Assignment 2

Learning Diary
Group Members

MBA/11/2736 H.G.S Alagiyawanna

MBA/11/2742 P.S.S.H Ariyasinghe
MBA/11/2758 E.A.K Daminda
MBA/11/2817 T.G.R Kailashinie
MBA/11/2883 G. Samdinesh
MBA/11/2922 B. D. N. Wijesinghe

Course : MBA 507: Managerial Finance

Instructor : Mr. Mario Fonseka
Term : July – September 2011

Postgraduate Institute of Management

University of Sri Jayewardenepura
Session 1 – Learning Outcomes
The role and function of accounting and finance
● Accounting is a process of identifying measuring and communicating economic
information to permit informed judgments and decisions by users of the information. It is
considered as the language of business. Accounting has two main branches as Financial
Accounting and Management Accounting and Financial Accounting can be further divide
in to financial accounting and financial management.
● Financial Accounting deals with identifying, recording classifying summarizing and of
financial transactions and reporting the results to the interested parties. Whereas financial
management is about creating shareholder value through prudent management of
financial resources. It deals with the decisions regarding the sourcing and employment of
organization’s funds.
● Management accounting helps organization to make strategic and operational decisions
through cost accounting and various other management accounting tools and techniques.
● The process of preparation of source documents, recording of the transactions to the day
books and to the ledger, and preparation of trial balance and financial statements are
known as book keeping. The total process including book keeping and interpretation of
financial statements is known as Financial accounting
● Out of nine accounting concepts two accounting concepts were discussed.

Entity Concept
The business and its owner(s) are two separate existence entity. Therefore financial
transactions should be recorded in business point of view.
Examples; Recording of Owners Capital as a liability
Money Measurement Concept
All transactions of the business are recorded in terms of money. It provides a common
unit of measurement
Examples: Organization’s human capital, value of brands are not recorded in the financial
statements.

Session 2 – Learning Outcomes

The role and function of accounting and finance and Understanding Basic
Financial Statements.
Out of the nine concepts two concepts were discussed during the first session and other seven
concepts were discussed in the second session as follows.

Going Concern Concept

Accounting records the business transactions and prepares financial statements under the
assumption that it will continue in operational existence for a foreseeable future. That is
Financial statements should be prepared on a going concern basis unless management either
intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so.

Examples:
Possible losses from the closure of business will not be anticipated in the accounts.
Prepayments, depreciation provisions may be carried forward in the expectation of proper
matching against the revenues of future periods.
Fixed assets are recorded at historical cost.

Accrual Concept
Under this concept, Revenues are recognized when they are earned, but not when cash is
received. Expenses are recognized as they are incurred, but not when cash is paid. And the net
income for the period is determined by subtracting expenses incurred from revenues earned.

Example:
Expenses incurred but not yet paid in current period should be treated as accrual/accrued
expenses under current liabilities
Expenses incurred in the following period but paid for in advance should be treated as
prepayment expenses under current asset
Depreciation should be charged as part of the cost of a fixed asset consumed during the period of
use.

Historical Concept
According to this concept, Assets should be shown on the balance sheet at the cost of purchase
instead of market value

Example:
The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes
all expenditure made to prepare the asset for its intended use. It included the invoice price of the
assets, freight charges etc.

Prudence Concept
Under this concept Revenues, Expenses, Assets and Liabilities are identified at the worst
scenario.

Examples:
Stock valuation sticks to rule of the lower of cost and net realizable value.
The provision for doubtful debts should be made.

Consistency Concept
This concept outlines the need of companies to choose the most suitable accounting methods and
treatments, and to consistently apply them in future periods. Changes are permitted only when
the new method is considered better and can reflect the true and fair view of the financial
position of the company better. The change and its effect on profits should be disclosed in the
financial statements

Materiality Concept
Immaterial amounts may be aggregated with the amounts of a similar nature or function and
need not be presented separately. The Materiality depends on the size and nature of the item.

