6 % interest and compounding is done semi-annually. Determine the amount at the end of 10 years.
Solution:
= Rs. 40,000 [*1.86] = Rs. 72,240
Note: * See compound value of one rupee Table for 20 years at 3 % rate of interest.
For Instance (Quarterly compounding): Suppose that a firm deposits Rs. 50 lakhs at the end of each year for 4 years
at the rate of 8 % interest and compounding is done on quarterly basis. What is the compound value at the end of
4 year?
Solution:
= Rs. 50, 00,000 [CVIF 2%..........16y]

= Rs. 50, 00,000 x 1.373 = Rs. 68, 65,000
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Calculation of Compound Growth Rate

Compound growth rate can be calculated with the following formula:
gr:
Where gr= Growth rate in percentage
V= Variable for which the growth rate is needed to found (i.e. sales, revenue, dividend at the end of year '0')
Vo = Variable value at the end of year 1
Vn = Variable value (amount) at the end of year 'n'
For instance:
From the following dividend data of a company calculate compound rate of growth for period (1998-2003).
Year 1998 1999 2000 2001 2002 2003

Dividend per share (Rs.) 21 22 25 26 28 31
Solution:
gr= 8%
Note
See compound one rupee Table for 5 years (total years – one year) till you find closest value to the compound factor,
at closest value see upward to the table to get growth rate.
Compound Value of Series of cash Flows

Annuity means a series of cash flows (inflow or outflow) of a fixed amount for a specified number of years. Compound
value of a series of cash flows can be calculated by the following formula (uneven cash flows)
Where CVn= Compound value at the end of' 'n' year

P1 = Payment at the end of year 1, P2 = Payment at the end of year 2
Pn = Payment at the end of year 'n', I = Interest rate
CVn = P1 (CVIF I.1) + P2 (CVIF I.2) + …………… Pn (1+I I.n)
For instance
Mr. Shyam deposits Rs. 5,000, Rs. 10,000, Rs. 15,000, Rs. 20,000 and Rs. 25,000 in his savings bank account in
year 1,2,3,4 and 5 respectively. Interest rate of 6 %, he wants to know his future value of deposits at the end of 5
years.
Solution: + +
= 6,610 + 11,910 + 16,860 + 21,200 + 25,000

= Rs. 81,280
Compound Value of Annuity (Even Cash Flow)

Annuity is a series of even cash flows for a specified duration. It involves a regular cash outflow or inflow. For
instance like the payment of LIC premium, depositing in a recurring deposit account, and the like. Cash flows may
happen either at the end of year or beginning of the year. If cash flows happen at the beginning of the year, it is called
as an annuity due, where as when the cash flows happen at the end it is called as a regular or deferred annuity.
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Compound Value of Deferred Annuity
For instance: Mr. Ram deposits Rs. 500 at the end of every year for 6 years at 6 % interest. Determine Ram's money
value at the end of 6 years.
Solution:
+
= 500(1.338) + 500(1.262) + 500(1.191) + 500(1.124) + 500(1.060) + 500(1.00)

= 669 + 631 + 595.5 + 562 + 530 + 500
= Rs. 3487.5
Short cut formula for the above is:
Where,
P = Fixed periodic cash flow, I – Interest rate
n = duration of the amount
= (CVIFA I.n)
(CVIFA I.n) = Future value for interest fact or annuity at 'I' interest and for 'n' years.
For the example above this formula can be used as below.
= 500(6.975)
= Rs. 3,487.5
Note: See compound value interest factor annuity Table of one rupee Table for 6 years at 6 % interest.
Compound Value of Annuity Due

When the cash flows involves at the beginning of the year compound value of annuity is calculated with the following
formula:
OR
For instance
Suppose you deposit Rs. 2,500 at the beginning of every year for 6 years in a saving bank account at 6 % compound
interest. What is your money value at the end of 6 years?
Solution:
= 2,500 (6.975) (1+0.06)

= Rs. 18, 4863.75
2.4 Doubling Period

Doubling period is the period required to double the amount invested at a given rate of interest.
Doubling period can be computed by adopting two rules:

• Rule of 72: To get doubling period, 72 is dividend by interest rate.
Doubling period (DP) = 72 ÷ I
Where I = Interest rate, (%)
DP = Doubling period in years
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For instance:
If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?
Solution: DP = 72÷ I = 72 ÷ 10 = 7.2 years (approx.)
Rule of 69
Rule of 72 may not give exact doubling period, but rule of 69 gives a more accurate doubling period. The formula
to calculate doubling period is
DP =0.35 + 69/I
For instance: If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?
Solution: 035 + 69/10 = 7.25 years
Effective rate of interest (ERI) in case of doubling period

Effective rate of interest can be defined with the use of following formula.
• In case of rule of 72
ERI = 72 ÷ Doubling period (DP)
Where ERI = effective rate of interest, DP = Doubling period
• In case of rule of 69
For instance
A financial institute has come with an offer to the public, where the institute pays double the amount invested in
the institute at the end of 8 years. Mr. A who is interested to deposit with institute wants to know the effective rate
of interest that will be given by institute.
Solution as per rule of 72: 72 ÷ 8 years = 9 %
Solution as per rule of 69: = 9 % (approx.)
2.5 Present Value

The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value to the
present value. The processes of determining present value of future cash flows are called discounting. It is concerned
with determining the present value of a future amount, assuming that the decision maker has an opportunity to earn a
certain return on individual's money. This return is referred as discount rate, cost of capital or an opportunity cost.
Present value of a single amount

Present value can be calculated by the following formula:
OR
PV = Present value
= Future value receivable at the end of 'n' years
I = Interest rate or discounting factor or cost of capital
n = Duration of the cash flow
= present value interest facts at 'I' interest and for 'n' years
For instance
An investor wants to find the present value of Rs. 40,000 due 3 years. His interest rate is 10 %.
Solution:
= Rs. 40,000 [1
= Rs. 40,000 (0.751*)
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= Rs. 30,040
Note: * Present value of one rupee Table at 3 years for the arte of 10 %
Present value of a series of cash flows

We have calculated the present value of a single amount to be received after a specified period. In many cases, we
may need to calculate present value of series cash flows. For example, in capital budgeting decisions, there is a need
to convert the future cash inflows into present values to take decision and in case of raising funds through debt also
needs to convert the future cash outflows into present values. Cash flows over a period may be even or uneven.
Present Value of Uneven Cash Flows
OR + …… +
PV = Present value
I = Interest rate or discounting factor or cost of capital
n = Duration of the cash inflows stream
t = Year in which cash inflows are receivable
For instance
From the following information, calculate the present value at 10% interest rate.
Year 0 1 2 3 4 5
Cash inflow (Rs.) 2,000 3,000 4,000 5,000 4,500 5,500
Solution:
= 2,000+ 2,727 + 3,304 + 3,755 + 3,073.5 + 3,415.5

= Rs. 18,275
Present Value of even Cash Flows (annuity)
PVA = Present value of annuity

I = Interest rate or discounting factor
n = Duration of the annuity
CIF = Cash inflows
For instance
Mr. Ram wishes to determine the PV of the annuity consisting of cash flows of Rs. 40,000 per annum for 6 years.
The rate of interest he can earn from his investment is 10 %.
Solution:
= Rs. 40,000 X
= Rs. 4000 X * 4.355 = Rs. 17,420
*See present value of annuity for 6 years at 10 %
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Present Value of Annuity Due
(1+I)
For instance: Mr. Krishna has to receive Rs. 500 at the beginning of each year for 4 years. Calculate present value
of annuity due assuming 10 % rate of interest.
Solution:
= Rs. 1,743.5
2.6 Effective Vs Nominal Rate

Nominal rate of interest or rate of interest per year is equal. Effective and nominal rate are equal only when the
compounding is done yearly once, but there will be a difference, that is effective rate is greater than the nominal
rate for shorter compounding periods. Effective rate of interest can be calculated with the following formula.
Where, I = Nominal rate of interest

m = Frequency of compounding per year.
For instance
Mr. Y deposited Rs. 1,000 in a bank at 10% of rate of interest with quarterly compounding. He wants to know the
effective rate of interest.
Solution:
= 1.1038-1
= 0.1038 OR 10.38 %
2.7 Sinking Fund Factor

Financial manager may need to estimate the amount of annual payments so as to accumulate a predetermined
amount after a future date to purchase assets or to pay a liability. The following formula is useful to calculate the
annual payment.
Where, = Annual payment, , I = Interest rate

For instance: Finance manager of a company wants to buy an asset costing Rs. 1, 00,000 at the end of 10 years. He
Requests you to find out the annual payment required, if the savings earn an interest rate of 12% per annum.
Solution:
= 1, 00,000 (0.12/2.1058)
= Rs. 5.689
Present Value of Perpetuity

Perpetuity is an annuity of infinite duration. It may be expressed as:
Where: PV = Present value of a perpetuity
CIF = Constant annual cash inflow
= PV interest factor for perpetuity
= CIF/I
For instance: Mr. X an investor expects a perpetual amount of Rs. 1000 annually from his investment. What is his
present value of perpetuity if the interest rate is 8 %?
Solution: = CIF/I
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= 1000/0.08 = Rs. 12,500
2.8 Loan Amortisation

Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is known
as amortisation. Financial manager may take loan and may be interested to know the amount of equal installment
to be paid every year to repay the complete loan amount including interest. Installment can be calculated with the
following formula.
OR LI
Where: LI = Loan installment, = Principal amount, I = Interest, n = Loan repayment period at specified interest
rate.
For instance: ABC company raised Rs. 10, 00,000 lakhs for an expansion program from IDBI at 7% interest per
year. The amount has to be repaid in 6 equal annual installments. Calculate the installment amount.
Solution:
= 10, 00,000 ÷ 7.767
= Rs. 1, 28,750
Present Value of Growing Annuity

Growing annuity means the cash flows that grow at a constant rate for a specified period of time.
Steps involved in calculation of growing annuity:
• Calculate the series of cash flows
• Convert the series of cash flows into present values at a given discount factor
• Add all the present values of series of cash flows to get total PV of a growing annuity
Formula:
PVGA= PV of growing annuity

CIF = Cash inflows
g= Growth rate
I = discount factor
n= Duration of the annuity
For instance: A Real estate Agency has rented out one of their apartment for 5 years at an annual rent of Rs. 6,00,000
with the stipulation that rent will increase by 5% in every year. If the agency's required rate at return is 14%. What
is the PV of expected (annuity) rent?
Solution: Calculate on series of annual rent

Year Amount of Rent (Rs.)
1 6,00,000
2 6,00,000 X (1+0.05) 6,30,000
3 6,30,000 X (1+0.05) 6,61,500
4 6,61,500 X (1+0.05) 6,94,575
5 6,94,575 X (1+0.05) 7,29,303.75
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2.9 Shorter Discounting Periods

Generally cash flows are discounted once a year, but some times cash flows have to be discounted less than one
(year) time, like, semi-annually, quarterly, monthly or daily. The general formula used for calculating the PV in the
case of shorter discounting period is:
Where, PV = Present vale, = Cash inflow after 'n' year, m= No. of times per year discounting is done
I= Discount rate
For instance: Mr. P expected to receive Rs. 1, 00,000 at the end of 4 years. His required rate of return is 12% and
he wants to know PV of Rs. 1, 00,000 with quarterly discounting.
Solution:
= 1, 00,000 X
= 1, 00,000 X 0.623
= Rs. 62,300
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Summary
• One of the most fundamental concepts in finance is that money has a “time value.” That is to say that money
in hand today is worth more than money that is expected to be received in the future.
• Simple interest is the interest paid on only the original amount, or principle borrowed.
• Simple amount is a function of three components such as principle amount borrowed or lent, interest per annum
and the number of years for which the interest rate is calculated.
• Doubling period is the period required to double the amount invested at a given rate of interest.
• The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value
to the present value.
• Effective and nominal rate are equal only when the compounding is done yearly once, but there will be a
difference, that is effective rate is greater than the nominal rate for shorter compounding periods.
• Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is
known as amortisation.
References
• Introduction to the Time Value of Money, [Online] Available at: <https://www.boundless.com/accounting/time-
value-money/introduction-to-time-value-money/> [Accessed 27 May 2013].
• Introduction to the Time Value of Money, [Pdf] Available at: <http://www2.fiu.edu/~changch/Chapter2_4.pdf>
• Paramasivan, C. & Subramanian, T., 2009. Financial Management, New Age International.
• Ramagopal, C., 2008. Financial Management, New Age International.
• 2013. Financial Management: Lecture 2, Chapter 5: Part 1 - Time Value of Money, [Video online] Available
at: <http://www.youtube.com/watch?v=vpJszYCLH3o> [Accessed 27 May 2013].
• Prof. Ahmed, M., 2010. Time Value of Money, [Video online] Available at: <http://www.youtube.com/
watch?v=CnRJ6Jypsj4> [Accessed 27 May 2013].
Recommended Reading
• Drake, P. P., 2009. Foundations and Applications of the Time Value of Money. Wiley
• Benninga, S., 2006. Principles of Finance with Excel. Oxford University Press, USA
• Block, S., 2008. Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in
card. 13th ed., McGraw-Hill/Irwin.
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Self Assessment
1. Individual prefers ________opportunity to receive money now rather than waiting for one or more years to
receive the same
a. value
b. money
c. interest
d. principle
2. ________ is an amount raised from outsiders at an interest and repayable at a specified period
a. Money
b. Loan
c. Principle
d. Value
3. ________ rate of interest or rate of interest per year is equal

a. Sinking
b. Present value
c. Nominal
d. Principle
4. The present value of a future cash inflow (or outflow) is the amount of _________ cash that is of equivalent
value to the present value
a. current
b. future
c. past
d. lost

a. Annuity is a series of odd cash flows for a specified duration
b. Simple interest is the interest paid on only the original amount
c. Growing annuity means the cash flows that grow at a constant rate for a specified period of time
d. The processes of determining present value of future cash flows are called discounting
6. Compounding interest is also referred as __________.

a. future value
b. current value
c. asset value
d. amount value
7. ________ period is the period required to double the amount invested at a given rate of interest.
a. Compounding
b. Growth
c. Discounting
d. Doubling
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8. If cash flows happen at the beginning of the year, it is called as an?
a. Annuity due
b. Deferred annuity
c. Regular annuity
d. Mixed annuity
9. A rupee, which is received today, is more valuable than a rupee receivable in ______.
a. past
b. present
c. future
d. today
10. The process of determining present value of future cash flows is called?
a. Sinking
b. Billing
c. Discounting
d. Amounting
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Chapter III
Valuation of Bonds and Shares
Aim
• explain the concept of valuation
• explicate types of values
• elucidate the basic bond valuation model
Objectives
• explain various types of bonds
• explicate bond valuation
• elucidate redeemable bond
Learning outcome
• understand relationship between bond value and time to maturity period
• identify zero coupon bonds
• describe current yield
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3.1 Introduction to Valuation
Valuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset depends
on the cash flow it is expected to provide over the holding period. The fact is that, as on date there is no method by
which prices of shares and bonds can be accurately predicted. It should be kept in mind by an investor before one
decides to take an investment decision.
3.2 Nature of Value

• Book value: It is an accounting concept. Assets are recorded in balance sheet at their book values. Book value
of an asset is cost of acquisition less accumulated depreciation. It is determined by the formula below.
• Market value: Market value of an asset is the price at which the asset is bought or sold in the market. Market
value per share is generally higher than the book value per share for profitable and growing firms.
• Going concern value: It is the value that a firm can be realised if it sells its business as a continuing operating
business. This value would be higher than the liquidation and book value. Valuation of securities is always
considered as going concern, because if the firm is not running, investors would not invest in securities
• Liquidation value: Liquidation value is the actual amount that can be realised when an asset is sold. Liquidation
value of a equity stock is the actual amount that would be received if all of the firm's assets were sold at their
market value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.
• Intrinsic value: Investors invest on equity stock with an expectation of intrinsic cash inflow stream. The present
value of the cash inflows expected from a security over its holding period. Present value is computed by
discounting future cash inflows at an appropriate rate. It is also called economic value.
3.3 Bond Valuation

A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and setting
forth the terms under which they are issued and are to be paid. Bond is also known as 'debenture'. Bonds are issued
by different types of organisations like the government, financial institutions, public sector undertaking and private
sector organisations.
Few important terms in bond valuation are as follows:

• Par value: The par value (Face Value) is stated on the face of the bond. It is the amount at which a bond is issued
to public, and promises to pay either at the end of maturity period or in pre-decided installments.
• Coupon rate: Coupon rate is the interest rate with which a bond is issued. The interest payable at regular intervals
is the product of the par value and the coupon rate broken down to the relevant time horizon.
• Maturity period: Refers to the number of years after which the par value becomes payable to the bond-holder.
• Redemption value: It is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a
premium (bond-holder gets more than the par value of the bond) or at a discount (bond-holder gets less than
the par value of the bond)
• Market value: It is the price at which the bond is traded in the stock exchange. Market price is the price at which
the bonds can be bought and sold and this price maybe different from par value and redemption value.
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3.3.1 Types of Bonds

Following are the types of bonds:
Redeemable Bond
A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. The appropriate
discount rate is cost of debt (kd) required rate of return on bond (debenture).
OR
Where,
BVo = Value of bond (debenture) at time 'zero'

I = Annual interest paid per year
M = Maturity of bond
N = Number of years to maturity
kd= Required rate of return, or cost of debt
PVIF = Present value interest factor
PVIFA = Present value interest factor annuity
For instance: AB company issues Rs. 1,000 par value bond at 12%. The bond is redeemable after 10 years. Determine
value of bond assuming required rate of return is 14%.
Solution:
BVo = (Rs.120 X 5.216) + (Rs. 1,000 X 0.270)

BVo = Rs. 625.92 + Rs. 270
BVo = Rs. 895.92
Bond values with semi-annual interest

With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with
annual interest payments. Hence the bond valuation equation can be modified as:
OR
For instance: MNC company issues bonds with face value of Rs. 1,000 each, at 12% per coupon rate with interest
payable semi-annually. The bonds are redeemable after 5 years. Determine value of bond if required rate of return
on this type of bond is 14%.
Solution:
BVo = (Rs. 60 X 7.024) + (Rs. 1,000 X 0.508
= Rs. 421.44 + Rs. 508
= Rs. 929.44
Irredeemable Bond
Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity period.
Value of perpetual bond is determined by the following formula.
OR
For instance: A company has issued 12 % perpetual bond of Rs. 1,000 each. Determine value of bond assuming 15
% cost of debt.
Solution: BVo = = Rs.120/.015 = Rs.800
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Zero Coupon Bonds
In India Zero coupon bonds are also known as Deep discount bonds. These bonds have no coupon rate, that is, there
is no interest to be paid out. Instead, these bonds are issued at a discount to their face value, and the face value is
the amount payable to the holder of the instrument on maturity. The difference between the discounted issue price
and face value is effective interest earned by the investor. These are called deep discount bonds because these bonds
are long term bonds whose maturity some time extends up to 25 to 30 years.
3.4 Bond Yields

Along with the bond value, investors are also interested in knowing the yield on bonds. Yields on bonds can be
measured by applying various measures. They are:
Yield to Maturity (YTM)

It is the rate of return that an investor earns if they buy a bond at a specific price and hold it until maturity.
If bond is sold at par and realised par value fully then yield to maturity equals to interest rate YTM is computed
by using the following formulae.
Where,
SP = Sales proceeds a bond (price of bond)

I = Annual Interest payment (Rs.)
M = Maturity value of bond
n= Maturity period
Kd= Yield to maturity
Illustration: XYZ company bond, currently sells for Rs.1, 000 (Face value 900) it has a 10% interest rate, and with
a maturity period of 10 years.
OR
Alternatively
Years CIFs (Rs.) DF PV (Rs.)

