FINANCIAL MANAGEMENT

(MCM3C11)

STUDY MATERIAL

III SEMESTER

M.Com.
(2019 Admission)

UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
CALICUT UNIVERSITY P.O.
MALAPPURAM - 673 635, KERALA

190611
School of Distance Education
University of Calicut
Study Material
III Semester Core Course
M.Com. (2019 Admission)
MCM3C11: Financial Management

Prepared by:
Module 1
Sri. RAJAN
Assistant Professor of Commerce
School of Distance Education
University of Calicut.

Module 2, 3, 4 & 5
Dr. P.V. BASHEER AHAMMED
Head, DCMS
SAFI Institute of Advanced Study
Vazhayoor 673 633.

Scrutinized by:
Sri. MUHAMMED FAISAL T.
Assistant Professor of Commerce
EMEA College of Arts & Science, Kondotty.

DISCLAIMER

"The author(s) shall be solely responsible

for the content and views
expressed in this book".
 CONTENTS

Unit - 1 Foundation of finance 1-16

Unit - 2 Sources of finance 17-37

Unit - 3 Working capital management- part – I 38-51

Unit - 4 Working capital management – part - II 52-88

Unit - 5 Management securities 89-108

Unit - 6 Inventory management 109-131

Unit - 7 Receivables management 132-149

Unit - 8 Cost of capital 150-183

Unit - 9 Capital structure part – I 184-200

Unit - 10 Capital structure part – II 201-228

Unit - 11 Dividend policy 229-264

 MCM3C11: Financial Management

UNIT 1
FOUNDATION OF FINANCE

Learning Objectives:
After reading this unit you should be able to understand the
following:
 Meaning, evolution and importance of finance.
 Finance function.
 Approaches to finance function.
 Objectives of financial management.
 Financial decisions- investment, financing and dividend
decisions.
 Functions of financial manager.
MEANING OF FINANCIAL MANAGEMENT
Finance is the lifeblood of a business firm. The health of
every business concern mainly depends on the efficient
handling of finance functions. In simple term, Financial
Management may be defined as the management of the finance
or funds of a business unit in order to realize the objective of
the firm in an efficient manner. It is broadly concerned with
the mobilization and use of funds by a business firm. Hence,
finance function refers to the process of procurement of funds
and the judicious use of such funds with a view to realize the
objective function of a firm more effectively.
FINANCE FUNCTION
Finance function is the most important of all business
functions. It remains a focus of all activities. It is not possible
to substitute or eliminate this function because the business
will close down in the absence of finance. The need for money
is continuous. It starts with the setting up of an enterprise and
remains at all times. The development and expansion of

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business rather needs more commitment for funds. The funds

will have to be raised from various sources. The sources will
be selected in relation to the implications attached with them.
The receiving of money is not enough, its utilization is more
important. The money once received will have to be returned
also. If its use is proper, then its return will be easy otherwise it
will create difficulties for repayment. The management should
have an idea of using the money profitably. It may be easy to
raise funds but it may be difficult to repay them. The inflows
and out flows of funds should be properly matched.
APPROACHES TO FINANCE FUNCTION
A number of approaches are associated with finance
function but for the sake of convenience, various approaches
are divided in to two broad categories:
1. The traditional Approach
2. The modern Approach
The Traditional Approach: The traditional approach to
the finance function relates to the initial stages of its evolution
during 1920s and 1930s when the term ‗corporation finance‘
was used to describe what is known in the academic world
today as the ‗financial management‘. According to this
approach, the scope, of finance function was confined to only
procurement of funds needed by a business on most suitable
terms.
The Modern Approach: The modern approach views
finance function in broader sense. It includes both raising of
funds as well as their effective utilization under the purview of
finance. The finance function does not stop only by finding out
sources of raising enough funds; their proper utilization is also
to be considered. The cost of raising funds and the return from
their use should be compared. The funds raised should be able
to give more returns than the costs involved in procuring them.

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The utilization of funds requires decision making. Finance has

to be considered as an integral part of overall management. So
finance functions, according to this approach, covers financial
planning, raising of funds, allocation of funds, financial
control etc.
AIMS OF FINANCE FUNCTION
The primary aim of finance function is to arrange as
much funds for the business as are required from time to time.
This function has the following aims:
Acquiring sufficient funds: The main aim of finance function
is to assess the financial needs of an enterprise and then
finding out suitable sources for raising them. If funds are
needed for longer periods, then long term sources like share
capital, debentures, term loans etc. may be explored.
Proper utilization of funds: The effective utilization of funds
is more important than raising funds. The returns from their
use should be more than their cost. No fund should remain
idle.
Increasing profitability: To increase profitability, sufficient
funds will have to be invested. A proper control should also be
exercised.
Maximizing firm’s value: it is generally said that a concern‘s
value is linked with its profitability. Besides profit, the type of
sources used for raising funds, the costs of funds, the
condition of money market, the demand for products etc. are
some other considerations which influence a firm‘s value.
IMPORTANCE OF FINANCIAL MANAGEMENT
Finance is the life blood and nerve centre of a business,
just as circulation of blood is essential in the human body for
maintaining life, finance is very essential to smooth running of
the business. It has been rightly termed as universal lubricant

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which keeps the enterprise dynamic. No business, whether big,

medium or small can be started without an adequate amount
of finance. Right from the beginning, i.e conceiving an idea
to business, finance is needed to promote or establish the
business, acquire fixed assets, make investigation such as
market surveys, etc., develop product, keep men and machine
at work and encourage management to make progress and
create values. Even an existing concern may require further
finance for making improvements of expanding the business.
Thus, the importance of finance cannot be over emphasized
and the subject of business finance has become utmost
important both to the academicians and practicing managers.
Financial management is applicable to every type of
organization, irrespective of its size.
MODERN FINANCIAL DECISIONS/FUNCTIONS
With the increase in the complexities involved in the
modern business decision situations, the role of finance
manager has completely changed and become more
complicated. His area of functions has extended, in addition to
procurement of funds, to their effective and efficient
utilization also. While exercising these functions, he is to
keep in view the objectives the firm as well as the expectations
of the suppliers of such funds. The following are the salient
features of modern approach to financial management:
 Modern financial decisions are more analytical and
quantitative. Application of mathematical and statistical
tools has made the financial decision making more
scientific.
 The scope of finance has extended to the effective
utilization of funds in the light of appropriate decisions
criteria.
 The management or insiders‘ point of view has become

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more dominant.
Ezra Solomon has defined the scope of modern
approach to financial management as follows:
 What is the total funds requirement of the firm?
 What specific assets are to be acquired?
 What should be the pattern of financing of assets?
Investment Decision: Investment refers to the commitment of
funds to various assets. The assets may be financial assets such
as shares, debentures, bonds, term deposits, etc., or fixed assets
like land and buildings, plant and machinery, furniture, etc.,
and current assets like inventory, book debts, marketable
securities, cash and bank balances, etc. accordingly the
investment decisions may be classified in to three types as
follows:
 Securities or Portfolio investment: Investing firm‘s funds in
financial assets;
 Capital Expenditure Decision: Investing funds in fixed
assets; and
 Working Capital Management: Planning for the current
assets and their financing.
Generally investment decision relates to the selection
of best investment proposals and commitment of funds to such
proposals in order to maximize the firm‘s earnings and
thereby maximize the value of the firm. The Finance Manager
is to evaluate different alternatives of investment based on
their risk-return measures for choosing the best investment
proposal and estimates the investment levels in the different
fixed assets and current assets. He is to fix priorities, measure
risk and uncertainty in the investment proposal, and allocate or
ration out funds.
Financing Decisions: It is the one of the important

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functions of a Finance Manager. It relates to the

procurement of funds for the firm‘s investment proposals and
its working capital requirements. Under this function the
Finance Manager is to involve in the following decisions:
 Capitalization Decision: Under this decision the Finance
Manager is to estimate the funds requirements for fixed
assets and working capital purposes and also to identify the
different sources available to raise such funds.
 Cost of Capital: While identifying the different sources. He
is to assess the individual cost such as cost of debt, cost of
equity, etc., and also the overall cost of capital of the
financing mix. This will enable him to identify the best
financing mix.
 Capital Structures Planning: Capital Structures refers to the
debt-equity mix in the total capital employed. Depending
upon the advantages and disadvantages of the debt
component, the Finance Manager should determine the
degree or level of gearing i.e., adding debt into the capital
structure.
Dividend Decision: It is the decision relating to the
distributions of earnings of the firm among the shareholders
and the amount to be retained by the firm for future internal
use. The Finance Manager should determine the right dividend
and retention policies in order maximize the objective function
of the firm. Number of factors like availability of profitable
investment proposals, tax position of shareholders, the trend
of earnings, etc., influence the dividend policy of a business
enterprise. The Finance Manager should take in to
consideration all those factors that influence the dividend
policy and design an appropriate policy to the firm.
OBJECTIVES OF FINANCIAL MANAGEMENT
What business firm are seeking to achieve and therefore,

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what financial decisions should seek to promote is a vital

question to financial management. In order to make the
financial decisions more rational the firms must have an
objective. It is generally agreed that the financial objective
should be the maximization. However, there are different
views on objective of financial management and some of them
are discussed below.
Profit Maximization: Traditionally a business firm is a
profit seeking economic institution and profit it used as a
common and unique measurement of efficiency. Hence, profit
maximization may be assumed to be a rational and
appropriate financial objective for the following reasons:
 It is rational measure. A business venture is an economic
activity and it attempts to maximize the utility value to the
owners. Utility can be easily measured through profits.
Hence, profit maximization may be considered as a rational
financial objective.
 Profit maximization enables economic natural selection and
only profit maxi- misers can survive at the end.
 It also maximizes socio-economic welfare.
 It will act as an incentive to face competition and be a
motive force to attain growth.
Wealth Maximization: wealth may be defined as the
net present worth or value of the stream of net benefits
obtained from a course of action. Prof. Ezra Solomon has
suggested that adoption of wealth maximization is the best
criterion for the financial decisions-making. The gross present
value of a course of action is equal to capitalized value of the
flow of future benefits, discounted at a rate that reflects the
certainty. Net present worth is the difference between the gross
present worth and the amount of investment required to
achieve the flow of benefits. Any financial decisions, which

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results in positive net worth is preferable and shall be taken up.

In other words, if the course of action results in negative net
worth it shall be rejected. In short maximization of wealth or
net present worth may be taken as the operating objective for
financial management.
Algebraically, net present worth (wealth) may be
defined as follows:

Where B1, B2, ........................ Bn represent the stream of

expected benefits from a course of action, C is the cost of
such action, and k is the appropriate risk adjusted discount
rate. W is the wealth, which is the excess of the gross present
worth of the stream of benefits over the initial cost or
investment. The firm should adopt a course of action when it
generates positive wealth or which maximizes the wealth of
the owners of the firm.
The objective of wealth maximization eliminates all the
limitations of profit maximization objective.
Market Value Maximization: The wealth maximization
objective is consistent with the objective of maximizing the
owners‘ economic welfare, which in turn maximizes the utility
of their consumption over time. It also enables the owners to
adjust their flow of funds in such a way as to optimize their
consumption. The wealth of the owners of a company is
reflected by the market value of the company‘s shares. Hence,
it is implied that the financial objective of a firm should be to
maximize the market value of its shares. The market price of
the shares reflects the value of the shares and it, in turn
depends on the quality of financial decisions taken by the

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management. Hence, the market price of the share serves as an

indicator of a firm‘s management efficiency and its progress.
A firm‘s market price is influenced by a number of internal
and external factors. In practice, innumerable factors influence
the price of a particular company‘s share and these factors
change very frequently and also vary from share to share.
BASIC CONSIDERATIONS
While taking financial decisions, the finance manager
should take in to consideration their two important dimensions,
viz., liquidity – profitability, and risk – return trade off. These
two dimensions are like two sides of a coin. The concern for
one will automatically affect the other. For example, the
concern for liquidity will affect the profitability position and
the concern for profitability will affect the liquidity position of
the firm. Similarly the concern for return will affect the risk
component and the risk will affect the return perspective of the
decisions.
Risk – Return Trade Off
Risk and return are two inherent of each and every
financial decision. They are positively correlated. It means that
a high return is normally associated with a high risk and low
return with low risk. From the financial angle they are the
relevant aspects of financial decisions. In the case of
investment decisions the relevant dimensions are risk and
return. A highly risky project will normally yield very high
return. Otherwise the project will not qualify for selection. And
a project with low risk will normally yield low return. In the
case of financing decisions, the relevant dimensions are cost
and return. The cost is the inverse of return and therefore, the
basic dimensions are return and risk. A tradeoff between risk
and return needs to be carefully analyzed in order to achieve
the objective function i.e., value maximization.

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Liquidity and Profitability Trade Off

Liquidity and Profitability are inherent of every financial
decision. The finance manager confronts with the problems of
liquidity and profitability choices while taking financial
decisions. Hence, he has to strike a balance between these two.
Liquidity refers to the ability of the firm to meet its short as
well long – term obligations. Liquidity positions determine the
solvency status of the firm. Profitability refers to the ability to
the earn more profits. The profitability goal requires that the
funds of the firm are so used as to yield high returns. Liquidity
and profitability are closely related and negatively correlated.
High liquidity will decrease profitability and high profitability
with minimum cash reserve may endanger liquidity. For
example, liberal credit policy may boost up sales and profits,
but the liquidity will decrease.
Liquidity and risk have direct relationship. High risk may
affect the liquidity of the firm. And high return will increase
the profitability. Liquidity and profitability, and risk and return
are interrelated and inherent qualities of each and every
financial decision. While taking financial decisions, the
finance manager is to strike balances between the two
associated items.
FUNCTIONS OF A FINANCE MANAGER
Now, let us see what the functions of a finance
manager are. The increasing pace of industrialization, rise of
large scale units, innovations in information processing
techniques, intense competition etc. have increased the need
for financial planning and control. In the present business
context, the role of a finance manager is to perform the
following functions:
1) Financial forecasting and planning: A finance manager
has to estimate the financial needs of a business, for

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purchasing fixed assets and meeting working capital

needs.
2) Acquisition of funds: There are number of sources
available for supplying funds, like shares, debentures,
financial institutions, commercial banks etc. The
selection of an appropriate source is a difficult task to
be exercised by the finance manager.
3. Investment of funds: The funds so raised should be
used in the best possible way. The cost of acquiring
them and the returns from their investment should be
compared. The technique of capital budgeting may be
helpful in selecting a project.
4. Helping in valuation decisions: A finance manager is
supposed to assist the management in making valuation
when mergers and consolidations take place.
5. Maintain proper liquidity: Every concern is required to
maintain some liquidity for meeting day-to-day needs.
A finance manager is required to determine the need for
liquid assets and then arrange liquid assets in such a
way that there is no scarcity of funds.
Time value of money
The simple concept of time value of money is that the
value of the money received today is more than the value of
same amount of money received after a certain period. In
other words, money received in the future is not as valuable
as money received today, the sooner one receives money,
the better it is. Taking the case of a rational human being,
given the option to receive a fixed amount of money at
either of the two time periods, he will prefer to receive it at
the earliest. If you are given choice of receiving `1000 today
or after one year, you will definitely opt to receive today
than after one year. This is because you value the current
receipt of money higher than future receipt of money after

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one year. The phenomenon is referred to as time preference

for money.
Reason for time preference of money
1. The future is always and involves risks, an individual can
never be certain of getting cash inflow in future and hence
he will like to receive money today instead of waiting for
the future.
2. People generally prefer to use their money for satisfying
their present needs in buying more food, or clothes or
another car, than deferring them for future, the present
needs are considered urgent as compared to future needs.
Moreover, there may also be a fear in one‘s mind that he
may not be able to use the money in future for fear of
illness or death.
3. Money has time value because of the opportunities
available to invest money received at earlier dates at some
interest or otherwise to enhance future earnings. For
example, if you have `100 today, you can put it in your
bank account and earn interest. After one year the interest
would be `8 (taking rate of interest at 8% p.a) and you
would have ` 108 at the end of the year. So, if you have a
choice between ` 100 today or after one year, it is the
same as a choice between ` 108 next year or ` 100 next
year. Any rational person would prefer the large amount.
Techniques of time value of money
There are two techniques for adjusting the time of
money
1. Compounding technique
2. Discounting or Present Value Technique
Compounding technique
The time preference for money encourages a person

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to receive the money at present instead of waiting for future.

But he may like to wait if he is duly compensated for the
waiting time by way of ensuring more money in future. For
example, a person being offered Rs. 100 today may wait for
a year if he is ensured of Rs. 110 at the end of one year
(taking his preference for an interest of 10% p.a). the cash
flow of Rs. 100 at present or Rs. 110 after one year will be
the same for this person.
The future value of at the end of period I can be
calculated by a simple formula given below:

Where, V1 = Future value at the period 1

V0 = Value of money
i = interest rate
Taking the example given above,
V1 = 100 (1+10)
= 110.
In the above example given above, we have only
considered the future value after one period. But we may
need to calculate future values over longer periods. For
example, what will be the value of Rs. 100 after two years
at 10% p.a. rate of interest neither the principal sum of Rs.
100 nor interest is withdrawn at the end of one year? The
answer to this question lies in understanding that the second
years interest will be paid on both original principal and the
interest earned at the end of first year. This paying of
interest is called compounding.
The value of money after 2 years can be calculated as :
V2 = V1 (1+i)

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= 110 (1+10)
= Rs. 121
Similarly, the value of Rs. 100 after 3 years shall be:
V3 = V2 (1+i)
= 121 (1+.10)
= 133.10
And in the same manner we could calculate the time
value of money after any number of years. We can
generalize that the future value of a current sum of money at
period n is :

So, after 10 years the value of Rs.100 at 10% rate of interest

shall be:
V10 = 100(1+.10)
= 100 (1.10)
= Rs. 259.4
Compound factor tables
We have noted above that as n becomes large, the
calculation of (1+i) becomes difficult.
Compound Factor Tables
Period Percent (i)
(n) 2 4 6 8 10
1 1.020 1.040 1.060 1.080 1.100
2 1.040 1.082 1.124 1.166 1.210
3 1.061 1.125 1.191 1.260 1.331
4 1.082 1.170 1.262 1.360 1.464

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5 1.104 1.217 1.338 1.469 1.611

6 1.126 1.265 1.419 1.587 1.772
7 1.149 1.316 1.504 1.714 1.949
8 1.172 1.369 1.594 1.851 2.144
9 1.195 1.423 1.689 1.999 2.358
10 1.219 1.480 1.791 2.159 2.594

Discounting or Present value technique

Present value is the exact opposite of compound or
future value. While future value shows how much a sum of
money becomes at some future period, present value shows
what the value is today of some future sum of money. In
compound or future value approach the money invested
today appreciates because the compound interest is added to
the principal. The present value of money to be received on
future date will be less because we have lost the opportunity
of investing it at some interest. Thus, the present value of
money to be received in future will always be less. It is for
this reason that the present value technique is called
discounting.
Suppose, for example, you have an opportunity to
buy a debenture today and you will get back Rs. 1000 after
one year. What will you be willing to pay for the debenture
today if your time preference for money is 10% per annum?
We can calculate the present value of Rs. 1000 to be
received after one year at 10% time preference rate as
below:
Vn = V0 (1+i)
Where Vn = future value n period
And V0 = Present value

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= Rs. 909
Present value or discount factor table
Discount Factor Table
Period (n) 2 4 6 10
1 .980 .962 .943 .926 .909
2 .961 .925 .890 .857 .826
3 .942 .889 .840 .794 .751
4 .924 .855 .792 .735 .683
5 .906 .822 .747 .681 .621
6 .888 .790 .705 .630 .564
7 .871 .760 .665 .583 .513
8 .853 .731 .627 .540 .467
9 .837 .703 .592 .500 .424
10 .820 .676 .558 .463 .386

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UNIT- 2
SOURCES OF FINANCE

Learning Objectives:
 Various sources of raising short-term and long-term funds
 Kinds of ownership securities and their evaluation.
 Kinds of creditors ship securities.
 Internal financing
 Loan financing.
 Specialized financial institutions
 Innovative sources of finance.
 Focus on long-term sources of finance.
INTRODUCTION
Having learnt the meaning and importance of financial
management in the last unit, we shall examine the various
sources from which the required finance can be raised.
In our present day economy, finance is defined as the
provision of money at the time when it is required. Every
enterprise, whether big, medium or small, needs finance to
carry on its operations and to achieve its targets.
Capital required for a business can be classified under
two main categories, viz.,
(i) Fixed Capital, and
(ii) Working capital.
Every business needs funds for two purposes-for its
establishment and to carry out its day-to-day operations. Long-
term funds are required to create production facilities through

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purchases of fixed assets such as plant, machinery, land,

building, furniture, etc. Investments in these assets represent
that part of firm's capital which is blocked on a permanent or
fixed basis and is called fixed capital. Funds are also needed
for short-term purposes for the purchase of raw materials,
payment of wages and other day-to-day expenses, etc. These
funds are known as working capital.
The various sources of raising long-term funds include
issue of shares, debentures, ploughing back of profits and loans
from financial institutions, etc. The short-term requirements of
funds can be met from commercial banks, trade credit,
installment credit, advances, factoring or receivable credit,
accruals, deferred incomes, and commercial paper, etc. The
various sources of finance have been classified in many
ways, such as:
1. According to Period
(a) Short-term sources, viz; bank credit, customer advances,
trade credit, factoring, accruals, commercial paper, etc.
(b) Medium-term sources, viz; Issue of preference shares,
debentures, and bank loans, public deposits/fixed deposits, etc.
(c) Long term sources, viz; issue of shares, debentures,
ploughing back of profits, loans from specialized financial
institutions, etc
2. According to Ownership
(a) Owned capital, viz., share capital, retained earnings,
profits and surpluses, etc.
(b) Borrowed capital such as debentures, bonds, public
deposits, loans, etc.
3. According to Source of Finance
(a) Internal sources such as ploughing back of profits,
retained earnings, profits, surpluses and depreciation funds,
etc.

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(b) External sources, viz; shares, debentures, public deposits,

loans, etc.
4. According to Mode of Financing
(a) Security financing or External Financing; i.e., financing
through raising of corporate securities such as shares,
debentures etc.
(b) Internal financing, i.e., financing through retained
earnings, capitalisation of profits and depreciation of funds,
etc.
(c) Loan financing through raising of long-term and short
term loans.
For the sake of convenience, let us discuss the various
sources of finance according to the mode of financing in this
unit.
I SECURITY FINANCING
Corporate securities can be classified under two categories;
(a) Ownership securities or capital stock
(b) Creditorship securities or Debt Capital

A. OWNERSHIP SECURITIES
The term 'ownership securities', also known as 'capital

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stock' represents shares.

Shares are the most universal form of raising long-term
funds from the market.
The various kinds of shares are discussed as follows:
1. Equity Shares
Equity shares, also known as ordinary shares or common
shares represent the owners' capital in a company. The holders
of these shares are the real owners of the company. They have
a control over the working of the company. Equity
shareholders are paid dividend after paying it to the preference
shareholders. They may be paid a higher rate of dividend or
they may not get anything.
2. Preference Shares
As the name suggests, these shares have certain
preferences as compared to other types of shares. These
shares are given two preferences. There is a preference for
payment of dividend at a fixed rate, whenever the company has
distributable profits. The second preference for these shares is
the repayment of capital at the time of liquidation of the
company.
B. Creditorship Securities
The term 'creditorship securities', also known as 'debt
capital', represents debentures and bonds. They occupy a very
significant place in the financial plan of the company. A
debenture or a bond is a certificate issued by a company under
its seal acknowledging a debt due by it to its holders.
DEBENTURES OR BONDS
A debenture is an acknowledgement of a debt.
According to Thomas Evelyn. "A debenture is a document
under the company's seal which provides for the payment of a
principal sum and interest thereon at regular intervals. A

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debenture holder is a creditor of the company.

Types of Debentures
The debentures are of the following types:
(a) Simple, Naked or Unsecured Debentures. These
debentures are not given any security on assets. They have no
priority as compared to other creditors.
(b) Secured or Mortgaged Debentures. These debentures
are given security on assets of the company. In case of default
in the payment of interest or principal amount, debenture
holders can sell the assets in order to satisfy their claims.
(c) Bearer Debentures. These debentures are easily
transferable. They are just like negotiable instruments. The
debentures are handed over to the purchaser without any
registration deed.
(d) Registered Debentures. As compared to bearer
debentures which are transferred by mere delivery, registered
debentures require a procedure to be followed for their
transfer. Both the transferer and the transferee are expected to
sign a transfer voucher. The form is sent to the company
along with the registration fees. The name of the purchaser is
entered in the register.
(e) Redeemable Debentures. These debentures are to be
redeemed on the expiry of a certain period. The interest on
the debentures is paid periodically but the principal amount is
returned after a fixed period. The time for redeeming the
debentures is fixed at the time of their issue.
(f) Irredeemable Debentures. Such debentures are not
redeemable during the life time of the company. They are
payable either on the winding up of the company or at the time
of any default on the part of the company.
(g) Convertible Debentures. Sometimes convertible

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debentures are issued by a company and the debenture holders

are given an option to exchange the debentures into equity
shares after the lapse of a specified period.
Convertible debentures may be either 'Fully Convertible
Debentures' (FCD's) or 'Partly Convertible Debentures'
(PCD's) with or without buy back facilities. Fully convertible
debentures are converted into equity shares after the lapse of a
certain period specified at the time of issue of such debentures.
PCD's are converted into equity shares partly and the balance
is not converted into equity.
(h) Zero Interest Bonds/ Debentures. Zero interest bond
is an instrument recently introduced in India by some
companies. It is usually a convertible debenture which yields
no interest.
(i) Zero Coupon Bonds. Another instrument which has
recently become popular in India is the zero coupon bond
(ZCB). Zero coupon bond does not carry any interest but it is
sold by the issuing company at deep discount from its eventual
maturity value. The difference between the issue price and the
maturity value represents the gain or interest earned by its
investor.
(j) First Debentures and Second Debentures. From the
view of priority in the payment of interest and repayment of
the principal amount, the debentures may be either first
debentures or second debentures, etc.
(k) Guaranteed Debentures. These are debentures or
bonds on which the payment of interest and principal is
guaranteed by third parties, generally, banks and Government
etc.
(l) Collateral Debentures. A company may issue
debentures in favour of a lender of money, generally the banks
and financial institutions, as a collateral, i.e subsidiary or

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secondary, security for a loan raised by it.