Examples:
Small payments such as postage, stationery and cleaning expenses should not be disclosed
separately. They should be grouped together as sundry expenses.
The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to
the profit and loss account as revenue expenditures, although they can last for more than one
accounting period.

Objectivity Concept
The accounting information should be free from bias and capable of independent verification and
it should not be subjective. The information should be based upon verifiable evidence such as
invoices or contracts.
Example

The recognition of revenue should be based on verifiable evidence such as the delivery of goods
or the issue of invoices.

● Result of consumption of a resource for a particular purpose is known as Cost. And cost
can be divided to have two types of cost behaviors, as Variable cost and fixed cost.
Variable cost is the cost that increased with the increase of activity level or production units, and
fixed cost is the cost that is not increasing with units produced or activity level. Thus fixed cost
per unit decreases as the output or the activity level increases.

● Preparation of trading account reveals the gross profit earned for a period. Gross profit or
loss is the difference between net turnover earned and the cost incurred in for the sales
made. The profit and loss statement reveals the net profit or loss earned after deducting
all the selling and distribution, administration and financial expenses.

● Balance sheet is a snap shot of an entity’s financial position as at a particular date.

Balance sheet can be prepared in both vertical format and horizontal format. Balance
sheet provides information regarding the entity’s fixed assets, current assets, stated
capital, Reserves, long term and short term liabilities and the working capital as at a
particular date. The information in the balance sheet and the income statement reveals lot
of information regarding the organization. Financial position shows the overall health of
the organization as at a particular date. Liquidity information helps management to plan it
working capital requirements well. Gearing information is helpful to ascertain the ability
of the organization to serve it debts. Balance sheet aids organization in calculating the net
 worth of the organization. It also helps organization to take Strategic decisions like
upgrading, replacing, purchasing of the fixed assets, as well as operational decisions like
areas to manage costs and wastages, Determining credit periods of customers etc..

Determination of capital adequacy and over trading rations are also possible with the financial
statement information.

● There is some information that the balance sheet can not provide such as some intangible
assets like Brands, human capital are not shown in the balance sheet. it only provides
information as at a particular date, thus the information on the organization’s future is not
adequately provided. And due to the pressure situation the management can manipulate
accounting information, so that it gives better picture of the organization, even the reality
could be different.
Learning Diary - Lecture 3

Analysis and Interpretation of Financial Statements

Introduction
Analysis and interpretation of financial statements enables to make sense about great relations on
information in found in the the P/L and balance sheet by analyzing and interpreting information
found in the P/L and balance Sheet. This analysis is not performed by book keepers but is
normally performed by financial accounts. In terms on analysis and interpreting the following
three tools are being used. They are namely Horizontal analysis, Vertical analysis and ratio
analysis

Horizontal analysis
Horizontal analysis is about the time dimension and is also called trend analysis. This enables to
identify what kind of trends exists in the financial data. For an E.g. We could look at % growth
of sales over the years and identify the trend. This could be how much of increase or decrease of
growth has taken place during the period. This could be applied for Net assets, Loans Etc

Vertical Analysis
Vertical analysis is about analysis of financial information with a particular year and is also
called common size analysis. In this common size analysis we look at the items in the P/L as a %
of the value of total sales considering sales as 100%. Common size analysis is performed for the
balance sheet for each meaningful category that could considered. The % weight of each item in
each category is compared against the total value of each category. The mainly considered
categories are fixed Assets, current Assets, Current Liabilities, Long-term Liabilities,
Shareholders finds etc. This enables you to compare companies of different size and scale
because all are brought to a same common base.

Ratio Analysis
Liquidity Ratios
Liquidity ratios provide information about an organization’s ability to meet its short term financial
obligations. Thus it conveys the financial health of the organization. Liquidity can be measured in
different ways.

1) Current Ratio

Current Ratio is calculated from the below formula.