10% 6% 10% 6%
553.05 662.4
1 to 10 90 6.145 7.360
347.40 502.2
900.45 1164.6
10 900 0.386 0.558
1000.00 1000.00
(-) Sales price (-)99.55 164.6
Yield to maturity:
= 6% +
= 6% + 2.49
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= 8.49 %
Yield to Call (YTC)

Yield to call is exactly similar to YTM, but here yield is found till the call of the bond. Some corporate issues bonds
with call feature that allows the company call back the bond before maturity period. In such cases bond holder would
not have the option of holding the bond until the maturity period. Therefore, YTM would not ne earned. YTC is
computed with the following formula:
Where, CP = Call price of bond, n*= Number of years until the assumed call date
For instance: ABC company issues 10 % callable bonds with a face value of Rs. 1000. The bond is currently selling
of Rs. 1,100. Maturity period is 10 years. Determine YTC assuming company calls bonds after 5 years because
interest rate has fallen by 2% at Rs. 1000.
Solution:
Years CIFs (Rs.) DF PV (Rs.)

10% 5% 10% 5%
379.1 432.9
1 to 5 100 100 3.791
621.0 784
1000.1 1216.9
5 1000 1000 0.621
1100 1100.00
(-) Current price (-)99.55 116.9
Yield to Call =
= 5% +
= 5% + 2.69
= 7.69 %
Current yield
It is the yield that relates to the annual interest to the annual interest to the current market price.
Current Yield = I  CMP

Where: I = Annual Interest (Rs.)
CMP = Current market price
For instance: From the following determine current yield on a bond
Face value of bond – Rs.1200

Interest Rate – 13 %
Maturity – 10Years
Current market price – Rs. 1000
Solution:
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From the above calculation we can see that yield represents analyse interest rate, it excludes capital gain or loss. It
ignores time value of money. Therefore, it is not a accurate measure of the bonds expected return.
3.5 Bond Value Behaviors

Following are the bond values discussed below.
3.5.1 Required Rate of Return and Bond Values

Whenever there is change in the required rate of return, bond value shows fluctuations from its par value. Required
rate of return may change, due to shift in the basic cost of long-term sources of finance, and the change in the firm's
risk level.
Let us determine value of bond considering the following three cases.
• Value of bond when interest-rate equals to required rate of return – in this case value of bond is equals to par
value.
For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors
required rate of return is 12%. Determine value of bond.
Solution:
B = (Rs.120 X4.111) + (Rs. 1,000 X 0.507)

= Rs. 493.32 + 507
= Rs. 1,000
• Value of bond when required rate of return is higher than the interest- rate– in this case value of bond would
be less than par value
required rate of return is 15%. Determine value of bond
Solution:
B = (Rs.120 X3.784) + (Rs. 1,000 X 0.432)

= Rs. 454.08 + 432
= Rs. 886.08
• Value of bond when required rate of return is less than interest rate – In this case, value of bond would be above
par value.
required rate of return is 10%. Determine value of bond
Solution:
B = (Rs.120 X4.355) + (Rs. 1,000 X 0.564)

= Rs. 522.60 + 564
= Rs. 1086.6
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In nutshell the relationship between bond values and required rate of return is given below:
• Interest Rate > Required Rate: Bond Value > Par Value
• Interest Rate = Required Rate: Bond Value = Par Value
• Interest Rate < Required Rate: Bond Value < Par Value
3.5.2 Time to Maturity and Bond Values

• Value of Bond: When I (%) = Kd (%) and change in the time period- In this case value of bond is equals to par
value, whatever may be the maturity period.
• For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period
is 10 year. Required rate of return is 10%. Determine value of bond when time period is (i) 5 years, and (ii) 15
years.
Solution: Value Bond: I(%) = Kd (%) [10%=10%]
Maturity Period Equation Value of Bond (Rs.)

(i) 5 years (100 X3.79)+(1000X0.621) 379 + 621= 1,000
10 years (100 X6.145)+(1000X0.386) 614 + 386 = 1,000
(ii) 15 years (100 X7.606)+(1000X0.239) 761 + 239 = 1,000
• Value of bond remains same (at par value) when interest rate equals to required rate of return, with the change
in time period to maturity.
• Value of Bond: When I (%) < Kd (%) and change in the time period - In this case, value of bond decreases
when the time period to maturity increases and vice versa.
years.
Solution: Value Bond: I(%)< Kd (%) [10% < 12%]

(i) 5 years ((100 X3.605)+(1000X0.567) 360.5 +567 = 927.5
10 years (100 X5.650)+(1000X0.322) 565 + 322 = 887
(ii) 15 years (100 X6.811)+(1000X0.183) 681.1 + 183 = 864.1
Value of bond decreases with the increase time period of maturity.
• Value of Bond: When I (%) > Kd (%) and change in the time period to maturity – In this case value of bond
increases when time period to maturity increases.
years.
Solution: Value Bond: I (%)>Kd (%) [10% > 6%]

(i) 5 years (100 X4.212)+(1000X0.747) 421.2 + 747 = 1,168.20
10 years (100 X7.360)+(1000X0.558) 736 + 558 = 1,294
(ii) 15 years (100 X9.712)+(1000X0.417) 971.2 + 417 = 1,388.2
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Value of bond increased when increase in time period for maturity
3.5.3 Relationship between Bond Value and Time to Maturity Period

Figure below shows the relationship between time to maturity period; required return and bond value.
1,600
1,400
Premium Bond
1297 Required Rate 6%
1,200
Face value bond

1000
1168 Required Rate 10%
800
887 Discount Bond

Required Rate 12%
600
400
200
10 9 8 7 6 5 4 3 2 1 0
Fig. 3.1 Bond value and time to maturity
Following points can be extracted from the figure above:

• When required rate of return equals to coupon rate, a bond will sell at face value. At the time of issue of bond
interest rate is set at par with required rate of return, to sell bond of par initially.
• When required rate of return increases above coupon rate then, the bond value falls below par value. Such bond
is known as 'discount bond'.
• When required rate of return falls below the interest rate, then the band values goes above par value. This bond
is called as 'premium bond'
• Increase in required rate of return affects bond values (go up or fall below par value).
• Market value of bond will always reach its face value by the end of its maturity period, provided the firm does
not go bankrupt.
3.6 Valuation of Shares

A company's shares may be categorised as
• Ordinary / Equity shares
• Preference shares
The returns these shareholders receive are called dividends. Preference shareholders get a preferential treatment
as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a
fixed rate of dividends. Some important features of preference and equity shares are.
Dividends
Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off
after accumulation. The dividend rate is not fixed for equity shareholders. The dividend rate is not fixed for equity
shareholders.
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Claims
In the event of the business closing down, the preference shareholders have a prior claim on the assets of the company.
Their claims shall be settled first and the balance if any will be paid off to equity shareholders.
Redemption
Preference shares have a maturity date on which day the company pays off the face value of the share to the holders.
Preference shares are of two types – redeemable and irredeemable.
Conversion
A company can issue convertible preference shares. After a particular period as mentioned in the share certificate,
the preference shares can be converted into ordinary shares.
3.6.1 Valuation of Preference Shares

Preference share gives some preferential rights to preference stockholders. The preferential rights are payment of fixed
rate of dividend and payment of principal amount at the time of liquidation, before paying to equity stockholders.
Value of preference stock is the present value of fixed annual dividends expected and he principal amount.
OR
Where, = Value of Preference stock

= Preference dividend (Rs.)
= Required rate of return (%) or cash of preference share
PVIFA = Present value interest factor annuity

PVIF = Present value interest factor
For instance
ABC company issued 12% perpetual preference stock with a face value of Rs. 100. Compute value of preference
stock assuring 14% require rate of return.
Solution: = = Rs. 85.71
For instance
A company issued 12% preference stock with a face value of Rs. 100, redeemable after 5 years. Required rate of
return is 10%. Determine value of preferred stock.
Solution:
= (Rs.12 X 3.791) + (100x 0.621)
= Rs. 45.492 + 62.1
= Rs. 107.592
3.6.2 Valuation of Equity/Ordinary Shares

People hold common stocks for two reasons:
• To obtain dividends in a timely manner
• To get a higher amount when sold.
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The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated
with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the
company, dividends paid and expected and future definite prospects of the company.
Basic share valuation model

Stock value is present value of future cash inflows (dividends) that it is expected to provide over an infinite time
horizon. An investor who buys a stock with the intention of holding in forever, on this case the value of equity stock
is the present value of a stream of dividends expected over an infinite period.
Where: ESo = Value of equity stock

Dt = Expected dividend per share at the end of year 't'
Ke = Required return on equity (cash of equity)
Under this we learn valuation of equity share using three models:

• Zero growth
• Constant growth
• Variable growth
Single period valuation

Here the value of the equity share is determined assuming an investors holds stock for one year period.
Where, = Value of stock

= expected dividend at the end of one year
= Price of the share at the end of one year
= Required rate of return
For instance
Mr. A purchased an equity stock of Gokul Company at Rs. 100 per share, it is expected to provide a dividend of Rs.
10 per share, and fetch a price of Rs. 110 after one year. Compute stock value assuming required date of return.
Solution:
= (Rs. 10x0.877) + (Rs. 110 X 0.877)

= Rs.8.77 + Rs. 96.47
= Rs. 105.24
• Zero Growth Model: It is the model under which value of stock is determined assuming dividends are not
expected to grow, (non-growing). Here value of equity stock is the present value of perpetuity of dividends:
• Constant Growth (Gorden) Model: In this model value of equity stock is valued assuming that dividends would
growth at a constant rate.
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• Variable Growth Model: Growth of the firm should be different life cycle. That is in the early stages growth's much
be faster than that of economy as a whole. Economic growth in the later stages the growth comes down.
It is calculated in four step process.

• Compute the value of the dividends at the end of each year during the super normal growth period.
• Compute the present value of the dividends expected during the initial growth period
• Determine PV value of stock at the end of the initial growth period.
PV of stock is
• Add the PV found in step 2 and step 3 to get intrinsic value of stock. (ESo)
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Summary
• Valuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset
depends on the cash flow it is expected to provide over the holding period.
• Book value is an accounting concept. Assets are recorded in balance sheet at their book values. Book value of
an asset is cost of acquisition less accumulated depreciation.
• Market value of an asset is the price at which the asset is bought or sold in the market. Market value per share
is generally higher than the book value per share for profitable and growing firms.
• Liquidation value of a equity stock is the actual amount that would be received if all of the firm's assets were
sold at their market value, liabilities were paid, and the remaining proceeds were by number of equity shares
outstanding.
• A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and
setting forth the terms under which they are issued and are to be paid.
• Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity
period.
References
• Introduction to Bond Valuation, [Pdf] Available at: <http://www.arts.uwaterloo.ca/~kvetzal/AFM271/bond.
pdf> [Accessed 28 May 2013].
• Bond Valuation, [Online] Available at: <http://www.prenhall.com/divisions/bp/app/cfl/BV/BondValuation.html>
• Jonathan, B., 2010. Financial Management, Pearson Education India.
• Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron's Educational Series.
• Prof. Ahmed, M., 2012. Bond Valuation, [Video online] Available at: <http://www.youtube.com/
watch?v=tid0RVUmY3M>[Accessed 28 May 2013].
• 2012. Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.
com/watch?v=pfhjJ00IuW4>[Accessed 28 May 2013].
Recommended Reading
• Staff, I., 2005. Stocks, Bonds, Bills, and Inflation 2005 Yearbook. Ibbotson Associates
• Agarwal, O.P., 2009. International Financial Management. Global Media.
• Satyaprasad, B.G. & Raghu, G.A. 2010. Advanced Financial Management.Global Media.
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Self Assessment
1. _________ is divided by the number of equity shows outstanding to get book value per share.
a. Net worth
b. Yield
c. Equity stock
d. Premium bond
2. Value of bond equals to __________ value when required rate equals to interest rate.
a. present
b. current
c. par
d. net

a. Preference stock is also known as hybrid security.
b. Liquidation value equals to value of assets minus value of liabilities
c. Value of bond is less than par value when required rate of return than interest rate.
d. Cash inflows, timing and required return are the three inputs required to value any asset.
4. Bond value equals to par value when it reaches to __________ period.

a. maturity
b. premium
c. value
d. completion
5. Current yield relates to the annual interest to the current________.

a. cost price
b. asset price
c. market price
d. specific price
6. A bond is said to be premium bond when its value is:

a. Higher than the par value
b. Less than the par value
c. Equal to than the par value
d. Higher than the present value
7. Intrinsic value is the __________ value of cash flows expected over a series years of holding an asset.
a. coming
b. going
c. present
d. net
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8. Preference stock is also known as:
a. Equity stock
b. Ordinary stock
c. Hybrid security
d. Security stock
9. When required rate of return is different from the interest rate the length of time to maturity effects _______
values.
a. bond
b. equity
c. share
d. net
10. Value of bond is less than par value when required rate of return higher than ________ rate.
a. interest
b. return
c. required
d. present
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Chapter IV
Cost of Capital
Aim
• explain the concept of cost of capital
• elucidate the cost of different sources of finance
• explicate the capital asset pricing model approach
Objectives
• define the cost of equity
• determine the cost of preference shares – cost of irredeemable and redeemable share
• enlist the factors affecting WACC
Learning outcome
• understand the concept of Weighted Average Cost of Capital (WACC)
• identify the steps involved in the computation of WACC
• describe the importance of cost of capital
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4.1 Introduction to Cost of Capital
Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal
provided by the business concern. It is used as a discount rate in determining the present value of future cash flows
associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required
rate of return. When the firms are using different sources of finance, the finance manager must take careful decision
with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity
of the firm.
Meaning of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and
retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it
will result in the reduction of overall wealth of the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept of the cost of
capital.
According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment
in order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-
off rate of capital expenditure”.
According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the allocation of capital
to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the
stock”.
According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be
earned on the net proceeds to provide the cost elements of the burden at the time they are due”.
Cost of capital from three different viewpoints

• Investors view point: The measurement of the sacrifice made by the individual for capital formation"
• Firm's view point: It is the minimum required rate of return needed to justify the use of capital. It is supported
by Hompton, John.
• Capital Expenditure view point: The cost of capital is the minimum required rate of return or the cut off rate
used to value cash flows.
Importance of cost of capital

Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern. Following points illustrates the importance of cost of capital.
• Importance to capital budgeting decision: Capital budget decision largely depends on the cost of capital of each
source. According to net present value method, present value of cash inflow must be more than the present value
of cash outflow. Hence, cost of capital is used to capital budgeting decision.
• Importance to structure decision: Capital structure is the mix or proportion of the different kinds of long term
securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to
take decision regarding structure.
• Importance to evolution of financial performance: Cost of capital is one of the important determine which
affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial
performance of the firm.
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• Importance to other financial decisions: Apart from the above points, cost of capital is also used in some other
areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.
4.2 Cost of Different Sources of Finance

It can be further classified into below mentioned categories:
4.2.1 Cost of Equity

Firms may obtain equity capital in two ways:
• Retention of earnings
• Issue of equity shares to the public
The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders are
providing funds to the firm to finance firm's investment proposals. Retention of earnings involves an opportunity cost.
Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional
equity shares, the cost of equity is same. But issue of additional equity shares to the public involves a flotation cost
where as there is no flotation cost for retained earnings.
Cost of Retained Earnings (Kre)

Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders.
The opportunity cost of retained earnings is the rate of return the shareholders forgoes by not putting their funds
elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the
following formulae.
Where, Ke = Cost of equity capital [D ÷P or (E/P) + g]

Ti = Marginal tax rate applicable to the individuals concerned
Tb = Cost of purchase of new securities
D = Expected dividend per share
NP = Net proceeds of equity share
g= Growth rate (%)
For instance
A company paid a dividend of Rs. Per share, market price per share is Rs. 20, income tax rate is 60% and brokerage
is expected to be 2%. Compute cost of retained earnings.
Solution:
= 0.10 X 0.408 X 100 = 4.1 %
Cost of Issue of Equity Shares (Ke)

The cost of equity capital (Ke) may be defined as the minimum rate of return that a firm must earn on the equity
financed portions of an investment project in order to leave unchanged the market price of the shares. The cost of
equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed
rate every year.
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It is the most difficult and controversial cost to measure there is no common basis for computation.
4.2.2 Cost of Preference Shares

Preference share is one of the types of shares issued by companies to raise funds from public. Preference share is
the share that has two preferential rights over equity shares:
• Preference in payment of dividend, from distributable profits
• Preference in the payment of capital at the time of liquidation of the company
Cost of Irredeemable (Perpetual) Preference Share

Share that cannot be paid till liquidation of the company are called as irredeemable preference shares. The cost is
measured by the following formulas:
Where, Kp = Cost of preference share

D= Dividend per share
CMP = Current market price per share
NP = Net proceeds
Cost of irredeemable preference stock (with dividend tax)
Where Dt = Tax on preference dividend
For instance
(Kp with dividend tax) : A coy planning to issue 14% irredeemable preference share at the face value of Rs. 250 per
share, with an estimated flotation cost of 5%. What is cost of preference share with 10% dividend tax.
Solution:
= 16.21 %
Cost of Redeemable Preference Share

Shares that are issued for a specific maturity period or redeemable after a specific period are known as redeemable
preference shares. Cost of preference share when the principal amount is repaid in one lump sum amount.
Where, Kp = Cost of preference share