(m) Other Innovative Debt Instruments. In the fast
changing capital market scenario, the corporate sector has
devised many other innovative debt instruments for raising
funds from the market. Some of these are outlined below.
(i) Equity Warrants. The equity warrant is a paper
attached to a bond or preferred stock that gives the holder
the right to buy a fixed number of company's equity shares at
a predetermined price at a future date.
(ii) Secured Premium Notes (SPNs). The secured
premium note is a tradable instrument with detachable warrant
against which the holder gets equity shares after a fixed period
of time.
(iii) Callable Bond. A callable bond is a bond that can be
called in and paid off by the issuer at a price, called the 'call
price', stipulated in the bond contract.
(iv) Floating/Variable or Adjustable Rate Bonds. The
rate of interest payable on these bonds varies periodically
depending upon the market rate of interest payable on the gilt
edged securities.
(v) Deep Discount Bonds (DDBs). The deep discount
bond does not carry any interest but it is sold by the issuer
company at a deep discount from its eventual maturity
(nominal) value. The industrial Development Bank of India
(IDBI) issued such DDBs for the first time in the Indian
capital market at a price of Rs.2,700 against the nominal value
of Rs.1 lakh payable after 25 years.
(vi) Inflation Adjusted Bonds (IABs). These are the
bonds on which both interest as well as principal is adjusted in
line with the price level changes or the inflation rate.

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I RETAINED EARNINGS OR PLOUGHING BACK OF

PROFITS
The 'Ploughing Back of Profits' is a technique of financial
management under which all profits of a company are not
distributed amongst the share holders as dividend, but a part
of the profits is retained or reinvested in the company. This
process of retaining profits year after year and their utilisation
in the business is known as ploughing back of profits.
It is actually an economical step which a company takes,
in the sense, that instead of distributing the entire earnings by
way of dividend, it keeps a certain percentage of it to be re-
introduced into the business for its development. Such a
phenomenon is also known 'Self-Financing'; Internal
Financing; or 'Inter Financing'.
The Necessity of Ploughing Back
The need for re-investment of retained earnings or
ploughing back of profits arises for the following purposes:
1. For the replacement of old assets which have become
obsolete.
2. For the expansion and growth of the business.

3. For contributing towards the fixed as well as working

capital needs of the company.
4. For improving the efficiency of the plant and equipment.
5. For making the company self-dependent of finance from
outside sources.
6. For redemption of loans and debentures.
III LOAN FINANCING
The third important mode of finance is raising of both (i)
short-term loans and credits; and (ii) term loans including

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medium and short-term loans. These sources of finance have

been discussed in the following pages of this unit.
1. Indigenous Bankers
Private money lenders and other country bankers used to
be the only sources of finance prior to the establishment of
commercial banks.
2. Trade Credit
Trade credit refers to the credit extended by the suppliers
of goods in the normal course of business. As present day
commerce is built upon credit, the trade credit arrangement of
a firm with its suppliers is an important source of short-term
finance.
3. Installment Credit
This is another method by which the assets are purchased
and the possession of goods is taken immediately but the
payment is made in installments over a pre- determined period
of time.
4. Advances
Some business houses get advances from their customers
and agents against orders and this source is a short-term source
of finance for them.
5. Factoring or Accounts Receivable Credit
Another method of raising short-term finance is through
account receivable credit offered by commercial banks and
factors. A commercial bank may provide finance by
discounting the bills or invoices of its customers. Thus, a firm
gets immediate payment for sales made on credit. A factor is a
financial institution which offers services relating to
management and financing of debts arising out of credit sales.
Factoring is becoming popular all over the world on account of
various services offered by the institutions engaged on it.

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Factors render services varying from bill discounting facilities

offered by commercial banks to a total takeover of
administration of credit sales including maintenance of sales
ledger, collection of accounts receivables, credit control and
protection from bad debts, provision of finance and rendering
of advisory services to their clients.
6.Accrued Expenses
Accrued expenses are the expenses which have been
incurred but not yet due and hence not yet paid also. These
simply represent a liability that a firm has to pay for the
services already received by it. The most important items of
accruals are wages and salaries, interest and taxes.
7. Deferred Incomes
Deferred incomes are incomes received in advance before
supplying goods or services. They represent funds received by
a firm for which it has to supply goods or services in future.
8. Commercial Paper
Commercial paper represents unsecured promissory notes
issued by firms to raise short-term funds. It is an important
money market instrument in advanced countries like USA. In
India, the Reserve Bank of India introduced commercial paper
in the Indian money market on the recommendations of the
Working Group on Money Market (Vaghul Committee).
The maturity period of commercial paper, in India,
mostly ranges from 91 to 180 days. It is sold at a discount
from its face value and redeemed at face value on its maturity.
Commercial paper is usually bought by investors including
banks, insurance companies, unit trusts and firms to invest
surplus funds for a short-period.
9. Commercial Banks
Commercial banks are the most important source of

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short-term capital. The major portion of working capital loans

are provided by commercial banks. They provide a wide
variety of loans tailored to meet the specific requirements of a
concern. The different forms in which the banks normally
provide loans and advances are as follows:
(a) Loans
(b) Cash Credits
(c) Overdrafts
(d) Purchasing and discounting of bills
(a) Loans: When a bank makes an advance in lump-sum
against some security it is called a loan. In case of a loan, a
specified amount is sanctioned by the bank to the customer.
The entire loan amount is paid to the borrower either in cash or
by credit to his account. Commercial banks generally provide
short-term loans up to one year for meeting working capital
requirements. But, now –a-days, term loans exceeding one
year are also provided by banks. The term loans may be either
medium-term or long- term loans.
(b) Cash Credit: A cash credit is an arrangement by
which a bank allows his customer to borrow money up to a
certain limit against some tangible securities or guarantees.
The customer can withdraw from his cash credit limit
according to his needs and he can also deposit any surplus
amount with him.
(c) Overdrafts: Overdraft means an agreement with a
bank by which a current account-holder is allowed to withdraw
more than the balance to his credit up to a certain limit. There
are no restrictions for operation of overdraft limits.
(d) Purchasing and Discounting of Bills: Purchasing
and discounting of bills is the most important form in which a
bank lends without any collateral security. The seller draws a

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bill of exchange on the buyer of goods on credit. Such a bill

may be either a clean bill or a documentary bill which is
accompanied by documents of title to goods such as a railway
receipt.
Letter of Credit
L/C is simply a guarantee by the bank to the suppliers
that their bills up to a specified amount would be honored. In
the case the customer fails to pay the amount, on the due date,
to its suppliers, the bank assumes the liabilities of its customer
for the purchases made under the letter of credit arrangement.
10. Public Deposits
Acceptance of fixed deposits from the public by all type
of manufacturing and non-bank financial companies in the
private sector has been a unique feature of Indian Financial
system. Companies have been accepting deposits directly from
the public by offering higher rates of interest as compared to
banks and post offices to meet their requirements of funds. But
even by offering higher rates of interest to the investors, the
cost of funds raised through public deposits to the companies
has been lower than the minimum rate of interest on bank
advances.
B. TERM LOANS
In addition to the raising of funds by means of share
capital, debentures, public deposits and internal financing,
firms may also raise term loans for meeting their medium-term
and long-term financial needs. Medium-term loans are for
periods ranging from one to five years and long-term loans are
granted for periods beyond five years. There are two major
sources of term lending, (a) Specialized Financial Institutions
or Development Banks; and (b) Commercial Banks.

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(a) Specialised Financial Institutions Or Development

Banks
After independence a number of financial institutions
have been set up at all India and regional levels for
accelerating the growth of industries by providing financial
and other assistance required.
There are four important financial institutions at the
national level i.e., the Industrial Finance Corporation of India
(IFCI), Industrial Development Bank of India (IDBI),
Industrial Credit and Investment Corporation of India (ICICI),
and Industrial Reconstruction Corporation of India (IRCI) now
called Industrial Investment Bank of India Ltd., (IIBIL). In
addition, there are 19 State Financial Corporation's (SFCs)
and 24 State Industrial Development Investment Corporations.
Apart from these specialized Financial Institutions,
Commercial banks, industrial co-operatives, small industrial
development corporations, Unit Trust of India, Life Insurance
Corporation, National Industrial Development Corporation,
etc. also provide finances for the development of industries in
the country. Besides these institutions commercial banks
provide short term as well long term finances. The Reserve
bank of India is also providing industrial finance through other
financial institution.
(b) Term Financing By Commercial Banks
Commercial banks normally concentrated on providing
short-term financial assistance to industrial sector. The
working capital needs of industrial enterprises were met. A
massive investment in industries during second plan and after
changed the priority of bank lending.
SOME OTHER INNOVATIVE SOURCES OF FINANCE
1. Venture Capital
The term 'venture capital' represents financial investment

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in a highly risky project with the objective of earning a high

rate of return. There is a significant scope for venture capital
companies in our country because of increasing emergence of
technocrat entrepreneurs who lack capital to be risked. These
venture capital companies provide the necessary risk capital
to the entrepreneurs so as to meet the promoters' contribution
as required by the financial institutions. In addition to
providing capital, these VCFs (Venture capital firms) take an
active interest in guiding the assisted firm.
2. Seed Capital
At the time of financing a project, financial institutions
always insist that the promoter should contribute a minimum
amount, called promoter's contribution, towards the project.
But there are number of technically qualified entrepreneurs
who lack financial capability to provide the required amount of
contribution. The Industrial Development Bank of India
(IDBI) has opened schemes to provide such funds to the
'eligible' entrepreneurs.
3. Bridge Finance
There is usually a time gap between the date of
sanctioning of a term loan and its disbursement by the
financial institution to the concerned borrowing firm. In the
same manner, there may be a time gap between the sanctioning
of a grant or subsidy and its actual release by the Government
or the institution. The same delay may occur in case of public
issue of shares with regard to receipt of public subscription.
Therefore, to avoid delay in implementation of the project, the
firms approach commercial banks for short-term loans for the
period for which delay may otherwise occur. Such a loan is
called 'Bridge Finance'.
4. Lease Financing
In addition to debt and equity financing, leasing has

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emerged as another important source of intermediate and long-

term financing of corporate enterprises. Leasing is an
arrangement that provides a firm with the use and control over
assets without buying, the cost of leasing the asset should be
compared with the cost of financing the asset through normal
sources of financing, i.e., debt and equity. Since payment of
lease rentals is similar to payment of interest on borrowings
and lease financing is equivalent to debt financing, financial
analysts argue that the only appropriate comparison is to
compare the cost of leasing with that of cost of borrowing.
Hence, lease financing decisions relating to leasing or buying
options primarily involve comparison between the cost of
debt-financing and lease financing. Types of Leasing
There are two basic kinds of leases:
1. Operating or Service Lease
2. Financial Lease
1. Operating or Service Lease
An operating lease is usually characterized by the
following features:
(i) It is a short-term lease on a period to period basis. The
lease period in such a contract is less than the useful life
of the asset.
(ii) The lease is usually cancelable at short-notice by the
lessee.
(iii) As the period of an operating lease is less than the useful
life of the asset, it does not necessarily amortize the
original cost of the asset. The lessor has to make further
leases or sell the asset to recover his cost of investment
and expected rate of return.
(iv) The lessee usually has the option of renewing the lease
after the expiry of lease period.

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(v) The lessor is generally responsible for maintenance,

insurance and taxes of the asset. He may also provide
other services to the lessee.
(vi) As it is short-term cancelable lease, it implies higher risk
to the lessor but higher lease rentals to the lessee.
2. Financial Lease
A lease is classified as financial lease if it ensures the
lessor for amortization of the entire cost of investment plus the
expected return on capital outlay during the term of the lease.
Such a lease is usually for a longer period and non-cancelable.
As a source of funds, the financial lease is an alternative
similar to debt financing.
A financial lease is usually characterized by the
following features:
(i) The present value of the total lease rentals payable during
the period of the lease exceeds or is equal to substantially
the whole of the fair value of the leased asset. It implies
that within the lease period, the lessor recovers his
investment in the asset along with an acceptable rate of
return.
(ii) As compared to operating lease, a financial lease is for a
longer period of time.
(iii) It is usually non-cancelable by the lessee prior to its
expiration data.
(iv) The lessee is generally responsible for the maintenance,
insurance and service of the asset. However, the terms of
lease agreement, in some cases may require the lessor to
maintain and service the asset. Such an arrangement is
called 'maintenance or gross lease'. But usually an
operating lease, it is the lessee who has to pay for
maintenance and service costs and such a lease is known

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as 'net lease'.
(v) A financial lease usually provides the lessee an option of
renewing the lease for further period at a nominal rent.
Forms of Financial Lease
The following are the important kinds of financial lease
arrangements:
(i) Sale and Leaseback. A sale and leaseback arrangement
involves the sale of an asset already owned by a firm
(vendor) and leasing of the same asset back to the vendor
from the buyer.
(ii) Direct Leasing. In contrast with sale and leaseback,
under direct leasing a firm acquires the use of an asset
that it does not already own. A direct lease may be
arranged either from the manufacturer supplier directly or
through the leasing company.
(iii) Leveraged Lease. A leveraged lease is an arrangement
under which the lessor borrows funds for purchasing the
asset, from a third party called lender which is usually a
bank or a finance company. The loan is usually secured
by the mortgage of the asset and the lease rentals to be
received from the lessee.
(iv) Straight Lease and Modified Lease. Straight lease
requires the lessee firm to pay lease rentals over the
expected service life of the asset and does not provide for
any modifications to the terms and conditions of the basic
lease.
Modified lease, on the other hand, provides several
options to the lessee during the lease period. For example,
the option of terminating the lease may be providing by
either purchasing the asset or returning the same.

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(v) Primary and Secondary Lease (Front-ended and

Back-ended Lease). Under primary and secondary lease,
the lease rentals are changed in such a manner that the
lesser recovers the cost of the asset and acceptable profit
during the initial period of the lease and then a secondary
lease is provided at nominal rentals. In simple words, the
rentals charged in the primary period are much more
than that of the secondary period. This form of lease
arrangement is also known as front-ended and back-
ended lease.
5. Hire Purchase Finance
Hire purchase means a transaction where goods are
purchased and sold on the terms that (i) payment will be made
in installments, (ii) the possession of the goods is given to the
buyer immediately, (iii) the property (ownership) in the goods
remains with the vendor till the last installment is paid, (iv) the
seller can repossess the goods in case of default in payment of
any installment and (v) each installment is treated as hire
charges till the last installment is paid.
Leasing Versus Hire Purchase
Both Leasing and hire purchase provide a source of
financing fixed assets. However the two are not similar on
many accounts. The following points of distinction are
worth consideration from points of view of the lessee and the
hirer:

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6. Euro Issues
Euro issue is a method of raising funds required by a
company in foreign exchange. It provides greater flexibility to
the issuers for raising finance and allows room for controlling
their cost of capital. The term 'Euro issue' means an issue made
abroad through instruments denominated in foreign currency
and listed on an European stock exchange, the subscription
for which may come from any part of the world. The idea
behind Euro issues is that any one capital market can absorb
only a limited amount of company's stock at any given time
and cost. The following are the primary instruments through
which finance is raised by Indian companies in International
market:
(i) Foreign Currency convertible Bonds (FCCBs)
(ii) Global Depository Receipts (GDRs).
(iii) American Depository Receipts (ADRs)
(i) Foreign Currency convertible Bonds. FCCBs are
bonds issued to and subscribed by a non-resident in foreign
currency which are convertible into certain number of

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ordinary shares at a pre-fixed price. They are like

convertible debentures, have a fixed interest rate and a definite
maturity period. These bonds are listed on one or more
overseas stock exchanges. Euro convertible bonds are listed on
a European Stock Exchange. The issuer company has to pay
interest on FCCBs in foreign currency till the conversion
takes place and if the conversion option is not exercised by the
investor, the redemption of bond is also to be made in foreign
currency. Essar Gujarat, Reliance Industries, ICICI, TISCO
and Jindal Strips are some of the Indian companies which have
successfully issued such bonds.
(ii) Global Depository Receipts. GDR is an instrument,
denominated in dollar or some other freely convertible foreign
currency, which is traded in Stock |Exchanges in Europe or the
US or both. When a company issues equity outside its
domestic market, and the equity is subsequently traded in the
foreign market, it is usually in the form of a Global
Depository |Receipt. Through the system of GDRs; the shares
of a foreign company are indirectly traded. The issuing
company works with a bank to offer to its shares in a foreign
country via the sale of GDRs. The bank issues GDRS as an
evidence of ownership.
(iii) American Depository Receipts (ADRs) are the US
version of GDRs. American Depository Receipts have almost
the same features as of GDRs with a special feature that
ADRs are necessarily denominated in US dollars and pay
dividend in US dollars.
REVIEW QUESTIONS
Essay Type Questions
1. Between equity shares and debentures which is profitable
for raising additional long-term capital for a
manufacturing company and why?

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2. What different forms of securities can a public limited

company issue? Discuss their significance in detail in
relation to the financial structure of a company.
3. "Debentures occupy a very important place in the
financial plan". Discuss the statement and point out the
limitations of debenture financing.
4. What are various sources available to Indian businessmen
for raising funds? Explain.
5. What are the main sources of finance available to
industries for meeting short- term as well as long-tem
financial requirements? Discuss.
6. "Leasing is beneficial to both, the lessee as well as the
lessor." Examine.

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UNIT - 3
WORKING CAPITAL MANAGEMENT- PART - 1

Learning Objectives:
 Understand the meaning, concept and kinds of working
capital.
 Importance of adequate working capital.
 Forecast working capital requirements
We have seen the different sources from which both
long term and short term capital can be raised. In this unit a
detailed study is made regarding the working capital
requirements, its estimation, and various methods of estimating
working capital requirements.
MEANING OF WORKING CAPITAL
Capital required for a business can be classified under
two main categories viz.,
(i) Fixed Capital, and
(ii) Working Capital.
Every business needs funds for two purposes-for its
establishment and to carry out its day-to-day operations. Long-
term funds are required to create production facilities through
purchase of fixed assets such as plant and machinery, land,
building, furniture, etc. Investments in these assets represent
that part of firm's capital which is blocked on a permanent or
fixed basis and is called fixed capital. Funds are also needed
for short-term purposes for the purchase of raw materials,
payment of wages and other day-to-day expenses, etc. These
funds are known as working capital. In simple 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,
marketable securities, debtors and inventories. Funds, thus,

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invested in current assets keep revolving fast and are being

constantly converted into cash and these cash flows out again
in exchange for other current assets. Hence, it is also known as
revolving or circulating capital or short-term capital.
In the words of Shubin, "Working capital is the amount
of funds necessary to cover the cost of operating the
enterprise."
According to Gerstenberg, "Circulating capital means
current assets of a company are changed in the ordinary course
of business from one form to another, as for example, from
cash to inventories, inventories to receivables, receivables into
cash."
CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital:
(A) Balance Sheet Concept
(B) Operating Cycle or Circular Flow Concept
(A) Balance Sheet Concept
There are two interpretations of working capital under
the balance sheet concept:
(i) Gross Working Capital
(ii) Net Working Capital.
Gross Working Capital = Total of current assets
Net Working Capital = Current Assets - Current liabilities.
Net working capital may be positive or negative. When
the current assets exceed the current liabilities the working
capital is positive and the negative working capital results
when the current liabilities are more than the current assets.
Current assets are those assets which can be converted into
cash within a short span of time, normally one accounting year
or even less than that. Current liabilities are those liabilities

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which are intended to be paid in the ordinary course of

business within a short period of normally one accounting year
out of the current assets or the income of the business.
Examples of current assets are:
Constituents of Current Assets
1. Bills Receivable.
2. Sundry debtors or Accounts receivable.
3. Accrued or outstanding income.
4. Prepaid expenses, short term marketable securities etc.
5. Inventory (Stock of Raw Materials, Work in Progress and
Finished Goods).
6. Cash in hand and at Bank.

Examples of current liabilities are:

Constituents of Current Liabilities
1. Bills payable.
2. Sundry creditors or accounts payable.
3. Accrued or outstanding expenses.
4. Short-term loans, advances and deposits.
5. Dividends payable.
6. Bank overdraft.
7. Provision for taxation, if it does not amount to
appropriation of profits.

The gross working capital concept is financial or going

concern concept whereas net working capital concept is
accounting concept of working capital.

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The following example explains both the concepts of

working capital:
Balance Sheet of Pearl India Ltd.
as on 31.3.2016.
Liabilities Rs. Assets Rs.
Equity Shares 2,00,000 Goodwill 20,000
8% Debentures 1,00,000 Land and Buildings 1,50,000
Reserve & Surplus 50,000 Plant and Machinery 1,00,000
Sundry Creditors 1,50,000 Inventories:
Bills Payable 30,000 Finished Goods 60,000
Outstanding 20,000 Work-in-progress 40,000
Expenses
Bank Overdraft 50,000 Prepaid Expenses 20,000
Provision of Taxation 20,000 Marketable Securities 60,000
Proposed Dividend 30,000 Sundry Debtors 90,000
Bills Receivables 20,000
Cash & Bank Balances 90,000

6,50,000 6,50,000
====== ======

(i) Gross Working Capital = Total of Current Assets

= 60,000+40,000+20,000+60,000+90,000+20,000+90,000
= Rs.3,80,000
(ii) Net Working Capital=Current Assets-Current Liabilities
Total of Current Assets = Rs.3,80,000
Total of Current Liabilities =
1, 50,000+30,000+20,000+50,000+20,000+30,000

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= Rs.3,00,000
WC (Net) = Rs 3,80,000-3,00,000 = Rs.80,000
B) Operating Cycle or Circular Flow Concept
As discussed earlier, working capital refers to that part of
firm's capital which is required for financing short-term or
current assets such as cash, marketable securities, debtors
and inventories. Funds, thus, invested in current assets keep
revolving fast and are being constantly converted into cash and
these cash flows out again in exchange for other current assets.
Hence, it is also known as revolving or circulating capital.
The circular flow concept of working capital is based upon this
operating or working capital cycle of a firm. The cycle starts
with the purchase of raw material and other resources and
ends with the realisation of cash from the sale of finished
goods. The speed/time duration required to complete one cycle
determines the requirements of working capital-longer the
period of cycle, larger is the requirement of working capital.
The gross operating cycle of a firm is equal to the length
of the inventories and receivables conversion periods. Thus,

Where
RMCP = Raw Material Conversion Period
WIPCP = Work-in-Process Conversion Period
FGCP = Finished Goods Conversion Period
RCP = Receivables Conversation Period
However, a firm may acquire some resources on credit
and thus defer payments for certain period. In that case, net
operating cycle period can be calculated as below:
Net operating cycle period = Gross operating cycle period-
payable deferral period

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Further, following formula can be used to determine

the conversion periods.

The following example explains the determination of

operating cycle.
Problem. 1. From the following information extracted from
the books of a manufacturing concern compute the operating
cycle in days:

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Solution
Computation of Operating Cycle:

Problem 2. From the following data, compute the duration of

operating cycle for each of the two companies:

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X Ltd. Y Ltd.
Rs Rs
Stock
Raw materials 40,000 60,000
Work-in-process 30,000 45,000
Finished goods 25,000 38,000
Purchase/consumption of raw material 1,60,000 2,70,000
Cost of goods produced/sold 3,00,000 3,80,000
Sale (all credit) 3,60,000 4,32,000
Debtors 72,000 1,08,000
Creditors 20,000 27,000
Assume 360 days per year for computational purposes.
Solution:

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CLASSIFICATION OR KINDS OF WORKING

CAPITAL
Working capital may be classified in two ways:
(a) On the basis of concept
(b) On the basis of time.
On the basis of concept, working capital is classified as
gross working capital and net working capital as discussed
earlier. This classification is important from the point of
view of the financial manager.
On the basis of time, working capital may be classified
as:
1. Permanent or fixed working capital.
2. Temporary or variable working capital.

Permanent or Fixed Working Capital: Permanent or

1.
fixed working capital is the minimum amount which is
required to ensure effective utilisation of fixed facilities and
for maintaining the circulation of current assets. There is
always a minimum level of current assets which is

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continuously required by the enterprise to carry out its normal

business operations. For example, every firm has to maintain
a minimum level of raw materials, work-in-process, finished
goods and cash balance. This minimum level of current assets
is called permanent or fixed working capital as this part of
capital is permanently blocked in current assets.
2. Temporary or Variable Working Capital:
Temporary or variable working capital is the amount of
working capital which is required to meet the seasonal
demands and some special exigencies. Variable working
capital can be further classified as seasonal working capital
and special working capital. Most of the enterprises have to
provide additional working capital to meet the seasonal and
special needs. The capital required to meet the seasonal needs
of the enterprise is called seasonal working capital. Special
working capital is that part of working capital which is
required to meet special exigencies such as launching of
extensive marketing campaigns for conducting research, etc.
IMPORTANCE (ADVANTAGES) OF ADEQUATE
WORKING CAPITAL
No business can run successfully without an adequate
amount of working capital. The main advantages of
maintaining adequate amount of working capital are as
follows:
1. Solvency of the business: Adequate working capital
helps in maintaining solvency of the business by
providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business
concern to make prompt payments and hence helps in
creating and maintaining goodwill.
3. Easy loans: A concern having adequate working capital,
high solvency and good credit standing can arrange loans

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from banks and others on easy and favourable terms.

4. Cash discounts: Adequate working capital also enables a
concern to avail cash discount on the purchases and hence
it reduces costs.
5. Regular supply of raw materials: Sufficient working
capital ensure regular supply of raw materials and
continuous production.
6. Regular payment of salaries, wages and other day-to-
day commitments: A company which has ample
working capital can make regular payment of salaries,
wages and other day-to-day commitments which raises
the morale of its employees, increases their efficiency,
reduces wastages and costs and enhances production and
profits.
7. Exploitation of favourable market conditions: Only
concerns with adequate working capital can exploit
favourable market conditions such as purchasing its
requirements in bulk when the prices are lower and by
holding its inventories for higher prices.
8. Ability to face crisis: Adequate working capital enables
a concern to face business crisis in emergencies such as
depression because during such periods, generally, there
is much pressure on working capital.
9. Quick and regular return on investments: Every
Investor wants a quick and regular return on his
investments. Sufficiency of working capital enables a
concern to pay quick and regular dividends to its
investors.
FACTORS DETERMINING THE WORKING CAPITAL
REQUIREMENTS
The working capital requirements of a concern depend

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upon a large number of factors such as nature and size of

business, the character of their operations, the length of
production cycles, the rate of stock turnover and the state of
economic situation. It is not possible to rank them because all
such factors are of different importance and the influence of
individual factors changes for a firm over time.
However, the following are important factors generally
influencing the working capital requirements.
1. Nature or Character of Business: The working
capital requirements of a firm basically depend upon the
nature of its business. Public utility undertakings like
Electricity, Water Supply and Railways and very limited
working capital because they offer cash sales only and supply
services, not products, and as such no funds are tied up in
inventories and receivables. On the other hand trading and
financial firms require less investment in fixed assets but have
to invest large amounts in current assets like inventories,
receivables and cash; as such they need large amount of
working capital.
2. Size of Business/Scale of Operations: The working
capital requirements of a concern are directly influenced by the
size of its business which may be measured in terms of scale of
operations. Greater the size of a business unit, generally
larger will be the requirements of working capital.
3.Production Policy: In certain industries the demand is
subject to wide fluctuations due to seasonal variations. The
requirements of working capital, in such cases, depend upon
the production policy.
4. Manufacturing Process/Length of Production
Cycle: In manufacturing business, the requirements of working
capital increase in direct proportion of length of manufacturing
process. Longer the process period of manufacture, larger is

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the amount of working capital required.