Current Ratio = Current Assets/Current Liabilities
If the current ratio is less than 1, it tells that the organization has liquidity issues. If it is greater than 1 or
equal 1, it is considered that current assets can satisfy the company’s short term obligations. So this ratios,
implies the company’s ability to meet its short term liabilities with its current assets.
Typically the value for the current ratio varies by firm and industry. And short-term creditors would
prefer higher the ratio as it would reduce their risk. And Shareholder would prefer to have a lower current
ratio, as it indicates that most of the assets are being used for the growth of the business.

2) Quick Asset Ratio (Acid Test Ratio)

Generally inventories are difficult to liquidate. In quick ratio analysis it removes this part from the current
assets and follows the same formula.
Quick Ratio=Current Assets-Inventories/Current liabilities
So the quick ratio indicates the assets which have high liquidity. Eg: Cash, Notes receivable, accounts
receivable.

3) Cash Ratio

The cash ratio is the most conservative liquidity ratio. I include only the most liquid assets such cash and
cash equivalent. So it indicates the ability of the firm to pay off its current liabilities at an immediate
demand.
Cash Ratio=(Cash + Marketable Securities)/ Current Liabilities

Asset Management / Efficiency Ratios

Asset management ratios (also called as turnover ratios or efficiency ratios) helps analyzing how
effectively and efficiency a business is managing its assets to produce sales.

It is important to know that whether the right amount has invested in each of your asset accounts. It is
done by comparing a firm to with other companies in the same industry and see how much others have
invested in asset accounts.

Inventory Turnover Ratio

The inventory turnover ratio is one of the most important asset management or asset turnover ratios. it is
more important for companies that sell physical products. It is calculated as follows:

In simple terms it tells how long it takes for your stocks to be sold.

(Average Stock / Cost of Sales) X 360 (or 365)

Days' Sales Outstanding (average collection) or Debtors turnover

The Days' Sales in Inventory ratio shows how many days, on average, it takes to sell inventory. The usual
rule is that the lower the DSI is, the better, since it is better to have inventory sell quickly than to have it
sit on your shelves. Therefore the ideal Days' Sales Outstanding is considered as 30 days.

(Average Debtors/ Credit Sales) X 360

Fixed Assets Turnover

The fixed asset turnover ratio looks at how efficiently the company uses its fixed assets, like plant and
equipment, to generate sales. In other words how many times 'sale', as compared to the fixed assets.

If a company can't use its fixed assets to generate sales, it is losing money because it has those fixed
assets. Property, plant, and equipment is expensive to buy and maintain. In order to be effective and
efficient, those assets must be used as well as possible to generate sales.

The fixed asset turnover ratio is an important asset management ratio because it helps the business owner
measure that efficiency.

(Turn Over/ Fixed Assets)

(Total) Assets Turnover

The total asset turnover ratio shows how efficiently your assets generate sales. If there is a problem with
inventory, receivables, working capital, or fixed assets, it will show up in the total asset turnover ratio.

The higher the total asset turnover ratio, the better and the more efficiently a company's use of asset base
to generate sales.

Sales/Total Assets

Debt Management and Gearing Ratios

1. Debt Ratio

This ratio indicates what proportion of debt a company has relative to its assets.

Long Term Debt (LTL) / Total Assets

The measure gives an idea to the leverage of the company along with the potential risks the
company faces in terms of its debt-load. That is it reveals the companies capability of settling its debts
over its assets.
 1. Debt to Equity Ratio
Debt * 100 Equity *100
Total capital Total capital

The debt-to-equity ratio is a measure of the relationship between the capital contributed by
outside parties’ to the organization (creditors) and the capital contributed by shareholders. It also
shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in
the event of liquidation.

In other words, it says about how the company has balanced their capital. If debt portion is more
than 50%, the company is said to be a high geared or high leveraged company and if it is less
than 50% the company is said to be a low geared or low leveraged company.

3. Times Interest Earned to Interest Cover

The times interest earned ratio is another debt ratio that measures the long-term solvency of a business. It
measures how well a company can meet its interest expense obligations.