NP = Net sales proceeds (after discount, flotation cost)
D = Dividend on preference share
Pn = Repayment of principal amount at the end of ‘n’ years
Short cut formula is :
4.2.3 Cost of Debentures

Companies may raise debt capital through issue of debentures or raise loan from financial institutions or deposits
from public. All these resources involve a specific rate of interest. Computation of cost of debenture or debt capital
depends on their nature.
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Cost of Irredeemable Debt

Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm till liquidation. Cost
of perpetual debt is the rate of return that lender expect. The following formulae used to compute cost of debentures
or debt of bond.
• Pre-tax cost =
• Post-tax cost =
Where, Kdi = Pre-tax cost of debentures, I – Interest , P = Principle amount or face vlue
P = Net sales proceeds , t = Tax rate
For instance: XYZ Company Ltd., decides to float perpetual 12%, debentures of Rs. 100 each. The tax rate is 50.
Calculate cost of debenture (pre and post tax cost)
Solution: Pre-tax cost =
Post-tax cost =
Cost of Redeemable Debt

Redeemable debentures are those having a maturity period or repayable after a certain given period of time. These
type of debentures are issued by many companies when they require capital for temporary needs. It is calculated
by the following formula:
Where, Kd = Cost of debentures, n = Maturity period, NI= Net interest (after tax adjustment)
Pn = Principal repayment in the year ‘n’
4.3 Capital Asset Pricing Model Approach (CAPM)

CAPM was developed by William F.Sharpe. From cost of capital point of view, CAPM explains the relationship
between the required rate of return, and the non-diversifiable or relevant risk, of the firm as reflected in its index of
non-diversifiable risk that is beta (β). It shows the relationship between risk and return for efficient and inefficient
portfolios. Symbolically,
Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)
β= Beta coefficient, Rmf = Required rate of return on the market portfolio of assets, that can be viewed as the
average rate of return on all assets.
Assumptions of CAPM
CAPM approach is based on the following assumptions
Perfect Capital Market: all investors have same information about securities
• There are no restrictions on investments
• Securities of completely divisible
• There are no transaction costs
• There are no taxes
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Investors Preference: Investors are risk averse
• Investors have homogenous expectations regarding the expected returns, variances and correlation of returns
among all securities.
• Investors seek to maximise the expected utility of their portfolios over a single period planning horizon
For instance
The capital Ltd. Wishes to calculate its cost of equity capital using the Capital Asset Pricing Model (CAPM)
approach. Company’s analyst found that its risk free rate if return equals 12%, beta equals 1.7 and the return on
market portfolio equals 14.5 %.
Solution:
= 12 + [14.5 – 12]1.7
= 12+4.25= 16.25 %
4.4 Weighted Average Cost of Capital (WACC)

A company has to employ a combination of creditors and owners funds. The composite cost of capital lies between
the least and most expensive funds. This approach enables the maximisation of profits and the wealth of the equity
shareholders by investing the funds in projects earning in excess of the overall cost of capital.
Steps involved in computation in WACC

• Determination of the source of funds to be raised and their individual share in the total capitalization of the
firm
• Computation of cost of specific source of funds
• Assignment of weight to specific source of funds
• Multiply the cost of each source by the appropriate assigned weights
• Add individual source weight cost to get cost of capital
Assignment of Weights
The weights to specific funds may be assigned based on the following:
• Book values: Book value weights are based on the values found on the balance sheet. The weight applicable to a
given source of fund is simply the book value of the source of fund divided by the book value of total funds.
• Capital structure weights: Under this method weights are assigned to the components of capital structure based
on the targeted capital structure. Depending on target, capital structures have some difficulties in using it. They
are
A company may not have a well defined target capital structure
It may be difficult to precisely estimate the components capital cost, if the target capital is different from
present capital structure.
• Market value weights: Under this method, assigned weights to a particular component of capital structure is
equal to the market value of the component of capital dividend by the market value of all components of capital
and capital employed by the firm.
For instance a firm has the following capital structure as the latest statement
Source of finance Amount (Rs.) After Tax Cost %

Debt Capital 30,00,000 4.0
Preference Share Capital 10,00,000 8.5
Equity Share Capital 20,00,000 11.5
Retained earnings 40,00,000 10.0
Total 100,00,000
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Solution:
Computation of cost of capital
Source of Finance Weights Specific Cost (%) Weighted Cost

Debt 0.30* 4.0 1.2
Preference share 0.10 8.5 8.5
Equity share 0.20 11.5 2.3
Retained earnings 0.40 10.0 4.0
1.00 8.35
Note * Debt weight =
4.4.1 Factors Affecting WACC

Weighted average cost of capital is affected by a number of factors. They are divided into two categories such as:
• Controllable factors (Internal factor)
• Uncontrollable factors (External factors)
Controllable factors (Internal factor): Controllable factors are those factors that affect WACC, but the firm can
control them. They are:
• Capital structure policy
• Dividend policy
• Investment policy
Uncontrollable factors (External factors): The factors those are not possible to be controlled by the firm and
mostly affects the cost of capital. These types of factors are known as external factors.
• Tax rates
• Level of interest rates
• Market risk premium
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Summary
• Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal
provided by the business concern.
• Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds.
• Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained
earnings.
• Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern. Following points illustrates the importance of cost of capital.
• The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders
are providing funds to the firm to finance firm's investment proposals.
• Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns.
• Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders
References
• Reddy, G. S., 2008. Financial Management. Mumbai: Himalaya publications.
• Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.
• Defining the cost of capital, [Pdf] Available at: <http://www.iassa.co.za/articles/002_may1973_02.pdf> [Accessed
28 May 2013].
• The cost of capital, [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/
Summary%20-%20Cost%20of%20Capital.pdf> [Accessed 28 May 2013].
• 2009. Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/
watch?v=AGaoDQgicVg>[Accessed 28 May 2013].
• 2013. Cost of Capital Part 1, [Video online] Available at: <http://www.youtube.com/
watch?v=suqQ3huNtrk>[Accessed 28 May 2013].
Recommended Reading
• Pratt , S. P., 2010. Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.
• Tennent, J., 2008. Guide to Financial Management, Profile Books/The Economist.
• Avadhani, V.A., 2010. International Financial Management. Global Media.
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Self Assessment
1. Existence of perfect capital market is one of the assumptions of ______.
a. WACC
b. CAPM
c. equity
d. debentures
2. Cost of the capital is the ___________ required rate of return expected by investors.
a. minimum
b. maximum
c. higher
d. reduced

a. Cost of capital comprises of three components
b. Cost of capital is the minimum required rate of needed to justify
c. There is no cost for internally generated funds
d. CAPM approach is one of the approaches used in computation of equity capital
4. _______ value weights are based on the values found on the balance sheet
a. Book
b. Capital
c. Market
d. Weighted
5. CAPM stands for?

a. Capital asset price model
b. Capital asset pricing model
c. Capital asset pricing maturity
d. Capital assignment pricing model
6. The composite cost of capital lies between the least and most _________ funds.
a. expensive
b. costly
c. low cost
d. cheap
7. ____________debentures are those having a maturity period or repayable after a certain given period of time.
a. Redeemable
b. Irredeemable
c. Capital
d. Asset
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8. Retention of earnings involves an __________ cost
a. opportunity
b. fixed
c. capital
d. explicit
9. Retained earnings are those parts of ________ earnings that are retained by the firm for investing in capital
budgeting proposals instead of paying them as dividends to shareholders
a. reduced
b. net
c. complete
d. entire
10. Cost of preference share when the _______ amount is repaid in one lump sum amount.
a. interest
b. total
c. principal
d. half
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Chapter V
Capital Structure and Leverages
Aim
• explain the concept of capital structure
• explicate the features of appropriate capital structure
• elucidate the factors that determine a firm's capital structure
Objective
The objective of the chapter is to:
• define capital structure
• enlist the forms of capital structure
• define leverage
Learning outcome
• undertsand the concept of leverages
• decribe the types of leverages
• identify the objectives of capital structure
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5.1 Meaning of Capital Structure
Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business
concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level
of capital, it will earn high profit and they can provide more dividends to its shareholders.
Meaning of capital structure

Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the
mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans
and retained earnings. The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure
is the important decision of the financial management because it is closely related to the value of the firm. Capital
structure is the permanent financing of the company represented primarily by long-term debt and equity.
Definition of capital structure

The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up
of its capitalization and it includes all long-term capital resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented
by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference,
and debt”.
According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”.
Capital Structure is that part of financial structure, which represents long-term sources. The term capital structure
is generally defined to include only long-term debt and total stockholders investment.
To quote Bogan "Capital structure may consists of a single class of stock, or it may be comprised by several issues
of bonds and preferred stock, the characteristics of which may vary considerably". Capital structure is indicated by
the following equations:
Capital Structure = Long-term Debt + Preferred Stock + Net worth OR

Capital Structure = Total assets – Current Liabilities
Optimum capital structure

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum. Optimum capital structure may be defined as the capital structure or
combination of debt and equity, that leads to the maximum value of the firm.
Objectives of capital structure

Decision of capital structure aims at the following two important objectives:
• Maximize the value of the firm.
• Minimize the overall cost of capital
Forms of capital structure

Capital structure pattern varies from company to company and the availability of finance. Normally the following
forms of capital structure are popular in practice.
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• Equity shares only

• Equity and preference shares only
• Equity and Debentures only.
• Equity shares, preference shares and debentures
Factors determining capital structure

The following factors are considered while deciding the capital structure of the firm.
• Leverage: It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing
such as debt, equity and preference share capital. It is closely related to the overall cost of capital.
• Cost of Capital: Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
longterm finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital
increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the
business. If the business consists of long period of operation, it will apply for equity than debt, and it will
reduce the cost of capital.
Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can
manage the financial requirements with the help of internal sources. But if it is small size, they will go for
external finance. It consists of high cost of capital.
Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure
of a firm. For example, banking companies are restricted to raise funds from some sources.
Requirement of investors: In order to collect funds from different type of investors, it will be appropriate
for the companies to issue different sources of securities.
• Government policy: Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy regarding the capital
structure
5.2 Features of an Appropriate Capital Structure

An appropriate capital structure should have the following features:
• Profitability
• Solvency
• Flexibility
• Conservation
• Control
Considerations
Financial manager has to consider the following while developing optimum capital structure
Return on Investment (ROI)

Financial manager need to raise fixed cost sources) loans, debenture, preference shares) of funds, only when ROI
is higher that the fixed cost funds.
Tax benefit
Since debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in
determining tax payment. Hence, a business firm should take the advantage of tax deduction.
Perceived financial risk

Use of more debt in capital structure leads to increase perceived financial risk in the minds of equity shareholders
which reduces the market price of equity share, thereby firm's wealth. Therefore financial management should not
increase debt in capital structure when ordinary shareholders perceived an excessive risk.
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5.3 Determination of Capital Structure
The capital structure should be determined keeping in mind the objective of wealth maximisation. Following are
the factors affecting the capital structure:
• Tax benefit of debt
• Flexibility
• Control
• Industry leverage ratios
• Seasonal variations
• Degree of competition
• Industry life-cycle
• Timing of public issue
• Requirements of investors
Patterns of capital structure

Construction of optimum capital structure is possible only when there is a appropriate mix of the above sources
(debt and equity). The following are the forms of capital structure
• Complete equity share capital
• Different proportions of equity and preference share capital
• Different proportions of equity and debenture (debt) capital and
• Different proportions of equity, preference, and debenture (debt) capital
5.4 Theories of Capital Structure

Equity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and
equity in a firm's capital structure has to be independently decided case to case. Many theories have been propounded
to understand the relationship between financial leverage and firm value.
Assumption of capital structure theories

• There are only two sources of funds i.e.: debt and equity.
• The total assets of the company are given and do no change.
• The total financing remains constant. The firm can change the degree of leverage either by selling the shares
and retiring debt or by issuing debt and redeeming equity.
• Operating profits (EBIT) are not expected to grow.
• All the investors are assumed to have the same expectation about the future profits.
• Business risk is constant over time and assumed to be independent of its capital structure and financial risk.
• Corporate tax does not exit.
• The company has infinite life.
• Dividend payout ratio = 100%
5.4.1 Net Income Approach

According to net income approach the firm can increase its value or lower the overall cost of capital by increasing
the proportion of debt in the capital structure.
Assumptions of the Net Income (NI) Approach

• The use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, Ke,
and the debt capitalisation rate Kd, remain constant with changes in leverage.
• The debt capitalisation rate is less than the equity capitalisation rate
• The corporate income taxes do not exist.
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Give below is the graphical representation of the net income approach:
Ke, Ko Ke,
Cost
Ko
Kd. Kd
Debt
Fig. 5.1 Net income approach
According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they
remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the
firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100
per cent debt financing under NI approach.
For instance:
Assume that a firm has an expected annual net operating income of Rs.200,000 an equity rate, Ke, of 10% and Rs.
10,00,000 of 6% debt.
Solution: The value of the firm according to Net Income approach:
Net Operating Income NI = 2, 00,000
Total cost of debt Interest = KdD (10, 00,000 X 0.6) = 60,000
Net Income available to shareholders, NOI-I = Rs.1, 40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) = 14, 00,000
Market Value of debt D (Rs. 60,000/.06) = 10, 00,000
Total = 24, 00,000
The cost of equity and debt are respectively 10% and 6% and are assumed to constant under the Net income
approach.
Ko = NOI/V = 200,000/24, 00,000 = 0.0833 = 8.33%
5.4.2 Net Operating Income (NOI) Approach

In Net operating income approach the market value of the firm is not affected by the change in capital structure, the
weighed average cost of capital is said to be constant.
Assumptions of the Net Operating Income (NOI) Approach

• The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not
important
• The market uses an overall capitalisation rate Ko to capitalise the net operating income. Ko depends on the
business risk. If the business risk is assumed to remain unchanged, Ko is a constant.
• The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate
to increase.
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Give below is the graphical representation of the net operating income approach:
Ke, Ko Ke,
Cost
Ko
Kd. Kd
Debt
Fig. 5.2 Net operating income approach
According to NOI approach the value of the firm and the weighted average cost of capital are independent of the
firm’s capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive
the same cash flows regardless of the capital structure and therefore, value of the company is the same.
For instance:
Assume that a firm annual net operating income of Rs. 2,00,000 an average cost of capital Ko, of 10% and intial
debt of Rs. 10,00,000 at 6%.
Solution: Net operating Income = 2,00,000
Therefore, Market value of firm, V = S+D = 2,00,000/0.10 = 20,00,000
Market value of the debt, D = 10,00,000
Market value of the equity S= V-D = 10,00,000
Ko = NOI/V = 200,000/0.10 = 20,00,000
Here, Ke is not constant as that in NI approach. It is computed using the formula:
Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10+0.06)10,00,000/10,00,000
= 0.10 + 0.04(1) = 0.14
To verify that the weighted average cost of capital is a constant:
Ko = Kd(D/V) + Ke(S/V)
= 0.06(10, 00,000/20, 00,000) + 0.14(10, 00,000/20, 00,000)
= 0.06(0.50) + 0.14(0.5)
= 0.03 + 0.07 = 0.10
5.4.3 Traditional Approach

This is also known as intermediate approach. It is a compromise between the NI and NOI approach. According to
this view the value of the firm can be increased or the cost of the capital can be reduced by a judicious mix of dent
and equity capital.
This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with
the leverage.
This approach has the following propositions as shown in the Fig. below:
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Ke,
Ko
Cost Kd
Debt
Fig. 5.3 Traditional approach
• kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate
• ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply
• as a sequence to the above 2 propositions, ko decreases till a certain level, remains constant for moderate
increases in leverage and rises beyond a certain point
5.4.4 Miller and Modigliani Approach

Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and
Ko being constant at all degrees of leverage. The assumptions for their analysis are:
Perfect Capital Markets
Securities can be freely traded, there are no hindrances on the borrowing, no presence of transaction costs, securities
infinitely divisible, availability of all required information at all times.
Investors Behave Rationally

They choose that combination of risk and return that is most advantageous to them
Homogeneity
of investors risk perception, that is, all investors have the same perception of business risk and returns.
Taxes
There is no corporate or personal income tax
Dividend pay-out is 100%

that is, the firms do not retain earnings for future activities.
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 market value of debt and is
independent of the degree of leverage.
Proposition II
The expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.
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Proposition III
The average cost of capital is not affected by the financing decisions as investment and financing decisions are
independent.
Criticism of MM Propositions
Risk perception
The assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate
leverage is different.
Convenience:
Investors find personal leverage inconvenient.
Transaction Costs:
Due to presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the
same amount of return.
Taxes:
When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails the fails
to explain the financing decision and firm's value.
5.5 Leverages
Financial decision is one of the integral and important parts of financial management in any kind of business
concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total
amount of capital (capitalisation) and cost of capital (Ko ). Capital structure is one of the significant things for the
management, since it influences the debt equity mix of the business concern, which affects the shareholder’s return
and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market
value of the shares. The debt equity mix of the company can be examined with the help of leverage. The concept of
leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.
Meaning of leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy
objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to
use fixed cost assets or funds to increase the return to its shareholders.
Definition of leverage
James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or
fixed return. Types of Leverage Leverage can be classified into three major headings according to the nature of the
finance mix of the company.
Types of Leverages
• Operating leverage
• Financial leverage
5.5.1 Operating Leverage

Operating leverage is present any time in a firm when it has operating (fixed) costs regardless of the level of
production. It can be defined as "The firm's ability to use operating costs to magnify the effects of changes in sales
on its earnings before interest and taxes. The operating costs are categorised into three:
• Fixed Costs: which do not vary with the level of production they must be paid regardless of the amount of
revenue available
• Variable Costs: raw materials, direct labor, costs and so on that varies directly with the level of production
• Semi-variable Cost: which partly vary and partly fixed
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The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for
a given change in % of sales revenue.
When the data is given for one year, then we have to compute operating leverage, by the following formula:
For instance:
From the following particulars of ABC Ltd., calculate degree of operating leverage.
Particulars Previous Year 2009 Current Year 2010

Sales revenue 10,00,000 12,50,000
Variable cost 6,00,000 7,50,000
Fixed cost 2,50,000 2,50,000
Solution: Calculation of EBIT on a percentage change
Particulars 2009 2010 % change

Sales Revenue 10,00,000 12,50,000 25
Less: Variable cost 6,00,000 7,50,000 25
Contribution 25
Less: fixed cost
EBIT 66.67
4,00,000 5,00,000
2,50,000 2,50,000
1,50,000 2,50,000
Operating leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.66 times.
Application of operating leverage

• It is helpful to know how operating profit would change with a given change in units produced.
• It will be helpful in measuring business risk.
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5.5.2 Financial Leverage
Financial manager job is to raise funds for long-term activities with different composition of sources. The required
funds may be raised by two sources: equity and debt. The use of fixed charge sources of funds such as debt and
preference share capital along with the equity share capital in capital structure is described as financial leverage.
According to Lawrence, financial leverage is "the ability of the firm to use fixed interest bearing securities to magnify
the rate of return as equity shares". It is also known as "trading as equity".
Formula for calculating financial leverage is given below:
OR
For instance
A firm has sales of 1, 00,000 units at Rs. 10/ unit. Variable cost of the produced products is 60% of the total sales
revenue. Fixed cost id Rs. 2, 00,000. The firm has used a debt of Rs. 5, 00,000 at 20% interest. Calculate the operating
leverage and financial leverage.
Solution: Calculation of EBT
Particulars Amount (Rs.)