5.Seasonal Variations: In certain industries raw material
is not available throughout the year. They have buy raw
materials in bulk during the season to ensure an uninterrupted
flow and process them during the entire year.
6. Working Capital Cycle: In a manufacturing concern,
the working capital cycle starts with the purchase of raw
material and ends with the realisation of cash from the sale of
finished products.

The speed with which the working capital completes one

cycle determines the requirements of working capital-longer
the period of the cycle larger are the requirement of working
capital.
7. Rate of Stock Turnover: There is a high degree of
inverse co- relationship between the quantum of working
capital and the velocity or speed with which the sales are
effected. A firm having a high rate of stock turnover will need
lower amount of working capital as compared to a firm having
a low rate of turnover.
8. Credit Policy: The credit policy of a concern in its

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dealings with debtors and creditors influence considerably the

requirements of working capital. A concern that purchases its
requirements on credit and sells its products/services on cash
requires lesser amount of working capital.
9. Business Cycles: Business cycle refers to alternate
expansion and contraction in general business activity. In
period of boom i.e., when the business is prosperous, there is
a need for larger amount of working capital due to increase
in sales, rise in prices, optimistic expansion of business, etc).
10.Rate of Growth of Business: The working capital
requirements of a concern increase with the growth and
expansion of its business activities.
11. Earning Capacity and Dividend Policy: Some
firms have more earning capacity than others due to quality of
their products, monopoly conditions, etc. Such firms with high
earning capacity may generate cash profits from operations
and contribute to their working capital. The dividend policy
of a concern also influences the requirements of its working
capital.
12. Price Level Changes: Changes in the price level also
affect the working capital requirements. Generally, the rising
prices will require the firm to maintain larger amount of
working capital as more funds will be required to maintain the
same current assets.
13. Other Factors: Certain other factors such as
operating efficiency, management ability, irregularities of
supply, import policy, asset structure, importance of labour,
banking facilities etc., also influence the requirements of
working capital.

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UNIT – 4
WORKING CAPITAL MANAGEMENT – PART - II

Learning Objectives:
Methods of estimating working capital requirements.
 Mathematical and simulation models of working capital
decisions
 Percentage of sales method, regression analysis method, cash
forecasting method, operating cycle method and projected
balance sheet method.
INTRODUCTION
Working capital, in general practice, refers to the excess
of current assets over current liabilities. The basic goal of
working capital management is to manage the current assets
and current liabilities of a firm in such a way that a satisfactory
level of working capital is maintained, i.e., it is neither
inadequate nor excessive. This is so because both inadequate
as well as excessive working capital positions are bad for any
business. Inadequacy of working capital may lead the firm to
insolvency and excessive working capital implies idle funds
which earn no profits for the business. Working capital
management policies of a firm have a great effect on its
profitability, liquidity and structural health of the organisation.
Working capital management should be considered as an
integral part of overall corporate management. In the words of
Louis Brand, "We need to know when to look for working
capital funds, how to use them and how to measure, plan and
control them‖. To achieve the objectives of working capital
management, the financial manager has to perform the
following basic functions:
1. Estimating the working capital requirements.

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2. Financing of working capital needs.

3. Analysis and control of working capital.
ESTIMATE OF WORKING CAPITAL REQUIRE-
MENTS
"Working capital is the life-blood and controlling nerve
centre of a business." No business can be successfully run
without an adequate amount of working capital. To avoid the
shortage of working capital at once, an estimate of working
capital requirements should be made in advance so that
arrangements can be made to procure adequate working
capital.
Now, let us see what the methods of estimating
working capital requirements are.
Methods of Estimating Working Capital Requirements
1. Percentage of Sales Method
2. Regression Analysis Method (Average Relationship
between Sales and Working Capital).
3. Cash Forecasting Method
4. Operating Cycle Method
5. Projected Balance Sheet Method
1. Percentage of Sales Method
This method of estimating working capital requirements
is based on the assumption that the level of working capital for
any firm is directly related to its sales value. Thus, if sales for
the year 2015 amounted to Rs 30,00,000 and working
capital required was Rs 6,00,000; the requirement of working
capital for the year 2008 on an estimated sales of Rs
40,00,000 shall be Rs 8,00,000 .i.e, 20% of Rs 40,00,000. The
individual items of current assets and current liabilities can
also be estimated on the basis of the past experience as a
percentage of sales.

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Problem 1. The following information has been provided by a

company for the year ended 30.3.2015:
Liabilities Rs. Assets Rs.
Equity share capital 2,00,000 Fixed assets less 3,00,000
depreciation
8% Debentures 1,00,000 Inventories 1,00,000
Reserves and 50,000 Sundry debtors 70,000
surplus
Long-term loans 50,000 Cash and bank 10,000
Sundry creditors 80,000

4,80,000 4,80,000
====== =====
Sales for the year ended 31.3.2015 amounted to Rs
10,00,000 and it is estimated that the same will amount to Rs
12,00,000 for the year 2015-16.
You are required to estimate the working capital
requirements for the year 2015-16 assuming a linear
relationship between sales and working capital
Solution:
Estimation of Working Capital Requirements
Percentage Estimate
Actual to Sales 2015-16
31-03-15 31-03-15 (Rs)
(Rs) (Rs)
Sales 10,00,000 100 12,00,000
Current Assets:
Inventories 1,00,000 10 1,20,000

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Sundry debtors 70,000 7 84,000

Cash and bank 10,000 1 12,000
Total Current Asset (CA) 1,80,000 18 2,16,000
Current Liabilities:
Sundry creditors 80,000 8 96,000
Total Current Liabilities (CL) 80,000 8 96,000
Working Capital (CA - CL) 1,00,000 10 1,20,000

2. Regression Analysis Method (Average Relationship

between Sales and Working Capital)
This method of forecasting working capital requirements
is based upon the statistical technique of estimating or
predicting the unknown value of a dependent variable from the
known value of an independent variable. It is the measure of
the average relationship between two or more variables, i.e.,
sales and working capital, in terms of the original units of the
data.
The relationship between sales and working capital is
represented by the equation:
y = a + bx

Where, y = Working capital (dependent variable) a = Intercept

of the least square
b = Slope of the regression line x = Sales (independent
variable)
For determining the values 'a' and 'b' two normal
equations are used which can be solved simultaneously:

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Problem 2: The sales and working capital figures of Suvidha

Ltd. for a period of 5 years are given as follows:
Sales (Rs Working Capital
Year lakhs) (Rs lakhs)
2010-11 60 12
2011-12 80 15
2012-13 120 20
2013-14 130 21
2014-15 160 23

You are required to forecast the working capital

requirements of the company for the year 2015-16 taking the
estimated sales of Rs 200lakhs.
Solution:
The relationship between sales and working capital can be
represented by:
y = a + bx
Working
Year Sales (x)
Capital (y)
xy x2

2010-11 60 12 720 3,600

2011-12 80 15 1,200 6,400
2012-13 120 20 2,400 14,400
2013-14 130 21 2,730 16,900
2014-15 160 23 3,680 25,600
n=5 x = 550 y = 91 xy = 10,730 x2 = 66,900

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y = na + b x
xy = a x + x2
Putting the values in the above equations:
91 = 5a + 550 b (i)
10,730 = 550a + 66,900 b (ii)
Multiplying equation (i) with 110, we get:
10010 = 550a + 60,500 b ............. (iii)
Subtracting equation (iii) equation (ii)
720 = 0 + 6400 b
b = 0.1125
Putting the value of b in equation (i)
91 = 5a + 550 x 0.1125

3. Cash Forecasting Method

This method of estimating working capital requirements
involves forecasting of cash receipts and disbursements during
a future period of time. Cash forecast will include all
possible sources from which cash will be received and the
channels in which payments are to be made so that a
consolidated cash position is determined. This method is

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similar to the preparation of a cash budget. The excess of

receipts over payments represents surplus of cash and the
excess of payments over receipts causes deficit of cash or the
amount of working capital required. The following illustration
explains the cash forecasting method of estimating working
capital requirements.
Problem 3: Texas Manufacturing Company Ltd. is to
start production on 1st January, 2009. The prime cost of a unit
is expected to be Rs 40 out of which Rs 16 is for materials and
Rs 24 for labour. In addition, variable expenses per unit are
expected to be Rs 8 and fixed expenses per month Rs 30,000.
Payment for materials is to be made in the month following
the purchases. One-third of sales will be for cash and the rest
on credit for settlement in the following month. Express are
payable in the month in which they are incurred. The selling
price is fixed at Rs 80 per unit. The number of units
manufactured and sold is expected to be as under:
January 900
February 1,200
March 1,800
April 2,100
May 2100
June 2,400

Draw up statement showing requirements of working

capital from month to month, ignoring the question of stocks.

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Solution :
Statement Showing requirement of Working Capital
January Februar y March
April Rs May Rs June Rs
Rs Rs Rs
Payments:
Materials - 14,400 19,200 28,800 33,600 33,600
Wages 21,600 28,800 43,200 5,400 50,400 57,600
Fixed Expenses 30,000 30,000 30,000 30,000 30,000 30,000
Various Expenses 7,200 9,600 14,400 16,800 16,800 19,200

58,800 82,800 1,06,8 1,26,000 1,30,800 1,40,400

====== ====== 00 ====== ====== ======
=====
Receipts:
Cash Sales 24,000 32,000 48,000 56,000 56,000 64,000
Debtors - 48,000 64,000 96,000 1,12,000 1,12,000
-
_ 80,000 1,52,000 _
24,000 ====== 1,12,0 ====== 1,68,000 _
====== 00 ====== 1,76,000
= ===== = ======
Working Capital 34,800 2,800 - - - -
Required
(Payments-
Receipts)
Surplus - - 5,200 26,000 37,200 35,600
Cumulative 34,800 37,600 32,400 6,400 - -
Requirements of
Working Capital:

Surplus Working - - - - 30,800 66,400

Capital

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Working Notes:
(i) As payment for material is made in the month following
the purchase, there is no payment for material in January.
In February, material payment is calculated as 900 x 16=
Rs 14,400 and in the same manner for other months.
(ii) Cash sales are calculated as: For January 900 x 80 x 1/3
= Rs 24,000 and in the same manner for other months.
(iii) Receipts from debtors are calculated as:
For Jan. – Nil, because cash from debtors is collected in the
month following the sales.

4. Operating Cycle Method

This method of estimating working capital requirements
is based upon the operating cycle concept of working capital,
We have discussed earlier, in this chapter, the concept and
determination of duration of operating cycle. The cycle starts
with the purchase of raw material and other resources and ends
with the realisation of cash from the sale of finished goods. It
involves purchase of raw materials and stores, its conversion
into stock of finished goods through work-in- process with
progressive increment of labour and service costs, conversion
of finished stock into sales, debtors and receivables, realisation
of cash and this cycle continues again from cash to purchase of
raw material and so on. The speed/time duration required to
complete one cycle determines the requirement of working
capital - linger the period of cycle, larger is the requirement
of working capital and vice-versa. The requirements of
working capital be estimated as follows:

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Working Capital Required

Problem 4. Details of X Ltd. for the year 2007- 08, are given
as under:

Cost of goods sold Rs 48,00,000

Operating cycle 60 days
Minimum desired level of cash balance Rs 75,000

You are required to calculate the expected working capital

requirement by assuming 360 days in a year.
Solution :

For proper computation of working capital under this

method, a detailed analysis is made for each individual
component of working capital. The value of each individual
item of current assets and current liabilities is determined on
the basis on the basis of estimated sales or budgeted
production or activity levels as follows:
(a) Stock of Raw Materials. The amount of working capital
finds to be invested in holding stock of raw material can be
estimated on the basis of budgeted units of production,
estimated cost of raw material per unit and the average
duration for which the raw material is held in stock by using
the following formula:

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(Notes: 360 days in a year may be assumed in place of 365 to

simplify calculations in some cases).
(b) Stock of Work-in-Process. In manufacturing/
processing industries the production is carried on continuous
basis. At the end of the period, some work remains incomplete
even though all or some expenses have been incurred, this
work is known as work-in-progress or partly completed or
semi-finished goods. The work-in-process consists of direct
material, direct labour and production overheads locked up in
this semi finished goods.

Note: (i) 360 days a year may be assumed to simplify

calculations.
(ii) In the absence of information about stage of
completion of WIP with regard to material, labour and
overheads, 100% of materials cost, and 50% of labour and
production overheads cost may be assumed as the estimated
cost of work-in-process
(iii) In case cash cost approach is followed for estimation
of working capital, then depreciation should be excluded from
production overheads while calculating cost of work-in-
process. However, under the total approach, depreciation is
also included.
(c) Stock of Finished Goods. The amount of funds to be
invested in holding stock of finished goods can be estimated

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on the basis of annual budgeted units of production, estimated

cost of production per unit and the average holding period of
finished goods stock by using the following formula:

(d) Investment in Debtors/Receivables. When the sales

are made by a firm on cash basis, the amount is realised
immediately and no funds are blocked for after sale period.
However, in case of credit sales, there is a time lag between
sales and realisation of cash. Thus, funds are to be invested in
receivables, i.e. debtors and bills receivables. However, actual
amount of funds locked up in receivables is only to the extent
of cost of sales and not the actual sales which include profit. It
would, therefore, be more appropriate to ascertain the amount
of funds to be invested in debtors/receivables at cost of sales
and not the selling price. But in case, total approach is
followed for estimation of working capital then receivables
may be computed on the basis of selling price.

Note (i) Cost of sales = Cost of goods produced/sold + Office

and administrative overheads+ selling and distribution
overheads
(ii) Selling price per unit should be considered in place of cost
of sales per unit in case total approach is to be followed for
estimate of working capital. Under the total approach, all costs
including depreciation and profit margin are included.
(e) Cash and Bank Balance. Cash is one of the current
assets of a business. It is needed at all times to keep the
business going. A business firm has to always keep sufficient

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cash to meet its obligations. Thus, a minimum desired cash

and bank balance to be maintained by a firm should be
considered as an important component of current assets while
estimating the working capital requirements.
(f) Prepaid Expenses. Some of the expenses like wages,
manufacturing overheads, office and administrative expenses
and selling and distribution expenses etc. may have to be paid
in advance. Such prepayment of expenses should also be
estimated while computing working capital requirements of a
firm.
(g) Trade Creditors. The term trade creditors refer to the
creditors for purchase of raw material, consumable stores etc.
The suppliers of goods, generally, extend some period of credit
in the normal course of business. The trade credit arrangement
of a firm with its suppliers is an important source of short-
term finance. It reduces the amount of net working capital
required by a firm. The amount of funds to be provided by
creditors can be estimated as follows:

(h) Creditors for Wages and Other Expenses. Wages and

salaries are usually paid on monthly, fortnightly nor weekly
basis for the services already rendered by employees. The
longer the payment - period, the greater is the amount of
current liability towards employees or the funds provided by
them. In the same manner, other expenses may also have to be
paid after the lag of a certain period. The amount of such
accrued or outstanding expenses reduces the level of net
working capital requirements of a firm. The creditors for
wages and other overheads may be computed as follows:

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Note .(i) The creditors for wages and each of the overheads
may be calculated separately.
(ii) In case of selling overheads, budgeted annual sales in
units should be considered in place of budgeted production
units.
(i) Advances Received. Sometimes a payment may be
received in advance along with purchase order; such
advances reduce the amount of net working capital
required by a firm.
Factors Requiring Consideration While Estimating
Working Capital
The estimation of working capital requirement is not an
easy task and a large number of factors have to be considered
before starting this exercise. For a manufacturing organisation,
the following factors have to be taken into consideration while
making an estimate of working capital requirements:
Factors Requiring Consideration While Estimating
Working Capital
1. Total costs incurred on material, wages and overheads.
2. The length of time for which raw materials are to remain in
stores before they are issued for production.
3. The length of the production cycle or work-in-process, i.e.,
the time taken for conversion of raw material into finished
goods.
4. The length of sales cycle during which finished goods are
to be kept waiting for sales.

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5. The average period of credit allowed to customers.

6. The amount of cash required to pay day-to-day expenses of
the business.
7. The average amount of cash required to make advance
payments, if any,
8. The average credit period expected to be allowed by
suppliers.
9. Time-lag in the payment of wages and other expenses.
10. The average amount of advances received, if any

From the total amount blocked in current assets

estimated on the basis of the first seven items given above, the
total of the current liabilities, i.e., the last three items, is
deducted to find out the requirements of working capital.
In case of purely trading concerns, points 1, 2 and 3
would not arise but all other factors from points 4 to 10 are to
be taken into consideration.
In order to provide for contingencies, some extra amount
generally calculated as a fixed percentage of the working
capital may be added as a margin of safety.
5. Projected Balance Sheet Method
Under this method, projected balance sheet for future date
is prepared by forecasting of assets and liabilities by following
any of the methods stated above. The excess of estimated total
current assets over estimated current liabilities, as shown in the
projected balance sheet, is computed to indicate the estimated
amount of working capital required.
Problem 5. Prepare an estimate of working capital
requirement from the following information of a trading
concern:

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Solution:
Statement of Working Capital Requirements
Rs
Current Assets
Debtors (8 weeks):6,00,000x8/52 (At Cost) 92,308
Stock (12 weeks): 6,00,000 x 12/52 1,38,462
Less: Current Liabilities: 2,30,770
Creditors (4 weeks): 6,00,000 x 4/52 46,154
Net working capital 1,84,616
Add 10% for contingencies 18,462
Working Capital Required 2,03,078
=======

Working Notes:
(a) Sales = 1,00,000 x 8 = Rs 8,00,000
Profit = 25% of Rs 8,00,000 = Rs 2,00,000
Cost of Sales = Rs 6,00,000
(b) As, it is a trading concern, cost of sales, are assumed to
be the purchases.

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(c) Profits have been ignored as funds provided by profits

may or may not be used as working capital.
Problem 6: X & Co. is desirous to purchase a business and
has consulted you and one point on which you are asked to
advise them is the average amount of working capital which
will be required in the first year's working.
You are given the following estimates and are instructed
to add 10% to your computed figure to allow for
contingencies:
Figures for the year Rs
(i) Amount blocked up for stocks:
Stocks of finished product 5,000
Stocks of stores, materials, etc 8,000
(ii) Average credit given:
Inland Sales-6 weeks credit 3,12,000
Export Sales 1 ½ weeks credit 78,000
(iii) Lag in payment of wages and other outgoing :
Wages - 1 ½ Weeks 2,60,000
Stocks of materials etc, 1 ½ months 48,000
Rent, Royalties etc 6 months 10,000
Clerical staff = ½ month 62,400
Manager ½ month 4,800
Miscellaneous Expenses 1 ½ months 48,000
(iv) Payment in Advance:
Sundry Expenses (paid Quarterly in advance) 8,000
(v) Undrawn profit on the average throughout the 11,000
year

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Set up your calculations for the average amount of working

capital required.
Solution:

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Note: Undrawn Profits have been ignored for the following

reasons:
(i) Profits may or may not be used as working capital.
(ii) Even if it is to be used for working capital, it should be
reduced by the amount of income-tax, drawings,
dividend paid etc.
Problem 7: From the information given below you are
required to prepare a projected Balance Sheet, Profit and Loss
Account and then an estimate of working capital requirements:
Rs
(a) Issued share capital 3,00,000
6% debentures 2,00,000
Fixed assets at cost 2,00,000
(b) The expected rations to selling price are:
Raw Materials 50%
Labour 20%
Overheads 20%
Profit 10%
(c) Raw materials are kept in store for an average of two
months
(d) Finished goods remain in stock for an average period
of three months
(e) Production during the previous year was 1,80,000
units and it is planned to maintain the same in the
current year also
(f) Each unit of production is expected to be in process
for half a month
(g) Credit allowed to customers is three months and
given by suppliers is two months
(h) Selling price is Rs 4 per unit

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(i) There is a regular production and sales cycle

(j) Calculation of debtors may be made at selling price

Solution

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Projected Profit and Loss Account

Rs Rs
To cost of goods sold: By Sales 7,20,0
To Raw Materials 3,60,000 00
To Labour 1,44,000
To Overheads 1,44,000
To Gross Profit 72,00
To interest on By Gross Profit
Debentures To Net 7,20,000
Profit ====== - 7,20,000
12,000 =======
60,000
----------- 72,000
72,000 -------
======
72,000
====
Projected Balance Sheet
Liabilities Rs. Assets Rs.
Share Capital 3,00,000 Fixed Assets (at 2,00,000
cost)
6% Debentures 2,00,000 Current Assets:
Profit and Loss Account 60,000 Stocks: 60,000

Creditors 60,000 Work -in- 21,

000
process
Bank overdraft 3,000 Finished 1,6

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(balancing 2,
figure) Goods 000 4,23,000
--------- Debtors 1,8
0,
6,23,000 000 -------
====== ----- 6,23,000
--
=====
=

Working Capital = Current Assets -Current Liabilities Current

Assets = Rs. 4,23,000
Current Liabilities = Sundry Creditors (Rs. 60,000) + Bank
Overdraft (Rs. 3,000) = Rs. 63,000
So, Working Capital = Rs. 4, 23, 000-63,000 = Rs. 3,60,000
Problem: 8, Raju Brothers Private Limited sells goods on
a gross profit of 25%. Depreciation is taken into account as a
part of cost of production. The following are the annual figures
given to you:
Rs
Sales (two months' credit) 18,00,000
Material consumed (one month credit) 4,50,000
Wages (one month lag in payment) 3,60,00
Cash manufacturing expenses (one month lag in payment) 4,80,000
Administration expenses (one month lag in payment) 1,20,000
Sales promotion expenses (paid quarterly in advance) 60,000
Income-tax payable in 4 installments of which one lies in 1,50,000
next year

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The company keeps one month's stock each of raw

material and finished goods. It also keeps Rs. 1,00,000 in cash.
You are required to estimate the working capital requirements
of the company on cash cost basis assuming 15% safety
margin. Ignore work-in-progress.
Solution

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Problem 9: A company newly commencing business in 2011

has the under mentioned projected profit and loss account
Rs Rs
Sales 42,00,000
Cost of goods sold 30,60,000
Gross profit 11,40,000

Administrative expense 2,80,000

Selling expenses 2,60,000 5,40,000
Profit before tax 6,00,000
Provision for taxation 2,00,000
profit after tax 4,00,000

Wages and manufacturing expenses 12,50,000

Depreciation 4,70,000
34,00,000
Less: Stock of finished goods (10% of goods 3,40,000
produced
not yet sold) ------------
30,60,000

The figures given above relate only to finished goods and

to work in progress. Goods equal to 15% of the year‘s
production (in terms of physical units) will be in process on the
average requiring full materials but only 40% of the other
expenses. The company believes in keeping material equal to
two months consumption in stock)
All expenses will be paid one month in arrear;
Suppliers of material will extend 1 ½ month credit; sales will

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be 20% for cash and the rest at two months credit; 90% of
the income tax will be paid in advance in quarterly
installments: The company wishes to keep Rs 1,00,000 in cash.
Prepare an estimate of the requirements of (i) working
capital (total basis) and (ii) cash cost of working capital
Solution:
Estimate of the Requirements of working capital (Total
Approach)
Rs Rs
Currents Assets:
1 Stock of Finished Goods (10% of goods
produced):
Raw Materials 16,80,00x10/100 1,68,000
Wages and Manufacturing Expenses 1,25,000 3,40,000
12,50,000x10/100
Depreciation 4,70,000x10/100 47,000
2 Work-in-process (15% of the
production):

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FINANCING OF WORKING CAPITAL

The working capital requirements of a concern can be
classified as:
(a) Permanent or Fixed working capital requirements
(b) Temporary or Variable working capital requirements
In any concern, a part of the working capital investments
are as permanent investments in fixed assets. This is so
because there is always a minimum level of current assets
which are continuously required by the enterprise to carry out
its day- to-day business operations and this minimum cannot
be expected to reduce at any time. This minimum level of
current assets gives rise to permanent or fixed working
capital as this part of working capital is permanently blocked
in current assets.
Similarly, some amount of working capital may be
required to meet the seasonal demands and some special
exigencies such such as rise in prices, strikes, etc. this
proportion of working capital gives rise to temporary or
variable working capital which cannot be permanently
employed gainfully in business.

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The fixed proportion of working capital should be

generally financed from the fixed capital sources while the
temporary or variable working capital requirements of a
concern may be met from the short term sources of capital.
The various sources for the financing of working
capital are as follows:

FINANCING OF PERMANENT/FIXED OR LONG-TERM

WORKING CAPITAL
Permanent working capital should be financed in such a
manner that the enterprise may have its uninterrupted use for a
sufficiently long period. There are five important sources of
permanent or long-term working capital.
1. Shares: Issue of shares is the most important source for
raising the permanent or long-term capital.
2. Debentures: A debenture is an instrument issued by the
company acknowledging its debt to its holder. It is also an
important method of raising long- term or permanent working
capital.
3. Public Deposits: Public deposits are the fixed deposits
accepted by a business enterprise directly from the public.
This source of raising short term and medium-term finance

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was very popular in the absence of banking facilities.

4. Ploughing Back of profits: Ploughing back of profits
means the reinvestments by a concern of its surplus earnings in
its business. It is an internal source of finance and is most
suitable for an established firm for its expansion,
modernisation and replacement etc.
5. Loans from Financial Institutions: Financial institutions
such as commercial Banks, Life Insurance corporation,
Industrial Finance Corporation of India, State Financial
Corporations, Sate Industrial Development Corporations,
Industrial Development Bank of India, etc. also provide short-
term, medium-term and long-term long.
FINANCING OF TEMPORARY, VARIABLE OR
SHORT -TERM WORKING CAPITAL
The main source of short-term working capital are as
follows:
1. Indigenous Bankers
2. Trade Credit
3. Installment Credit
4. Advances
5. Accrued Expenses
6. Deferred Incomes
8. Commercial paper
9. Commercial Banks
DETERMINING THE WORKING CAPITAL FINANCING
MIX
Broadly speaking there are two sources of financing
working capital requirements: (i) Long-term sources, and (ii)
short-term sources. Therefore, a question arises as to what

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portion of working capital (current assets) should be financed

by long-term sources and how much by short-term sources?
There are three basic approaches for determining an
appropriate working capital financing mix.