Operating Profit / Interest

For example, if a company owes interest on its long-term loans or mortgages, the times interest earned
ratio can measure how easily the company can come up with the money to pay the interest on that debt.
Thus higher the figure of the ratio better for the company.
If the company is performing well, it is better off with the debt, because otherwise the company have to
pay high dividends for its equity shareholders. That is because the dividend percentage is normally higher
than the borrowing or the interest percentage and thus it is beneficial for the company.

Profitability Ratios

1. Gross Profit margin and Gross Profit Mark-Up

GP Margin = GP/ Turnover * 100

GP Markup = GP / Cost of Sales *100

Gross margin is the difference between revenue and cost before accounting for certain other costs. Thus
the gross profit margin reveals the percentage coming back as gross profit out of the revenue made.
Gross Profit Markup is the percentage the company has raised its price as the gross profit out of its cost
of sales.

2. Operating Profit Margin

Operating Profit / Turnover *100

This ratio reveals the percentage of sales recovering as the operating profit. Operating profit is the profit
earned from a firm's normal core business operations. This value does not include any profit earned from
the firm's investments and the effects of interest and taxes. It is also known as the Earnings before interest
and taxes (EBIT).

3. Net Profit Margin

Net Profit / Turnover *100

Net Profit margin reveals the percentage of profit before tax retained within the company out of
the companies’ turnover. The Net profit figure should be a lower figure than to the figures of
Gross profit margin and Operating profit margin of the company.

4. Return on Total Assets

Net Profit Before Tax (NPBT) / Total Assets * 100

This ratio measures the generation of earnings by the company’s assets and answer the question
of whether the earnings of the assets are enough or not. Thus the ratio is considered as an indicator
of how effectively a company is using its assets to generate its net earnings.

5.Return on Net Assets

Net Profit Before Tax (NPBT) / Net Assets * 100

Here the Net Assets are equal to the net worth of the business which means net assets equals to the equity
share holder funds. Thus this ratio measures the net earnings earned before tax as a percentage to the
equity shareholder funds. Higher the ratio better would be for the equity shareholders which suggest the
return they get is high compared to their investment.

6. Return on Capital Employed

Operating Profit (EBIT) / Capital Employed * 100

Here the capital employed includes both capitals employed by debt and equity. ROCE compares
earnings with capital invested in the company and measures the return earned on the capital
employed. It measures the management’s efficiency in generating profits from resource
available. Here the operating profit has been taken to avoid the effects of cost of financing
choices.
7. Return on Equity (ROE)

Profit Attributable for Ordinary shareholders / Equity (Share Holders Funds)

This ratio measures the return for ordinary share holders on the capital they have employed. It
measures a firm's efficiency at generating profits from every unit of shareholders' equity (also
known as net assets or assets minus external liabilities).

8. Expenses to Sales Ratio

Expenses / Sales * 100%

Expense ratios indicate the relationship of various expenses to net sales. The operating expenses
to sales ratio give an indication of the efficiency of the cost structure of your business.

Debt Management and Gearing Ratios

1. Debt Ratio

This ratio indicates what proportion of debt a company has relative to its assets.

Long Term Debt (LTL) / Total Assets

The measure gives an idea to the leverage of the company along with the potential risks the
company faces in terms of its debt-load. That is it reveals the companies capability of settling its debts
over its assets.

1. Debt to Equity Ratio

Debt * 100 : Equity *100
Total capital Total capital

The debt-to-equity ratio is a measure of the relationship between the capital contributed by
outside parties’ to the organization (creditors) and the capital contributed by shareholders. It also
shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in
the event of liquidation.

In other words, it says about how the company has balanced their capital. If debt portion is more
than 50%, the company is said to be a high geared or high leveraged company and if it is less
than 50% the company is said to be a low geared or low leveraged company.

3. Times Interest Earned to Interest Cover

The times interest earned ratio is another debt ratio that measures the long-term solvency of a business. It
measures how well a company can meet its interest expense obligations.
Operating Profit / Interest
For example, if a company owes interest on its long-term loans or mortgages, the times interest earned
ratio can measure how easily the company can come up with the money to pay the interest on that debt.
Thus higher the figure of the ratio better for the company.
If the company is performing well, it is better off with the debt, because otherwise the company have to
pay high dividends for its equity shareholders. That is because the dividend percentage is normally higher
than the borrowing or the interest percentage and thus it is beneficial for the company.