Sales Revenue (1,00,000 units X Rs.10/unit) 10,00,000
6,00,000
Less: Variable cost (10,00,000 X 0.60) 4,00,000

2,00,000
Contribution 2,00,000
1,00,000
Less: Fixed cost 1,00,000

EBIT
Less: Interest (5,00,000 X 20/100)
Earning Before Tax (EBT)
Operating Leverage = Contribution ÷ EBIT = 4, 00,000 ÷ 2, 00,000 = 2times

Financial Leverage = EBIT÷EBT = 2, 00,000 ÷ 1, 00,000 = 2 times
Application of financial leverage

• It is helpful to know how EPS would change with a change in operating profit.
• It is helpful for measuring financial risk.
5.5.3 Combined Leverage

The operating leverage has its effects on operating risk and is measured by the % change in EBIT due to the %
change in sales. The financing leverage has its effects on financial risk and is measured by the % change in EPS due
to the % change in EBIT. Since, both these leverages are closely related with the ascertainment of the firm's ability
to cover fixed charges, the sum of them gives us the total leverage or combined leverage and the risk associated
with combined leverage is known as total risk.
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The degree of combined leverage may be defined as the % change in EPS due to the % change in sales. Thus
combined leverage is:
For instance:
ABC corporation has sales of Rs. 40 lakhs, variable cost 70% of the sales and fixed cost is Rs. 8,00,000. The firm
has raised Rs. 20 lakhs funds by issue of debentures at the rate of 10%. Compute operating, financial and combined
leverages.
Solution: Calculation of EBT or PBT
Particulars Amount (Rs.)

Sales revenue 40,00,000
28,00,000
Less: Variable cost (40,00,000 X 0.70)
Contribution 12,00,000
8,00,000
Less: Fixed Cost
EBIT 4,00,000
2,00,000
Less: interest (20,00,000 X 0.10)
EBT 2,00,000
Operating leverage = Contribution ÷ EBIT = 12, 00,000 ÷ 4, 00,000 = 3 times

Financial leverage = EBIT ÷ EBT = 4, 00,000 ÷ 2, 00,000 = 2 times
Combined leverage = OL x FL = 3x2 = 6 times
The combined leverage can work in both directions. It is favorable if sales increase and unfavorable when sales
decrease.
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Summary
• Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the
business concern.
• The term capital structure refers to the relationship between the various long-term source financing such as
equity capital, preference share capital and debt capital.
• Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.
• Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads
to the maximum value of the firm
• The capital structure should be determined keeping in mind the objective of wealth maximisation.
• Construction of optimum capital structure is possible only when there is a appropriate mix of debt and equity.
• Equity and debt are the two important sources of long-term sources of finance of a firm.
• In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.
References
• Khan, M. Y.., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill
Education.
• Capital Structure and Leverage, [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20
Chpts%2013%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf>
• Capital Structure and Leverage, [Pdf] Available at: <http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>
• 2011. Capital Structure class I, [Video online] Available at: <http://www.youtube.com/watch?v=lqHuYKGByIQ>
• 2011. Capital Structure class II, [Video online] Available at: <http://www.youtube.com/watch?v=6vtuNgGxbso>
Recommended Reading
• Brigham,E. F., 2003. Fundamentals of Financial Management. 10th ed., South-Western College Pub.
• Brigham, E. F. & Ehrhardt, M. C., 2008. Financial management: theory and practice, 12th ed., Cengage
Learning.
• Gitman, 2007. Principles Of Managerial Finance, 11th ed., Pearson Education India.
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Self Assessment
1. Optimum capital structure may be defined as the capital structure or combination of debt and __________, that
leads to the maximum value of the firm.
a. liabilities
b. assets
c. equity
d. cost
2. Contribution is equal to sales minus _________ cost.

a. fixed
b. variable
c. operating
d. semi-variable

a. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that
leads to the maximum value of the firm.
b. Use debt to any extent to maximise EPS.
c. Financial leverage is multiplied by financial leverage to get combined leverage.
d. Financial leverage is also known as trading on equity.
4. S-V-EBIT =?
a. Variable cost
b. Fixed cost
c. Operating cost
d. Profit
5. The use of leverage is essential to maximise ____________.

a. profit
b. loss
c. earnings
d. contribution
6. Total assets – Current liabilities =?

a. Optimal capital structure
b. Financial leverage
c. Operating leverage
d. Capital structure
7. _________ of operating leverage and high degree of financial leverage is ideal situation
a. Low degree
b. High degree
c. Medium degree
d. Optimum degree
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8. Financial leverage is also known as __________.
a. indifference point
b. trading on equity
c. combined leverage
d. capital structure
9. Increased use of debt ______ the financial risk of equity shareholders.

a. increases
b. decreases
c. constant
d. reduces
10. Contribution is divided by EBIT to get ________ leverage

a. financial
b. operating
c. combined
d. fixed
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Chapter VI
Capital Budgeting
Aim
• introduce the term capital budgeting
• explicate the methods for evaluating the capital investment proposals
• elucidate profitability index method and its rule of acceptance
Objectives
• explain the formula for reciprocal pay-back period
• explicate principles or factors of capital budgeting decisions
• define capital budgeting
Learning outcome
• distinguish between traditional methods and discounted cash flow method
• understand importance of capital budgeting
• identify capital budgeting process
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6.1 Introduction
The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments. The capital expenditure may be:
• Cost of mechanization, automation and replacement.
• Cost of acquisition of fixed assets, e.g., land, building and machinery etc.
• Investment on research and development.
• Cost of development and expansion of existing and new projects.
6.2 Definition of Capital Budgeting

Capital Budget is also known as “Investment Decision Making or Capital Expenditure Decisions” or “Planning
Capital Expenditure” etc. Normally such decisions where investment of money and expected benefits arising there
from are spread over more than one year, it includes both rising of long-term funds as well as their utilisation.
Charles T. Horngnen has defined capital budgeting as “Capital Budgeting is long term planning for making and
financing proposed capital outlays.”
In other words, capital budgeting is the decision making process by which a firm evaluates the purchase of major
fixed assets including building, machinery and equipment. According to Hamption, John. J., “Capital budgeting is
concerned with the firm’s formal process for the acquisition and investment of capital.” From the above definitions,
it may be concluded that capital budgeting relates to the evaluation of several alternative capital projects for the
purpose of assessing those which have the highest rate of return on investment.
6.3 Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:
• Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
• Capital budgeting involves commitment of large amount of funds.
• Capital decisions are required to assessment of future events which are uncertain.
• Wrong sale forecast; may lead to over or under investment of resources.
• In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market
for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.
• Capital budgeting ensures the selection of right source of finance at the right time.
• Many firms fail, because they have too much or too little capital equipment.
• Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.
6.4 Objectives of Capital Budgeting

The following are the important objectives of capital budgeting:
• To ensure the selection of the possible profitable capital projects.
• To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial
requirements.
• To make estimation of capital expenditure during the budget period and to see that the benefits and costs may
be measured in terms of cash flow.
• Determining the required quantum takes place as per authorisation and sanctions.
• To facilitate co-ordination of inter-departmental project funds among the competing capital projects.
• To ensure maximisation of profit by allocating the available investible.
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6.5 Principles or Factors of Capital Budgeting Decisions

A decision regarding investment or a capital budgeting decision involves the following principles or factors:
• A careful estimate of the amount to be invested.
• Creative search for profitable opportunities.
• Careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under
consideration.
• A listing and consideration of non-monetary factors influencing the decisions.
• Evaluation of various proposals in order of priority having regard to the amount available for investment.
• Proposals should be controlled in order to avoid costly delays and cost over-runs.
• Evaluation of actual results achieved against those budget.
• Care should be taken to think all the implication of long range capital investment and working capital
requirements.
• It should recognise the fact that bigger benefits are preferable to smaller ones and early benefits are preferable
to latter benefits
6.6 Capital Budgeting Process

The following procedure may be considered in the process of capital budgeting decisions:
• Identification of profitable investment proposals
• Screening and selection of right proposals
• Evaluation of measures of investment worth on the basis of profitability and uncertainty or risk
• Establishing priorities, i.e., uneconomical or unprofitable proposals may be rejected.
• Final approval and preparation of capital expenditure budget
• Implementing proposal, i.e., project execution
• Review the performance of projects
6.7 Types of Capital Expenditure

Capital Expenditure can be of two types:
• Capital expenditure increases revenue
• Capital expenditure reduces costs
Capital Expenditure Increases Revenue: It is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.
Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby
increases the profitability of existing operations. It can be done by replacement of old machine by a new one.
6.8 Types of Capital Budgeting Proposals

A firm may have several investment proposals for its consideration. It may adopt after considering the merits and
demerits of each one of them. For this purpose capital expenditure proposals may be classified into:
• Independent Proposals
• Dependent Proposals or Contingent Proposals
• Mutually Exclusive Proposals
Independent Proposals: These proposals are said be to economically independent which are accepted or rejected on
the basis of minimum return on investment required. Independent proposals do not depend upon each other.
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Dependent Proposals or Contingent Proposals: In this case, when the acceptance of one proposal is contingent upon
the acceptance of other proposals, it is called as “Dependent or Contingent Proposals.” For example; construction
of new building on account of installation of new plant and machinery describes it.
Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance of one proposal results in the
automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be
rejected and the other can be accepted. It is easier for a firm to take capital budgeting decisions on such projects.
6.9 Methods of Evaluating Capital Investment Proposals

There are number of appraisal methods which may be recommended for evaluating the capital investment proposals.
We shall discuss the most widely accepted methods. These methods can be grouped into the following categories:
Traditional Methods
Traditional methods are grouped in to the following:
• Pay-back period method or Payout method
• Improvement of Traditional Approach to Pay-back Period Method
Post Pay-back profitability Method
Discounted Pay-back Period Method
Reciprocal Pay-back Period Method
• Rate of Return Method or Accounting Rate of Return Method
Time Adjusted Method or Discounted Cash Flow Method

Time Adjusted Method further classified into:
• Net Present Value Method
• Internal Rate of Return Method
• Profitability Index Method
6.9.1 Traditional Methods

Pay-back Period Method: Pay-back period is also termed as “Pay-out period” or Pay-off period. Pay out Period
Method is one of the most popular and widely recognised traditional methods of evaluating investment proposals.
It is defined as the number of years required to recover the initial investment in full with the help of the stream of
annual cash flows generated by the project. Calculation of Pay-back Period: Pay-back period can be calculated into
the following two different situations:
• In the case of constant annual cash inflows.
• In the case of uneven or unequal cash inflows.
In the case of constant annual cash inflows: If the project generates constant cash flow the Pay-back period can be
computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be
used to ascertain pay-back period:
Pay-back Period =
Example 1:
A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflow of Rs. 10,000 for 6
years. You are required to find out pay-back period.
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Solution:
Calculation of Pay-back period:
Pay-back Period =
= 4 years
Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.
Example 2: In the case of Uneven or Unequal Cash Inflows

In the case of uneven or unequal cash inflows, the Pay-back period is determined with the help of cumulative cash
inflow. It can be calculated by adding up the cash inflows until the total is equal to the initial investment.
From the following information you are required to calculate pay-back period:
A project requires initial investment of Rs. 40,000 and generates cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000
and Rs. 6,000 in the first, second, third, and fourth year respectively.
Solution:
Calculation Pay-back Period with the help of “Cumulative Cash Inflows”
Annual Cash Inflows Cumulative Cash Inflows

Year
Rs. Rs.
1 16,000 16,000
2 14,000 30.000
3 8,000 38,000
4 6,000 44,000
The above table shows that at the end of 4th years the cumulative cash inflows exceeds the investment of Rs. 40.000.
Thus the pay-back period is as follows:
Pay-back Period = 3 Years+
= 3 Years+
= 3.33 Years
Accept or Reject Criterion

Investment decisions based on pay-back period are used by many firms to accept or reject an investment proposal.
Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off period, the
project would be accepted, if not it would be rejected.
Advantages of Pay-back Period Method

• It is an important guide to investment policy.
• It is simple to understand and easy to calculate.
• It facilitates to determ.ine the liquidity and solvency of a firm.
• It helps to measure the profitable internal investment opportunities.
• It enables the firm to select an investment which yields a quick return on cash funds.
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• It used as a method of ranking competitive projects.
• It ensures reduction of cost of capital expenditure.
Disadvantages or Pay-back Period Method

• It does not measure the profitability of a project
• It does not value projects of different economic lives
• This method does not consider income beyond the pay-back period
• It does not give proper weight to timing of cash flows
• It does not indicate how to maximise value and ignores the relative profitability of the project
• It does not consider cost of capital and interest factor which are very important factors in taking sound investment
decisions.
6.9.2 Improvement of Traditional Approach to Pay-back Period

The demerits of the pay-back period method may be eliminated in the following ways:
(a) Post Pay-back Profitability Method
One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project. To rectify
the defect, post pay-back period method considers the amount of profits earned after the pay-back period. This
method is also known as Surplus Life over Payback Method. According to this method, pay-back profitability is
calculated by annual cash inflows in each of the year, after the pay-back period. This can be expressed in percentage
of investment.
Post Pay-back Profitability = Annual Cash Inflow x (Estimated Life - Pay-back Period)
The post pay-back profitability index can be determined by the following equation:
Post Pay-back Profitability Index =
(b) Discounted Pay-back Method

This method is designed to overcome the limitation of the payback period method. When savings are not leveled, it
is better to calculate the pay-back period by taking into consideration the present value of cash inflows. Discounted
pay-back method helps to measure the present value of all cash inflows and outflows at an appropriate discount rate.
The time period at which the cumulated present value of cash inflows equals the present value of cash outflows is
known as discounted pay-back period.
(c) Reciprocal Pay-back Period Method

This methods helps to measure the expected rate of return of income generated by a project Reciprocal pay-back
period method is a close approximation of the Time Adjusted Rate of Return, if the earnings are leveled and the
estimated life of the project is somewhat more than twice the pay-back period. This can be calculated by the
following formula:
Reciprocal Pay-back Period =
Example 3:
The company is considering investment of Rs. 1, 00,000 in a project. The following are the income forecasts, after
depreciation and tax, 1st year Rs. l 0,000, 2nd year Rs. 40.000, 3rd year Rs. 60,000, 4th year Rs. 20,000 and 5th
year Rs. Nil. From the above information you are required to calculate: (1) Pay-back Period (2) Discounted Pay-
back Period at 10% interest factor.
Solution:
(1) Calculation of Pay-back Period
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Annual Cash Inflows Cumulative Cash Inflows

Year
Rs. Rs.
1 10,000 10,000
2 40,000 50,000
3 60.000 1,10,000
4 20,000 1,30.000
5 -- 1,30,000
The above table shows that at the end of 3rd year the Cumulative Cash Inflows exceeds the investment of Rs. 1,
00,000. Thus the Pay-back Period is as follows:
Pay-back Period = 2 Years +
= 2 Years +
= 2 Years + 0.833 = 2.833 Years
(2) Calculation of Discounted Pay-back Period 10% Interest Rate
Year Cash Inflows Discontinuing Pres- Present Value of Cumulative Value

ent Value Cash Inflows of Cash Inflows
Factor at 10% (Z x3)
1 2 3 4 Rs.
Rs.
1 10,000 0.9091 9,091 9.091
2 40,000 0.8265 33,060 42,151
3 60,000 0.7513 45,078 87,229
4 20,000 0.6830 13,660 1,00,889
5 -- 0.6209 -- 1,00,889
From the above table, it is observed that up to the 4th year Rs. 1, 00,000 is recovered. Because the Discounting
Cumulative Cash Inflows exceeds the original cash outlays of Rs. 1, 00,000. Thus the Discounted Pay-back Period
is calculated as follows:
Pay-back Period = 3 Years +
= 3 Years+
= 3 Years + 0.935 == 3.935 Years
6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method
Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the
average net income generated in a project in relation to the project’s average investment outlay. This method involves
accounting profits not cash flows and is similar to the pe1formance measure of return on capital employed.
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The average rate of return can be determined by the following equation:
Average Rate of Return (ARR) =
Where,
Average investment would be equal to the Original investment plus salvage value divided by 2.
Average Investment =
(or)
Advantages
• It considers all the years involved in the life of a project rather than only pay-back years
• It applies accounting profit as a criterion of measurement and not cash flow
Disadvantages
• It applies profit as a measure of yardstick not cash flow
• The time value of money is ignored in this method
• Yearly profit determination may be a difficult task
6.9.4 Discounted Cash Flow Method (or) Time Adjusted Method

Discount cash flow is a method of capital investment appraisal which takes into account both the overall profitability
of projects and also the timing of return. Discounted cash flow method helps to measure the cash inflow and outflow
of a project as if they occurred at a single point in time so that they can be compared in an appropriate way. This
method recognises that the use of money has a cost, i.e., interest foregone. In this method risk can be incorporated
into Discounted Cash Flow computations by adjusting the discount rate or cut off rate.
Disadvantages
The following are some of the limitations of Discounted Pay-back Period Method:
• There may be difficulty in accurately establishing rates of interest over the cash flow period.
• Lack of adequate expertise in order to properly apply the techniques and interpret results.
• These techniques are based on cash flows, whereas reported earnings are based on profits.
The inclusion of Discounted Cash Flow Analysis may cause projected earnings to fluctuate considerably and thus
have an adverse on share prices.
6.9.5 Net Present Value Method (NPV)