Approaches to financing mix

The hedging or The conservative The Aggressive

matching approach approach approach

1. The Hedging or Matching Approach

The term 'hedging' usually refers to two off-selling
transactions of a simultaneous but opposite nature which
counter balance the effect of each other. With reference to
financing mix, the term hedging refers to 'a process of
matching maturities of debt with the maturities of financial
needs'. This approach is also known as matching approach'. It
classifies the requirements of total working capital into two
categories:
(i) Permanent or fixed working capital which is the
minimum amount required to carry out the normal
business operations. It does not vary over time.
(ii) Temporary or seasonal working capital which is required
to meet special exigencies. It fluctuates over time.
The hedging approach suggests that the permanent
working capital requirements should be financed with funds
from long-term sources while the temporary or seasonal
working capital requirements should be financed with short-
term funds.

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2. The Conservative Approach

This approach suggests that the entire estimated
investments in current assets should be financed from long-
term sources and the short-term sources should be used only
for emergency requirements.
3. The Aggressive Approach
The aggressive approach suggests that the entire
estimated requirements of currents asset should be financed
from short-term sources and even a part of fixed assets
investments be financed from short-term sources. This
approach makes the finance-mix more risky, less costly and
more profitable.
ZERO WORKING CAPITAL APPROACH
We have discussed earlier that the net working capital of
a firm may be positive or negative, i.e the total of current
assets may exceed the total of current liabilities or vice-versa.
However, in some cases, there may neither be any positive nor
any negative working capital; the total of the current assets
may just be equal to the total of current liabilities. Such a
situation may be called as zero working capital situation.
Review Questions:
1. Define the term working capital. What factors would you
take into consideration in estimating the working capital
needs of a concern?
2. Describe the need and determinants of working capital in
a business.
3. What factors would you take into consideration in
estimating the working capital needs of a concern?
4. In managing working capital, the finance manager faces
the problem of compromising the conflicting goals of
liquidity and profitability. Comment what strategy should

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he develop to solve this problem.

EXERCISES
Ex. 1. Traders Ltd. are engaged in large-scale retail business.
From the following information, you are required to forecast
their working capital requirements:

Ex. 4. The board of Directors of Nanak Engineering Company

Private Ltd. requests you to prepare a statement showing the
Working Capital Requirement for a level of activity of
1,56,000 units of production.
The following information is available for your
calculations:

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20% of the output is sold against cash. Cash in hand and

at bank is expected to be Rs 60,000. It is to be assumed that
production is carried on evenly throughout the year, wages and
overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
[Ans: Working Capital Required = Rs 62,61,000]
[Note: As degree/stage of completion of work-in process
is not given, it has been assumed to be 100% complete as
regards material and 50% for labour and overheads. Further, it
is stated that wages and overheads accrue evenly throughout
the year].
Ex. 5. From the information given below you are required to
prepare a projected Balance Sheet, Profit and Loss Account
and then an estimate of working capital requirements:
Rs
(a) Issued Share Capital 2,00,000
8% bonds 75,000
Fixed Assets at Cost 2,00,000
(b) The expected ratios of cost to selling price are:
Raw Materials 40%
Labour 30%
Overheads 20%
Profit 10%

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(c) Raw materials are kept in store for an average of

two months
(d) Finished goods remain in stock for an average
period of one
month
(e) Work-in-process (100% complete in regard to
material and 50%
for labour and overheads) will approximately be to
half a month's
production
(f) Credit allowed to customers is two months and
given by suppliers
is one month
(g) Production during the previous year was 40,000
units and it is
planned to maintain the same in the current year
also.
(h) Selling price is Rs 9 per unit.
(i) Calculation of debtors may be made at selling price.

[Ans: N.P. Rs 30,000; total of B/S Rs 3,20,750; W.C. Rs

1,05,000]
[Hint: Working Capital has been calculated after preparing
Projected Balance Sheet, i.e. Current Assets - Current
liabilities].
Ex.6. The following information has been extracted from the
cost sheet of a company:
Rs per Unit
Raw materials 45
Direct labour 20

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Overheads 40
Total 105
Profit 15
Selling Price 120

The following further information is available:

(1) Raw materials are in stock on an average two months.
(2) The material are in process on an average for 4 weeks.
The degree of completion is 50% in all respects.
(3) Finished goods stock on an average is for one month.
(4) Time lag in payment of wages and overheads is 1½
weeks
(5) Time lag in receipt of proceeds from debtors is 2 months.
(6) Credit allowed by suppliers is one month.
(7) 20% of the output is sold against cash
(8) The company expects to keep a cash balance of Rs
10,000
(9) Take 52 weeks per annum
(10) Calculation of debtors may be made at selling price.
(11) The company is poised for a manufacture of 14,400 units
in the year
You are required to prepare a statement showing the
working capital requirements of the company.
[Ans: Rs 4,53,631]
Ex. 7: Foods Ltd. is presently operating at 60% level
producing 36,000 packets of snack foods and proposes to
increase capacity utilisation in the coming year by 331/3% over

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the existing level of production.

The following data has been supplied:
(i) Unit cost structure of the product at current level:

Rs
Raw materials 4
Wages 2
Overheads (Variable) 2
Fixed Overhead 1
Profit 3
Selling Price 12

(ii) Raw materials will remain in stores for 1 month before

being issued for production. Material will remain in process
for further 1 month. Suppliers grant 3 months credit to the
company.
(iii) Finished goods remain in go down for 1 month
(iv) Debtors are allowed credit for 2 months
(v) Lag in wages and overhead payments is 1 month and
these expenses accrue evenly throughout the production
cycle.
(vi) No increase either in cost of inputs or selling price is
envisaged.
(vii) Calculation of debtors may be made at selling price
Prepare a projected profitability statement and the
working capital requirement at the new level, assuming that a
minimum cash balance Rs 19,500 has to be maintained)
[Ans: Profit Rs 1,56,000; Working Capital Required Rs 1,25,
000]

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[Hints :(1) Work-in process is assumed to be 50% complete as

regards wages and overheads with full material consumption.
As wages and overheads are given to accrue evenly throughout
the production cycle, it is assumed that these will be in process
for half a month on an average.
(2) It has been assumed that there will be no increase in
the stock levels due to increase in capacity].

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UNIT- 5
MANAGEMENT OF CASH AND
MARKETABLE SECURITIES
Learning objectives
 Nature of cash
 Motives for holding cash
 Cash management
 Managing cash flows
 Determining optimum cash balance
 Cash management models
 Investment of surplus funds
In this unit we will focus on the necessity for managing
cash and marketable securities. Cash being one of the
important constituents of working capital, it is essential to have
an efficient cash management system for the smooth conduct
of the business.
INTRODUCTION
Cash is one of the current assets of a business. It is
needed at all times to keep the business going. A business
concern should always keep sufficient cash for meeting its
obligations. Any shortage of cash will hamper the operations
of a concern and any excess of it will be unproductive. It is in
this context that cash management has assumed much
importance.
Nature of Cash
Cash itself does not produce goods or services. It is used
as a medium to acquire other assets. It is the other assets which
are used in manufacturing goods or providing services. The
idle cash can be deposited in bank to earn interest.

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There remains a gap between cash inflows and cash

outflows. Sometimes cash receipts are more than the
payments or it may be vice-versa at another time.
Motives For Holding Cash
The firm's needs for cash may be attributed to the
following needs: Transactions motive, Precautionary motive
and Speculative move.
Transaction Motive
A firm needs cash for making transactions in the day to
day operations. The cash is needed to make purchases, pay
expenses, taxes, dividend etc. The cash need arise due to the
fact that there is no complete synchronization between cash
receipts and payments. Sometimes cash receipts exceed ash
payments or vice-versa.
Precautionary Motive
A firm is required to keep cash for meeting various
contingencies. Though cash inflows and cash outflows are
anticipated but there may be variations in these estimates. Such
contingencies often arise in a business. A firm should keep
some cash for such contingencies or it should be in a position
to raise finances at a short period. The cash maintained for
contingency needs is not productive or it remains idle.
However, such cash may be invested in short-period or low-
risk marketable securities which may provide cash as and
when necessary.
Speculative Motive
The speculative motive relates to holding of cash for
investing in profitable opportunities as and when they arise.
Such opportunities do not come in a regular manner. These
opportunities cannot be scientifically predicted. These
transactions are speculative because prices may not move in a

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direction in which we suppose them to move.

Cash Management
Cash management has assumed importance because it is
the most significant of all the current assets. It is required to
meet business obligations and it is unproductive when not
used. Cash management deals with the following:
i. Cash inflows and outflows
ii. Cash flows within the firm
iii. Cash balance held by the firm at a point of time.
Cash management needs strategies to deal with various
facets of cash.
Following are some of its facets:
a. Cash Planning
Cash planning is a technique to plan and control the use
of cash. A project cash flow statement may be prepared, based
on the present business operations and anticipated future
activities.
b. Cash Forecasts and Budgeting
A cash budget is an estimate of cash receipts and
disbursements during a future period of time. It is an analysis
of flow of cash in business over a future, short or long period
of time.
The finance manager will make estimates of likely
receipts in the near future and the expected disbursements in
that period. He should keep in mind the sources from where he
will meet short-term needs. He should also plan for productive
use of surplus cash for short periods.
The long-term cash forecast are also essential for proper
cash planning. These estimates may be for three, four, five or
more years. Long term forecasts indicate company's future

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financial needs for working capital, capital project etc.

Both short-term and long-term cash forecasts may be
made with the help of following methods:
i. Receipts and disbursement method
ii. Adjusted net income method
i. Receipts and Disbursement Method. In this method
the receipts and payments of cash are estimated. The cash
receipts may be from cash sales, collections from debtors, sale
of fixed assets, receipts of dividend or other income of all the
items; it is difficult to forecast sales. The sales may be on cash
as well as credit basis. Cash sales will bring receipts at the time
of sale while credit sales will bring cash later on. The
collections from debtors (credit sales) will depend upon the
credit policy of the firm. Payments may be made for cash
purchase, to creditors for goods, purchase of fixed assets, for
meeting operating expenses such as wage bill, rent, rates, taxes
or other usual expenses, dividend to shareholders etc.
Any shortfall in receipts will have to be met from
banks or other sources. Similarly, surplus cash may be invested
in risk free marketable securities.
ii. Adjusted Net Income Method. This method may also
be known as sources and uses approach. It generally has three
sections: sources of cash, uses of cash and adjusted cash
balance. The adjusted net income method helps in projecting
the company's need for cash at some future date and to see
whether the company will be able to generate sufficient cash.
If not, then it will have to decide about borrowing or issuing
shares etc. This method helps in keeping a control on
working capital and anticipating financial requirements.
MANAGING CASH FLOWS
After estimating the cash flows, efforts should be made to

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adhere to the estimates of receipts and payments of cash. Cash

management will be successful only if cash collections are
accelerated and cash disbursements, as far as possible are
delayed. The following methods of cash management will
help:
Method of Accelerating Cash Inflows
1. Prompt Payment by Customers. In order to
accelerate cash inflows, the collections from customers should
be prompt. This will be possible by prompt billing.
2. Quick conversion of Payment into cash. Cash
inflows can be accelerated by improving the cash collecting
process. Once the customer writes a cheque in favour of the
concern the collection can be quickened by its early collection.
3. Decentralized Collections. A big firm operating over
wide geographical area can accelerate collections by using the
system of decentralised collections. A number of collecting
centres are opened in different areas instead of collecting
receipts at one place.
4. Lock Box System. Lock box system is another
technique of reducing mailing, processing and collecting time.
Under this system the firm selects some collecting centres at
different places. The places are selected on the basis of number
of consumers and the remittance to be received from a
particular place. The firm hires a Post Box in post office and
the parties are asked to send the cheques on that post box
number. A local bank is authorised to operate the post box.
Methods of Slowing Cash Outflows
A company can keep cash by effectively controlling
disbursements. The objective of controlling cash outflows is to
slow down the payments as far as possible. Following methods
can be used to delay disbursements:

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1. Paying on Last Date. The disbursements can be

delayed on making payments on the last due date only. If the
credit is for 10 days then payment should be made on 10th day
only.
2. Adjusting Payroll Funds. Some economy can be
exercised on payroll funds also. It can be done by reducing the
frequency of payments. If the payments are made weekly then
this period can be done to a month.
4. Centralisation of Payments. The payments should be
centralised and payments should be made through drafts or
cheques. When cheques are issued from the main office then it
will take time for the cheques to be cleared through post.
5. Inter-bank Transfer. An efficient use of cash is also
possible by inter- bank transfers. If the company has accounts
with more than one bank then amounts can be transferred to
the bank where disbursements are to be made.
6. Making use of Float. Float is the difference between
the balances shown in company's cash book (Bank column)
and balance in passbook of the bank. Whenever a cheque is
issued, the balance at bank in cash book is reduced.
The party to whom the cheque is issued may not
present it for payment immediately. If the party is at some
other station then cheque will come through post and it may
take a number of days before it is presented. Until the time, the
cheque is not presented to the bank for payment, there will be a
balance in the bank. The company can make use of this float if
it is able to estimate it correctly.
Determining Optimum Cash Balance
A firm has to maintain a minimum amount of cash for
settling the dues in time. The cash is needed to purchase raw
materials, pay creditors, day to day expenses, dividend etc. The
test of liquidity of the firm is that it is able to meet various

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obligations in time.
Thus, a firm should maintain an optimum cash balance,
neither a small nor a large cash balance. Cash budget is the
most important tool in cash management.
Cash budget
A cash budget is an estimate of cash receipts and
disbursements of cash during a future period of time. It is a
device to plan and control the use of cash. The cash budget
pin points the period when there is likely to be excess or
shortage of cash.
The cash receipts from various sources are anticipated.
The estimated cash collections from sales, debts, bills
receivable, interests, dividends and other incomes and sale of
investments and other assets will be taken into account. The
amounts to be spent on purchase of materials, payment to
creditors and meeting various other revenue and capital
expenditure needs should be considered. The preparation of
cash budget has been explained in the problems below:
Problem 1. From the following forecast of income and
expenditure, prepare a cash budget for the months January to
April 2016.

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Additional information is as follows:

1. The customers are allowed a credit period of 2 months
2. A dividend of Rs 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on
15th January for Rs 5,000 ; a Building has been purchased
on 1st March and the payments are to be made in monthly
installments of Rs 2,000 each.
4. The creditors are allowing a credit of 2 months
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2016 is
Rs.15,000.
Solution

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Problem 2.
ABC Company wishes to arrange overdraft facilities with its
bankers during the period
April to June, 2016 when it will be manufacturing mostly for
stock. Prepare a cash budget for the above period from the
following data, indicating the extent of the bank facilities the
company will require at the end of each month.
(a) Sales Purchase Wages
2016
Rs Rs Rs
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000

(b) 50 percent of credit sales are realised in the month

following the sales and remaining 50 percent in the second

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month following. Creditors are paid in the month

following the month of purchase.
(c) Cash at Bank on 01.04.2016 (estimated) Rs 25,000
Solution
Cash Budget for Three Months from April to June, 2011
April Rs May Rs June Rs

(a) Receipts :
Opening Balance 25,000 53,000 (-)51,000
Sales 90,000 96,000 54,000
Amount received from Sales 96,000 54,000 87,000
Total Receipts 2,11,000 2,03,000 90,000
(b) Payments:
Purchases 1,44,000 2,43,000 2,46,000
Wages 14,000 11,000 10,000
Total Payments 1,58,000 2,54,000 2,56,000
(-)51,000
Closing Balance (a-b) 53,000 (-) 1,66,000

Note: Workers are paid on 1st of the following month, ie., wages
for March will be paid in April and for April in May and so
on.
Problem 3. From the following budget data, forecast the cash
position at the end of April, May and June 2016.

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Sales Purchases Wages

Month Miscellaneous
Rs Rs Rs
February 1,20,000 84,000 10,000 7,000
March 1,30,000 1,00,000 12,000 8,000
April 80,000 1,04,000 8,000 6,000
May 1,16,000 1,06,000 10,000 12,000
June 88,000 80,000 8,000 6,000

Additional Information:
Sales: 20% realised in the month of sales, discount
allowed 2%. Balance realised equally in two subsequent
months.
Purchase: These are paid in the month following the month of
supply.
Wages: 25% paid in arrears following month.
Miscellaneous expenses. Paid a month in arrears.
Rent: Rs 1,000 per month paid quarterly in advance, due in
April.
Income-tax: First installment of advance tax Rs 25,000 due on or
before 15th June. Income from investments. Rs 5,000 received
quarterly, in April, July etc.
Cash in hand: Rs 5,000 in 1st April 2016.

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Solution
Cash Budget
for the months from April to
June 2016
April May June
Rs Rs Rs
Receipts
Opening Balance 5,000 5,680 (-)7,084
Receipts from Debtors and 1,15,680 1,06,736 95,648
Sales (1)
5,000
Income from Investments 1,25,680 1,12,416 88,564
Payments:
Creditors 1,00,000 1,04,000 1,06,000
Wages (2) 9,000 9,500 8,500
Rent 3,000 --
Miscellaneous Expenses 8,000 6,000 12,000
Income tax -- -- 25,000
Closing Balance 1,20,000 1,19,500 1,51,500
5,680 (-)7,084 (-
)62,936

Working notes:
(1) Calculations of amount received from debtors and sales
April
16,000
Cash sales (20% on 80,000) 320

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Less 2% discount ----------

15,680
Add 40% of Rs 1,30,000 (Sales 52,000
March)
Add 40% of Rs 1,20,000 (Sales 48,000
of Feb.)
1,15,680

May Cash sales (20% 1,16,000) 23,200

Less 2% discount 464
22,736
Add 40% of Rs 80,000 (Sales of 32,000
April)
Add 40% of Rs 1,30,000 (Sales of 52,000
March)
1,06,736
June Cash sales 20% of 88,000 17,600
352
Less 2% discount -------
17,248
Add 40% of Rs 1,16,000 (Sales 46,400
for May)
Add 40% of 80,000 (Sales of 32,000
April)
(2) Calculation of payment for wages ---------
95,648

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April 25% of 12,000 Rs 12,000 (Wages for 3,000

March)
75% of Rs 8,000 (Wages for April 6,000

9,000

May 25% of Rs 8,000 (Wages for April) 2,000

7,500
75% of Rs 10,000 (Wages for May)
9,500
June 25% of Rs 10,000 (Wages for May) 2,500
6,000
75% of Rs 8,000 (Wages of June) 8,500

MANAGEMENT OF MARKETABLE SECURITIES

The marketable securities are the short term highly liquid
investments in money market instruments that can easily be
converted into cash. A firm has to maintain a reasonable
balance of cash to keep the business going. Instead of keeping
the surplus cash as idle, the firm should invest in marketable
securities so as to earn some income to the business. As the
amount of cash kept in the business earns no explicit return,
the firm should hold a minimum level of cash and the excess
balance of cash may be invested in marketable securities which
earns some return as well as provide opportunities to be
converted easily into cash (through sale of securities) as and
when required.
The management of investments in marketable securities
is an important function of financial management. The basic
objective of investment in marketable securities is to earn

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some return for the business. Thus, the return available is an

important criterion while choosing among the alternative
securities, yet investment of surplus cash in marketable
securities need a prudent and cautious approach. The selection
of securities should be carefully made so that cash can be
raised quickly on demand by sale of these securities. The
following are some of the important factors that should be
considered while choosing among alternative securities to be
purchased:
1. Safety. Since a firm invests cash in marketable
securities to earn some return on surplus cash but with the
primary motive of converting them back into cash easily
through sale of securities as and when required, the firm will
tend to invest in very safe marketable securities.
2. Maturity. The maturity of the marketable securities
should be matched with the length of time for which the
surplus cash is expected to be available.
3. Liquidity and Marketability. Liquidity refers to the
ability to convert a security into cash immediately without any
significant loss of value. So the securities selected should have
ready market and may be realisable in a very short- period as
and when required even before the maturity date.
4. Return or Yield. Other things equal, a firm would like
to choose the securities which give higher return of yield on its
investment. However, it must be remembered that safety and
liquidity risk are of greater importance than the return risk in
making decision about investments in marketable securities.
Review Questions
Essay Type
1. What do you understand by cash management? How can
it be undertaken?

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2. "Efficient cash management will aim at maximizing the

cash inflows and showing cash outflows."
3. What is a lock box system? How does it help to reduce
the cash balances?
4. Explain various methods of investing surplus cash. What
criteria should a firm use in investing in marketable
securities?
5. Explain and illustrate the utility and preparation of cash
budget as a tool of cash management.
6. "The twin objectives in managing the cash flows should
be to accelerate cash collection and decelerate or delay
cash disbursements as much as possible." Discuss.
1. Prepare cash budget for July-December from the
following information.
(i) The estimated sales, expenses etc., are as follows:
Rs
lakhs)
June July Aug. Sept. Oct. Nov.
Dec.
Sales 35 40 40 50 50 60 65
Purchases 14 16 17 20 20 25 28
Wages and
12 14 14 18 18 20 22
Salaries
Misc. Expenses 5 6 6 6 7 7 7
Interest Received 2 - - 2 - - 2
Sales of Shares - - 20 - - - -
ii. 20% of the sales are on cash and the balance on credit.
iii. 1% of the credit sales are returned by the customers. 2% of
the total accounts receivable constitute bad debt losses.

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50% of the good account receivable are collected in the

month of the sales, and the rest in the next month.
iv. The time lag in the payment of misc. expenses and
purchases is one month. Wages and salaries are paid
fortnightly with a time lag of 15 days.
v. The company keeps minimum cash balance of Rs 5 lakhs.
Cash in excess of Rs 7 lakhs is invested in Govt. securities
in the multiple of Rs 1 lakh, Shortfalls in the minimum cash
balance are made good by borrowing from banks. Ignore
interest received and paid.
2. From the following information, prepare a cash budget for
the months of January to April.
Expected Purchase Rs Expected Sales Rs
January 48,000 60,000
February 80,000 40,000
March 81,000 45,000
April 90,000 40,000

Wages to be paid to workers Rs 5,000 each month, Balance at

Bank on 1st January Rs 8,000.
It has been decided by the management that:
i. In case of deficit of fund within the limit of Rs 10,000 an
arrangement can be made with the bank.
iii. In case of deficit of fund exceeding Rs 10,000 but within
the limit of Rs 42,000 issue of debentures is to be
preferred.
iii. In case of deficit of fund exceeding Rs 42,000 issue of
shares is preferred (considering the fact that it is within
the limit of authorised capital)

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(Ans: Total deficiency Rs 1,26,000; Total receipts Rs 1,93,000.

Total payments Rs 3,19,000)
4. A company expects to have Rs 25,000 in bank on 1st
May 2011, and requires you to prepare an estimate of cash
position during the three months – May June and July, 2011.
Office Factory Selling
Month Sale Purchase Wages
expenses Expenses Expenses
March 50,000 30,000 6,000 4,000 5,000 3,000
April 56,000 32,000 6,500 4,000 5,500 3,000
May 60,000 35,000 7,000 4,000 6,000 3,500
June 80,000 40,000 9,000 4,000 7,500 4,500
July 90,000 40,000 9,500 4,000 8,000 4,500

Other Information:
i. 20% of sales are in cash, remaining amount is collected in
the month following that of sales
ii. Suppliers supply goods at two month's credit
iii. Wages and all other expenses are paid in the month
following the one in which they are incurred.
iv. The company pays dividends to shareholders and bonus
to workers of Rs 10,000 and Rs 15,000 respectively in the
month of May.
v. Plant has been ordered and is expected to be received in
June. It will cost Rs 80,000 to be paid.
vi. Income tax Rs 25,000 is payable in July.
(Ans. Balance May Rs 7,800, June Rs (-) 60,700 in July
Rs (-) 63,700)

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Name of service or
Cost unit
undertaking
Passenger Transport Per passenger kilometre
Goods Transport Per tonne kilometre
Hospital Per patient bed or per patient day or
week
Electricity supply Per kilowatt hour (KWH)
Canteen Per meal person
Cinema Theatre Per man show
Hotel or Lodge Per person per day

Classification of Costs
In service costing, costs are classified into three heads
as follows:
1. Fixed Costs or Standing Charges – These include salary of
operating manager, supervisor, etc., insurance, motor
vehicle tax.
2. Semi-variable Costs, Maintenance Charges, or
Manufacturing Charges.
3. Variable Costs or Operating and Running Charges.
The classification of various items of costs into the
above three groups should not be attempted as a matter of rule.
It depends basically on the circumstances of each case.
Transport Costing
Transport industries include air, water, road and
railways. Motor transport includes private cars, buses, taxis,
carriers, lorries, etc. The objectives of motor transport costing
may be as under:

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1. It helps in controlling, operating and maintenance costs.

2. Cost of using own vehicle and hired vehicle can be
compared.
3. Operating costs of different vehicles can be compared and
thus efficiency can be improved.
4. Comparison of oil consumption and time taken for a trip
with other trips is possible.
5. Proper apportionment of costs to different departments
which use the service is possible.
6. It provides information for giving quotation and fixing the
rates.
Procedure of Operating Costing
While determining the operating costs in transport
undertakings the following procedure is adopted:
(a) Collection of costs
(b) Classification of costs.
(c) Selection of appropriate cost unit.
(d) Preparation of operating cost statement.