Profitability Ratios

1. Gross Profit margin and Gross Profit Mark-Up

GP Margin = GP/ Turnover * 100

GP Markup = GP / Cost of Sales *100

Gross margin is the difference between revenue and cost before accounting for certain other costs. Thus
the gross profit margin reveals the percentage coming back as gross profit out of the revenue made.
Gross Profit Markup is the percentage the company has raised its price as the gross profit out of its cost
of sales.

2. Operating Profit Margin

Operating Profit / Turnover *100

This ratio reveals the percentage of sales recovering as the operating profit. Operating profit is the profit
earned from a firm's normal core business operations. This value does not include any profit earned from
the firm's investments and the effects of interest and taxes. It is also known as the Earnings before interest
and taxes (EBIT).

3. Net Profit Margin

Net Profit / Turnover *100

Net Profit margin reveals the percentage of profit before tax retained within the company out of
the companies’ turnover. The Net profit figure should be a lower figure than to the figures of
Gross profit margin and Operating profit margin of the company.

4. Return on Total Assets

Net Profit Before Tax (NPBT) / Total Assets * 100

This ratio measures the generation of earnings by the company’s assets and answer the question
of whether the earnings of the assets are enough or not. Thus the ratio is considered as an indicator
of how effectively a company is using its assets to generate its net earnings.

5. Return on Net Assets

Net Profit Before Tax (NPBT) / Net Assets * 100

Here the Net Assets are equal to the net worth of the business which means net assets equals to the equity
share holder funds. Thus this ratio measures the net earnings earned before tax as a percentage to the
equity shareholder funds. Higher the ratio better would be for the equity shareholders which suggest the
return they get is high compared to their investment.

6. Return on Capital Employed

Operating Profit (EBIT) / Capital Employed * 100

Here the capital employed includes both capitals employed by debt and equity. ROCE compares
earnings with capital invested in the company and measures the return earned on the capital
employed. It measures the management’s efficiency in generating profits from resource
available. Here the operating profit has been taken to avoid the effects of cost of financing
choices.

7. Return on Equity (ROE)

Profit Attributable for Ordinary shareholders / Equity (Share Holders Funds)

This ratio measures the return for ordinary share holders on the capital they have employed. It
measures a firm's efficiency at generating profits from every unit of shareholders' equity (also
known as net assets or assets minus external liabilities).

8. Expenses to Sales Ratio

Expenses / Sales * 100%

Expense ratios indicate the relationship of various expenses to net sales. The operating expenses
to sales ratio give an indication of the efficiency of the cost structure of your business.

Market / Investor Ratios

Market ratios measure investor response to owning a company's stock and also the cost of
issuing stock. These are concerned with the return on investment for shareholders, and with the
relationship between return and the value of an investment in company’s shares.

Dividend Cover
This shows how many times over the profits could have paid the dividend.
Earnings per Share
Dividend per Share

Dividend Yield
A financial ratio that shows how much a company pays out in dividends each year relative to its
share price. In the absence of any capital gains, the dividend yield is the return on investment for
a stock.
Annual dividend per share
Price per share

Earnings per Share

The portion of company’s profit allocated to each outstanding share of common stock. Earnings
per share serves as an indicator of a company’s profitability.
Net earnings
Number of Shares

Price-Earnings ratio
A valuation ratio of a company’s current share price compared to its per-share earnings.
Market value per Share
Earnings per Share

Dividend Payout Ratio

The percentage of earnings paid to shareholders in dividends.
Yearly dividend per Share
Earnings per Share

Earnings Yield
The earnings per share for the most recent 12 month period divided by the current market price
per share.
Earnings per Share
Market price per Share

Session 4 – Learning Outcomes

Cash Flow Statements

Cash flow statement is a financial statement that reflects inflow of revenues and outflow of
expenses resulting from operating, investing, and financing activities of a firm during a
specific period of time.
Cash flow statements and projections express a business's results or plans in terms of cash in and
out of the business, without adjusting for accrued revenues and expenses. The cash flow
statement doesn't show whether the business will be profitable, but it does show the cash position
of the business at any given point in time by measuring revenue against outlays.
Cash flow is determined by looking at three components by which cash enters and leaves a
company: core operations, investing and financing,

Operations
Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company’s products or
services.

Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes
from investing are a “cash out” item, because cash is used to buy new equipment, buildings or
short-term assets such as marketable securities. However, when a company divests of an asset,
the transaction is considered “cash in” for calculating cash from investing.

Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash
from financing are “cash in” when capital is raised, and they’re “cash out” when dividends are
paid. Thus a company issue a bond to the public, the company receives cash financing; however,
when interest is paid bondholders, the company is reducing its cash.

Cash versus profit

The ideal position for any business is to be profitable and cash generative. But it’s much harder
to survive without cash than profit.

That said profitability is a measure of success. Profit – from Latin meaning ‘to make progress’ –
reflects development, increased wealth and status. Profit is a want, cash is a need.

A business that isn’t profitable can survive for long periods of time with adequate cash flow.
Some business owners are content simply paying the bills and taking a healthy salary. Profit isn’t
necessarily an objective.

Even if profit is an objective, insufficient cash flow stumps growth and undermines a business’s
ability to survive. In addition, a cash generative business has increased potential to be profitable
because the disciplines necessary to ensure healthy cash flow will invariably promote
profitability.

Working capital management

A managerial accounting strategy focusing on maintaining efficient levels of both components of
working capital, current assets and current liabilities, in respect to each other. Working capital
management ensures a company has sufficient cash flow in order to meet its short-term debt
obligations and operating expenses.

Implementing an effective working capital management system is an excellent way for many
companies to improve their earnings. The two main aspects of working capital management are
ratio analysis and management of individual components of working capital.

A few key performance ratios of a working capital management system are the working capital
ratio, inventory turnover and the collection ratio. Ratio analysis will lead management to identify
areas of focus such as inventory management, cash management, accounts receivable and
payable management.
Session 5 – Learning Outcomes
Sources of Finance & Cost of Capital

The objective of this session is to study the sources of funding for an organization and the
cost of it’s capital obtained from each type of source of funding. Funding is mainly
performed from mainly two types namely equity and debt capital. Equity capital id what is
what you get from the owners. These consists of capital and reserves which are the
undistributed profits. the company is to pay dividends for these types of funding. Debt
capital is when the organization gets funds via a long term liability such as a loan and the
organization is to pay interest on the debt capital invested.

Equity Capital

Equity capital could be obtained in the following forms

IPO - This could be obtain by an IPO by issuing shares to general public. An organization will
issue shared to the general public the first time in an IPO

Rights issues - This is when the organization performs a re-issue of shares.The shares will be
initially provided to the existing shareholders at a better rate than the market price of the share.
Therefore the existing shareholders could benefit from this. This will be a cheaper way to raise
funds for the organization

Bonus Issue -
Organizations do this when they make profits and don't intend to pay dividends. Therefore they
issue shares than paying off dividends and the shareholder funds increase due to this This is
called capitalisation of profits. These shares will be issued free for the existing share holders as
per the ratios stated by the Organization. The double entry for this would be debit reserves and
credit share capital.

Institutional Investors
Institutional investors are non-bank persons or organizations that trade securities in large enough
share quantities or rupee amounts that they qualify for preferential treatment and lower
commissions. Institutional investors face fewer protective regulations because it is assumed that
they are more knowledgeable and better able to protect themselves.
Insurance Companies:
Insurance companies earn investment profits on "float". Float, or available reserve, is the amount
of money on hand at any given moment that an insurer has collected in insurance premiums but
has not paid out in claims. Insurers start investing insurance premiums as soon as they are
collected and continue to earn interest or other income on them until claims are paid out.