This is one of the Discounted Cash Flow techniques which explicitly recognise the time value of money. In this
method all cash inflows and outflows are converted into present value (i.e., value at the present time) applying an
appropriate rate of interest (usually cost of capital).
In other words, Net Present Value Method discount inflows and outflows to their present value at the appropriate
cost of capital and set the present value of cash inflow against the present value of outflow to calculate Net Present
Value. Thus, the Net Present Value is obtained by subtracting the present value of cash outflows from the present
value of cash inflows.
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Advantages of Net Present Value Method

• It recognises the time value of money and is thus scientific in its approach.
• All the cash flows spread over the entire life of the project are used for calculations.
• It is consistent with the objectives of maximising the welfare of the owners as it depicts the positive or otherwise
present value of the proposals.
Disadvantages
• This method is comparatively difficult to understand or use.
• When the projects in consideration involve different amounts of investment, the Net Present Value Method
may not give satisfactory results.
6.9.6 Internal Rate of Return Method (IRR)

Internal Rate of Return Method is also called as “Time Adjusted Rate of Return Method.” It is defined as the rate
which equates the present value of each cash inflows with the present value of cash outflows of an investment. In
other words, it is the rate at which the net present value of the investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected
cash inflows from a project equals the present value of expected cash outflows of the project. The Internal Rate
of Return can be found out by Trial and Error Method. First, compute the present value of the cash flow from an
investment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained
with the investment cost.
If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again.
On the other hand if the calculated present value of the expected cash inflows is lower than the present value of cash
outflows a lower rate should be tried. This process will be repeated until and unless the Net Present Value becomes
zero. The interest rate that brings about this equality is defined as the Internal Rate of Return.
Alternatively, the internal rate can be obtained by Interpolation Method when we come across two rates; one with
positive net present value and other with negative net present value. The IRR is considered as the highest rate of
interest which a business is able to pay on the funds borrowed to finance the project out of cash inflows generated
by the project. The Interpolation formula can be used to measure the Internal Rate of Return as follows:
Lower Interest Rate + × (higher rate – lower rate)
Evaluation
A popular discounted cash flow method, the internal rate of return criterion has several virtues:
• It takes into account the time value of money.
• It considers the cash flows over the entire life of the project.
• It makes more meaningful and acceptable to users because it satisfies them in terms of the rate of return on
capital.
Limitations
• The internal rate of return may not be uniquely defined.
• The IRR is difficult to understand and involves complicated computational problems.
• The internal rate of return figure cannot distinguish between lending and borrowings and hence high internal
rate of return need not necessarily be a desirable feature.
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6.9.7 Profitability Index Method
Profitability Index is also known as Benefit Cost Ratio. It gives the present value of future benefits, computed at the
required rate of return on the initial investment. Profitability Index may either be Gross Profitability Index or Net
Profitability Index. Net Profitability Index is the Gross Profitability Index minus one. The Profitability Index can
be calculated by the following equation:
Profitability Index =
Rule of Acceptance
As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should be
accepted as it will have Positive Net Present Value. Likewise if Profitability Index is less than one the project is not
beneficial and should not be accepted.
Advantages of Profitability Index:

• It duly recognises the time value of money.
• For calculations when compared with internal rate of return method it requires less time.
• It helps in ranking the project for investment decisions.
• As this method is capable of calculating incremental benefit cost ratio, it can be used to choose between mutually
exclusive projects.
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Summary
• The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments.
• Capital Budget is also known as “Investment Decision Making or Capital Expenditure Decisions” or “Planning
Capital Expenditure” etc.
• According to Hamption, John. J., “Capital budgeting is concerned with the firm’s formal process for the
acquisition and investment of capital.”
• Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
• Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.
• Capital Expenditure Increases Revenue is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.
• A firm may have several investment proposals for its consideration.
• There are number of appraisal methods which may be recommended for evaluating the capital investment
proposals.
• Pay-back period is also termed as “Pay-out period” or Pay-off period.
• One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project.
• Discounted pay-back method helps to measure the present value of all cash inflows and outflows at an appropriate
discount rate.
• Average Rate of Return Method is also termed as Accounting Rate of Return Method.
• Discount cash flow is a method of capital investment appraisal which takes into account both the overall
profitability of projects and also the timing of return.
• Net Present Value is obtained by subtracting the present value of cash outflows from the present value of cash
inflows.
• Internal Rate of Return Method is also called as “Time Adjusted Rate of Return Method.
• Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected
cash inflows from a project equals the present value of expected cash outflows of the project.
• Profitability Index is also known as Benefit Cost Ratio.
• As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should
be accepted as it will have Positive Net Present Value.
Reference
• Peterson, P. P. & Fabozzi, J. F., 2004. Capital Budgeting: Theory and Practice, John Wiley & Sons.
• Periasamy, P., 2010. A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global
Media.
• WHAT IS CAPITAL BUDGETING? [Pdf] Available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/
CapitalBudget/CapitalBudgetingTraining.pdf> [Accessed 16 May 2013].
• CHAPTER 29 Capital Budgeting [Pdf] Available at: <http://mfile.narotama.ac.id/files/Accounting%20
&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20
(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf> [Accessed 16 May 2013].
• Irfanullah, A., 2011. CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online]
Available at: <http://www.youtube.com/watch?v=qfzQwqLdXH0> [Accessed 16 May 2013].
• Capital Budgeting [Video online] Available at: <http://www.youtube.com/watch?v=qGgVGUcBqAg> [Accessed
16 May 2013].
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Recommended Reading
• Jacobs & Davina, F., 2006. A Reviews of Capital Budgeting Practices, International Monetary Fund.
• Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge
University Press.
• Baker, K. H. & English, P., 2011. Capital Budgeting Valuation: Financial Analysis for Today’s Investment
Projects, John Wiley & Sons.
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Self Assessment
1. ___________ is concerned with the firm’s formal process for the acquisition and investment of capital.
a. Investment
b. Capital budgeting
c. Capital expenditure
d. Planning

a. Capital budgeting involves commitment of small amount of funds.
b. Wrong sale forecast; may lead to over or under investment of resources.
c. Many firms fail, because they have too much or too little capital equipment.
d. Capital decisions are required to assessment of future events which are uncertain.
3. ____________ is the expenditure which brings more revenue to the firm either by expanding the existing
production facilities or development of new production line.
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
4. What reduces the cost of present product and thereby increases the profitability of existing operations?
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
5. ____________ refer to the acceptance of one proposal results in the automatic rejection of the other proposal.
b. Dependent Proposals
c. Contingent Proposals
d. Independent Proposals
6. Which proposals are said be to economically independent?

c. Dependent Proposals
d. Contingent Proposals
7. Which of the following formula calculates Profitability Index?
a. Average Rate of Return (ARR) =
b. Lower Interest Rate + × (higher rate – lower rate)
c. Reciprocal Pay-back Period =
d. Profitability Index =
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8. ____________ is defined as the number of years required to recover the initial investment in full with the help
of the stream of annual cash flows generated by the project.
a. Profitability Index Method
b. Internal Rate of Return Method
c. Pay out Period Method
d. Net Present Value Method
9. If the project generates constant cash flow the pay-back period can be computed by dividing __________ by
annual cash inflows.
a. constant annual cash inflows
b. investment proposals
c. cash inflows
d. cash outlays
10. ____________ is a method of capital investment appraisal which takes into account both the overall profitability
of projects and also the timing of return.
a. Discount cash flow
b. Cash flow
c. Net present value method
d. Internal rate of return method
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Chapter VII
Management of Working Capital
Aim
The aim of this chapter is to enable the students to:
• explain working management
• elucidate components, aspects and need for working capital
• explicate the determinants of working capital
Objectives
• enlist the types of working capital
• explain gross working capital
• elucidate the components of working capital
Learning outcome
At the end of the chapter, you will be able to:
• define working capital
• understand the factors influencing the working capital
• identify net working capital
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7.1 Introduction
Working capital may be regarded as the lifeblood of a business enterprise. It is, closely, related to the day-to-day
operations of the business. Every business needs funds for two purposes. Longterm funds are required for creation
of production facilities such as plant and machinery, land, building and furniture, etc. Investment in these assets
represents that part of firm’s capital, which is permanently blocked on a permanent or fixed basis and is called fixed
capital. The form of these assets does not change, in the normal course.
Funds are, also, needed for purchase of raw materials, payment of wages and other day-today expenses etc. These
funds are known as working capital. Funds invested in these assets keep revolving, fast. These assets are converted
into cash and, again, cash is converted into current assets. So, working capital is also called revolving or circulating
capital. The assets change the form, on a continuous basis. In other words, working capital refers to that part of the
firm’s capital, which is required for financing short-term or current assets such as cash, debtors, inventories and
marketable securities, etc.
Capital is divided into fixed capital and working capital. Fixed capital required for establishment of a business,
where as working capital required to utilise fixed assets.
• The efficiency of a business enterprise depends largely on its ability to manage its working capital.
• Working capital management therefore, is one of the important facets of a firm’s overall financial
management.
7.2 Meaning and Definition of Working Capital

Working capital refers to current assets that can be defined as:
• Those which are convertible into cash or equivalent within a period of one year and those which are required
to meet day-to-day operation
• It is concerned with the management of the firm’s current assets and current liabilities.
• It refers to the problems that arise in attempting to manage the current assets, current liabilities and their
interrelationship between them
• If a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and even forced
into bankruptcy.
To quote Ramamurthy, “It refers to the funds, which a company must possess to finance its day-to-day
operations”.
J. S. Mill, "The sum of the current assets is the working capital of the business."
7.3 Classification of Working Capital

Working capital can be classified in two ways
• On the basis of concept
• On the basis of time
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Kinds of Working Capital
Concept Base Time Base
Gross Working Net Working Permanent or Temporary or

Capital or Capital or Regular Working Variable Working
Quantitative Qualitative Capital Capital
Fig. 7.1 Types of working capital
On the basis of concept, working capital is classified as gross and net as discussed earlier.
Gross working capital

Gross working capital refers to the firm’s investment in total current assets of the enterprise. Current assets are those,
which can be converted into cash, within an accounting year (or operating cycle). They include cash, debtors, bills
receivable, stock and marketable securities etc. In a broader sense, working capital refers to gross working capital.
liabilities are accounting outstanding
Net working capital

In the narrow sense, working capital refers to net working capital. Net working capital is the difference between
current assets and current liabilities. Current of outsiders, which are expected to mature for payment, within an
include creditors, bills payable, bank overdraft/cash credit account and those claims year. They expenses.
If the payment of current liabilities is delayed, the firm gets the availability of funds to that extent. So, a part of the
funds required to maintain current assets is financed by the current liabilities. The firm is required to invest in the
current assets, to that extent, not financed by the current liabilities.
If current assets are in excess of current liabilities, net working capital is positive. A negative working capital occurs
when the current liabilities exceed current assets.
Treatment of Bank overdraft/cash credit account: Bank overdraft/cash credit account is treated as current liability
as the sanction of bank is for one year. It is a different matter bank renews these facilities on a continuous basis, at
the request of the borrower, on submission
While, on the basis of time, working capital is divided in two types:

• Permanent working capital
• Variable working capital
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Permanent working capital
• It refers to the minimum amount of investment required in all current assets at all times to carry on the day-to-
day operation of firm’s business.
• The minimum level of current assets has been given the name of “Core current assets’ by the Tandon
Committee.
• It is also known as fixed working capital.
Variable/Temporary working capital

• It is known as variable working capital or fluctuating working capital.
• The working capital keeps on fluctuating from time to time on the basis of business activities.
• The additional working capital required as per the changing production and sales level of a firm is known as
temporary working capital.
• The firm’s working capital requirements vary depending upon the seasonal changes in demand for a firm’s
products.
7.4 Components of Working Capital

The main components of working capital are:
• Current assets: Current assets consist of cash, marketable securities, inventories, sundry debtors, bills receivables,
short term investments, prepaid expenses etc. Current assets are those assets that, in the ordinary course of
business, can be turned into cash within an accounting period (not exceeding one over) within undergoing
diminution in value and without disrupting the operations.
• Current liabilities: They consist of loans and advances, sundry creditors, short-term borrowing, bank over-
draft, taxes and proposed dividend. Current liabilities are those liabilities intended to be paid in the ordinary
course of business within a reasonable period (normally within a year) out of the current assets or revenue of
the business.
7.5 Aspects of Working Capital Management

The following four aspects are involved in the management of working capital.
• Determining the total funds required to meet the current operation of the firm; determining the level of current
assets.
• Deciding the structure of current assets; the proportion of long-term and short-term capital to finance current
assets.
• Evolving suitable policies, procedures and reporting systems for controlling the individual components of current
assets; mainly cash, receivables and inventory
• Determining the various sources of working capital.
For determining the sources of working capital (short term and long term) capital the net concept becomes
useful
For determining the level and composition of working capital it is the gross concept, which becomes more
meaningful.
7.6 Need for Working Capital

Working capital is needed till a firm gets cash on sale of finished products as sales do not convert into cash immediately.
There is an invisible time lag between the sale of goods and receipts of cash. Therefore, sufficient working capital
is necessary to sustain sales activity.
The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. The
time that elapses to convert raw materials into cash (elapses between the purchase of raw materials and the collection
of cash from sale) is known as operating cycle.
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The following elements are the operating cycle of the firm:

• Conversion of cash into raw materials
• Conversion of raw materials into work-in-process
• Conversion of work-in-process into finished goods
• Time for sale of finished goods-cash sales and credit sales.
• Time for realisation from debtors and Bills receivables into cash
• Credit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and
overheads.
Debtor
Cash
Sales
Raw Materials
Finished goods
Work-in Process
Fig 7.2 Operating cycle
Operating Cycle can be computed with the following formula:

OC = ICP + ARP
Where
OC = Operating Cycle
ICP = Inventory Conversion Period
ARP = Accounts Receivable Period
Example ABC company provided the following information and requested you to compute operating cycle:
Sales Rs. 3,000 lakhs;
Inventory: Opening Rs. 610 lakhs; closing Rs. 475 lakhs
Receivable: Opening Rs. 915 lakhs; closing Rs. 975 lakhs
Cost of goods sold Rs. 2,675 lakhs
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Solution
OC = ICP + ARP
=

= 74 days
= 114.97 days
OC = 74 days + 115 days
= 189 days
OC 189 days indicates that ABC company takes (requires) 189 days to convert raw materials into cash. In other
words, some amount of cash blocked for 189 days, therefore there is a need to have working capital.
Cash conversion cycle

The amount of time a firm’s resources are tied up; calculated by subtracting the average payment period from the
operating cycle. In other words, the time period between the dates a firm pays its suppliers and the date it receives
cash from its customers.
Calculation of Cash Conversion Cycle (CCC) (see the fig. below)
CCC = OC – APP
Where: OC = Operating Cycle
APP = Accounts Payable Period
OC = AAI + ARP
AAI = Average Age of Inventory
ARP = Average Collection (receivables) Period
From the financial statements we can determine the constituents of Cash Conversion Cycle i. ., AAI, ARP,
APP
AAI = Average Inventory (Cost of Goods sold / 365)
ARP = Average Accounts Receivables (Annual Sales / 365)
APP = Average Accounts Payables (Cost of Goods Sold / 365)
Purchase of Sales of Goods Collection of

Raw Materials on Credit Accounts
on Credit Receivables
Average Age Accounts
of Inventory Receivables
(AAI) Period (ARP)
Accounts
Payable
Period (APP)
Payment to
Suppliers
Receipt of Operating Cycle (OC)
Invoice Cash Conversion Cycle (CCC)
Example
From the following financial information calculate Cash Conversion Cycle.
Average use of Inventories 80 days; accounts receivables collection period 50 days, and accounts payable period
is 40 days.
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Solution:
CCC = OC – APP
OC = AAI + ARP
= 80 + 50 = 130 days
CCC = 130 days – 40 = 90 days
Determinants of working capital

A large number of factors influence the working-capital-needs of a firm.
• The basic objective of a firm’s working capital management is to ensure that the firm has adequate working
capital for its operation, neither too much nor too little working capital.
• There is no set of rules or formulae to determine the working capital requirements of a firm.
• The total working capital requirement is determined by a wide variety of factors.
• The factors, however, affect different firm’s working capital
• The relative importance of these factors should be made in order to determine the total investment in working
capital
The following will give description of the general factors influencing the working capital needs of a firm:
• Nature and size of business: The working capital requirements of a firm are basically influenced by the nature
of the business.
The nature of the business - influence the working capital decisions.
The proportion of current assets needed in some lines of business activity varies from other lines.
Trading and financial firms have less investment in fixed assets but requires a large sum of money to be
invested in working capital.
Size may be measured in terms of scale of operations.
A firm with large scale of operation normally requires more working capital than a firm with a low scale
of operation.
• Manufacturing cycle: It is a factor, which has bearing on the quantum of working capital.
The term is refer to the time involves in manufacturing of goods.
It covers the time span between the procurement of raw materials and the completion of the manufacturing
process leading to the production of finished goods.
Longer the manufacturing cycle, the higher will be the working capital requirement and vice versa.
• Production policy: The requirement on working capital is determined on the basis of production policy of the
firm.
Production policy means whether it is continuous or seasonal production.
There are two production policy that the company or the firm can follow
They can confine their production only to periods when goods are purchased or
They can follow a steady production policy throughout the year and produce goods at a level to meet peak
demand.
FMCG goods business of production and sales goes simultaneously and the amount of working capital
required is less.
Umbrella business sales will be only in seasonal and production will take place throughout the year
continuously the amount of working capital required is very high.
• Terms of purchase and sales: Terms (cash or credit) of purchase and sales also affect the amount of working
capital.
If a company purchases all goods or raw materials in cash and sells its finished goods or product on credit,
it will require larger amount of working capital
On the contrary, a concern having credit facilities and allowing no credit to its customers will require lesser
amount of working capital.
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Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by
changing economic conditions
• Operating efficiency: Operating efficiency relates to the optimum utilisation of a firm’s resources at minimum
costs.
The firm with high efficiency in operation can bring down the total investment in working capital to lower
level.
Effective utilisation of resources helps the firm in bringing down the investment in working capital.
If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in
turn, release greater funds for working capital purposes.
• Business cycle: The amount of working capital requirements of a firm varies with every movement of business
cycle.
• When there is an upward swing in the economy sales will increase, and also the firm’s investment in inventories
and book debts will increase, thus it will increase the working capital requirement of the firm and vice versa.
• Growth and expansion: As company grows, it is logical to expect that a larger amount of working capital
required.
A growing firm may need funds to invest in fixed assets in order to sustain its growing production and sales.
This will, in turn, increase investment in current assets to support increased scale of operations.
Therefore, a growing firm needs additional funds continuously.
• Profit margin and dividend policy: The magnitude of working capital in a firm is dependent upon its profit
margin and dividend policy.
• A high net profit margin contributes towards the working capital pool.
• To the extent the net profit has been earned in cash, it becomes a source of working capital. This depends upon
the dividends results in a drain on cash resources and thus reduces company’s working capital to that extend.
The working capital position of the firm is strengthened if the management follows conservation dividend
policy and vice versa.
• Conditions of supply of raw material: If the supply of raw material is scarce the firm may need to stock it in
advance and hence need more WC and vice-versa.
• Availability of credit: The working capital requirement of a firm are also affected by credit terms granted by
its suppliers, i.e., creditors.
The need for working capital will be less in a firm, if liberal credit terms are available to it.
• Similarly, the availability of credit from banks also influences the firm’s working capital needs.
• A firm, which can get bank credit easily on favorable conditions, will be operated with less working capital
than a firm without such a facility.
• Taxation policy: The tax policies of the Government will influence the working capital decisions.
If the Government follows regressive policy, i.e., imposing heavy tax burdens on business firms, they are
left with very little profits for distribution and retention purpose.
Consequently, the firm has to borrow additional funds to meet their increased working capital needs.
When there is a liberalised tax policy, the pressure on working capital requirement is minimised.
• Other factors: There are many other factors which affect the requirement of working capital like infrastructural
facilities, import policy, changes in the technology, co-ordination activities in firm, distribution policies and
so on.
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7.7 Estimation of Working Capital Requirements