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UNIT- 6
INVENTORY MANAGEMENT

Learning Objectives:
 Understand the meaning and nature of inventory
 Purpose of holding inventories
 Risk and costs of holding inventories
 Inventory management
 Tools and techniques of inventory management
 Determination of stock levels
INTRODUCTION
Every enterprise needs inventory for smooth running of
its activities. It serves as a link between production and
distribution processes. There is, generally, a time lag between
the recognition of a need and its fulfilment. The greater the
time-lag, the higher the requirements for inventory. The
unforeseen fluctuations in demand and supply of goods also
necessitate the need for inventory. It also provides a cushion
for future price fluctuations.
The investment in inventories constitutes the most
significant part of current assets/working capital in most of the
undertakings. Thus, it is very essential to have proper control
and management of inventories. The purpose of inventory
management is to ensure availability of materials in sufficient
quantity as and when required and also to minimise investment
in inventories.
MEANING AND NATURE OF INVENTORY
Inventory includes the following things:
(a) Raw Material. Raw materials form a major input into

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the organisation. They are required to carry out production

activities uninterruptedly.
(b) Work-in-Progress. The work-in-progress is that stage
of stocks which are in between raw materials and finished
goods.
(c) Consumables. These are the materials which are
needed to smoothen the process of production. These materials
do not directly enter production but they act as catalysts, etc.
Consumables may be classified according to their consumption
and criticality. Generally, consumable stores do not create any
supply problem and form a small part of production cost.
There can be instances where these materials may account for
much value than the raw materials. The fuel oil may form a
substantial part of cost.
(d) Finished goods. These are the goods which are ready
for the consumers. The stock of finished goods provides a
buffer between production and market. The purpose of
maintaining inventory is to ensure proper supply of goods to
customers.
(e) Spares. Spares also form a part of inventory. The
Consumption pattern of raw materials, consumables, finished
goods are different from that of spares. The stocking policies
of spares are different from industry to industry. Some
industries like transport will require more spares than the other
concerns. The costly spare parts like engines, maintenance
spares etc. are not discarded after use, rather they are kept in
ready position for further use. All decisions about spares are
based on the financial cost of inventory on such spares and the
costs that may arise due to their non-availability
Purpose/Benefits of Holding Inventories
Al though holding inventories involves blocking of firm's
funds and the costs of storage and handling, every business

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enterprise has to maintain a certain level of inventories to

facilitate uninterrupted production and smooth running of
business. Generally speaking, there are three main purposes or
motives of holding inventories:
i. The Transaction Motive which facilities continuous
production and timely execution of sales orders.
ii. The Precautionary Motive which necessitates the holding
of inventories for meeting the unpredictable changes in
demand and supplies of materials.
iii. The Speculative Motive which induces to keep inventories
for taking advantage of price fluctuations, saving in re-
ordering costs and quantity discounts, etc.
Risk and Costs of Holding Inventories
The holding of inventories involves blocking of a firm's
funds and incurrence of capital and other costs. It also
exposes the firm to certain risks. The various costs and risks
involved in holding inventories are as below:
(i) Capital Costs. Maintaining of inventories results in
blocking of the firm's financial resources. The firm has,
therefore, to arrange for additional funds to meet the cost of
inventories.
(ii) Storage and Handling costs. Holding of inventories
also involves costs on storage as well as handling of materials.
The storage costs include the rental of the go down, insurance
charges, etc.
(ii) Risk of Price Decline. There is always a risk of
reduction in the prices of inventories by the suppliers in
holding inventories. This may be due to increased market
supplies, competition or general depression in the market.
(iii) Risk of Obsolescence. The inventories may become
obsolete due to improved technology, changes in

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requirements, change in customer's tastes, etc.

(iv) Risk Deterioration in Quality. The quality of the
materials may also deteriorate while the inventories are kept in
stores.
INVENTORY MANAGEMENT
It is necessary for every management to give proper
attention in inventory management. A proper planning of
purchasing, handling, storing and accounting should form a
part of inventory management. An efficient system of
inventory management will determine (a) what to purchase (b)
how much to purchase (c) from where to purchase (d) where
to store etc.
OBJECTS OF INVENTORY MANAGEMENT
The following are the objectives of inventory
management.
1. The ensure continuous supply of materials, spares and
finished goods so that production should not suffer at any
time and the customers demand should also be met.
2. To avoid both over-stocking and under-stock of inventory.
3. To maintain investments in inventories at the optimum
level as required by the operational and sales activities.
4. To keep material cost under control so that they
contributes in reducing cost of production and overall
costs.
5. To eliminate duplication in order or replenishing stocks.
This is possible with the help of centralising purchases.
6. To minimise losses through deterioration, pilferage,
wastages and damages.
7. To design proper organisation for inventory management.
A clear cut accountability should be fixed at various levels

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of the organisation.
8. To ensure perpetual inventory control so that materials
shown in stock ledgers should be actually lying in the
stores.
9. To ensue right quality goods at reasonable price. Suitable
quality standards will ensure proper quality of stocks. The
price-analysis, the cost-analysis and value-analysis will
ensure payment of proper prices.
10. To facilitate furnishing of data for short-term and long-
term planning and control of inventory.
TOOLS AND TECHNIQUES OF INVENTORY
MANAGEMENT
The following are the important tools and techniques of
inventory management and control:
1. Determination of Stock Levels.
2. Determination of Safety Stocks
3. Selecting a proper System of Ordering for Inventory
4. Determination of Economic Order Quantity
5. A.B.C. Analysis
6. V.E.D Analysis
7. Inventory Turnover Ratios
8. Aging Schedule of Inventories
9. Classification and Codification of Inventories
10. Preparation of Inventory Reports
11. Lead Time
12. Perpetual Inventory System
13. JIT Control System

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1. Determination of Stock Levels

Carrying of too much and too little of inventories is
detrimental to the firm. If the inventory level is too little, the
firm will face frequent stock-outs involving heavy ordering
cost and if the inventory level is too high it will be unnecessary
tie-up of capital. Therefore, an efficient inventory management
requires that a firm should maintain an optimum level of
inventory where inventory costs are the minimum and at the
same time there is no stock-out which may result in loss of sale
or stoppage of production. Various stock levels are discussed
as such.
(a) Minimum Level. This represents the quantity which
must be maintained in hand at all times. If stock is less than the
minimum level then the work will stop due to shortage of
materials. Following factors are taken into account while
fixing minimum stock level.
Lead Time. A purchasing firm requires some time to
process the order and time is also required by the supplying
firm to execute the order. The time taken in processing the
order and then executing it is known as lead time. It is essential
to maintain some inventory during this period.
Rate of Consumption. It is the average consumption of
materials in the factory. The rate of consumption will be
decided on the basis of past experience and production plans.
Nature of Material. The nature of material also affects
the minimum level. If a material is required only against
special orders of the customer then minimum stock will not be
required for such materials. Minimum stock level can be
calculated with the help of following formula:
Minimum stock level=Re-ordering level-(Normal
consumption x Normal Re-order period

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(b) Re-ordering Level. When the quantity of materials

reaches at a certain figure then fresh order is sent to get
materials again. The order is sent before the materials reach
minimum stock level. Re-ordering level or ordering level is
fixed between minimum level and maximum level. The rate of
consumption, number of days required to replenish the stocks,
and maximum quantity of materials required on any day are
taken into account while fixing re-ordering level. Re-ordering
level is fixed with the following formula:
Re-ordering Level = Maximum Consumption x Maximum
Re-order period
(c) Maximum Level. It is the quantity of materials beyond
which a firm should not exceed its stocks. If the quantity
exceeds maximum level limit then it will be overstocking. A
firm should avoid overstocking because it will result in high
material cost. Overstocking will mean blocking of more
working capital, more space for storing the materials, more
wastage of materials and more chances of losses from
obsolescence. Maximum stock level will depend upon the
following factors.
1) The availability of capital for the purchase of materials.
2) The maximum requirements of materials at any point of
time.
3) The availability of space for storing the materials.
4) The rate of consumption of materials during lead time.
5) The cost of maintaining the stores.
6) The possibility of fluctuations in prices.
7) The nature of materials. If the materials are perishable in
nature, then they cannot be stored for long.
8) Availability of materials. If the materials are available only
during seasons then they will have to be stored for the rest

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of the period.
9) Restrictions imposed by the Government. Sometimes,
government fixes the maximum quantity of materials
which a concern can store. The limit fixed by the
government will become the limiting factor and maximum
level cannot be fixed more than this limit.
10) The possibility of change in fashions will also affect the
maximum level. The following formula may be used for
calculating maximum stock level:

Maximum Stock Level= Re-ordering Level + Re-ordering Quantity-

(Minimum Consumption x Minimum Re-ordering period)

(d) Danger Level

It is the level beyond which materials should not fall in
any case. Danger level is determined with the following
formula:

Danger Level=Average Consumption x Maximum re-order period

for emergency purchases

(e) Average Stock Level

The average stock level is calculated as such:

Average Stock Level = Minimum Stock Level + ½ of re-order

quantity

(1) Determination of Safety Stocks

Safety stock is a buffer to meet some unanticipated
increase in usage. In order to protect against the stock out
arising out of usage fluctuations, firms usually maintain some
margin of safety or safety stocks.

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3. Ordering Systems of Inventory

The basic problem of inventory is to decide the re-order
point. This point indicates when an order should be placed.
The re-order point is determined with the help of these things:
(a) average consumption rate, (b) duration of lead time (c)
economic order quantity, when the inventory is depleted to
lead time consumption, the order should be placed. There are
three prevalent systems of ordering and a concern can choose
any one of these:
a) Fixed order quantity system generally known as
economic order quantity (EOQ) system;
b) Fixed period order system or periodic re-ordering system
or periodic review system;
c) Single order and scheduled part delivery system.
4. Economic Order Quantity (EOQ)
A decision about how much to order has great
significance in inventory management. The quantity to be
purchased should neither be small nor big because costs of
buying and carrying materials are very high. Economic order
quantity is the size of the lot to be purchased which is
economically viable. This is the quantity of materials which
can be purchased at minimum costs. Generally, economic
order quantity is the point at which inventory carrying costs
are equal to order costs. In determining economic order
quantity it is assumed that cost of managing inventory is made
up solely of two parts ie. ordering costs and carrying costs.
(A) Ordering costs. These are the costs which are
associated with the purchasing or ordering of materials. These
costs include:
1) Costs of staff posted for ordering of goods. A purchase
orders is processed and then placed with suppliers. The

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labour spent on this process is included in ordering costs.

2) Expenses incurred on transportation of goods purchased
3) Inspection costs of incoming materials.
4) Cost of stationery, typing, postage, telephone charges, etc.
These costs are also known as buying costs and will arise
only when some purchases are made.
When materials are manufactured in the concern then
these costs will be known as set-up costs. These costs will
include costs of setting up machinery for manufacturing
materials, time taken up in setting, costs of tools, etc.
The ordering costs are totalled up for the year and then
divided by the number of orders placed each year. The
Planning Commission of India has estimated these costs
between Rs 10 to Rs 20 per order.
(B) Carrying Costs. These are the costs for holding the
inventories. These costs will not be incurred if inventories are
not carried. These costs include:
1) The cost of capital invested in inventories. An interest will
be paid on the amount of capital locked-up in inventories.
2) Cost of storage which could have been used for other
purposes.
3) The loss of materials due to deterioration and
obsolescence. The materials may deteriorate with passage
of time. The loss of obsolescence arises when the
materials in stock are not usable because of change in
process or product.
4) Insurance cost
5) Cost of spoilage in handling of materials.
The Planning Commission of India had estimated these
costs between 15 per cent to 20 per cent of total costs. The

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longer the materials kept in stocks, the costlier it becomes by

20 per cent every year. The ordering and carrying costs have
a reverse relationship. The ordering cost goes up with the
increase in number of orders placed. On the other hand,
carrying costs go down per unit with the increase in number of
units, purchased and stored. It can be shown in the diagram as
below.

The ordering and carrying costs of materials being high,

an effort should be made to minimise these costs. The quantity
to be ordered should be large so that economy may be made in
transport costs and discounts may also be earned. On the other
hand, storing facilities, capital to be locked up, insurance costs
should also be taken into account.
Assumptions of EOQ. While calculating EOQ the following
assumptions are made.
1) The supply of goods is satisfactory. The goods can be
purchased whenever these are needed.
2) The quantity to be purchased by the concern is certain.
3) The prices of goods are stable. It results to stabilise
carrying costs.
When above-mentioned conditions are satisfied,
economic order quantity can be calculated with the help of
the following formula:

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Where,
A = Annual consumption in rupees. S = Cost of placing an
order.
I = Inventory carrying costs of one unit.
The materials are divided into a number of categories for
adopting a selective approach for material control. It is
generally seen that in manufacturing concern, a small
percentage of items contribute a large percentage of value of
consumption and a large percentage of items of materials
contribute a small percentage of value. In between these two
limits there are some items which have almost equal
percentage of value of materials. Under A-B-C analysis, the
materials are divided into three categories viz., A, B and C.
Past experience has shown that almost 10 per cent of the items
contribute to 70 per cent of value of consumption and this
category is called 'A' Category. About 20 per cent of the items
contribute about 20 percent of value of consumption and this is
known as category 'B' materials. Category 'C' covers about
7per cent of items of materials which contribute only 10
percent of value of consumption. There may be some
variation in different organisations and an adjustment can be
made in these percentages.
6. VED Analysis
The VED analysis is used generally for spare parts. Spare
parts are classified as Vital (V), Essential (E) and Desirable
(D). The vital spares are a must for running the concern
smoothly and these must be stored adequately. The non-
availability of vital spares will cause havoc in the concern.
The E type of spares are also necessary but their stocks may
be kept at low figures. The stocking of D type of spares may

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be avoided at times. If the lead time of these spares is less, then

stocking of these spares can be avoided.
7. Inventory Turnover Ratios
Inventory turnover ratios are calculated to indicate
whether inventories have been used efficiently or not.

8. Aging Schedule of Inventories

Classification of inventories according to the period (age)
of their holding also helps in identifying slow moving
inventories thereby helping in effective control and
management of inventories.
9. Classification and Codification of Inventories
The classification and coding of inventories enables the
introduction of mechanised accounting. It also helps in
maintaining secrecy of description. It also helps the prompt
issue of stores.
10. Inventory Reports
From effective inventory control, the management should
be kept informed with the latest stock position of different
items. This is usually done by preparing periodical inventory
reports. These reports should contain all information
necessary for managerial action. On the basis of these reports
management takes corrective action wherever necessary. The
more frequently these reports are prepared the less will be the
chances of lapse in the administration of inventories.

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11. Lead Time

Lead time is the period that elapses between the
recognition of a need and its fulfilment. There is a direct
relationship between lead time and inventories. The level of
inventory of an item depends upon the length of its lead time.
Suppose, lead time is one month. Any action taken now will
have an effect only one month later. So inventory for the
current month must be in hand. During lead time there will be
no delivery of materials and consuming departments will have
to be served from the inventories held.
Lead time has two components: Lead time for company
(administrative lead time) from initiation of procurement
action until the placing of an order, and the lead time for the
producer, known as delivery lead time from the placing of an
order until the delivery of the ordered material. Administrative
lead time also follows after the delivery is taken. The
functions of inspection, material handling, and transportation
in the factory also take some time. Administrative lead time is
in the hands of those who are dealing with material
procurement. Delivery lead time has to be negotiated at the
time of preparing purchase contract.
It is often seen that bulk of the lead time is taken up by
administrative lead time. This is the time over which company
has control but still too much time is taken up in receiving and
inspection of goods. A businessman may find to his frustration
that the goods which he has persuaded a supplier to deliver in
an extremely short time have been lying in his own goods
inwards department after delivery. Stock control or purchase
section of the organization should maintain lead time
schedules for all groups of materials.
12. Perpetual Inventory System
The stock taking may either be done annually or

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continuously. In the latter method, the stock taking continues

throughout the year. A schedule is prepared for stock taking of
various bins (store rooms). One bin is selected at random and
the goods are checked as per shown in the bin card. Then some
other bin is selected at random and so on. The personnel
associated with store-keeping are not told of stock taking
programme because store rooms are chosen at random. The
Institute of Cost and Management Accountants, London
defines perpetual inventory system as "a system of records
maintained by the controlling department, which reflects the
physical movements of stocks and their current balance". The
stores ledger and bin cards are helpful in this system because
these records help in knowing the movement of stores. This
facilitates regular checking of stores without closing down
the plant.
1.3 Just In Time (JIT) Inventory control System
Just in time philosophy, which aims at eliminating waste
from every aspect of manufacturing and its related activities,
was first developed in Japan. Toyota introduced this technique
in 1950's in Japan, however, U.S. companies started using this
technique in 1980's. The term JIT refers to a management tool
that helps to produce only the needed quantities at the needed
time.
Problem 1. From the following information, calculate
minimums stock level, maximum stock level and re-ordering
level:

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Solution

Problem 2. From the following information, find out

Economic Order Quantity. Annual Usage, 10,000 units
Cost of placing and receiving one order Rs 50 Cost of
materials per unit Rs. 25
Annual carrying cost of one unit : 10% of inventory value.
Solution:

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Solution:

Problem 4. Following information is given about materials:

Annual usage = Rs. 2,00,000
Cost of placing and receiving one order: Rs 80 Annual
carrying cost: 10% of inventory value Find out the economic
order quantity
Solution:

Problem 5. The annual demand for a product is 6,400 units.

The unit cost is Rs 6 and inventory carrying cost per unit per
annum is 25% of the average inventory cost. If the cost of
procurement is Rs 75 determine:
(a) Economic Order Quantity (EOQ)
(b) Number of orders per annum; and

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(c) Time between two consecutive orders.

Solution:

Problem 6. Gotham Ltd. produces a product which has a

monthly demand of 4,000 units. The product requires a
component X which is purchased at Rs 20. For every finished
product, one unit of the component is required. The ordering
cost is Rs 120 per order and the holding cost is 10% p.a.
You are required to calculate:
(i) Economic order quantity
(ii) If the minimum lot size to be supplied is 4000 units, what
is the extra cost, the company has to incur?

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Solution:

Problem 7. Vision Tubes Ltd. is the manufacturers of picture

tubes for TV. The following are the details of their operations
during 2015-2016.

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Required:
(i) Economic order quantity. If the supplier is willing to
supply 1500 units at a discount of 5% is it worth
accepting?
(ii) Re-order level
(iii) Maximum level of stock
(iv) Minimum level of stock
Solution

Review Questions
1) What do you mean by inventory?
2) What is the nature of inventories?
3) Give three objectives of holding inventories.
4) What are the risks and costs of holding inventories?

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5) Name various tools of inventory management.

6) Explain danger level of inventories.
7) What is VED analysis?
8) What is inventory turnover ratio?
9) What is meant by Inventory Management? What is it
essential to a business concern?
10) Define the term 'Inventory Control'.What are the
Inventory Control System?
11) Explain various tools and techniques used for inventory
management?
12) What is A-B-C analysis? How is it useful as a tool
of inventory management?
13) What is meant by 'Economic Order Quantity'? What are
the various costs which affect economic order quantity?
Exercise
1. A manufacturing company uses Rs 1,00,000 materials
per year. The administration cost per purchase is Rs
100, and carrying cost is 20% of the average inventory.
Calculate Economic Order Quantity for the company.
(Ans. Rs 10,000)
2. A manufacturer buys certain equipment from outside
suppliers at Rs 30 per unit. Total annual needs are 800
units. The following further data are available:
Annual return on investment, 10%
Rent, insurance, taxes per unit per year, Rs.1 Cost of
placing an order, Rs 100.
Determine the economic order quantity. (Ans. 200
units)
3. What do you understand by maximum level, minimum

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level, re-ordering level? Calculate the above from the

following data:
Re-order quantity 1,500 units
Re-order period 4 to 6 weeks
Maximum consumption 400 units per week
Normal consumption 300 units per week
Minimum consumption 250 units per week
(Ans: Re-order quantity 2,400 units; Maximum level
2,900 units; Minimum level 900 units)
4. Two materials, X and Y are used as follows: Minimum
usage – 50 units per week each; Maximum usage – 150
units per week each; Normal usage – 100 units per week
each; Ordering quantity: X-600 units and Y-1,000 units;
Delivery period : X-4 to 6 weeks; Y-2 to 4 weeks
Calculate for each material:
(a) Minimum level, (b) Maximum level, (c) Ordering level.
(Ans: (a) X = 400 units, Y = 300 units; (b) X=1,300 units,
Y=1,500 units; (c) X=900 units, Y=600 units
5. The following information is available in respect of
component 020:

You are required to calculate:

(a) Re-order level
(b) Re-order quantity
(Ans: (i) 6,000 units; (ii) 4,000 units)

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6. Ace Ltd. Manufactures a product and the following

particulars are collected for the year ended March, 2011:

Monthly demand 100 units

Cost of placing an order Rs 100
Annual carrying cost Rs 15 per unit
Normal usage 50 units per week
Minimum usage 25 units per week
Maximum usage 75 units per week
Re-order period 4-6 weeks
You are required to calculate:
Re-order quantity
Re-order level
Minimum level
Maximum level
Average stock level
(Ans:(a) 186 units, (ii) 450 units; (iii) 200 units; (iv) 536 units;
(v) 368 units, or 293 units)

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UNIT – 7
RECEIVABLES MANAGEMENT

Learning objectives
 Understand the meaning of receivables
 Costs of maintaining receivables
 Factors influencing the size of receivables
 Meaning and objectives of receivables management
 Dimensions of receivables management
INTRODUCTION
An efficient use of financial resources is necessary to
avoid financials distress. Receivables result from credit sales.
A concern is required to allow credit sales in order to expand
its sales volume. It is not always possible to sell good on gash
basis only.
Thus receivable constitute a significant portion of current
assets of a firm. But, for investment in receivables, a firm has
to incur certain costs. Further, there is a risk of bad debts
also. It is, therefore, very necessary to have a proper control
and management of receivables.
Meaning of Receivable
Receivables represent amounts owed to the firm as a
result of sale of goods or services in the ordinary course of
business. Receivables are also known as accounts receivables,
trade receivables, customer receivables or book debts. The
purpose of maintaining or investing in receivable is to meet
competition, and to increase the sales and profits.
Costs of Maintaining Receivables
The allowing of credit to customers means given of funds

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for the customer's use. The concern incurs the following costs
on maintaining receivables:
1. Cost of Financing, Receivables. When goods and
services are provided on credit then concern's capital is
allowed to be used by the customers. The receivables are
financed from the funds supplied by shareholders for long
term financing and through retained earnings. The concern
incurs some cost for collecting funds which finance
receivables.
2. Cost of Collection. A proper collection of receivables
is essential for receivables management. The customers who
do not pay the money during a stipulated credit period are sent
reminders for early payments. Some persons may have to be
sent for collecting these amounts. In some cases legal recourse
may have to be taken for collecting receivables. All these costs
are known as collection costs which a concern is generally
required to incur.
3. Bad debts. Some customers may fail to pay the
amounts due towards them. The amounts which the customers
fail to pay are known as bad debts. Though a concern may be
able for reduce bad debts through efficient collection
machinery but one cannot altogether rule out this cost.
Factors Influencing the Size of Receivables
Besides sales, a number of other factors also influence the
size of receivables. The following factors directly and
indirectly affect the size of receivables.
(1). Size of Credit Sales. The volume of credit sales is
the first factor which increases or decreases the size of
receivables. If a concern sells only on cash basis, as in the case
of Bata Shoe Company, then there will be no receivables. The
higher the part of credit sales out of total sales, figures of
receivables will also be more or vice versa.

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(2) Credit Policies. A firm with conservative credit

policy will have a low size of receivable while a firm with
liberal credit policy will be increasing this figure. The vigour
with which the concern collects the receivables also affects its
receivables. If collections are prompt then even if credit is
liberally extended the size of receivables will remain under
control. In case receivables remain outstanding for a longer
period, there is always a possibility of bad debts.
(3). Terms of Trade. The size of receivables also
depends upon the terms of trade. The period of credit allowed
and rates of discount given are linked with receivables. If
credit period allowed is more than receivables will also be
more. Sometimes trade policies of competitors have to be
followed otherwise it becomes difficult to expand the sales.
The trade terms once followed cannot be changed without
adversely affecting sales opportunities.
(4) Expansion Plans. When a concern wants to expand
its activities, it will have to enter new markets. To attract
customers, it will give incentives in the form of credit
facilities. The periods of credit can be reduced when the firm is
able to get permanent customers. In the early stages of
expansion more credit becomes essential and size of
receivable will be more.
(5) Relation with Profits. The credit policy is followed
with a view to increase sales. When sales increase beyond a
certain level the additional costs incurred are less than the
increase in revenues. It will be beneficial to increase sales
beyond a point because it will bring more profits. The increase
in profits will be followed by an increase in the size of
receivable or vice-versa.
(6) Credit Collection efforts. The collection of credit
should be streamlined. The customers should be sent
periodical reminders if they fail to pay in time.

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(7) Habits of Customers. The paying habit of

customers also have a bearing on the size of receivables. The
customers may be in the habit of delaying payments even
though they are financially sound. The concern should remain
in touch with such customers and should make them realise the
urgency of their needs.
Meaning And Objectives Of Receivable Management
Receivables management is the process of making
decisions relating to investment in trade debts. We have
already stated that certain investment in receivables is
necessary to increase the sale and the profits of firm.
Dimensions of Receivables Management
Receivables management involves the careful
consideration of the following aspects:
1. Forming the credit policy
2. Executing the credit policy
3. Formulating and executing collection policy.
1. FORMING OF CREDIT POLICY
For efficient management of receivables, a concern must
adopt a credit policy. A credit policy is related to decisions
such as credit standards, length of credit period, cash discount
and discount period etc. should compare the earnings resulting
from released funds and the cost of discount. The discount
should be allowed only of its cost is less than the earnings
from additional funds. If the funds, cannot be profitably
employed then discount should not be allowed.
(d) Discount period. The collection of receivables is
influenced by the period allowed for availing the discount.
The additional period allowed for this facility may prompt
some more customers to avail discount and make payments.
This will mean additional funds released from receivables

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which may be alternatively used. At the same time the

extending of discount period will result in later collecting of
funds because those who were getting discount and making
payments as per earlier schedule will also delay their
payments. For example, if the firm allowing cash discount for
payments within seven days now extends it to payments within
fifteen days. There may be more customers availing discount
and paying early but there will be those also who were paying
earlier within seven days will now pay in fifteen days. It will
increase the collection period of the concern. Hence, this
decision involves matching of the effect on collection period
with the increased cost associated with additional customers
availing the discount.
2. EXECUTING CREDIT POLICY
After formulating the credit policy, is proper executing is
very important. The evaluation of credit applications and
finding out the credit worthiness of customers should be
undertaken.
(a) Collecting Credit Information. The first step in
implementing credit policy will be to gather credit information
about the customers. This information should be adequate
enough so that proper analysis about the financial position of
the customers is possible. This type of investigation can be
undertaken only upto to certain limit because it will involve
cost. The cost incurred in collecting this information and the
benefit from reduced bad debt losses will be compared. The
credit information will certainly help in improving the quality
of receivables but the cost of collecting information should not
increase the reduction of bad debts losses.
The sources from which credit information will be
available should be ascertained. The information may be
available from financial statements, credit rating agencies,
reports from banks, firm's records etc. Financial reports of the

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customer for a number of years will be helpful in determining

the financial position and profitability position. The balance
sheets will help in finding out the short term and long-term
position of the concern. The income statements will show the
profitably position of the concern. The income figures will
help in finding out whether it is sufficient to enable the
payment of receivables or other business liabilities or not. The
liquidity position and current assets movement will help in
finding out the current financial position. A proper analysis of
financial statements will be helpful in determining the
creditworthiness of customers. There are credit rating agencies
which can supply information about various concerns. These
agencies regularly collect information about business units
from various sources and keep this information up to date.
The interpreted information can be had from these agencies.
These agencies supply this information to their subscribers on
a regular basis through circulars, periodicals etc. The
information is kept in confidence and may be used when
required. Such agencies are not available in India at present
but countries like America have so many agencies in this field.
Credit information may be available with banks too. The
banks have their credit departments to analyze the financial
position of a customer. The bank in which one has its accounts
can be helpful in supplying this information. If the customer is
at a different place then the bank can collect this information
through its branch at that place and bank may even request the
other banks for information deposited, etc. may be helpful to
know about the customers.
In case of old customers, business's own records may
help to know their credit worthiness. The frequency of
payments, cash discounts availed, interest paid on overdue
payments etc., may help to form an opinion about the quality
of credit. The salesman of the business may also be asked to
collect information about the customers.