Pension Fund:
A pension fund is any plan, fund, or scheme which provides retirement income. Pension funds
are important shareholders of listed and private companies. They are especially important to the
stock market where large institutional investors dominate.

Unit Trusts:
Unit trusts are open-ended investments; therefore the underlying value of the assets is always
directly represented by the total number of units issued multiplied by the unit price less the
transaction or management fee charged and any other associated costs. Each fund has a specified
investment objective to determine the management aims and limitations.

Venture Capital
Money provided by investors to startup firms and small businesses with perceived long-term
growth potential. This is a very important source of funding for startups that do not have access
to capital markets. It typically entails high risk for the investor, but it has the potential for above-
average returns.

Venture capital is a financial capital provided to high risk, early-stage, high-potential, 'growth'
start-up companies. The venture capital fund makes money by owning equity in the companies it
invests in, which usually have a novel technology or business model in high technology
industries, such as biotechnology, IT, software, etc.

If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which

he works, turnaround or revitalise a company, venture capital could help do this.Obtaining
venture capital is substantially different from raising debt or a loan from a lender. Lenders have a
legal right to interest on a loan and repayment of the capital, irrespective of the success or failure
of a business .

Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the
venture capitalist's return is dependent on the growth and profitability of the business. This return
is generally earned when the venture capitalist "exits" by selling its shareholding when the
business is sold to another owner.
Note: All venture capital is private equity, but not all private equity is venture capital.
Debt Capital

Debt capital is the capital that a business raises by taking out a loan. Normally the money is borrowed on
long term basis to repay at a future date. Creditors are given a fixed annual percentage on their loan and
not entitled for dividends. Because of this, creditors are not considered as part owners of the business.
And other important thing is, debt capital is ranked higher than the equity capital. Because of this, interest
on debt capital must be paid before any dividends are paid to company’s share holders.

There are different ways that a company provide funds to the company as debt capital.
•Term Loans:
Loans taken from a bank for a specific amount that has a specified repayment schedule with a
interest rate.
•Equipment Loans & Leases
When company wants to buy assets they can finance through equipment loans and leases. Eg:
Vehicle Lease
•Debentures
Debentures allowed the company to bypass the bank and get the money from depositors directly.
Only reputed companies can do this. Because people will not buy debenture if the company is
not a reputed one.
•Mortgages
Company can mortgage its assets like building, land etc. in order increase its capital.
•Sell & Lease Back
A sale and leaseback allows a company to raise money from the sale of assets, while retaining
use of them
•Preference Shares
Capital stock which provides a specific dividend which is paid before any dividend before being
paid to ordinary share holders.

Cost of Equity – Listed Companies

The cost of equity of listed companies is assessed in following ways
(1) Gordon’s Dividend Growth Model
ke = (d1 / p0) + g
(ke = Cost (k) of equity (e),d1 = Dividends in Y1,p0 = Price of Share in Y0,g = Growth rate in
dividends)
(2) Capital Asset Pricing Model (CAPM

ke = Rf + (Rm – Rf) b
(Rf = Risk Free Return, Rm = Market Return ,b = Beeta factor (risk factor))
Cost of equity – Unlisted Companies
A risk premium for business risk and financial risk should be added to a arrive to the cost of
equity of listed companies
Cost of Debt Capital
Bank Loan / Overdraft kd = I (1 - t)
Debentures – Irredeemable kd = [ I (1 - t) ] / MP
Debentures – Redeemable kd = IRR of Debenture
Preference Shares – Irredeemable kp = DPS / MPS
Preference Shares – Redeemable kp = IRR of Preference Share
Weighted Average Cost of Capital
If a company is financed using both equity and debt the following formula is used.
WACC = keVe + kdVd + kpVp
Ve + Vd + Vp