The best approach to estimate is based on operating cycle. Working capital consists of two components – current
assets and current liabilities. There is a need to follow the following four – steps procedure for estimation of working
capital
• Estimation of cash cost of the various current assets required by the firm.
• Estimation of spontaneous current liabilities of the firm.
• Compute net working capital by subtracting the estimated current liabilities (step (2)) from current assets (step
(1))
• Add some percentage (given in the problem) of net working capital if there is any contingency or safety working
capital required, to get the required working capital.
7.8 Sources of Working Capital

After the estimation of the working capital, the next step is financing the current assets. There are three financing
policies vis-à-vis’, to finance current assets. Adoption the specific policy is left out to the firm. The following are
the financing policies:
• Short-term: Generally current assets should be financed by short-term financial sources.
Short-term financing refers to borrowing funds or raising credit for maximum of 1 year period i.e., at the
most the debt is payable within a year.
The sources of short-term finance are loans from banks, short-term public deposits, commercial papers,
factoring of receivables, bills discounting, retention of profits etc
A firm which required short-term finance can go for any one of the above sources.
Long-term: Net current assets or working capital is supposed to be financed by long-term sources of
finance.
Long-term finance refers to the borrowing of funds or raising credit for one year or more.
Long-term finance is raised for a period of above five years.
The sources of long-term include- ordinary share capital, preference share capital, debentures, long-term
loans from bankers and surplus (includes retained earnings).
A firm that need to finance net current assets can go for any of the above sources, but it depends on
company’s attitude towards risk or control over the company, companies earnings, capacity and period of
loan reserved.
• Spontaneous financing: Refers to the automatic source of short term funds arising in the normal course of
business.
The source are trade credits and out standing expenses
The source of spontaneous finance is available at cost free
Firms that want to maximise owner’s wealth than it must and should utilise the sources to the fullest
extant
Some extant of current assets can be financed with the use of spontaneous source
The requiring current assets should be financed with the combination of long-term and short-term sources
of finance
• The policies for financing or working capital are divided into three categories:
Conservative financing policy: in which manager depends more on long-term funds.
Aggressive financing policy: in which the manger depends more on short term funds.
Moderate policy: suggests that the manager depends moderately on both long-term and short-term while
financing.
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Analysis of working capital
Determining the working capital is just not sufficient for a better performance. It should be analysed. It may be
analysed with a view to gross and net angles i.e., quantitative and qualitative.
The quantitative aspect of working capital refers to the quality of current assets while the qualitative aspect of
working capital refers to the liquidity and its adequacy.
The following are the aspects of working capital:
• Structure of working capital: It helps to have a better perspective of the working capital position of any
company.
• Working capital status: In order to ascertain the trends in working capital, indices of current assets, current
liabilities and net working capital of the firm may be computed.
First year of the selected period may be taken as base, for computing trends in current assets, current
liabilities and net working capital.
Working capital position in a concern would be satisfactory, provides the pace of increase in current assets
is more than that of the current liabilities and vice-versa.
If the net working capital indices also increase, it will further confirm that strength of working capital
position in a firm.
• Working Capital Leverage: It measures the sensitivity of return on investment (ROI) to the changes in ROI of
current assets.
• Working capital leverage (WCL) may be defined as the percentage change in ROI with given percentage change
in current assets.
Symbolically:
WCL = Percentage Change in ROI ÷ Percentage Change in Current Assets
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Summary
• Working capital may be regarded as the lifeblood of a business enterprise.
• Longterm funds are required for creation of production facilities such as plant and machinery, land, building
and furniture, etc.
• Investment in these assets represents that part of firm’s capital, which is permanently blocked on a permanent
or fixed basis and is called fixed capital.
• Gross working capital refers to the firm’s investment in total current assets of the enterprise. Current assets are
those, which can be converted into cash, within an accounting year (or operating cycle).
• If current assets are in excess of current liabilities, net working capital is positive. A negative working capital
occurs when the current liabilities exceed current assets.
• Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting
period (not exceeding one over) within undergoing diminution in value and without disrupting the operations
References
• Mathur, S. B., 2002. Working Capital Management and Control Principles & Practice. New Delhi. New Age
International (P) Limited.
• Dr. Rustagi, R. P., Principles of Financial Management. 4th ed., New Delhi. Taxmann Publications (P) Ltd.
• Working Capital Management, [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/703/7/07_
chapter1.pdf> [Accessed 29 May 2013].
• Working Capital Management, [Pdf] Available at: <http://www.ediindia.org/doc/SpecialPDF/chp-14.pdf>
• 2012. Working Capital Management, [Video online] Available at: <http://www.youtube.com/
watch?v=C0UOvhnIqxE> [Accessed 29 May 2013].
• 2010. Whats working capital? [Video online] Available at: <http://www.youtube.com/watch?v=AnwK1BQxJVw>
Recommended Reading
• Preve, L. & Sarria-Allende, V., 2010. Working Capital Management. Oxford University Press.
• Kumar, A. V., 2001. Working Capital Management. Northern Book Centre.
• Sagner, J., 2010. Essentials of Working Capital Management. John Wiley & Sons.
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Self Assessment
1. Which of the following cycle is the time period between the dates a firm pays its suppliers and the date it receives
cash from its customers?
a. Operating Cycle
b. Cash Conversion Cycle
c. Cash Conversion Period
d. Net Working Capital
2. Permanent Working Capital is also known as _________

a. total current assets
b. gross working capital
c. fixed working capital
d. net working capital
3. Operating cycle of a firm can be shortened by which of the following?

a. Increasing stock of raw material
b. Increasing credit period to customers
c. Increasing working-in-process
d. Increasing credit period from suppliers

a. In conservative approach, there is long term financing of working capital.
b. In aggressive approach, there is no short term financing of work capital.
c. Working Capital Leverage measures the sensitivity of return on investment (ROI) to the changes in ROI of
current assets.
d. The requirement on working capital is determined on the basis of production policy of the firm.
5. The amount of working capital requirements of a firm varies with every movement of ______________.
a. business cycle
b. production policy
c. manufacturing cycle
d. operating efficiency

a. commercial papers, factoring of receivables, bills discounting,
1. Concept of working capital
retention of profits etc
2. Short-term financing b. Current assets and Current liabilities
3. Structure of Working Capital c. Net working capital
d. helps to have a better perspective of the working capital

4. Components of working capital
position of any company
a. 1-b, 2-d, 3-a, 4-c.
b. 1-c, 2-a, 3-d, 4-b.
c. 1-d, 2-c, 3-a, 4-b.
d. 1-d, 2- a, 3-b, 4-c.
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7. Permanent working capital is the _______________ of current assets needed to conduct a business during the
normal season of the business.
a. maximum amount
b. moderate amount
c. minimum amount
d. increasing amount
8. Which of the following statements is true?

a. Conservative firm depends on more long-term funds for financing need.
b. Spontaneous Financing refers to the automatic source of long-term funds arising in the normal course of
business.
c. The requirement on working capital is determined on the basis of manufacturing policy of the firm.
d. Net working capital is the surplus of current liabilities over current assets and provisions

1. Temporary working capital a. Availability of Credit
2. Gross working capital b. Variable working capital
3. Determinants of Working Capital c. Aspects of Working Capital Management
4. Determining the various sources of working capital d. circulating capital

a. 1-c, 2-a, 3-d, 4-b.
b. 1-d, 2-c, 3-a, 4-b.
c. 1-c, 2-d, 3-b, 4-b.
d. 1-b, 2-d, 3-a, 4-c.
10. Working capital consists of _______________.

a. current assets and current liabilities
b. permanent and temporary working capital
c. gross and net working capital
d. concept based and time based working capital
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Chapter VIII
Inventory Management
Aim
• explain the types of inventory
• elucidate the objectives of inventory management
• define inventory
Objectives
• explain motives of inventory management
• enlist the risks of holding inventory
• elucidate the techniques of inventory control
Learning outcome
At the end of the chpater, you will be able to:
• understand the meaning, definition and objectives of inventory management
• identify the types of inventory
• understand the motives of inventory management
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8.1 Introduction
Inventories constitute a major component in current assets. It constitutes around 60% in the public limited companies,
in India. For the smooth running, every enterprise needs inventory. Inventories serve as a link between production
and distribution processes. Due to its major composition in current assets, the management of inventories occupies
a key role in working capital management. Excessive investment affects the liquidity. Inadequate investment makes
the firm to loose the business opportunities, otherwise available. Profitability would be affected with excessive or
inadequate investment. So, inventory management is essential to allow the firm to avail the opportunities to improve
profitability and at the same time does not impair its liquidity, with excessive or unproductive investment. A firm,
which neglects the inventory management, jeopardizes its longterm profitability. So, it is absolutely imperative to
control and manage inventory holding, both efficiently and effectively, to avoid unnecessary investment.
Inventory management occupies the most significant position in the structure of working capital. Inventories are the
most significant part of current assets. Inventory management is an important area of working capital management,
which plays a crucial role in economic operation of the firm. Maintenance of large size of inventories requires a
considerable amount of funds to be invested on them. Efficient and effective inventory management is necessary in
order to avoid unnecessary investment and inadequate investment. A considerable amount of funds is required to
be committed in inventories. It is absolutely imperative to manage inventories efficiently and effectively in order
to optimise investment in them cannot be ignored. Any lapse on the part of management of a firm in managing
inventories may cause the failure of the firm.
8.2 Meaning and Definition of Inventory

The term “Inventory” is originated from the French word “Inventaire” and the Latin “Inventariom” which implies
a list of things found. The term has been defined by the American Institute of Accountants as the aggregate of those
items of tangible personal property which:
• are held for sale in the ordinary course of business
• are in the process of production for such sales, or
• are to be currently consumed in the production of goods or services to be available for sale
The term inventory refers to the stockpile of the products a firm is offering for sales and the components that make up
the product. Inventories are the stocks of the product of a company, manufacturing for sale and the components that
make up the product. The various forms in which inventories exist in a manufacturing company are as follows:
• Raw materials
• Work-in process
• Finished goods
• Stores and spares
However, in commercial parlance, inventory usually includes stores, raw materials, work-in-process and finished
goods. The term inventory includes – raw material, work in process, finished goods packaging, spares and others
stocked in order to meet an unexpected demand or distribution in the future.
8.3 Types of Inventory

The following are the types of inventory:
• Raw materials: Raw materials are those inputs that are converted into finished goods through manufacturing
process. These form major inputs for manufacturing a product. In other words, they are very much needed for
uninterrupted production.
• Work-in-process: Work-in-process is that stage of stocks that are between raw materials and finished goods.
Work-in-process inventories are semi-finished products. They represent products that need to under go some
process to become finished goods.
• Finished products: Finished products are those products, which are ready for sale. The stock of finished goods
provides a buffer between production and market.
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• Stores and spares: Stores and spares inventory (include office and plant cleaning materials like soap, brooms,
oil, fuel, light, etc.) are those purchased and stored for the purpose of maintenance of machinery.
8.4 Inventory Management Motives

Managing inventories involves block of funds and inventory holding costs. There are three general motives for
holding inventories
• Transaction motives: It includes production of goods and sale of goods. It facilities uninterrupted production
and delivery of order at a given time (right time)
• Precautionary motive: This motive necessitates the holding of inventories for unexpected changes in demand
and supply factors.
• Speculative motive: This compels to hold some inventories to take the advantage of changes in prices and
getting quantity discounts.
8.5 Objectives of Inventory Management

The objectives of inventory management may be viewed in two. They are
• Operational: the operational objective is to maintain sufficient inventory, to meet demand for product by efficiently
organising the firm’s production and sales operations
• Financial: financial view is to minimise inefficient inventory and reduce inventory carrying costs.
These two conflicting objectives of inventory management can also be expressed in terms of costs and benefits
associated with inventory. The firm should maintain investment in inventory implies that maintaining an inventory
involves costs, such that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates
(benefits) the smooth functioning of the production. An effective inventory management should:
• ensure a continuous supply of raw materials and supplies to facilities uninterrupted production
• maintain sufficient stocks or raw materials in periods of short supply and anticipate price changes
• maintain sufficient finished goods inventory for smooth sales operation and efficient customers services
• minimise the carrying costs and time and
• control investment in inventories and keep it at an optimum level
Apart from the above, the following are also objects of inventory management. Control of materials costs; elimination
of duplication in ordering by centralisation of purchasers; supply of right quality of goods of reasonable prices,
provide data for short-term and long-term for planning and control of inventories.
Therefore, management of inventory needs careful and accurate planning so as to avoid both excess and inadequate
inventory in relation to the operational requirement of a firm. To achieve higher operational efficiency and profitability
of a firm, it is essential to reduce the amount of capital locked up in inventories. This will not only help in achieving
higher return on investment by minimising tied-up working capital, but will also improve the liquidity position of
the enterprise.
8.6 Costs of Holding Inventory

Minimising cost is one of the operating objectives of inventory management. There are three costs involved in the
management of inventories.
Ordering costs
Ordering costs are those costs that are associates with the acquisition of raw materials. In other words, the costs that
are spend from placing an order till the receipt of raw materials. They include the following:
• Cost of requisitioning the items (raw materials)
• Cost of preparation of purchase order (i.e., drafting typing, dispatch, postal etc)
• Cost of sending reminders to get the dispatch of the items expedited
• Cost of transportation of goods (items)
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• Cost of receiving and verifying the goods

• Cost of in unloading of the (items) of goods
• Shortage and stocking charges
However, incase of items manufactured in house the ordering costs would comprise the following costs:
• Requisitioning cost
• Set-up cost
• Cost of receiving and verifying the items
• Cost of placing and arranging/stacking of the items in the store etc.,
Ordering costs are fixed per order placed, irrespective of the amount of the order but ordering costs increases in
proportion to the number of order placed. If the firm maintains small inventory levels then the number of orders
will increase, there by ordering cost will increase and vice versa.
Carrying costs
Inventory carrying costs are those costs, which are associated with carrying or maintaining inventory. The following
are the carry costs of inventory:
• Capital cost (interest on capital locked in the inventories)
• Storage cost (insurance, maintenance on building, utilities serving costs)
• Insurance (on inventory – against fire and theft insurance)
• Obsolescence cost and deterioration
• Taxes
• Carrying costs usually constitute around 252 per cent of the value of inventories held
Shortage costs (Costs of stock out)

Shortage costs are those costs that arise due to stock out or either shortage of raw materials or finished goods.
Shortage of inventories of raw materials over affect the firm in one or more of the following ways:
• The firm may have to pay some what higher price, connected with immediate (cash) procurements
• The firm may have to compulsorily resort the some different production schedules, which may not be as efficient
and economical
Stock of finished goods – may result in the dissatisfaction of the customers and the resultant loss of rules
Thus, with a view to keep inventory costs of minimum level, we may have to arrive at the optional level of inventory
cost, it is the total orders costs plus carrying costs are minimal. In other words, we have to determine Economic
Order Quantity (EOQ), is that level at which the total inventory (ordering plus carrying less) cost is minimum.
8.7 Risks of Holding Inventory

Risk in inventory management refers to the chance that inventory management cannot be turned over into cash
through normal sales without loss. The following are the risk associated with inventory management
• Price decline: Price decline is the result of more supply and less demand (introduction of competitive product).
Generally prices are not controllable in the short-run by the individual firm. Controlling inventory is the only
way that a firm can counter act with these risks.
• Product deterioration: Holding inventory for a long period or shortage under improper conditions of light, heat,
humidity and pressure lead to product deterioration. Deterioration usually prevents selling in product through
normal channels.
• Product obsolescence: Product may become obsolete due to improved products, changes in customer tastes,
particularly in high style merchandise, changes in requirements etc. This risk may prove very costly for the
firms whose resources are limited and tied up in slow moving inventories. Product obsolescence cost risk least
controllable except by reduction in inventory investment.
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Thus, inventories are risky assets to manage and the effective way to minimising risks is setting up of efficient
inventory control system.
8.8 Benefits of Holding Inventory

Proper management of inventory will result in the following benefits to a firm:
• Ensures an adequate supply of materials and stores, minimises stock outs and shortages and avoids costly
interruptions in operations
• Keep down investment in inventories; inventory carrying costs and obsolescence losses to the minimum
• Facilitates purchasing economics through the measurement of requirements on the basis of recorded
experience
• Eliminates duplication in ordering stocks by centralising the source from which purchase requisitions
emanate
• Permits better utilisation of available stocks by facilitating inter-department transfers within a firm
• Provides a check against the loss of materials through careless or pilferage
• Perpetual inventory values provide a consistent and reliable basis for preparing financial statements a better
utilisation
8.9 Techniques of Inventory Control

There are many techniques used to management inventory. Some of them are listed below:
8.9.1 ABC Analysis