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(b) Credit Analysis. After gathering the required

information, the finance manager should analyse it to find out
the credit worthiness of potential customers and also to see
whether they satisfy the standards of the concern or not. The
credit analysis will determine the degree of risk associated
with the account, the capacity of the customer to borrow and
his ability and willingness to pay.
(c) Credit decision. After analysing the creditworthiness
of the customer, the finance manager has to take a decision
whether the credit is to be extended and if yes, then up to
what level. He will match the creditworthiness of the customer
with the credit standards of the company. If customer's
creditworthiness is above the credit standards then there is no
problem in taking a decision. It is only in the marginal cases
that such decisions are difficult to be made. In such cases the
benefit of extending the credit should be compared to the
likely bad debts losses and then a decision should be taken.
In case the customer's are below the company's credit
standards then they should not be out rightly refused. Rather
they should be offered some alternative facilities. A customer
may be offered to pay on delivery of goods, invoices may be
sent through bank and released after collecting dues or some
third party guarantee may be insisted. Such a course may help
in retaining the customers at present and their dealings may
help in reviewing their requests at a later date.
(d) Financing Investments in Receivables and
Factoring. Accounts receivables block a part of working
capital. Efforts should be made that funds are not ties up in
receivables for longer periods. The finance manager should
make efforts to get receivables financed so that working
capital needs are met in time.
The banks allow raising of loans against security of
receivables. Generally, banks supply between 60 to 80 per

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cent of the amount of receivables as loans against their

security. The quality of receivables will determine the amount
of loan. The banks will accept receivables of dependable
parties only. Another method of getting funds against
receivables is their outright sale to the bank. The bank will
credit the amount to the party after deducting discount and
will collect the money from the customers later. Here too, the
bank will insist on quality receivables only. Besides banks,
there may be other agencies which can buy receivables and
pay cash for them. This facility is known as factoring. The
factor will purchase only the accounts acceptable to him and
may refuse purchase in certain cases. The factoring may be
with or without recourse. If it is without recourse then any bad
debt loss is taken up by the factor but if it is with recourse then
bad debts losses will be recovered from the seller. The factor
may suggest the customer for whom he will extend this
facility. The factoring service varies from bill discounting
facilities offered by commercial banks to a total takeover of
administration of the sales ledger and credit control functions.
3. Formulating and Executing Collection Policy
The collection of amounts due to customers is very
important. The concern should devise procedure to be followed
when accounts become due after the expiry of credit period.
The collection policy be termed as strict and lenient.
FACTORING AND RECEIVABLES MANAGEMENT
A firm may avail the service of specialised institutions
engaged in receivables management, called factoring firms.
A factor is a financial institution which offers services
relating to management and financing of debts arising out of
credit sales. Factoring may broadly be defined as the
relationship, created by an agreement, between the seller of
goods/services and a financial institution called the factor,

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whereby the later purchases the receivables of the former and

also controls and administers the receivables of the former.
Functions of a Factor
Factors render a number of services to the selling firms.
Some of the important services rendered or functions
performed by a factor are as below:
(i) Bill discounting facilities
(ii) Administration of credit sales
(iii) Maintenance of sales ledger.
(iv) Collection of accounts receivables.
(v) Credit control
(vi) Protection from bad debts.
(vii) Provision of finance.
(viii) Rendering advisory services
Benefits of Factoring
A firm that enters into factoring agreement is benefited in
a number of ways as it is relieved from the problem of
collection management and it can concentrate on other
important business activities. Some of the important benefits
are outlined as under:
(a) It ensures a definite pattern of cash inflows from the
credit sales.
(b) It serves as a source of short-term finance.
(c) It ensures better management of receivables as factor firm
is a specialised agency for the same.
(d) It enables the selling firms to transfer the risk of non-
payments, defaults or bad debts to the factoring firms in
case of non-recourse activities.

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(e) It relieves the selling firms from the burden of credit

management and enables them to concentrate on other
important business activities.
(f) It saves in cost as well as space as it is a substitute for in-
house collection department.
(g) In provides better opportunities for working capital
management.
(h) The selling firm is also benefited by advisory services
rendered by a factor.
Problem 1. From the following information, calculate average
collection period:
Rs
Total Sales 1,00,000
Cash Sales 20,000
Sales Returns 7,000
Debtors at the end of the year 11,000
Bills Receivables 4,000
Creditors 15,000
Solution:

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Problem- 2. Dryson Ltd. provides the following information:

Rs
Cash sales during the year 1,50,000
Credit sales during the year 2,70,000
Returns inward 20,000
Trade debtors in the beginning 55,000
Trade debtors at the end 45,000
Provision for bad and doubtful debts 5,000
Calculate:
(i) Debtors Turnover Ratio
Problem 3. The following are the details regarding the
operation of a firm during a period of 12 months:
Sales 12,00,000
Selling price per unit 10
Variable cost per unit 7
Total cost per unit 9
Credit period allowed to customers One month

The firm is considering a proposal for a more liberal

credit by increasing the average collection period from one
month to two months. This relaxation is expected to increase
sales by 25%.
You are required to advise the firm regarding adopting of
the new credit policy, presuming that the firm's required return
on investment is 25 per cent.

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Solution:
(i) Calculation of new average cost per unit after adopting
new credit policy
Current sales = Rs 12,00,000
Selling price per unit = Rs 10
Number of units sold at present (12,00,000/10) 1,20,000
Current cost of sales (1,20,000 x 9) Rs 10,80,000
Add: Cost of additional sales (30,000 x 7) = Rs 2,10,000
Total cost for 1,50,000 units = Rs 12,90,000 New average
cost per unit (12,90,000/1,50,000) Rs 8.60
(ii) Calculation of average additional investment in
debtors
Current cost of sales Rs 10,80,000
Current credit period = 1 month
(a) Current investment in debtors (10,80,000 x = Rs 90,000
1/12)
Proposed cost of sales for 1,50,000 units = Rs 12,90,000
Proposed credit period = 2 months
(b) Proposed investment in debtors (12,90,000
x 2/12) = Rs 2,15,000
(c) Additional investment in debtors (b-a) 1,25,000
(iii) Calculation of profit on additional sales
Additional units sold x contribution per unit =
30,000 x 3 = Rs 90,000
(iv) Calculation of return on additional investment

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Advice: As the required rate of return (25%) is much lower

than the expected return on additional investment (72%), the
proposal should be accepted.
Problem 4. A trader whose current sales are Rs 15 lakhs per
annum and average collection period is 30 days wants to
pursue a more liberal credit policy to improve sales. A study
made by a consultant firm reveals the following information:
Increase in collection
Credit policy Increase in Sales
period
A 15 Days Rs 60,000
B 30 Days Rs 90,000
C 45 Days Rs 1,50,000
D 60 Days Rs 1,80,000
E 90 Days Rs 2,00,000

The selling price per unit is Rs 5. Average cost per unit

is Rs 4 band variable cost per unit is Rs 2.75. The required
rate if return on additional investment is 20%. Assume 360
days in a year and also assume that there are no bad debts.
Which of the above policies would you recommend for
adoption?

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Solution:

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CREDITORS/PAYABLES TURNOVER RATIO

Problem 5. From the following information calculate
creditors turnover ratio and average payment period:
Rs
Total Purchases 4,00,000
Cash purchases (included in above) 50,000
Purchases Returns 20,000
Creditors at the end 60,000
Bills Payable at the end 20,000
Reserve for discount on Creditors 5,000
Take 365 days in a year 5,000

Solution:

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Review questions
1. Write a note on factoring
2. What is the optimum level of receivables?
C. Essay Type Questions
1. What is 'receivables management'? How is it useful for
business concerns?
2. What should be the considerations in forming a credit
policy?
3. What do you understand by Receivables Management?
Discuss the factors which influence the size of
receivables.

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4. Discuss the various aspects or dimensions of receivables

management.
Exercise
1. A company sells goods on cash as well as on credit.
The following particulars are extracted from their books of
accounts:
Rs
Gross Total Sales 4,00,000
Cash Sales 80,000
Sales Returns 28,000
Debtors at the end 36,000
Bills Receivable at the end 8,000
Provision for doubtful debts 3,000
Total Creditors at the end 25,000
Calculate Average Collection Period
Take 365 days in a year
(Ans. 55 days)
2. As a part of the strategy to increase sales and profits,
the manager of a company proposes to sell goods to a group of
new customers with 10% risk of non- payment. This group
would require one and a half months credit and is likely to
increase sales by Rs 1,00,000 p.a. Production and selling
expenses amount to 80% of sales and the income-tax rate is
50%. The company's minimum required rate of return (after
tax) is 25%.
(a) Should the sales manager's proposal be accepted?
(b) Also find the degree of risk of non-payment that the
company should be willing to assume if the required rate

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of return (after tax) were (i) 30% (ii) 40% and (iii) 60%
(Ans. (a) Accepted as available rate of return is 50% (b) 14%:
12% and 8%)
A. A company currently has an annual turnover of Rs 10
lakhs and an average collection period of 45 days. The
company wants to experiment with a more liberal credit policy
on the ground that increase in collection period will generate
additional sales. From the following information, kindly
indicate which of the policies you would like the company to
adopt:
Increase in
Increase in Percentage of
Credit Policy collection
Sales Default
Period
1 15 days 50,000 2%
2 30 days 80,000 3%
3 40 days 1,00,000 4%
4 60 days 1,25,000 6%

The selling price of the product is Rs 5, average cost per unit

at current level is Rs 4 and the variable cost per unit is Rs 3.
The current bad debt loss is 1% and the required rate of
return on investment is 20%. A year can be taken to comprise
of 360 days.
(Ans. Policy, 1, i.e. 60 days)

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UNIT 8
COST OF CAPITAL
Learning Objectives
After studying this module, you should be able to understand:
 The meaning, concept and significance of cost of capital
 Computation of cost of specific sources of finance
 Computation of weighted average cost of capital
 Marginal cost of capital
 Capital Asset Pricing Model for computing cost of equity.
COST OF CAPITAL: MEANING, CONCEPT AND
DEFINITION
The items on the liability side of the balance sheet are
called capital components. The major capital components are
equity, preference and debt. Capital, like any other factor of
production, has a cost. A company‘s cost of capital is the
average cost of the various capital components (or securities)
employed by it. Putting differently, it is the average rate of
return required by the investors who provide capital to the
company.
The cost of capital of a firm is the minimum rate of
return expected by its investors. It is the weighted average
cost of various sources of finance used by the firm, viz.,
equity, preference and debt. The concept of cost of capital is
very important in financial management. It is used for
evaluating investment projects, for determining capital
structure, for assessing leasing proposals etc.
James C. Van Horne defines cost of capital as, ―a cut-
off rate for the allocation of capital to investments of projects.
It is the rate of return on a project that will leave unchanged
the market price of the stock.‖

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Solomon Ezra defines cost of capital as, ―the minimum

required rate of earnings or the cut-off rate of capital
expenditures‖.
Thus, we can say that cost of capital is that minimum
rate of return which a firm must, and is expected to earn on its
investments so as to maintain the market value of its shares.
Alternatively, cost of capital can be interpreted as the weighted
average cost of various sources of finance used by the firm, i.e.
equity, preference and debt capital.
Suppose that a accompany uses equity, preference and
debt in the following proportions: 50:10:40. If the specific cost
of equity, preference and debt are 16%, 12% and 8%
respectively, the weighted average cost of capital (WACC)
will be,
WACC = Proportion of equity x cost of equity + Proportion of
preference x cost of preference + Proportion of debt x cost of
debt
=(0.5x16) + (0.10x12) + (0.4x8) = 12.40%
If a firm‘s rate of return on its investments exceeds its cost of
capital, it creates the economic profit or value for its investors,
i.e. equity share holders.
For example, consider a firm which employs equity and debt in
equal proportions, and whose cost of equity and debt are 14%
and 6% respectively. The weighted average cost of capital
works out to 10%. (0.5x14+0.5x6). If the firm invests Rs. 100
million on a project which earns a rate of return of 12%, the
return on equity funds employed in the project will be:

Since 18% exceeds the cost of equity (14%), equity share

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holders benefit in the form of economic profit.

Significance of Cost of Capital
Cost of capital is a key concept in financial decision making.
It is useful from the point of view of both investment as well
as financing decisions. It further helps the management in
taking so many other financial decisions.
1. As an acceptance criterion in capital budgeting
According to the present value method of capital
budgeting, if the present value of expected returns from
investments is greater than or equal to the cost of investment,
the project may be accepted; otherwise, the project may be
rejected. The present value of expected returns is calculated by
discounting the expected cash inflows at cost of capital.
2. As a determinant of capital mix in capital structure decision
There should be a proper mix of debt and equity capital
in financing a firm‘s assets. While designing an optional
capital structure, the management has to keep in mind the
objective of maximizing the value of the firm and minimizing
the cost of capital.
3. As a basis for evaluating the financial performance
The actual profitability of a project is compared to the
projected overall cost of capital and the actual cost of capital of
funds raised. If the actual profitability of the project is more
than the projected profitability and the actual cost of capital,
the performance may be said to be satisfactory.
4. As a basis for taking other financial decisions
The cost of capital is also used in making other
financial decisions such as dividend policy, capitalization of
profits, right issues and working capital management.

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Classification of Cost of Capital

Having understood the concept of cost of capital, let us
see its classification now:
1. Historical cost and future cost
Historical costs are book costs related to the past or past cost.
Future costs are estimated costs for the future. Historical costs
act as a guide to the future costs.
2. Specific cost and composite cost
Specific cost refers to the cost of a specific source of capital.
Composite cost is combined cost of various sources of capital.
It is the weighted average cost of capital or the overall cost of
capital which is considered in the capital structure decisions.
3. Explicit cost and implicit cost
Explicit cost is the internal rate of return which equals the
present value of cash inflows with the present value of cash
outflows.
Implicit cost is the opportunity cost forgone in order to take up
a particular project. For example, the implicit cost of retained
earnings is the rate of return available to shareholders by
investing the funds elsewhere.
4. Average cost and marginal cost
Average cost of capital refers to the combined cost of various
sources of capital such as debentures, preference shares,
equity shares and retained earnings. It is the weighted
average cost of various sources of finance.
Marginal cost of capital refers to the average cost of capital to
be incurred to obtain additional funds required by a firm.
Computation of Cost of Capital
Computation of overall cost of capital involves two stages:

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A) Computation of specific cost of capital

B) Computation of weighted average cost of capital
First of all, we have to compute the cost of different sources of
funds:
A) COMPUTATION OF SPECIFIC COST OF CAPITAL
Computation of cost of each specific source of finance,
i.e. debt capital, preference share capital, equity share capital
and retained earnings is discussed below:
1) Cost of Debt Capital
Debt capital may be redeemable debt or irredeemable debt.
1.1 Cost of Irredeemable Debt or Perpetual Debt:
Cost of debt is the rate of interest payable on debt
capital. Calculation of cost of debt can be clear from the
following example:
A company issues Rs. 1,00,000, 10% debentures at par. The
before tax cost of this debt will be 10%.

If the debt is raised at premium or discount, we should

consider P as net proceeds received from the issue and not the
face value of securities.

Now, considering the tax implication of interest payments on

debt capital, the effective cost of debt can be calculated as:

where, Kda = after tax cost of debt and t= rate of tax.

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Problem 1:
a) X Ltd. issues Rs 50000, 8% debentures at par. The tax rate
applicable to the company is 50%. Compute cost of debt
capital.
b) Y Ltd. issues Rs 50000, 8% debentures at a premium of
10%. The tax rate applicable to the company is 60%.
Compute cost of debt capital.
c) A Ltd. issues Rs 50000, 8% debentures at a discount of
5%. The tax rate applicable to the company is 50%.
Compute cost of debt capital.
d) B Ltd issues Rs 100000, 9% debentures at a premium of
10%. The costs of floatation are 2%. The tax rate
applicable is 60%. Compute cost of debt capital.
Solution:

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1.2. Cost of Redeemable debt

Debt capital issued which are to be redeemed after a
certain period is known as redeemable debt. The cost of
redeemable debt capital may be computed by using Yield to
maturity, also called internal rate of return or trial and error
method.
a) Yield to maturity or Trial and error method
i) Before tax cost of redeemable debt

where, V0= Current value or issue price of debt

Vn= Redeemable value of debt
I1 , I2 … In = Amount of annual interest in period 1, 2, …,n
years.
n = Number of years to redemption
Kd= Yield to maturity or internal rate of return or cost of debt
The value of Kd (yield to maturity) can be found by trial and
error method using present value tables.
ii) After tax cost of redeemable debt

where, Kda= after tax cost of debt, Kdb= before tax cost of
debt and t= rate of tax.
Problem 2:
A five year Rs 100 debenture of a firm can be sold for a
net price of Rs, 95.90. The coupon rate of interest is 14% per

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annum, and the debenture will be redeemed at 5% premium on

maturity. The firm‘s tax rate is 35%. Compute the yield to
maturity and the after tax cost of debenture.
The present value factors (PVFs) at 15% and 17% are
given below.
Year 1 2 3 4 5
P.V.F at
0.870 0.756 0.658 0.572 0.497
15%
P.V.F at
0.855 0.731 0.624 0.534 0.456
17%
Solution:
Computation of yield to maturity:

By trial and error method using present value tables,

we can find the value of Kd = 16%.
Let us try 15%
14(0.870)+14(0.756)+14(0.658)+14(0.572)+14(0.497)+
105(0.497)
12.180+10.584+9.212+8.008+6.958+52.185 =99.12
Since present value of rupee at 15% (99.12) is greater than
the required present value (95.90), let us try higher rate of
17%.
14(0.855)+14(0.731)+14(0.624)+14(0.534)+14(0.456)+
105(0.456)
11.970+10.234+8.736+7.476+6.384+47.88 =92.68

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As present value at 17% (92.68) is less than the

required present value (95.90); the discount rate or yield to
maturity should be between 15% and 17%. At 15% the present
value is 6.44 more than the required present value and at 17%
present value is 3.22 less than the required present value; thus

Computation of after-tax cost of debenture:

b) Shortcut method to compute cost of redeemable debt

Before-tax cost of redeemable debt

where I= Annual interest

n = Number of years in which debt is to be redeemed
RV= Redeemable value of debt
NP= Net proceeds of debentures
After-tax cost of redeemable debt

where I= Annual interest

t =Tax rate
n = Number of years in which debt is to be redeemed
RV= Redeemable value of debt

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NP= Net proceeds of debentures

Problem 3:
A company issues Rs, 10,00,000, 10% redeemable debentures
at a discount of 5%. The costs of floatation amount to Rs.
30,000. The debentures are redeemable after 5 years.
Calculate the before-tax and after-tax cost of debt assuming a
tax rate of 50%.
Solution:
1) Before-tax cost of redeemable debt

2) After-tax redeemable debt

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Problem 4:
A five year Rs. 100 debenture of a firm can be sold for a
net price of 96.50, The coupon rate of interest is 14% per
annum, and the debenture will be redeemed at 5% premium on
maturity. The firm‘s tax rate is 40%. Compute the after-tax
cost of debenture.
Solution:
1) Before-tax cost of debt redeemable at premium

2) After-tax cost of debt redeemable at premium

Problem 5:
Assuming that a firm pays tax at 50% rate, compute the after-
tax cost of debt capital in the following cases:
1) A perpetual bond sold at par, coupon rate of interest being
7%
2) A 10 year, 8% Rs 1000 per bond sold at Rs. 950 less 4%
underwriting commission

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Solution:
1) Cost of perpetual bond

2) Cost of redeemable debt

Problem 6:
A company issues 9% irredeemable debentures of Rs 100 each
for Rs 5,00,000. The company‘s tax rate is 40%. Calculate the
cost of debt (before as well as after-tax), if the debentures are
issued at a) par, b) at 5% discount and c) 10% premium.
Solution:
a) Issued at par

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b) Issued at 5% discount

c) Issued at 10% premium

Problem 7:
A company issues 10 year 9% debentures of Rs. 100
each at par for 5,00,000 and incures issue expenses at 2%. The
company‘s tax rate is 40%. Calculate the effective cost of debt
assuming that the debentures are redeemable a) at par b) at 5%
discount and c) at 5% premium.
Solution:
d) Issued at par

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1.2 Cost of existing debt

To calculate the cost of existing debt capital, the
current market yield of the debt should be taken into
consideration.
Example: A firm has 10% debentures of Rs. 100 each,
outstanding on 1st January 2006 to be redeemed on 31st
December 2012. New debentures could be issued at a net
realizable price of Rs 90 in the beginning of 2008. Calculate
the current cost of existing debt.

1.3 Cost of zero coupon bonds

Zero coupon bonds or debentures are debentures issued
at zero interest rate, at a discount from their maturity value. No
interest is payable on such debentures, but at the time of
redemption the maturity value of the bond is paid to the
investors. The cost of such debt can be calculated by finding
the present values of cash flows as shown in the example
below:
Problem 8:
X Ltd. has issued redeemable zero coupon bonds of Rs.
100 each at a discount rate of Rs. 60, repayable at the end of 4th
year. Calculate the cost of debt.

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Solution:
Cash Flow Table at various assumed discount rates
Discount factor Discount factor
Year Cash flow PVCF PVCF
At 12% At 14%
0 60 1 (60) 1 (60)
4 100 0.636 63.60 0.592 59.20
3.60 -0.80
PVCF = Present Value of Cash Flow
The net present value of cash flow at 12% is Rs.3.60 and at
14% it is Rs.-0.80. It means that the cost of debt lies in
between 12% and 14%. This can be precisely calculated by
applying interpolation formula.

where LR = Low discount rate

HR = High discount rate
PV = Present value of cash inflow
NPV = Net present value = PV – Cash outflow

3) COST OF PREFERENCE CAPITAL

Usually a fixed rate of dividend is payable on
preference shares. The cost of preference capital is the function
of dividend expected by the preference shareholders.
Preference share capital may be perpetual or redeemable.
Cost of perpetual preference share capital can be calculated as:

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where Kp = Cost of preference capital

D = Annual preference dividend
P = Preference share capital (proceeds)
Further, if preference shares are issued at premium or
discount or when floatation costs are incurred to issue
preference shares, the face value of preference share capital
has to be adjusted to find out the net proceeds from the issue of
shares. Then cost of preference share capital would be:

Where, NP= Net proceeds from issue of shares

No adjustment is needed for tax as dividends are not
deductible in computation of tax.
Cost of redeemable preference share capital can be calculated
as:

where Kpr= Cost of redeemable preference shares

D = Annual preference dividend
MV= Maturity value of preference shares
NP = Net proceeds of preference shares
Problem 9
A company issues 10,000, 10% preference shares of
Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of

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preference capital, if these shares are issued a) at par b) at a

premium of 10% and c) at a discount of 5%.
Solution:

Problem 10:
A company issues 10,000, 10% preference shares of
Rs. 100 each, redeemable after 10 years at a premium of 5%.
The cost of issue is Rs 2 per share. Calculate the cost of
preference capital.
Solution:

Problem 11:
A company issues 1000, 7% preference shares of
Rs.100 each at a premium of 10%, redeemable after 5 years at

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par. Compute the cost of preference capital.

Solution:

Problem 12:
A preference share sold at Rs. 100 with 8% dividend
and a redemption price of Rs.110, if the company redeems it in
five years. Assuming that the company‘s tax rate is 50% ,
compute the after-tax cost of preference capital.
Solution:
Preference dividend is not a tax deductible item, as
debt interest. Hence tax rate has no impact on the cost.

4) COST OF EQUITY SHARE CAPITAL

Let us now see how the cost of equity is computed.
Share holders invest money in equity shares on the expectation
of getting dividend and the company must earn this minimum
rate so that the market price of the shares remains unchanged.
Hence, the cost of equity capital is a function of the expected
return by its investors. It is the minimum rate of return
expected by the equity shareholders though payment of
dividend to equity is not a legal binding.

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The cost of equity share capital can be computed in the

following ways:
a) Dividend Yield Method or Dividend/Price Ratio Method
Cost of equity fresh issues:

Cost of existing equity share capital:

where Ke= Cost of equity capital

D = Expected dividend per share
NP = Net proceeds per share
MP= Market price per share
This method is suitable only when the company has stable
earnings and stable dividend policy over a period of time.
Problem 13:
A company issues 1000 equity shares of Rs. 100 each
at a premium of 10%. The company has been paying 20%
dividend to equity shareholders for the past five years and
expects to maintain the same in the future also. Compute the
cost of equity capital. Will it make any difference if the
market price of equity share is Rs. 160?
Solution:

If the market [rice of an equity share is 160,

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b) Dividend Yield Plus Growth in Dividend Method

This method may be used to compute cost of equity
capital, when the dividends of the firm are expected to grow at
a constant rate of and the dividend-pay-out ratio is constant.
Cost of equity,

where
Ke= Cost of equity (fresh issue)
D1= Expected dividend per share at the end of the year
NP= Net proceeds per share
G = Rate of growth in dividends
D0= Previous year dividend
To calculate cost of equity share capital, net proceeds
(NP) in the above equation should be replaced by MP (Market
price per share),

Problem 14:
i) A company plans to issue 1000 new shares of Rs. 100
each at par. The floatation costs are expected to be 5% of the
share price. The company pays a dividend of Rs. 10 per share
initially and the growth in dividend is expected to be 5%.
Compute cost of new issue of equity shares.
ii) If the current market price of an equity share is Rs. 150,
calculate the cost of existing equity share capital.

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Solution:

Problem 15:
The shares of a company are selling at Rs. 40 per share,
and it had paid a dividend of Rs. 4 per share. The investors
market expects a growth rate of 5% per year.
i) Compute the company‘s equity cost of capital
ii) If the anticipated growth rate is 7% per annum, calculate
the indicated market price per share
Solution:

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c) Earnings Yield Method or Earnings Price Ratio

Under this method, the cost of equity is the discount
rate that equals the present value of expected future earnings
per share with the net proceeds (or current market price) of
share.

Where, EPS = Earnings per share

NP = Net Proceeds
Cost of existing capital:

Where, EPS = Earnings per share

MPS= Market price per share
Problem 16:
A firm is currently earning Rs.2,00,000 and its share is
selling at current market price of Rs.200. The company has
10,000 shares outstanding and has no debt. It decides to raise
additional funds of Rs.5,00,000. If the floatation costs are
Rs.10 per share and the company can sell the share for Rs.180,
what is the cost of equity? Assume that the earnings are stable.
Solution:
The cost can be calculated using the earnings per share
as the basis.