Session 6 – Learning Outcomes

Budgetary Controls

A budget can be defined as a formal statement that allocates financial resources in order to
achieve pre determined objectives within a given period of time. If budget is to be productive, it
should be compared with the actual results and corrective measures should be taken for any
deviations. Thus budget can be regarded as a controlling measure.
Characteristics of a good budget include participation, Comprehensiveness, Standards,
flexibility, feedback and analyses of costs and revenues.
When a budget is prepared all parties concerned relevant to the budget should be present. It
should be comprehensive with no missing items relevant to the budget. Budget helps to set
standards for its employees. Here the company should make sure that they set realistic and
challenging budgets that would capture the employees’ motivation of need for achievement,
otherwise unrealistic or over ambitious budgets will de motivate employees. Budget should be
flexible so that it could be changed where necessary. In order to monitor and assess the
effectiveness and efficiency of the budget, the actual results should be measured with the
budgeted figures. This is called the feedback. Analysis of costs and revenues on the basis of
product lines departments etc will aid in having a detailed analysis on the costs and revenues.
Thus the uses of the budgets can be summarized as follows. It can be regarded as a planning and
controlling tool, it helps organization to make the coordination and communication between
departments by allocating resources directing all the departments towards common objectives.
Further the budgets will help in motivating the employees by setting challenging but achievable
goals, and through which their performance can be evaluated.
There are two types of budgetary controls, feedback control and feed forward control. Feedback
controls involved measuring the actual output results with the standards set at the budgeting and
making necessary changes accordingly. Feed forward controls are the controls put in place with
the budget setting process. The budget setting process can be evaluated by monitoring,
predicting, regulating and standard setting process and then making the necessary adjustments to
the inputs and process as necessary.

There are both advantages and disadvantages of budgetary controls. Among the advantages are
promotion of coordination and communication, clarity of each person’s area of responsibility,
acting as an employee motivation process and performance evaluation tool, improvement of
allocation of scarce resources, use of management by exception principle and also it helps
managers to think about the organization’s future.
There are some disadvantages of budgetary controls. Interdepartmental conflicts due to resource
allocation problems can occur. People in the organization can take the budget as a pressure
device of the management and thus they might be inefficient as a result. Difficulties in goal
congruence can occur due to differences in personal, departmental and corporate objectives or
goals. When the organization sets unrealistic unattainable budgets, employees might get de-
motivated. Further, wastage of resources can occur due to over allocation of resources by the
management.
There are various types of budgets, namely cash budget, expenditure budget, revenue budgets,
capital expenditure budgets and master budget which include the budgeted profit and loss
account. Cash budget helps the organization in analyzing the cash inflows and outflows due for a
particular period of time and thus the management can plan for short fall or excesses in cash flow
position. In order to develop the budgets two main approaches are used, as Zero Based
Budgeting (ZBB) and Activity Based Budgeting. Zero based budgeting is where management
does not look at the historical data and prepare the budget based on the future requirements.
Activity based budgeting is about A method of budgeting in which the activities that incur costs
in every functional area of an organization are recorded and their relationships are defined and
analyzed. Activities are then tied to strategic goals, after which the costs of the activities needed
are used to create the budget. Activity based budgeting stands in contrast to traditional, cost-
based budgeting practices in which a prior period's budget is simply adjusted to account for
inflation or revenue growth. As such, ABB provides opportunities to align activities with
objectives streamline costs and improve business practices.
Limitations of Investment Appraisal Techniques (last two slides)
Even though the above discussed investment appraisal techniques have its benefits it has its
limitations too.
In determining the expected cash flows, the rate used to discount the cash flows has a significant
impact on the final outcome, thus incase of using an inaccurate discounting rate might result in a
wrong output or a decision being taken. Further, the project evaluation has been made difficult
because of the cost of capital which will not be fixed and may vary with the time.
Investment appraisal only takes financial factors in to consideration and there are non- financial
factors that should be taken in to account when evaluating an investment project for decision
making. Such significant non financial information include the organizational objectives,
external costs and benefits arising from the project, whether organization has the relevant
capabilities and competencies to undertake the project, The level of risk of the project, economic
state of the country and other alternative investing options available to the organization.
Thus in making a decision to select a viable project to be invest, both financial and non financial
factors should be taken in to account.
Session 10 – Learning Outcomes