It is one of the widely used techniques to identify various items of inventory for the purpose of inventory control.
In other words, it is very effective and useful tool for classifying, monitoring and control inventories.
• The firm should not keep same degree of control on all the items of inventory. The firm should put maximum
control on those items whose value is the highest, with the comparison of the other two items.
• It is based on Pareto's Law and is known as Selective Inventory Control.
• Usually a firm has to maintain several types of inventories, for proper control of them, firm should have
to classify inventories in the instance of their relative value. Hence, it is also known as Proportional Value
Analysis(PVA)
According to this technique the task of inventory management is proper classification of all inventory items in to three
categories namely A, B and C category. The ideal categorisation of inventory items is shown in the Table 12.1. The
higher value items are classified ' A items' and would be under tight control. At the other end of the classification we
find category 'C items', on these types of inventory firm cannot afford expenses of rigid controls, frequent ordering
and expending, because of the low value or low amounts. Thus with the 'C items', we may maintain somewhat higher
safety stocks, order more months of supply, expect lower levels of customer service, or all the three. 'B items' fall
in between 'A items' and 'C items' and require reasonable attention of management.
Category No. of Items (%) Items Value (%)

A 15 70
B 30 20
C 55 10
Total 100 100
Table 8.1 Categorisation of Inventory
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The above table indicates that only 15 per cent of the items may account for 70 per cent of the total value (A category
items), on which greater attention is required, when as 55 per cent of items may account for 10 per cent of the total
value of inventory (C category items), will be paid a reasonable attention. The remaining 30 per cent of inventory
account for 20 per cent of total value of inventory (B category items) will be paid a reasonable attention as this,
category value lies between the two other categories. The above data can be shown by the following graph.
100
80
Value of items (%)
60
40
Item A
Item B
Item C
20
0
10 20 30 40 50 60 70 80 90 100
No. of Items (%)
In the above Fig. numbers of items (%) are shown on 'X' axis and value of items (%) are represented on 'Y' axis.
Greater attention will be paid on category 'A' item, because greater benefit. The control of 'C' items may be released
due to less benefit (some times control cost may exceed benefit of control) and reasonable attention should be paid
on category 'B' items.
8.9.2 Economic Order Quantity (EOQ)

Economic order quantity (EOQ) refers to that level of inventory at which the total cost of inventory is minimal. The
total inventory cost comprising of ordering and carrying costs. Shortage costs are excluded in adding total cost of
inventory due to the difficulty in computation of shortage cost. EOQ are also known as Economic Lot S
e (ELS).
Assumptions of EOQ Model

The following assumptions are implied in the calculation of EOQ:
• Demand for the product is constant and uniform throughout the period
• Lead time (time from ordering to receipt) is constant
• Price per unit of product is constant
• Inventory holding cost is based on average inventory
• Ordering costs are constant, and
• All demand for the product will be satisfied (no back orders are allowed)
EOQ Formula
• EOQ can be obtained by adopting two methods
• Trail and Error approach
• Short cut or Simple mathematical formula
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Here for calculation of EOQ we have adopted simple short cut method. The formula is
Where:
A = Annual usage
O = Ordering cost per order
CC = Annual carrying per unit
CC = Price per unit × Carrying cost per unit in percentage
The above simple formula will not be sufficient to determine EOQ when more complex cost equations are
involved.
EOQ is applicable both to single and to any group of stock items with similar holding and ordering costs. Its use
causes the sum of the two costs to be lower than under any other system of replenishment.
Limitations
Apart from the above application it has its own limitations, which are mainly due to the restrictive nature of the
assumptions on which it is based
• Constant usage: It may not be possible to predict, if usage varies unpredictably, as it often does, no formula
will work well.
• Faulty basic information: Ordering and carrying costs is the base for calculation EOQ. It assumes that ordering
cost is constant per order, but actually varies from commodity to commodity. Carrying cost also can vary with
the company's opportunity cost of capital.
• Costly calculation: In many cases the cost estimating, cost of possession and acquisition and calculating EOQ
exceeds the savings made by buying that quantity.
8.9.3 Order Point Problem

If the inventory level is too high it will unnecessary block the capital and if the level is too low, it will disturb
production by frequent stock out and also involves high ordering cost. Hence, an efficient management of inventory
needs to maintain optimum inventory level, where there is no stock out and the costs are minimal. The different
stock levels are
Minimum level
• Minimum stock is that level that must be maintained always for smooth flow of production. While determination
of minimum stock level, lead time, and consumption rate, material nature must be considered.
• Lead-time is the number of days required to receive the inventory from the date of placing order. It is also called
as procurement time of inventory
• The average quantity of raw materials consumed daily. The consumption rate is calculated based on the past
experience and production plan.
• Requirement of materials for normal or regular production or special order production. If the material is required
for special order production, then the minimum stock levels need not to maintain.
Minimum stock level = Re-order level – (Average Usage × Average delivery time)
Reorder level
Reorder level is that level of inventory at which an order should be placed for replenishing the current stock of
inventory. Generally the reorder level lies between minimum stock level and maximum stock level.
Re-order point = Lead time (in days) × Average Daily usage
The above formula is based on the assumption that Consistent usage and Fixed lead-time.
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Safety Stock: Prediction of average daily usage and lead-time is difficult. Raw materials may vary from day to day
or from week to week, it is the case for lead-time also. Lead-time may be delayed if the usage increases, than the
company faces problem of stock out. To avoid stock out firm may require maintaining safety stock.
Formula (under uncertainty of usage and lead time)
RE-order point = (Lead time (in days) × Average usage) + Safety stock
Maximum level
Maximum level of stock is that level of stock beyond which a firm should not maintain the stock. If firm stocks
inventory beyond the maximum stock level is called as overstocking. Excess inventory (overstock) involves heavy
cost of inventory, because it blocks firms’ funds in inventory, excess carrying cost, wastage, obsolescence and theft
cost. Hence, firm should not stock above the maximum stock level. Safety stock is that minimum additional inventory
to serve as a safety margin or better or buffer or cushion to meet an unanticipated and increase in usage resulting
from an unusually high demand and or an uncontrollable late receipt of incoming inventory.
Maximum Stock Level = Reorder Level + Reorder Quantity – (Minimum Delivery Time)
Danger stock level

Danger level is that level of materials beyond that materials should not fall in any situation. When it falls in danger
level it will disturb production. Hence, the firm should not allow the stock level to go to danger level if at all falls
in that level then immediately stock should be arranged even if it costly.
Danger Level = Average Usage × minimum Deliver Time (for emergency purchase)
8.9.4 Just in Time (JIT)

Popularly known in its acronym JIT. It may be applied for either raw materials purchase or producing finished
goods. From raw materials purchase it means, that no inventories are held at any stage of production and the exact
requirement is bought in each and every successive stage of production of the right time. In other words, maintenance
of a minimum level of raw materials where by the inventory carrying cost could be minimised, and the risk of loss
due to stock-out position could be well avoided. From production of goods view JIT means goods are produced only
when the order are received, there by no storage of finished goods, and can avoid costs of carrying finished goods.
JIT is also known as "Zero Inventory Production System" (ZIPS), Zero Inventories (ZIN), Materials as Needed
(MAN) or Neck of Time (NOT).
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Summary
• Inventory management occupies the most significant position in the structure of Working capital.
• The types of inventory are: raw materials; work-in process; finished goods; and stores and spares.
• The two conflicting objectives of inventory management are: maintaining investment in inventory and to facilitate
(benefits) the smooth functioning of the production, which in turn meet the demand.
• Efficient management of inventory reduces the cost of production and consequently increases the profitability
of the enterprise by minimising costs associated with holding inventory.
• An effective inventory management should: Ensure a continuous supply of raw materials and supplies to
facilitates uninterrupted production; maintain sufficient finished goods inventory for smooth sales operations;
and efficient customer service; minimise the carrying costs and time; and Control investment in investment and
keep it at an optimum level.
• Minimising cost is one of the operating objectives of inventory management. The costs (excluding merchandise
cost), there are three costs involved in the management of inventories. They are Ordering Costs, Inventory
Carrying Costs and Shortage Costs.
• There are many techniques of management of inventory. Some of them are ABC analysis, Economic Order
Quantity (EOQ), Order Point Problem, Just in Time etc.
Reference
• 2008. Inventory Management, [Video online] Available at: <http://www.youtube.com/watch?v=HZPMaTifdBg>
• 2008. Lecture - 38 Basic Inventory Principles, [Video online] Available at: <http://www.youtube.com/
watch?v=HZPMaTifdBg> [Accessed 29 May 2013].
• Viale, J. D., Basics of Inventory Management, [Pdf] Available at: <http://www.axzopress.com/downloads/
pdf/1560523611pv.pdf> [Accessed 29 May 2013].
• Inventory Management,[Pdf] Available at: <http://highered.mcgraw-hill.com/sites/dl/free/0073525235/940447/
jacobs3e_sample_ch11.pdf> [Accessed 29 May 2013].
• Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.
• Axst ̃er, S.,2006. Inventory control, 2nd ed., Springer.
Recommended Reading
• Muller, M., 2003. Essentials of Inventory Management. AMACOM.
• Mullar, M., 2011. Essentials of Inventory Management, 2nd ed., AMACOM Books.
• Viale, J. D. & Christopher, C., 1996. Inventory Management: From Warehouse to Distribution Center, Course
Technology / Cengage Learning .
97/JNU OLE
Self Assessment
a. Transaction motive includes production of goods and sale of goods. It facilities interrupted production and
delivery out of order at a given time (right time)
b. Precautionary motive necessitates the holding of inventories for expected changes in demand and supply
factors.
c. Speculative motive compels to hold some inventories to take the advantage of changes in prices and getting
quantity discounts.
d. Lead-time is the number of days required to receive the inventory from the date of placing order and is also
called as procurement time of inventory.
2. Inventory is one of the components of _________ assets.

a. liabilities
b. cash budget
c. balance
d. current
3. Which of the following is true?

a. Price decline, product deterioration and product obsolescence are the risks of holding inventory.
b. Costs of holding inventory are ordering costs, capital costs and shortage costs.
c. Carrying costs are those costs that are associates with the acquisition of raw materials.
d. Price decline is the result of less supply and more demand
4. EOQ is the quantity that minimises:

a. Total Inventory Cost
b. Total Ordering Cost
c. Total Interest Cost
d. Safety Stock Level
5. _____________ values provide a consistent and reliable basis for preparing financial statements a better
utilisation.
a. Increase inventory
b. Perpetual inventory
c. Costs of Holding Inventory
d. Risks of Holding Inventory
6. Which of the following is one of the components of inventory carrying cost?

a. Price decline
b. Speculative motive
c. Capital cost
d. Work-in process
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1. Objectives of Inventory Management a. Economic Order Quantity (EOQ)
2. Risks of holding inventory b. operational and financial
3. Techniques of inventory control c. Zero Inventory Production System (ZIPS)
4. JIT is known as d. product obsolescence
a. 1-c, 2-d, 3-b, 4-a
b. 1-d, 2-a, 3-b, 4-c
c. 1-b, 2-c, 3-d, 4-a
d. 1-b, 2-d, 3-a, 4-c

a. ABC is also known as PAV.
b. The EOQ model attempts to minimising the total cost of holding inventory
c. EOQ model assumes a constant usage rate for a particular item.
d. Risk in inventory management refers to the chance that inventory management cannot be turned over into
cash through normal sales without loss
9. In EOQ formula √2AO÷CC, 'A' stands for Annual usage.

a. Biennial Usage
b. Perennial Usage
c. Annual usage
d. Monthly Usage
10. Which of the following is one of the risks of holding inventory?

a. Shortage Costs
b. Product Obsolescence
c. ABC analysis
d. Work-in Process
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Chapter IX
Dividend Decision
Aim
• explain the concept of dividend
• elucidate various dividend theories
• explicate Modigliani and Miller’s Approach
Objectives
• enlist the types of dividend
• explain Walter's model
• eluicdate dividend decision
Learning outcome
At the end of the chapter, you will be able to:
• understand Gordon's model
• describe dividend theories
• idenfity cash dividend
100/JNU OLE
9.1 Introduction
The financial manager must take careful decisions on how the profit should be distributed among shareholders.
It is very important and crucial part of the business concern, because these decisions are directly related with the
value of the business concern and shareholder’s wealth. Like financing decision and investment decision, dividend
decision is also a major part of the financial manager. When the business concerns decide dividend policy, they have
to consider certain factors such as retained earnings and the nature of shareholder of the business concern.
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as
the part of the profit of a business concern, which is distributed among its shareholders. According to the Institute
of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profits or reserves
available for this purpose”.
9.1.1 Types of Dividend/ Form of Dividend

Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified
into:
• Cash dividend
• Stock dividend
• Bond dividend
• Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the
business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed
by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type, cash
is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing
shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash dividend,
the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional
circumstance. This type of dividend is not published in India.
9.2 Dividend Decision

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines
the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for
financing its long term growth. Hence, dividend decision plays very important part in the financial management.
Dividend decision consists of two important concepts which are based on the relationship between dividend decision
and value of the firm.
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Dividend
Theories
Irrelevance of Relevance of
Dividend Dividend
Soloman MM Walter's Gordon's

Approach Approach Model Model
Fig. 9.1 Classification of dividend theories
9.2.1 Irrelevance of Dividend

According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the
company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the
value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.
Modigliani and Miller’s Approach

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not
affect the value of the firm. “Under conditions of perfect market, rational investors, absence of tax discrimination
between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have
no influence on the market price of shares”.
Assumptions
MM approach is based on the following important assumptions:
• Perfect capital market
• Investors are rational
• There are no tax
• The firm has fixed investment policy
• No risk or uncertainty
Proof for MM approach MM approach can be proved with the help of the following formula:
Where,
Po = Prevailing market price of a share.
Ke = Cost of e equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one.
P 1 can be calculated with the help of the following formula.
P1= Po (1+Ke) – D 1
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The number of new shares to be issued can be determined by the following formula:
M × P1 = I – (X – nD1)
Where, M = Number of new share to be issued.

P1 = Price at which new issue is to be made.
I = Amount of investment required.
X = Total net profit of the firm during the period.
nD1 = Total dividend paid during the period.
Example 1: X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs. 15 each.
The company expects the net profit of Rs. 2, 00,000 during the year and it belongs to a rich class for which the
appropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50 per
share for the current year. What will be the price of the share at the end of the year (i) if the dividend is paid and
(ii) if the dividend is not paid?
Solution:
(i) If the dividend is paid

Po= Rs. 15
Ke = 20%
D1= 2.50
P1=?
2.50 +P1= 15x1.2
P1= 18-2.50
P1=Rs. 15.50
(ii) If the dividend is not paid

Po= Rs. 15
Ke = 20%
D1= 0
P1=?
103/JNU OLE
0 +P1= 15x1.20
P1= Rs.18
Criticism of MM approach
MM approach consists of certain criticisms also. The following are the major criticisms of MM approach.
• MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm.
• MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present
day business life.
• MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm.
• MM approach considers only single decrement rate, it does not exist in real practice.
• MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors
will behave rationally.
9.2.2 Relevance of Dividend

According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies
that shareholders prefer current dividend and there is no direct relationship between dividend policy and value of
the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.
Walter’s Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm. Walter model is
based in the relationship between the following important factors:
• Rate of return I
• Cost of capital (k)
According to the Walter’s model, if r > k, the firm is able to earn more than what the shareholders could by reinvesting,
if the earnings are paid to them. The implication of r > k is that the shareholders can earn a higher return by investing
elsewhere.
If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:
• The firm uses only internal finance
• The firm does not use debt or equity finance
• The firm has constant return and cost of capital
• The firm has 100 recent payout
• The firm has constant EPS and dividend
• The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.
Where,
P = Market price of an equity share
D = Dividend per share
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r = Internal rate of return
E = Earning per share
Ke = Cost of equity capital
Example 2: From the following information supplied to you, ascertain whether the firm is following an optional
dividend policy as per Walter’s Model?
Total Earnings Rs. 2, 00,000
No. of equity shares (of Rs. 100 each 20,000)
Dividend paid Rs. 1, 00,000
P/E Ratio 10
Return Investment 15%
The firm is expected to maintain its rate on return on fresh investments. Also find out what should be the E/P ratio
at which the dividend policy will have no effect on the value of the share? Will your decision change if the P/E
ratio is 7.25 and interest of 10 %?
Solution
= = Rs. 10
P/E Ratio = 10
Ke = = = 0.10
DPS = = = Rs. 5
The value of the share as per Walter’s Model is
Rs. 12.5
Dividend Payout =
= 60%
r> Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend policy. In this case,
the optional dividend policy for the firm would be to pay zero dividend and the Market Price would be:
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Dividend Payout =
P= Rs. 200
So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead of 10 then the Ke
=1=0.138 and in this case Ke > r and the MP of the share is 7.25.
P = 5+5.435
P= Rs. 75.62
Criticism of Walter’s Model

The following are some of the important criticisms against Walter model:
• Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable.
• There is no possibility of constant return. Return may increase or decrease, depending upon the business situation.
Hence, it is applicable.
• According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the
business.
Gordon’s Model
Myron Gorden suggests one of the popular models which assume that dividend policy of a firm affects its value,
and it is based on the following important assumptions:
• The firm is an all equity firm
• The firm has no external finance
• Cost of capital and return are constant
• The firm has perpectual life
• There are no taxes.
• Constant relation ratio (g=br)
• Cost of capital is greater than growth rate (Ke >br)
Gordon’s model can be proved with the help of the following formula:
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Where,
P = Price of a share
E = Earnings per share
1–b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke= Capitalization rat
br Growth rate = rate of return on investment of an all equity firm.
Example 3: Raja company earns a rate of 12% on its total investment of Rs. 6, 00,000 in assets. It has 6, 00,000
outstanding common shares at Rs. 10 per share. Discount rate of the firm is 10% and it has a policy of retaining
40% of the earnings. Determine the price of its share using Gordon’s Model. What shall happen to the price of the
share if the company has payout of 60% (or) 20%?
Solution
According to Gordon’s Model, the price of a share is
Given:
E = 12% of Rs. 10=Rs. 1.20
r = 12%=0.12
Ke = 10%=0.10
t = 10%=0.10
b = 40%=0.40
Put the values in formula
P = Rs. 13.85
If the firm follows a policy of 60% payout then b= 20% = 0.20
The price is
= 0.05
r= 4%= 0.04, D= 25% of 10 = 2.50
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= Rs. 41.67
If payout ratio is 50%, D= 50% of 10= Rs. 5

r= 12%= 0.12, D= 50% of 10 = Rs. 5
= Rs. 83.33
r= 8%= 0.08, D= 50% of 10 = Rs. 5
= Rs. 69.42
r= 4%= 0.04, D= 50% of 10 = Rs. 5
= Rs. 55.58
If payout ratio is 20%, the value of b= 0.60 and the price of the share is
108/JNU OLE
= Rs 120
Criticism of Gordon’s
Model Gordon’s model consists of the following important criticisms:
• Gordon model assumes that there is no debt and equity finance used by the firm. It is not applicable to present
day business.
• Ke and r cannot be constant in the real practice. According to Gordon’s model, there is no tax paid by the firm.
It is not practically applicable.
9.3 Factors Determining Dividend Policy