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Problem 17:
A firm is considering an expenditure of Rs.60 lakhs for
expanding its operation. The relevant information is as
follows:

Compute the cost of existing equity share capital and of

new equity capital assuming that new shares will be issued at a
price of Rs.52 per share and the costs of new issue will be Rs.2
per share.
Solution:

d) Realized Yield Method

The Dividend yield method and Earnings yield
method suffer from a serious drawback of estimating
precisely future dividend expectations of the investors. The
realized yield method takes into account the rate of return
realized to the past along with the gain

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realized at the time of sale of shares. Thus the cost of equity

would be the realized rate of return by the shareholders.
e) Capital Asset Pricing Model (CAPM)
The CAPM divides the cost of equity into two
components- the risk free return available on investing in
Government securities and an additional premium for investing
in a particular share. The risk premium includes the average
return on the overall market portfolio and the beta factor (or
risk) of the particular investment. The cost of equity under
CAPM is:
Ke=Rf+Bi(Rm-Rf)
Where, Rf= Risk free rate of return (assured rate of return)
Bi= Beta of investment i
Rm= Average market return
Problem 18: The beta coefficient of A Ltd. is 1.40. The risk
free rate of interest on Government securities is 7%. The
expected rate of return on equity shares is 15%. Calculate the
cost of equity based on CAPM.
Solution:

Problem 19:
You are given the following facts about a firm
i) Risk-free rate of return is 11%
ii) Beta coefficient, Bi of the firm is 1.25
Compute the cost of equity capital using Capital Asset
Pricing Model (CAPM) assuming a maximum return of 15%
next year. What would be the cost of equity if Bi rises to 1.75?

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Solution:

5) COST OF RETAINED EARNINGS

Retained earnings are the funds accumulated by a
company over a period by keeping part of profit
undistributed. It is a major internal source of finance for
expansion and diversification programs. Retained earnings
are not cost free funds, though they are internally generated.
The cost of retained earnings is an opportunity cost to be
measured in terms of income forgone by the shareholders
that they could have earned by investing in some alternative
opportunities. Hence, cost of retained earnings is almost
equal to cost of equity. However, shareholders have to incur
floatation costs for new investments and pay personal taxes
on dividends received, which they need not pay when
earnings are retained. Thus cost of retained earnings will be
cheaper than cost of equity to the extent of p sonal tax rate
and floatation costs.

Problem 20:
A firm‘s Ke (return available to shareholders) is 15%, the
average tax rate of shareholders is 40% and it is expected that

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2% is brokerage cost that shareholders will have to pay while

investing their dividends in alternative securities. What is the
cost of retained earnings?
Solution:
Cost of retained earnings,

Problem 21:
A Ltd. is currently earning a net profit of Rs.60,000 per
annum. The shareholder‘s required rate of return (Ke) is 15%.
If earnings are distributed among the shareholders they can
invest in securities of similar type carrying a return of 15% per
annum. However, the shareholders will have to incur 2%
brokerage charges for making new investment. They are also
in 30% tax bracket. Compute the cost of retained earnings to
the company.
Solution:

Verification: suppose the company‘s payout ratio is 100%.

Dividends payable to the shareholders = 60,000
Less: Personal income tax@30% =18,000
After tax dividend available =42,000
Less: Brokerage @ 2% = 840
Net amount available for investment =41,160
Shareholders can earn at 15% on Rs.41,160, i.e. Rs.6,174. This

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is the opportunity income forgone by the shareholders if the

company retains Rs.60,000. Hence, the required return for
Rs.60,000 is Rs.6,174 and the rate of return is 10.29% [i.e.
(6,174/60,000)*100]. Hence, the required rate of return
expected by the shareholders from the company is 10.29%
which is considered as the cost of retained earnings.
B) WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
WACC is defined as the weighted average of the cost
of various sources of funding. WACC is also known as overall
cost of capital or composite cost of capital or average cost of
capital. Once the specific cost of individual sources of finance
is determined, we can compute the WACC by assuming
weights to the specific sources in proportion of each source to
the total capital structure. The weights may be given either by
using the book value of the specific sources or the market
value of the source. The market value weights are sometimes
preferred to book value weights because the market value
represents the true value of the investors. But it will be
difficult to determine the market values because of frequent
fluctuations. Hence, it is better to use the book value weights
which is readily available.
WACC can be computed as follows:

where Ko= WACC

X = Cost of specific source of fund
W= Weight in proportion of each source of fund
Problem 22:
A firm has the following capital structure and after-tax

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costs for the different sources of funds used:

Proportion After-tax cost
Source of funds Amount Rs.
% %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100

You are required to compute the weighted average cost

of capital.
Solution:
Computation of Weighted Average Cost of Capital
Weighted cost
Cost
Proportion %
Source of funds % Proportion*Cost
% (W)
(X)
(XW)%
Debt 25 5 1.25
Preference Shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
Weighted Average Cost of 9.60%
Capital

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Problem 23:
Excel limited has the following capital structure:
Rs. in lakhs
Particulars Market value Book value Cost %
Equity capital 80 120 18
Preference capital 30 20 15
Secured debt 40 40 14

Cost of individual sources of capital is net of tax.

Compute the company‘s weighted average cost of capital.

Solution:
WACC BASED ON MARKET VALUE
Market Weighted
Cost [net of
Capital value Weight% cost of
tax]
sources Rs.in lakhs [b] Capital
% [c]
[a] [b]x[c]%
Equity capital 80 8/15=53.33 18 9.60
Preference
30 3/15=20.00 15 3.00
capital
Secured debt 40 4/15=26.67 14 3.73
Total 150 I=100 16.33

WACC of the company based on market value = 16.33%

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WACC BASED ON BOOK VALUE

Weighted
Book value Cost [net of
Capital Weight% cost of
Rs.in lakhs tax]
sources [b] Capital
[a] % [c]
[b]x[c]%
Equity capital 120 6/9=66.67 18 12.00
Preference
20 1/9=11.11 15 1.67
capital
Secured debt 40 2/9=22.22 14 3.11
Total 180 I=100 16.78
WACC of the company based on book value = 16.78%
MARGINAL COST OF CAPITAL
Marginal cost of capital is the cost of additional funds
to be raised. It is the weighted average cost of new capital
calculated by using marginal weights of additional funds. In
case a firm employs the existing proportion of capital structure
and the component costs remain the same, the marginal cost of
capital shall be equal to the weighted average cost of capital.
But in practice, the marginal cost of capital shall not be equal
to the WACC because of the changes in the proportions or the
component costs of additional funds.
Problem 24:
A firm has the following capital structure and after-tax
costs for different sources of funds used:
Amount Proportion After-tax cost
Source of funds
Rs. % %
Debt 4,50,000 30 7
Preference Capital 3,75,000 25 10
Equity Capital 6,75,000 45 15
Total 15,00,000 100

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i) Calculate the weighted average cost of capital using

book-value weights
ii) The firm wishes to raise further Rs.6,00,000 for the
expansion of the project as below

Source of funds Amountn (Rs.)

Debt 3,00,000
Preference Capital 1,50,000
Equity Capital 1,50,000
Assuming the specific costs do not change, compute the
weighted marginal cost of capital.
Solution:
i) Computation of Weighted Average Cost of Capital
(WACC)

ii) Computation of Weighted Marginal Cost of Capital

(WMCC)

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In the former pages we have seen the computation of

specific cost of capital and then the overall cost of capital.
Now let us try to solve some more problems.
Exercise Problems:
1. Define the concept of capital.
2. Explain the components of cost of capital.
3. What is the relevance of cost of capital in corporate
investment and financing decisions?
4. Discuss briefly the different approaches to the
computation of equity capital.
5. State how you determine the weighted average cost of
capital of a firm. What weights should be used in its
calculation?
6. How do you determine the cost of debt?
7. What is cost of retained earnings?
8. How do you calculate the cost of preference share capital?
9. Examine the problems in the determination of overall cost
of capital.
10. A company issues Rs.10,00,000- 12% debentures of
Rs.100 each. The debentures are redeemable after the
expiry of fixed period of 7 years. The company is in 35%
tax bracket.
Required:
i) Calculate the cost of debt after tax if debentures are
issued at
a) Par
b) 10% discount
c) 10% premium
ii) If brokerage is paid at 2%, what will be the cost of
debentures, if issue is at par?
[Ans. (i)(a)7.8% (b)9.71% (c) 6.07%; (ii) 8.17%]

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11. i) A company issues 1000, 10% preference shares of

Rs.100 each at a discount of 5%. Costs of raising capital
are Rs.2,000. Compute the cost of preference capital.
ii) Assume that the firm pays tax at 50%.Cmpute the after-
tax cost of capital of a preference share sold at Rs.100
with a 9% dividend and a redemption price of Rs.100, if
the company redeems it in five years.
[Ans. (i) 10.75%; (ii) 10.47%]
12. Your company‘s share is quoted in the market at Rs.20
currently. The company pays a dividend of Rs.1 per share
and the investor‘s market expects a growth rate of 5%per
year.
a) Compute the company‘s equity cost of capital
b) If the anticipated growth rate is 6% p.a., calculate the
indicated market price per share
c) If the company‘s cost of capital is 8% and the anticipated
growth rate is 15% p.a., calculate the indicated market
price if the dividend of Rs. 1 per share is to be maintained.
[Ans. a) 10%; b) Rs.25; c) Rs.33.33]
13. Excel Industries Ltd. has assets of Rs.1,60,000 which have
been financed with Rs.52,000 of debt and Rs.90,000 of
equity and a general reserve of Rs.18,000. The firm‘s total
profits after interest and taxes for the year ended 31st
March, 2000 were Rs.13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900
equity shares of Rs.100 each selling at a market price of
Rs.120 per share. What is the weighted average cost of
capital?
[Ans. 9.74%]
14. Calculate the weighted average cost of capital (before and
after tax) from the following information. Assume that the
tax rate is 55%.

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Proportion in the
Before-tax cost
Type of capital new capital
of capital
structure
Equity capital 25% 24.44%
Preference capital 10% 27.29%
Debt capital 50% 7.99%
Retained earnings 15% 18.33%
[Ans. i) 15.58%; ii) 13.39%]
15. The capital structure of Bombay Traders Ltd. as on 31-3-
2015 is as follows:
Source of funds Amount
Rs.Crores
Equity Capital: 100 lakhs equity shares of Rs.10 10
each
Reserves 2
14% Debentures of Rs.100 each 3
For the year ended 31-3-2015 the company has paid equity
dividend at 20%. As the company is a market leader with good
future, dividend is likely to grow by 5% every year. The equity
shares are now treated at Rs. 80 per share in the stock
exchange. Income tax rate applicable to the company is 50%.
Required:
a) The current weighted cost of capital
b) The company has plans to raise a further Rs.5 crores by
way of long-term loan at 16% interest. When this takes
place the market value of equity shares is expected to fall
to Rs.50 per share. What will be the new weighted
average cost of capital of the company?
[Ans. a) 7.4%; ii) 8.45%

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UNIT – 9
CAPITAL STRUCTURE – PART - 1

Learning Objectives
 Distinguish between capitalisation, capital structure and
financial structure
 Financial break even point
 Optimal capital structure
 Risk and return trade off
INTRODUCTION
In order to run and manage a company, funds are needed.
Right from the promotional stage up to end, finance plays an
important role in a company's life. If funds are inadequate, the
business suffers and if the funds are not properly managed,
the entire organization suffers. It is, therefore, necessary that
correct estimate of the current and future need of capital be
made to have an optimum capital structure which shall help
the organisation to run its work smoothly and without any
stress.
Estimation of capital requirements is necessary, but the
formation of a capital structure is important. According to
Gerstenberg, "Capital structure of a company refers to the
composition or make-up of its capitalisation and it includes
all long-term capital resources viz: loans, reserves, shares and
bonds".
The capital structure is made up of debt and equity
securities and refers to permanent financing of a firm. It is
composed of long-term debt, preference share capital and
shareholder's funds.

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Capitalisation, Capital Structure and Financial Structure

The terms, capitalisation, capital structure and financial
structure, do not mean the same. While capitalisation is a
quantitative aspect of the financial planning of an enterprise,
capital structure is concerned with the qualitative aspect.
Capitalisation refers to the total amount of securities issued by
a company while capital structure refers to the kinds of
securities and the proportionate amounts that make up
capitalisation. For raising long-term finances, a company can
issue three types of securities viz. Equity shares, Preference
Shares and Debentures. A decision about the proportion
among these type of securities refers to the capital structure of
an enterprise. Some authors on financial management define
capital structure in a broad sense so as to include even the
proportion of short-term debt. In fact, they refer to capital
structure as financial structure. Financial structure means the
entire liabilities side of the balance sheet. "Thus, financial
structure, generally, is composed of a specified percentage of
short term debt, long-term debt and shareholder's funds.
Problem 1. Given the following information, you are required
to compute (i) Capitalisation, (ii) Capital Structure, and (iii)
Financial Structure:
Liabilities Rs.
Equity Share Capital 10,00,000
Preference Share Capital 5,00,000
Long-term Loans and Debentures 2,00,000
Retained Earnings 6,00,000
Capital Surplus 50,000
Current Liabilities 1,50,000
25,00,000

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Solution:

(i) Capitalisation refers to the total amount of securities

issued by a company.
It is computed as below:
Rs.
Equity Share Capital 10,00,000
Preference Share Capital 5,00,000
Long-term Loans and Debentures 2,00,000
Capitalisation 17,00,000
=======
(ii) Capital structure which refers to the proportionate
amount that makes up capitalisation is computed as below:
Rs. Proportion/
Mix
Equity Share Capital 10,00,000 58.82%
Preference Share Capital 5,00,000 29.41%
Long-term Loans and Debentures 2,00,000 11.77%

17,00,000 100%
======= ==========
Some authors include retained earnings and capital surplus
also for the purpose of capital structure; in that case capital
structure shall be:
Rs. Proportion/
Mix
Equity Share Capital 10,00.00 42.55%

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Preference Share Capital 5,0.000 21.28%

Long-term Loans and Debentures 2,00,000 8.51%
Retained Earnings 6,00,000 25.53%
Capital Surplus 50,000 2.13%

23,50,00 100%
======= ========
(iii) Financial Structure refers to all the financial resources,
short as well as long-term and is calculated as :
Rs. Proportion/
Mix
Equity Share Capital 10,00.00 40%
Preference Share Capital 5,00,000 20%
Long-term Loans and Debentures 2,00,000 8%
Retained Earnings 6,00,000 24%
Capital Surplus 50,000 2%
Current Liabilities 1,50,000 6%

25,00,000 100%
======= =======

Forms/Patterns of Capital Structure

The capital structure of a new company may consist of any of
the following forms:
a) Equity Shares only
b) Equity and Preferences Shares

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c) Equity Shares and Debentures

d) Equity Shares, Preferences Shares and debentures
Importance of Capital Structure
The term 'Capital structure' refers to the relationship
between the various long-term forms of financing such as
debenture, preference share capital and equity share capital.
Financing the firm's assets is a very crucial problem in every
business and as a general rule there should be a proper mix of
debt and equity capital in financing the firm's assets. The use
of long-term fixed interest bearing debt and preference share
capital along with equity shares is called financial leverage or
trading on equity. The long-term fixed interest bearing debt is
employed by a firm to earn more from the use of these sources
than their cost so as to increase the return on owner's equity.
The impact of leverage on earnings per share (EPS) can
be understood with the help of following example:
Problem 2. ABC Company has currently an all equity
capital structure consisting of 15,000 equity shares of Rs.100
each. The management is planning to raise another Rs.25 lakhs
to finance a major programme of expansion and is considering
three alternative methods of financing:
i. To issue 25,000 equity shares of Rs.100 each.
ii. To issue 25,000, 8% debentures of Rs.100 each.
iii. To issue 25,000, 8% preference shares of Rs.100 each.
The company's expected earnings before interest and
taxes will be Rs. 8 lakhs. Assuming a corporate tax rate of 50
per cent, determine the earnings per share (EPS) in each
alternative and comment which alternative is best and why?

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Solution:
(Rs. in lakhs)
Alternative
Alternative Alternative III
IEquity II Debt Preference
Financing Financing shares
Financing
Earnings before Interest and 8.00 8.00 8.00
Tax
(EBIT)
Less Interest - 2.00 -
Earnings after interest but
before tax 8.00 6.00 8.00
Less Tax @ 50% 4.00 3.00 4.00
Earnings After Tax (EAT)
4.00 3.00 4.00
Less Preference Dividend - - 2.00
Earnings Available to
Equity holders 4.00 3.00 2.00
Number of Equity Shares 40,000 15,000 15,000

4,00,000 3,00,000 2,00,000

40,000 15,000 15,000
Earnings per Share (EPS) Rs.10 Rs.20 Rs.13.33
Comments. As the earnings per share are highest in alternative
II, i.e., debt financing, the company should issue 25,000 8%
debentures of Rs.100 each. It will double the earnings of the
equity shareholders without loss of any control over the
company.

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Problem 3. A Limited company has equity share capital of Rs.

5, 00,000 divided into shares of Rs.100 each. It wishes to
raise further Rs. 3,00,000 for expansion cum modernisation
plans. The company plans the following financing schemes:
a) All common stock
b) Rs.one lakh in common stock and Rs. two lakhs in debt @
10% p.a.
c) All debts at 10% p.a.
d) Rs.one lakh in common stock and Rs. two lakh in preference
capital with the rate of dividend at 8%.
The company's expected earnings before interest and tax
(EBIT) are Rs.1,50,000. The corporate rate of tax is 50%.
Determine the Earnings per share (EPS) in each plan and
comment on the implications of financial leverage.
Solution:
Plan I Plan II Plan III Plan IV
Rs. Rs. Rs. Rs.
Earnings before interest and 1,50,000 1,50,000 1,50,000 1,50,000
tax
Less: Interest -- 20,000 30,000 --

1,50,000 1,30,000 1,20,000 1,50,000

Less: Tax @ 50% 75,000 65,000 60,000 75,000
Earnings after tax
75,000 65,000 60,000 75,000
Less: Preference dividend @ -- -- --
8%
16,000
Earnings available for equity 75,000 65,000 60,000
59,000

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holders
No. of common shares 8,000 6,000 5,000 6,000
Earnings per share Rs.9.375 Rs.10.83 Rs.12 Rs.9.83

Comments
In the four plans of fresh financing, Plan III is the most
leveraged of all. In this case, additional financing is done by
raising loans @ 10% interest. Plan II has fresh capital stock of
Rs. one lakh while Rs. two lakhs are raised from loans. Plan
IV does not have fresh loans but preference capital has been
raised for Rs. two lakhs.
The earnings per share is highest in Plan III, i.e, R.12.
This plan depends upon fixed cost funds and thus has
benefited the common stock-holders by increasing their share
in profits. Plan II is the next best scheme where EPS is
Rs.10.83. In this case too Rs.2 lakhs are raised through fixed
cost funds. Even Plan IV, where preference capital of Rs.2
lakhs is issued, is better than plan I where common stock of
Rs.3 lakh is raised.
The analysis of this information shows that financial
leverage has helped in improving earnings per share for equity
shareholders. It helps to conclude that higher the ratio of debt
to equity the greater the return for equity stockholders.
Impact of Leverage on Loss
If a firm suffers losses then the highly leveraged scheme
will magnify the losses per share. This impact is discussed in
the problem below:
Problem 4. Taking the figures in problem 3, the concern
suffers a loss of Rs.70,000. Discuss the impact of leverage
under all the four plans.

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Solution
Plan I Plan II Plan III Plan IV
Rs. Rs. Rs. Rs.
Loss before interest and tax -70,000 -70,000 -70,000 -70,000
Add: Interest -- -20,000 -30,000 --
Loss after interest -90,000 -1,00,000
-70,000 -70,000
No. of Equity (common)
Shares Loss per share 8,000 6,000 5,000 6,000
Rs. 8.75 Rs.15 Rs.20 Rs.11.67
Comments
The loss per share is highest in Plan III because it has the
higher debt-equity ratio while it is lowest in Plan I because all
additional funds are raised through equity capital. The
leverage will have adverse impact on earning if the firm suffers
losses because fixed cost securities will magnify the losses.
Problem 5. AB Ltd. needs Rs.10,00,000 for expansion. The
expansion is expected to yield an annual EBIT of Rs.1,60,000.
In choosing a financial plan, AB Ltd. has an objective of
maximizing earnings per share. It is considering the possibility
of issuing equity shares and raising debt of Rs.1,00,000 or
Rs.4,00,000 or Rs. 6,00,000. The current market price per
share is Rs.25 and is expected to drop to Rs.20 if the funds are
borrowed in excess of Rs.5,00,000.
Funds can be borrowed at the rates indicated below:
Upto Rs.1,00,000 at 8%
Over Rs.1,00,000 upto Rs.5,00,000 at 12% Over Rs.5,00,000
at 18%.

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Assume a tax rate of 50 percent. Determine the EPS for

the three financing alternatives and suggest the scheme which
would meet the objective of the management.
Solution

Suggestion: As the company has an objective of

maximising earnings per share, alternative II, ie. raising a debt
of Rs.4,00,000 and equity Rs.6,00,000 would meet the
objective. The EPS is the highest under alternative II.
FINANCIAL BREAK-EVEN POINT
Financial breakeven point may be defined as that level of
EBIT which is just equal to pay the total financial charges,
i.e., interest and preference dividend. At this point or level of

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earnings before interest and tax, the earnings per share equal
zero (EPS=0). It is a critical point in planning the capital
structure of a firm. If earnings before interest and tax are less
than the financial breakeven point, the earnings per share shall
be negative and hence fixed interest bearing debt or preference
share capital should be reduced in the capitalisation of the
firm. However, in case the level of EBIT exceeds the financial
breakeven point, more of such fixed cost funds may be
inducted in the capital structure. The financial breakeven point
can be calculated as below:
(a) When the capital structure consists of equity share
capital and debt only and no preference share capital
is employed:
Financial Break Even Point = Fixed interest charges
(b) When capital structure consists of equity share
capital, preference share capital and debt:

Where, I = Fixed interest charges

DP = Preference Dividend
t = Tax Rate
(As dividend on preference share capital is payable only out of
earnings after tax)
Problem 6. A firm has two alternative plans for raising
additional funds of Rs.10,00,000.
(i) Issue of 10,000 debentures of Rs. 100 each bearing 10%
interest per annum.
(ii) Issue of 4,000 debentures of Rs 100 each bearing 10%
interest per annum and balance by the issue of 12%
preference shares.

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You are required to calculate the financial Break Even Point

for each plan assuming a tax rate of 50%.
Solution
Plan 1. As the firm employs only debt and not preference
share capital the financial breakeven point shall be equal to the
fixed interest charges; or
Financial Break Even Point= Fixed Interest Charges
= Rs.1,00,000
Plan 2. As the firm employs debt and preference share
capital, the financial breakeven point can be calculated as:

POINT OF INDIFFERENCE
The EPS, (earnings per share), 'equivalency point' or
'point of indifference' refers to that EBIT, (earnings before
interest and tax), level at which EPS remains the same
irrespective of different alternatives of debt-equity mix. At this
level of EBIT, the rate of return on capital employed is equal
to the cost of debt and this is also known as breakeven level of
EBIT for alternative financial plans.
The equivalency or point of indifference can be
calculated algebraically, as below:

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Where, X = Equivalency Point or Point of Indifference or

Break Even EBIT
I1 = Interest under alternative financial plan 1.
I2 = Interest under alternative financial plan 2.
T = Tax Rate
PD = Preference Dividend
S1 = Number of equity shares or amount of equity share capital
under alternative 1.
S2 = Number of equity shares or amount of equity share capital
under alternative 2.
The following illustrative example explains the
calculation of point of indifference.
Problem 7. A project under consideration by your
company requires a capital investment of Rs. 60 lakhs.
Interest on term loan is 10% p.a. and tax rate is 50% Calculate
the point of indifference for the project, if the debt-equity ratio
insisted by the financing agencies is 2:1
Solution:
As the debt equity ratio insisted by the financing agencies
is 2:1, the company has two alternative financial plans:
(i) Raising the entire amount of Rs. 60 lakhs by the
issue of equity shares, thereby using no debt, and
(ii) Raising Rs. 40 lakhs by way of debt and Rs. 20 lakh
by issue of equity share capital.
Calculation of point of indifference:

Where, X = Point of Indifference

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I1 = Interest under alternative 1, i.e., .0 (no debt component)

I2 = Interest under alternative 2, i.e.,

T = Tax Rate i.e. 50% or .5

PD = Preference Dividend, i.e., 0 as there are no preference
shares
S1 = Amount of equity capital under alternative 1, i.e. 60
S2 = Amount of equity capital under alternative 2, i.e. 20.

Thus, EBIT, earnings before interest and tax, at point of

indifference is Rs. 6 lakhs. At this level (6 lakh) of EBIT, the
earnings on equity after tax will be 5% p.a. irrespective of
alternative debt-equity mix when the rate of interest on debt is
10% p.a.)
Problem 8. A new project under consideration requires a
capital outlay of Rs. 600 lakhs for which the funds can either
be raised by the issue of equity shares of Rs. 100 each or by
the issue of equity shares of the value of Rs. 400 lakhs and by
the issue of 15% loan of Rs. 200 lakhs. Find out the
indifference level of EBIT, given the tax rate at 50%.

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Solution

Thus, the indifferent level of EBIT is Rs. 90 lakhs. At

this level of EBIT, the earnings per share (EPS) under both
the plans would be the same.
OPTIMAL CAPITAL STRUCTURE
As discussed above, the capital structure decision can
influence the value of the firm through the cost of capital and
trading on equity or leverage. The optimum capital structure
may be defined as "that capital structure of combination of
debt and equity that leads to the maximum value of the firm"
Optimal capital structure 'maximises the value of the company
and hence the wealth of its owners and minimises the
company's cost of capital' (Solomon, Ezra, The Theory of
Financial Management). Thus, every firm should aim at
achieving the optimal capital structure and then to maintain it.
The following considerations should be kept in mind
while maximising the value of the firm in achieving the goal of
optimum capital structure:
i. If the return on investment is higher than the fixed cost of
funds, the company should prefer to raise funds having a
fixed cost, such as debentures, loans and preference share

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capital. It will increase earnings per share and market value

of the firm. Thus, a company should make maximum
possible use of leverage.
ii. When debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed
as a deductible expense in computation of tax. Hence, the
effective cost of debt is reduced, called tax leverage. A
company should, therefore, take advantage of tax leverage.
iii. The firm should avoid undue financial risk attached with
the use of increased debt financing. If the shareholders
perceive high risk in using further debt-capital, it will
reduce the market price of shares.
iv. The capital structure should be flexible.
RISK-RETURN TRADE OFF
i) Financial Risk. The financial risk arises on account of the
use of debt or fixed interest bearing securities in its capital. A
company with no debt financing has no financial risk. The
extent of financial risk depends on the leverage of the firm's
capital structure. A firm using debt in its capital has to pay
fixed interest charges and the lack of ability to pay fixed
interest increases the risk of liquidation. The financial risk also
implies the variability of earnings available to equity
shareholders.
ii) Non-Employment of Debt Capital (NEDC) Risk. If a
firm does not use debt in its capital structure, it has to face the
risk arising out of non-employment of debt capital. The NEDC
risk has an inverse relationship with the ratio of debt in its total
capital. Higher the debt-equity ratio or the leverage, lower is
the NEDC risk and vice-versa. A firm that does not use debt
cannot make use of financial leverage to increase its earnings
per share; it may also lose control by issue of more and more
equity; the cost of floatation of equity may also be higher as

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compared to costs of raising debt.