Following are the factors that determine dividend policy:
Profitable position of the firm
Dividend decision depends on the profitable position of the business concern. When the firm earns more profit, they
can distribute more dividends to the shareholders.
Uncertainty of future income

Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular
income, the firm should maintain regular dividend policy.
Legal constrains
The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly,
Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.
Liquidity position
Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can
provide cash dividend otherwise, they have to pay stock dividend.
Sources of finance
If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for retained
earnings.
Growth rate of the firm

High growth rate implies that the firm can distribute more dividend to its shareholders.
Tax policy
Tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives,
the company pays more dividend.
Capital market conditions

Due to the capital market conditions, dividend policy may be affected. If the capital is prefect, it leads to improve
the higher dividend.
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9.4 Types of Dividend Policy

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position. On the basis of
the dividend declaration by the firm, the dividend policy may be classified under the following types:
• Regular dividend policy
• Stable dividend policy
• Irregular dividend policy
• No dividend policy.
Regular dividend policy

Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small
investors, retired persons and others.
Stable dividend policy

Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend
policy consists of the following three important forms:
• Constant dividend per share
• Constant payout ratio
• Stable rupee dividend plus extra dividend.
Irregular dividend policy

When the companies are facing constraints of earnings and unsuccessful business operation, they may follow
irregular dividend policy. It is one of the temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.
No Dividend policy
Sometimes the company may follow no dividend policy because of its unfavourable working capital position of the
amount required for future growth of the concerns.
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Summary
• The financial manager must take careful decisions on how the profit should be distributed among
shareholders.
• Dividend refers to the business concerns net profits distributed among the shareholders.
• If the dividend is paid in the form of cash to the shareholders, it is called cash dividend..
• Stock dividend is paid in the form of the company stock due to raising of more finance..
• Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash
dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond
or notes.
• Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional
circumstance. This type of dividend is not published in India.
• Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines
the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings
for financing its long term growth.
• According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it
does not affect the value of the firm.
• Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between
dividend policy and value of the firm.
References
• Dividend Decisions, [Pdf] Available at: <http://220.227.161.86/19347sm_sfm_finalnew_cp4.pdf> [Accessed
30 May 2013].
• DIVIDEND POLICY, [Pdf] Available at: <http://www.morevalue.com/i-reader/ftp/Ch17.PDF> [Accessed 30
May 2013].
• 2012. Dividend Policy, [Video online] Available at: <http://www.youtube.com/watch?v=o972MF8rOKM>
• 2009. CF1. Dividend Policy, [Video online] Available at: <http://www.youtube.com/watch?v=3WURHeTxoRE>
• Khan, M. Y., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education
Recommended Reading
• Gallagher and Andrew, Financial Management; Principles and Practice. Freeload Press, Inc.
• Brigham, E. F. & Ehrhardt, M. C., 2011. Financial Management: Theory and Practice, 13th ed., Cengage
Learning.
• Apte, 2006. International Financial Management, 4th ed., Tata McGraw-Hill Education.
111/JNU OLE
Self Assessment
1. According to professors Soloman, Modigliani and Miller, ___________ has no effect on the share price of the
company.
a. dividend policy
b. financial policy
c. economic policy
d. market policy
2. Prof. James E. Walter argues that the dividend policy almost always affects the ________ of the firm
a. profit
b. value
c. income
d. revenue
3. Gordon model assumes that there is no debt and _______ finance used by the firm.
a. liability
b. arrears
c. equity
d. stock
4. Dividend policy depends upon the nature of the firm, type of ____________ and profitable position
a. shareholder
b. business
c. market
d. organisation

a. Dividend payable at the usual rate is called as regular dividend policy.
b. Dividend payable at the usual rate is called as stable dividend policy.
c. Dividend payable at the usual rate is called as irregular dividend policy.
d. Dividend payable at the usual rate is called as no dividend policy.
6. When the companies are facing constraints of earnings and unsuccessful business operation, they may follow
_______________ dividend policy.
a. regular
b. irregular
c. stable
d. unstable
7. Sometimes the company may follow ___________ policy because of its unfavourable working capital position
of the amount required for future growth of the concerns
a. regular
b. irrgualr
c. no dividend
d. stable
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8. Which of the dividend policy means payment of certain minimum amount of dividend regularly?
a. irregular
b. unstable
c. no dividend
d. Stable
9. ___________ growth rate implies that the firm can distribute more dividend to its shareholders
a. High
b. Low
c. Stable
d. Balance
10. _____________ position of the firms leads to easy payments of dividend.

a. Liquidity
b. Equity
c. Stable
d. Debt
113/JNU OLE
Application I
Trial Balance The accountant Mr. P.R. Vaidya of XYZ Ltd. is not an efficient one, and he has prepared the
trial balance as under-
ABC Ltd. appoints you as a senior accountant and it is your responsibility to correct the trial balance.
Debit Credit
Particulars
Rs. Rs.
Capital 1,556
Drawings 564
Land 741
Sales 2,756
Due from customers 530
Purchases 1,268
Purchase Returns 264
Loan from Bank 250
Creditors 528
Office Expenses 784
Bank 142
Bill Payable 100
Salaries 598
Opening Stock 264
Rent and Tax 465
Sales Returns 98
5,454 5,454
Solution:
Corrected Trial Balance
Particulars
Sr. No L.F.NO. (Rs.) Amount (Rs.) Amount
1. Capital 1,556
2. Drawings 564
3. Land 741
4. Sales 2,756
5. Due from Customers 530
6. Purchases 1,268
7. Purchase Returns 264
8. Loan from Bank 250
9. Creditors 528
10. Office Expenses 784
11. Bank 142
12. Bills Payable 100
13. Salaries 598
14. Opening Stock 264
15. Rent and Tax 465
16. Sales Returns 98
Total of Trial balance 5,454 5,454
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Application II
Ratio Analysis
The following are the profit and loss account of ABC Enterprises for the year ended on 31st March 2008.
Profit and loss Account
Particulars Rs. Particulars Rs.

To Opening Stock 4,40,000 By Sales 18,00,000
To Purchases 12,00,000 By Closing Stock 6,00,000
To Wages 3,20,000
To Gross Profit 4,40,000
24,00,000 24,00,000
To Administrative Expenses 80,000 By Gross profit 4,40,000
To Selling & Distributive Exp. 90,000 Interest 80,000
To Non-operating Exp. 80,000 By Profit on sale of investment 80,000
To Net Profit 3,50,000
6,00,000 6,00,000
Rate of tax is 40%.

You need to calculate:
• Gross Profit Ratio
• Net profit Ratio
115/JNU OLE
Application III
The following figures have been extracted from the records of Neha Fancy Stores, a proprietorship
concern, as on 31st December 2008
Particulars Rs.
Furniture 15,000
Proprietor’s Capital Account 54,000
Cash in Hand 3,000
Opening Stock 50,000
Fixed Deposit 1,34,000
Drawings 5,000
Provision For Bad Debts 3,000
Cash at Bank 10,000
Purchases 3,00,000
Salaries 19,000
Carriage Inwards 41,000
Insurance 6,000
Rent 22,000
Sundry Debtors 60,000
Sales 6,00,000
Advertisements 10,000
Postage & Telephones 3,400
Bad Debts 2,000
Printing &Stationery 9,000
General Charges 15,000
Sundry Creditors 30,000
Deposits From Customers 6,000
Prepare Trading, Profit and Loss Account and Balance Sheet after taking into consideration the following
additional information:
1. The closing stock as on 31st December 2008 was Rs. 10,000
2. A sale of Rs. 25,000made for cash had been entered to the purchases account
3. Salary of Rs. 3,000 paid to an employee had been entered in the Cash bank as Rs. 1,500
4. Charge depreciation of furniture at 10%
5. Furniture had been sold during the year for Rs. 10,000 and the proceeds had been credited to furniture Account.
The written down value of furniture sold was Rs. 5,000
6. A sum of Rs. 10,000 received from a party which had purchased some stocks belonging to a separate business
of the proprietor was credited to sundry debtors Account
7. The proceeds of a matured fixed deposit amounting to Rs. 25,500had been credited to the Fixed Deposit Account.
The original amount of the deposit was Rs. 20,000
8. There was an outstanding liability for Rent of Rs. 2,000
9. An advance of Rs. 1,000 paid to AN EMPLOYEE AGAINST HIS SALARY OF January 2007 had been debited
to salary account
10. The office premises were sub-let from December 2008 for a monthly rental of Rs. 1000 but the rent for December
has not yet been received
116/JNU OLE
Bibliography
References
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299&substcode=19&stcode=10> [Accessed 27 May 2013].
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<http://www.youtube.com/watch?v=vpJszYCLH3o> [Accessed 27 May 2013].
• Prof. Ahmed, M., 2010. Time Value of Money, [Video online] Available at: <http://www.youtube.com/
watch?v=CnRJ6Jypsj4> [Accessed 27 May 2013].
• Introduction to Bond Valuation, [Pdf] Available at: <http://www.arts.uwaterloo.ca/~kvetzal/AFM271/bond.
pdf> [Accessed 28 May 2013].
• Bond Valuation, [Online] Available at: <http://www.prenhall.com/divisions/bp/app/cfl/BV/BondValuation.html>
• Jonathan, B., 2010. Financial Management, Pearson Education India.
• Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron’s Educational Series.
• Prof. Ahmed, M., 2012. Bond Valuation, [Video online] Available at: <http://www.youtube.com/
watch?v=tid0RVUmY3M>[Accessed 28 May 2013].
• 2012. Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.
com/watch?v=pfhjJ00IuW4>[Accessed 28 May 2013].
• Reddy, G. S., 2008. Financial Management. Mumbai: Himalaya publications.
• Defining the cost of capital, [Pdf] Available at: <http://www.iassa.co.za/articles/002_may1973_02.pdf> [Accessed
28 May 2013].
• The cost of capital, [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/
Summary%20-%20Cost%20of%20Capital.pdf> [Accessed 28 May 2013].
• 2009. Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/
watch?v=AGaoDQgicVg>[Accessed 28 May 2013].
• 2013. Cost of Capital Part 1, [Video online] Available at: <http://www.youtube.com/
watch?v=suqQ3huNtrk>[Accessed 28 May 2013].
Education.
117/JNU OLE
• Capital Structure and Leverage, [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20Chpts%20

13%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf> [Accessed 29
May 2013].
• Capital Structure and Leverage, [Pdf] Available at: <http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>
• 2011. Capital Structure class I, [Video online] Available at: <http://www.youtube.com/watch?v=lqHuYKGByIQ>
• 2011. Capital Structure class II, [Video online] Available at: <http://www.youtube.com/watch?v=6vtuNgGxbso>
• Peterson, P. P. & Fabozzi, J. F., 2004. Capital Budgeting: Theory and Practice, John Wiley & Sons.
• Periasamy, P., 2010. A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global
Media.
• WHAT IS CAPITAL BUDGETING? [Pdf] available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/
CapitalBudget/CapitalBudgetingTraining.pdf> [Accessed 16 May 2013].
• CHAPTER 29 Capital Budgeting [Pdf] available at: <http://mfile.narotama.ac.id/files/Accounting%20
&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20
(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf> [Accessed 16 May 2013].
• Irfanullah, A., 2011. CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online]
Available at: <http://www.youtube.com/watch?v=qfzQwqLdXH0> [Accessed 16 May 2013].
• Capital Budgeting [Video online] Available at: <http://www.youtube.com/watch?v=qGgVGUcBqAg> [Accessed
16 May 2013].
• Mathur, S. B., 2002. Working Capital Management and Control Principles & Practice. New Delhi. New Age
International (P) Limited.
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chapter1.pdf> [Accessed 29 May 2013].
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• 2010. Whats working capital? [Video online] Available at: <http://www.youtube.com/watch?v=AnwK1BQxJVw>
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jacobs3e_sample_ch11.pdf> [Accessed 29 May 2013].
• Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.
• Axst ̃er, S.,2006. Inventory control, 2nd ed., Springer.
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30 May 2013].
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118/JNU OLE
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Education
Recommended Reading
• Brigham, E. F., 2010. Financial Management: Theory & Practice. 13th ed., South-Western College Pub.
• Shim, J. K., 2008. Financial Management (Barron’s Business Library). 3rd ed., Barron’s Educational Series.
• Brigham, E. F., 2009. Fundamentals of Financial Management. 12th ed., South-Western College Pub.
• Drake, P. P., 2009. Foundations and Applications of the Time Value of Money. Wiley
• Benninga, S., 2006. Principles of Finance with Excel. Oxford University Press, USA
• Block, S., 2008. Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in
card. 13th ed., McGraw-Hill/Irwin.
• Staff, I., 2005. Stocks, Bonds, Bills, and Inflation 2005 Yearbook. Ibbotson Associates
• Agarwal, O.P., 2009. International Financial Management. Global Media.
• Satyaprasad, B.G. & Raghu, G.A. 2010. Advanced Financial Management.Global Media.
• Pratt , S. P., 2010. Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.
• Tennent, J., 2008. Guide to Financial Management, Profile Books/The Economist.
• Avadhani, V.A., 2010. International Financial Management. Global Media.
• Brigham,E. F., 2003. Fundamentals of Financial Management. 10th ed., South-Western College Pub.
• Brigham, E. F. & Ehrhardt, M. C., 2008. Financial management: theory and practice, 12th ed., Cengage
Learning.
• Gitman, 2007. Principles Of Managerial Finance, 11th ed., Pearson Education India.
• Jacobs & Davina, F., 2006. A Reviews of Capital Budgeting Practices, International Monetary Fund.
• Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge
University Press.
• Baker, K. H. & English, P., 2011. Capital Budgeting Valuation: Financial Analysis for Today’s Investment
Projects, John Wiley & Sons
• Preve, L. & Sarria-Allende, V., 2010. Working Capital Management. Oxford University Press.
• Kumar, A. V., 2001. Working Capital Management. Northern Book Centre.
• Sagner, J., 2010. Essentials of Working Capital Management. John Wiley & Sons.
• Muller, M., 2003. Essentials of Inventory Management. AMACOM.
• Mullar, M., 2011. Essentials of Inventory Management, 2nd ed., AMACOM Books.
• Viale, J. D. & Christopher, C., 1996. Inventory Management: From Warehouse to Distribution Center, Course
Technology / Cengage Learning.
• Gallagher and Andrew, Financial Management; Principles and Practice. Freeload Press, Inc.
• Brigham, E. F. & Ehrhardt, M. C., 2011. Financial Management: Theory and Practice, 13th ed., Cengage
Learning.
• Apte, 2006. International Financial Management, 4th ed., Tata McGraw-Hill Education.
119/JNU OLE
Self Assessment Answers

Chapter I
1. b
2. c
3. a
4. c
5. b
6. c
7. b
8. c
9. d
10. a
Chapter II
1. a
2. b
3. c
4. a
5. a
6. a
7. d
8. a
9. c
10. c
Chapter III
1. a
2. c
3. b
4. a
5. c
6. a
7. b
8. c
9. a
10. a
Chapter IV
1. b
2. a
3. c
4. a
5. b
6. a
7. a
8. a
9. b
10. c
120/JNU OLE
Chapter V
1. c
2. b
3. b
4. b
5. a
6. d
7. a
8. b
9. a
10. b
Chapter VI
1. b
2. a
3. c
4. d
5. a
6. b
7. d
8. c
9. d
10. a
Chapter VII
1. b
2. c
3. d
4. b
5. a
6. b
7. c
8. a
9. d
10. a
Chapter VIII
1. c
2. d
3. a
4. a
5. b
6. c
7. d
8. a
9. c
10. b
121/JNU OLE
Chapter IX
1. a
2. b
3. c
4. d
5. a
6. b
7. c
8. d
9. d
10. a
122/JNU OLE

Financial Management

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Financial Management

This book is a part of the course by Jaipur National University, Jaipur.

The content in the book is copyright of JNU. All rights reserved.

II. List of Figures...........................................................VI

III. List of Tables......................................................... VII

V. Application. ............................................................ 114

VI. Bibliography.......................................................... 117

VII. Answers to Self Assessment............................... 120

Chapter VIII . ............................................................................................................................................ 89

Chapter IX................................................................................................................................................. 100

• explain the concept of financial management

• elucidate profit maximisation

• explicate financial planning

• explain the concept of management planning

• enlist various financial decisions

• explain the concept of capitalisations

• identify the types of financial decisions- investment, financing and dividend

• understand the process, benefits, factors of financial planning

• describe the merits and demerits of cost and earnings theory

1.1 Introduction to Financial Management

Financial management is concerned with three key activities namely:

Traditional approach to financial management

Modern approach to financial management

1.2 Goals of Financial Management

Limitations of Profit Maximisation

1.3 Financial Decisions

Investment Financing Dividend

Fig. 1.1 Financial decisions

Explicit cost Implicit cost

Table 1.1 Cost dimension

1.4 Interface between Finance and Other Business Functions

Relationship to HR (Human Resource)

1.5 Financial Planning

Process of financial planning

Factors affecting financial plan

1.6.1 Cost Theory

Merits of cost approach Demerits of cost approach

Table 1.2 Merits and demerits of cost approach

1.6.2 Earnings Theory

Merits of earnings theory Demerits of earnings theory

Table 1.3 Merits and demerits of earnings theory

Remedies for over-capitalisation

3. Which of the following statements is false?

6. Match the following

9. Financing decisions relate to the acquisition of funds at the _________ cost.

• explain the concept of time, value and money

• explain simple and compound interest

• elucidate variable compounding periods

• explain the compound value of series of cash flows

• elucidate the concept of doubling period and sinking fund factor

• explicate the concept of present value

• understand the concept of loan amortisation

• identify shorter discounting periods

2.1 Introduction to Time Value of Money

Concept - Time value of money

Rationale of time preference for money

2.2 Simple Interest

Solution: SI = Po (I) (n) = Rs.1, 00,000 X 0.07 X 5 years= Rs. 35,000

Solution: FVn = Po + Po (I) (n) OR SI + Po

2.3.1 Compounding Value of a Single Amount

2.3.2 Variable Compounding Periods

= Rs. 40,000 [*1.86] = Rs. 72,240

= Rs. 50, 00,000 [CVIF 2%..........16y]

Calculation of Compound Growth Rate