Thus a firm has to a reach a balance (trade-off) between
the financial risk and risk of non-employment of debt capital
to increase its market value.

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UNIT - 10
CAPITAL STRUCTURE – PART - II

Learning Objectives
 Theories of capital structure
 Determine the point of indifference
 Factors determining the capital structure
 Capital gearing
THEORIES OF CAPITAL STRUCTURE
Different kinds of theories have been propounded by
different authors to explain the relationship between capital
structure, cost of capital and value of the firm. The main
contributors to the theories are Durand, Ezra, Solomon,
Modigliani and Miller.
The important theories are discussed below:
1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach.
1. Net Income Approach: According to this approach, a firm
can minimise the weighted average cost of capital and
increase the value of the firm as well as market price of equity
shares by using debt financing to the maximum possible
extent. The theory propounds that a company can increase its
value and decrease the overall cost of capital by increasing the
proportion of debt in its capital structure. This approach is
based upon the following assumptions:
i. The cost of debt is less than the cost of equity

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ii. There are no taxes.

iii. The risk perception of investors is not changed by the use of
debt.
The total market value of a firm on the basis of Net
Income Approach can be ascertained as below:
V = S+D
Where, V = Total market value of a firm
S = Market value of equity shares

D = Market value of debt.

and, Overall Cost of Capital or Weighted Average Cost
of Capital can be calculated as:

Problem 1: X Ltd. is expecting an annual EBIT of Rs. 1 lakh.

The company has Rs. 4 lakhs in 10% debentures. The cost of
equity capital or capitalisation rate is 12.5%. You are required
to calculate the total value of the firm according to the Net
Income Approach.
Solution:
Calculation of the Value of the Rs.
Firm
Net Income (EBIT) 1,00,000
Less: Interest on 10% 40,000
Debentures of 4lakhs
Earnings available to equity 60,000

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shareholders
Market Capitalisation Rate 12.5%
Market Value of Equity (S) 4,80,000
=60,000x
100 / 12.5
Market Value of Debenture
(D) 4,00,000
Value of the Firm (S+D) 8,80,000
=======

Problem 2. (a) A company expects a net income of

Rs.80,000. It has Rs. 2,00,000, 8% Debentures. the equity
capitalisation rate of the company is 10% Calculate the value
of the firm and overall capitalisation rate according to the Net
Income Approach (ignoring income-tax).
(b) If the debenture debt is increased to Rs. 3,00,000, what
shall be the value of the firm and the overall capitalisation
rate?
Solution

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Thus, it is evident that with the increase in debt financing

the value of the firm has increased and the overall cost of
capital has decreased.
2. Net Operating Income Approach: According to this
approach, change in the capital structure of a company does
not affect the market value of the firm and the overall cost of
capital remains constant irrespective of the method of
financing. There is nothing as an optimal capital structure
and every capital structure is the optimum capital structure.
This theory presumes that:
i. the market capitalises the value of the firm as a whole;
ii. the business risk remains constant at every level of debt
equity mix;
iii. there are no corporate taxes.
The value of a firm on the basis of Net Operating Income
Approach can be determined as below:

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Where, V = Value of a firm

EBIT = Net operating income or Earnings before interest and
tax
K0 = Overall cost of capital
The market value of equity, according to this approach is
the residual value which is determined by deducting the market
value of debentures from the total market value of the firm.
S = V-D
Where, S = Market value of equity shares
V = Total market value of firm
D = Market value of debt
The cost of equity or equity capitalisation rate can be
calculated as below:
Cost of Equity or Equity Capitalisation Rate (K0) =

Problem 3. (a) A company expects a net operating income of

Rs 1,00,000. It has Rs 5,00,000, 6% Debentures. The overall
capitalisation rate is 10%. Calculate the value of the firm and
the equity capitalisation rate (cost of equity) according to the
Net Operating Income Approach.
(b) If the debenture debt is increased to Rs 7,50,000.
What will be the effect on the value of the firm and the equity
capitalisation rate?

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3. The Traditional Approach:

The traditional approach, also known as Intermediate
approach, is a compromise between the two extremes of net
income approach and net operating income approach.
According to this theory, the value of the firm can be increased
initially or the cost of capital can be decreased by using more
debt as the debt is a cheaper source of funds than equity. Thus,
optimum capital structure can be reached by a proper debt-
equity mix. Beyond a particular point, the cost of equity
increases because increased debt increases the financial risk of
the equity shareholders.

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Problem 4. Compute the market value of the firm, value of

shares and the average cost of capital from the following
information:
Net Operating income Rs 2,00,000
Total Investment 10,00,000
Equity Capitalisation Rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs 4,00,000 debentures 11%
(c) If the firm uses Rs 6,00,000 debenture 13%
Assume that Rs 4,00,000 debentures can be raised at 5%
rate of interest whereas Rs 6,00,000 debentures can be raised
at 6% rate of interest.
Solution

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Comments
It is clear from the above that if debt of 4,00,000 is used
the value of the firm increases and the overall cost of capital
decreases. But, if more debt is used to finance in place of
equity, i.e., Rs 6,00,000 debentures, the value of the firm
decreases and the overall cost of capital increases.
4, Modigliani and Miller Approach. M & M
hypothesis is identical with Net Operating Income approach if
taxes are ignored. However, when corporate taxes are
assumed to exist, their hypothesis is similar to the Net Income
Approach.
(a) In the absence of taxes. (Theory of Irrelevance)
The theory proves that the cost of capital is not affected by
changes in the capital structure or say that the debt-equity mix
is irrelevant in the determination of the total value of a firm.
The reason argued is that though debt is cheaper to equity,
with increased used of debt as source of finance, the cost of
equity increases. This increase in cost of equity offsets the
advantage of the low cost of debt. Thus, although the financial
leverage affects the cost of equity, the overall cost of capital
remains constant. The theory emphasises the fact that a firm's
operating income is a determinant of its total value.
The M & M approach is based upon the following
assumptions:
i. There are no corporate taxes.
ii. There is a perfect market.
iii. Investors act rationally.
iv. The expected earnings of all the firms have identical risk
characteristics.
v. The cut-off point of investment in a firm is capitalisation
rate.

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vi. Risk to investors depends upon the random fluctuations of

expected earnings and the possibility that the actual value of
the variables may turn out to be different from their best
estimates.
vii. All earnings are distributed to the shareholders.
Problem 5. The following information is available regarding
Mid Air Enterprises:
i. Mid Air currently has no debt, it is an all equity company;
ii. Expected EBIT = 24 lakhs. EBIT is not expected to increase
overnight, so Mid Air is in no growth situation;
iii. There are no taxes, so T = 0 per cent;
iv. Mid Air pays out all its income as dividends;
v. If Mid Air begins to use debt, it can borrow at the rate kd = 8
per cent. This borrowing rate is constant and it is independent
of the amount of debt. Any money raised by selling debt
would be used to retire common stock, so Mid Air's assets
would remain constant;
vi. The risk of Mid Air's assets, and thus its EBIT, is such that its
shareholders require a rate of return Kez = 12 per cent, if no
debt is used.
Using MM Model without corporate taxes and assuming a debt
of Rs 1 crore, you are required to:
a) Determine the firm's total market value;
b) Determine the firm's value of equity;
c) Determine the firm's leverage cost of equity.
Solution
(a) Firm's Total Market Value:

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(b) Firm's Market Value of Equity: S = V-D

2 – 1 = Rs 1 crore
(c) Firm's Leverage Cost of Equity :
= Cost of Equity + (Cost of Equity – Cost of Debt)
= 12% + (12% - 8%)
= 16%
b) When corporate taxes are assumed to exist (Theory of
Relevance): Modigliani and Miller, in their article of 1963
have recognized that the value of the firm will increase or the
cost of capital will decrease with the use of debt on account of
deductibility of interest charges for tax purpose. Thus, the
optimum capital structure can be achieved by maximizing the
debt mix in the equity of a firm.
According to the M & M approach, the value of a firm
unlevered can be calculated as:

and, the value of a Levered firms is: VL = Vu + tD

Where , Vu is value of unlevered firm and tD is the discounted
present value of the tax savings resulting from the tax
deductibility of the interest charges, t is rate of tax and D the
quantum of debt used in the mix.
Problem 6. A company has earnings before interest and
taxes of Rs. 1,00,000. It expects a return on its investment at a
rate of 12.5%. You are required to find the total value of the
firm according to the Miller-Modigliani theory.

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Solution:
According to the M and M theory, total value of the
firm remains constant. It does not change with the change in
capital structure.

Problem 7. There are two firms X and Y which are

exactly identical except that X does not use any debt in its
financing, while Y has Rs. 1,00,000 5% Debentures in its
financing. Both the firms have earnings before interest and tax
of Rs.25,000 and the equity capitalisation rate is 10%.
Assuming the corporation tax of 50% calculate the value of the
firm using M & M approach.
Solution:
The market value of firm X which does not use any debt

The market value of Firm Y which uses debt financing of Rs.

1,00,000
VL = Vu + tD
= Rs. 1,25,000 +0.5*1,00,000
= Rs. 1,25,000+50,000 =Rs. 1,75,000.

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How Does the Arbitrage Process Work?

We have noticed in the above problem that the market
value of the firm Y, which uses debt content in its capital
structure, is higher than the market value of firm X which does
not use debt content in its capital structure. According to M &
M theory, this situation cannot remain for a long period
because of the arbitrage process. As the investors in company
Y can earn a higher rate of return on their investment with
lower financial risk, they will sell their holding of shares in
company X and invest the same in company Y. Further, as
company X does not use any debt in its capital structure, the
financial risk to the investors will be less, thus, they will
engage in personal leverage by borrowing additional funds
equivalent to their proportionate share in firm X's debt at the
same rate of interest and invest the borrowed funds also in
company Y. The arbitrage process will continue till the prices
of shares of company X fall and that of company Y rise so as
to make the market value of the two firms identical. However,
in the arbitrage process, such investors who switch their
holdings will gain. Problem 8, given below, illustrates the
working of arbitrage process.
Problem 8. The following is the data regarding two companies
'A' and 'B' belonging to the same equivalent risk class.
Company A Company B
Number of ordinaryshares 1,00,000 1,50,000

8% Debentures 50,000 -
Market Price per share Rs 1.30 Rs.1.00
Profit before interest Rs 20,000 Rs 20,000

All profits after paying debenture interest are distributed as

dividends. You are required to explain how under Modigliani

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and Miller approach, an investor holding10% of shares in

company ‗A‘ will be better off in switching his holding to
company ‗B‘.
Solution:
In the opinion of Modigliani & Millier, two identical firms in
all respects except their capital structure cannot have different
market values because of arbitrage process. In case two
identical firms except for their capital structure have different
market values, arbitrage will take place and the investors will
engage in 'personal leverage' as against the 'corporate
leverage'. In the given problem, the arbitrage will work out as
below:
The investor will sell in the market 10% shares in
Company 'A' for Rs 13,000

The Investor will gain by switching his holding as below:

Present income of the investor in company 'A': Rs,
Profit before interest of the company 20,000
Less: Interest on debentures (8%) 4,000

Profit after interest 16,000

Share of the investor =10% of Rs 16,000,ie. 1,600

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Income of the Investor after switching holding to

company 'B'
Profit before interest for company 'B' 20,000
Less: Interest Nil

Profit after interest 20,000

Share of the investor = 20,000 x 18,000 2,400

1,50,000
Less: Interest paid on loan taken 8% of Rs 5000 400
Net income of the investor 2,000
As the net income of the investor in company ‗B‘ is higher
than the loss of income from company ‗A‘, due to switching
the holdings, the investor will gain in switching his holdings
to company ‗B‘
FACTORS DETERMINING THE CAPITAL
STRUCTURE
The capital structure of a concern depends upon a large
number of factors such as:
1. Financial Leverage or Trading on Equity: The use
of long-term fixed interest bearing debt and preference share
capital along with equity share capital is called financial
leverage or trading on equity.
2. Growth and Stability of Sales: The capital structure
of a firm is highly influenced by the growth and stability of its
sales. If the sales of a firm are expected to remain fairly
stable, it can raise a higher level of debt.
3. Cost of Capital: Cost of capital refers to the
minimum return expected by its suppliers. The capital
structure should provide for the minimum cost of capital.

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4. Risk: There are two types of risk that are to be

considered while planning the capital structure of a firm viz.,
(i) business risk and (ii) financial risk. Business risk refers to
the variability of earnings before interest and taxes. Business
risk can be internal as well as external. Internal risk is caused
due to improper product mix, non-availability of raw materials,
incompetence to face competition, absence of strategic
management etc. Internal risk is associated with the efficiency
with which a firm conducts its operations within the broader
environment thrust upon it. External business risk arises due
to change in operating conditions caused by conditions thrust
upon the firm which are beyond its control e.g., business
cycles, governmental controls, changes in business laws,
international market conditions, etc.
Financial risk refers to the risk of a firm that may not be
able to cover its fixed financial costs. Financial risk is
associated with the capital structure of a company. A company
with no debt financing has no financial risk.
5. Cash Flow Ability to Service Debt: A firm which
shall be able to generate larger and stable cash inflows can
employ more debt in its capital structure as compared to the
one which has unstable and lesser ability to generate cash
inflows.
6. Nature and Size of a Firm: Nature and size of a firm
also influence its capital structure. All public utility concern
has different capital structure as compared to other
manufacturing concern.
7. Control: Whenever additional funds are required by a
firm, the management of the firm wants to raise the funds
without any loss of control over the firm.
8. Flexibility: Capital structure of a firm should be
flexible, i.e., it should be such as to be capable of being

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adjusted according to the needs of the changing conditions. It

should be possible to raise additional funds, whenever the need
be, without much of difficulty and delay.
9. Requirements of Investors: The requirements of
investors are another factor that influences the capital
structure of a firm. It is necessary to meet the requirements of
both institutional as well as private investors when debt
financing is used.
10. Capital Market Conditions (Timing): Capital market
conditions do not remain the same forever. Sometimes there
may be depression while at other times there may be boom in
the market. The choice of the securities is also influenced by
the market conditions.
11. Assets Structure. The liquidity and the composition of
assets should also be kept in mind while selecting the capital
structure.
12. Purpose of Financing: If funds are required for a
productive purpose, debt financing is suitable and the company
should issue debentures as interest can be paid out of the
profit generated from the investment.
13. Period of Finance: The period for which the finances
are required is also an important factor to be kept in mind
while selecting an appropriate capital mix.
14. Costs of Floatation: Although not very significant,
yet costs of floatation of various kinds of securities should
also be considered while raising funds.
15. Personal Considerations: The personal considerations
and abilities of the management will have the final say on the
capital structure of a firm. Management which are experienced
and are very enterprising do not hesitate to use more of debt in
their financing as compared to the less experienced and
conservative management.

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16. Corporate Tax Rate: High rate of corporate taxes on

profits compel the companies to prefer debt financing, because
interest is allowed to be deducted while computing taxable
profits. On the other hand, dividend on shares is not an
allowable expense for that purpose.
17. Legal Requirements: The Government has also
issued certain guidelines for the issue of shares and
debentures. The legal restrictions are very significant as they
lay down a framework within which capital structure decision
has to be made.
PRINCIPLES OF CAPITAL STRUCTURE DECISIONS
The capital structure decisions are influenced by a variety
of factors discussed above. From these factors, we can
summarise the main principles of capital structure decisions as
follows:
1. Cost Principle
2. Risk Principle
3. Control Principle
4. Flexibility Principle
5. Timing Principle
All these principles have already been explained while
discussing factors determining the capital structure.
CAPITAL GEARING
The term 'capital gearing' refers to the relationship
between equity capital (equity shares plus reserves) and long-
term debt. In simple words, capital gearing means the ratio
between the various types of securities in the capital structure
of the company. A company is said to be in high-gear, when it
has a proportionately higher/large issue of debentures and
preference shares for raising the long-term resources, whereas

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low-gear stands for a proportionately large issue of equity

shares. For example:
Extracts of Balance Sheets
Liabilities A. Ltd. B. Ltd.
Rs Rs
Equity Share Capital 4,00,000 6,00,000
10% Preference Share Capital 3,00,000 2,00,000
9% Debentures 3,00,000 2,00,000
10,00,000 10,00,000

The total capitalisation of the above two companies is the

same i.e., Rs. 10,00,000 for each company, but the capital
structure differs. A Ltd. is high geared as the ratio of equity
capital in the total capitalisation of the company is only 40%.
But B Ltd. is low geared as its capital structure comprises of
60% of equity capital and only 40% of the fixed cost bearing
securities.
FINANCIAL DISTRESS AND CAPITAL STRUCTURE
(BANKRUPTCY AND AGENCY COSTS)
When a firm uses more and more of debt in its capital
mix the financial risk of the firm increases. It may not be able
to pay the fixed interest to the suppliers of data and they may
force the firm to liquidate. The firm runs into the cost of
financial distress and bankruptcy. The firm using more of
equity may not have to face such bankruptcy cost because it
may not pay dividends to the shareholders in absence of
sufficient profits. The bankruptcy costs include the direct costs
of litigation and the cost of managing the firm in liquidation.

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Further, when a firm raises debt the suppliers of debt put

restrictive conditions in the loan agreement resulting into
lesser freedom to the management in decision-making called
agency costs.
PECKING ORDER THEORY
The Pecking Order Theory was first suggested by
Donaldson in 1961 and it was modified by Myers in 1984
(Modified Pecking Order Theory). According to Donaldson's
theory, a firm has well defined order of preference for raising
finance. Whenever a firm needs funds, it will rely as much as
possible on internally generated funds. If the internally
generated funds are not sufficient to meet the financial
requirements, it will move to debt in the form of term loans
and then to non-convertible bonds and debentures, and then to
convertible debt instruments, and then to quasi-equity
instruments and after exhausting all other sources, it may
finally move to raise finance through issue of new equity share
capital.
Problem 9: The firm A and B are identical in all respects
including risk factors except for debt equity mix. Firm A has
issued 12% debentures of Rs 15 lakhs while B has issued only
equity. Both the firms earn 30% before interest and taxes on
their total assets of Rs 25 lakhs.
Assuming a tax rate of 50% and capitalisation rate of
20% for an all-equity company, you are required to compute
the value of the two firms using (i) Net Income Approach, and
(ii) Net Operating Income Approach.

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Solution:
Computerisation of Total Value of the Firms
(i) Net Income Approach Levered Unlevered
Firm A. Firm B
Rs Rs
EBIT, 30% on Rs 25,00,000 7,50,000 7,50,000
Less: Income on debentures 1,80,000 --

5,70,000 7,50,000
Less: Tax at 50% 2,85,000 3,75,000
Earnings available for equity
shareholders 2,85,000 3,75,000
Capitalized value of equity at 20%
Firm A : 2,85,000 x 100 14,25,000 --
20
Firm B : 3,75,000 x 100 15,00,000 18,75,000
20
Add: Value of Debt Total Value of Firm
29,25,000 18,75,000

(ii) Net Operating Income Approach:

= Rs 18,75,000
Value of Levered Firm A (VL) = V + M
= 18,75,000 + 5 x 15,00,000
= 18,75,000 + 7,50,000
= Rs 26,25,000

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Note: According to Net Operating Income Approach, change

in the capital structure of a company does not affect the
market value of the firm and every capital structure is the
optimum capital structure, provided there are no corporate
taxes. However, when the corporate taxes are assumed to exist
(as in the above illustration), the optimum capital structure can
be achieved by maximising the debt mix in the equity of a
firm.
Problem 10: A company's capital structure consists of the
following:
Equity share of Rs 100 each Rs 20 lakhs
Retained Earnings Rs 10 lakhs
9% Preference Shares Rs 12 lakhs
7% Debentures Rs 8 lakhs
Total Rs 50 lakhs
========
The company earns 12% on its capital. The income-tax
rate is 50%. The company requires a sum of Rs 25 lakh to
finance its expansion programme for which the following
alternatives are available to it:
(i) Issue of 20,000 equity shares at a premium of Rs 25 per
share
(ii) Issue of 10% preference shares
(iii) Issue of 8% debentures
It is estimated that the P/E ratios in the cases of equity,
preference and debenture financing would be 21.4, 17 and 15.7
respectively.
Which of the three financing alternatives would you
recommend and why?

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Solution
Evaluation of Various Financing Alternatives
Alternative
Alternative Alternative
(ii) (10%
(i) (Equity (iii) (8%
Preference
Shares) Debenture
Shares)
(Rs) s) (Rs)
(Rs)
Earnings Before Interest @ 9,00,000 9,00,000 9,00,000
Tax (EBIT) (12% on Rs 75
lakhs)
Less: Interest on Old 56,000 56,000 56,000
Debentures at 7%
8,44,000 8,44,000 8,44,000
Interest on New Debentures at -- -- 2,00,000
8%
Earnings Before Tax After 8,44,000 8,44,000 6,44,000
Interest
Less: Tax at 50% 4,22,000 4,22,000 3,22,000
4,22,000 4,22,000 3,22,000
Less: Preference Dividend on 1,08,000 1,09,000 1,08,000
Existing Shares at 9%
3,14,000 3,14,000 2,14,000
Preferences Dividend on New -- 2,50,000 --
Shares at 10%
Earnings for Equity 3,14,000 64,000 2,14,000
Shareholders (a)
Number of Equity Shares (b) 40,000 20,000 20,000
Earnings per Share (c) = [a+b] 7.85 3.20 10.70
Price/Earning Ratio (d) 21.4 17.0 15.7
Market Price per Share (c x d) 167.99 54.00 167.99

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Comments: Probable market price per share is the same in

alternative (i) and (iii), but earnings per share (EPS) is highest
in alternative (iii). Thus, alternative (iii), i.e., issue of 8%
Debentures should be preferred.
Review Questions
Short Answer Type Questions
1. Define capital structure.
2. What is optimal capital structure?
3. Name various theories of capital structure.
4. What is capital gearing?
5. What is trading on equity?
6. Write a note on 'Arbitrage Process'.
7. Explain the term point of indifference.
8. What do you understand by bankruptcy costs and agency
costs?
Essay Type Questions
1. What is meant by capital structure? What are the major
determinants of capital structure?
2. Define capital structure. What should generally be the
features of an appropriate capital structure?
3. Explain the meaning of the term capital structure and
mention the factors affecting capital structure.
4. Give a critical appraisal of the traditional approach and
the Modigliani- Millers approach to the problem of
capital structure.
5. What do you understand by capital gearing? What is its
significance? Discuss the effects of high and low gearing
on the financial position of a company during various
phases of trade cycle.

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6. Explain the net income approach to capital structure

planning and examine its rationality.
EXERCISES
1. ABC company has currently an ordinary share capital of
Rs 25 lakhs, consisting of 25,000 shares of Rs 100 each.
The management is planning to raise another Rs 20 lakhs
to finance a major programme of expansion through one
of four possible financial plans. The options are:
(i) Entirely through ordinary shares.
(ii) Rs 10 lakhs through ordinary shares and Rs 10 lakhs
through long- term borrowing at 8% interest per annum.
(iii) Rs 5 lakhs through ordinary shares and Rs 15 lakhs
through long- term borrowing at 9% interest per annum.
(iv) Rs 10 lakhs through ordinary shares and Rs 10 lakhs
through preference shares with 5% dividend.
The company's expected earnings before interest and taxes
(EBIT) will be Rs 8 lakhs. Assuming a corporate tax rate of
50%, determine the earnings per share in each alternative and
comment which alternative in the best and why?
[Ans: (i) Rs 8.88; (ii) Rs 10.29; (iii) Rs 11.07; (iv) Rs 10.00;
Plan III is the best].
2. XY Ltd. needs Rs 50,00,000 for the installation of a new
factory, the new factory is expected to yield annual
Earnings Before Interest and Tax (EBIT) of Rs
10,00,000. In choosing a financial plan, XY Ltd. has an
objective of maximising earnings per share. It is
considering the possibilities of issuing ordinary shares
and raising debt of Rs 5,00,000 at Rs 20,00,000 or Rs
30,00,000. The current market price per share is Rs300
and is expected to drop to Rs 250 if the funds are
borrowed in excess of Rs 20,00,000. Funds can be raised

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at the following rates:

Upto Rs 5,00,000 at 10%
Over Rs 5,00,000 to Rs 20,00,000 at 15%
Over Rs 20,00,000 at 20%
Assuming a tax rate of 50%, advise the company.
[Ans: I. Rs 51.67; II. Rs 36.25; III. Rs 32.81].
The second alternative which gives the highest earnings per
share is the best. Hence, the company is advised to raise Rs
20,00,000 through debt and Rs 30,00,000 by ordinary share.
3. A company is planning an expansion program which will
require Rs 60 crore and can be funded through one of the
three following options:
1. Issue further equity shares of Rs 100 each at par.
2. Raise a 15% loan.
3. Issue 12% preference shares.
The present paid up capital is Rs 120 crores and the annual
EBIT is Rs 24 crores. The tax rate may be taken at 50%. After
the expansion plan is adopted, the EBIT is expected to be Rs
30 crores.
Calculate the EPS under all the three financing options
indicating the alternative giving the highest return to equity
shareholders. Also determine the indifference point between
the equity share capital and debt financing (i.e., option 1 and
option 2 above).
[Ans: EPS : Option 1 Rs 8.33; Option 2 Rs 8.75; Option 3 Rs
6.50; Option 2 gives the highest return; indifference point
between option 1 and 2 Rs 27 crores].
4. (a) A company is expecting an annual earnings before
interest and tax (EBIT) of Rs 5,00,000. The company in
its capital structure has 12%. Debentures of Rs 15,00,000.
The cost of equity or capitalisation rate is 16%. You are
required to calculate the value of the firm and overall cost

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of capital according to the Net Income Approach.

(b) If the firm decides to raise further Rs 10,00,000 by the
issue of debentures and to use the proceeds thereof to
redeem equity shares, what shall be the value of the firm
and overall capitalisation rate according to NI Approach.
[Ans: (i) Rs 35,00,000; 14.28%
(ii) Rs 37,50,000; 13.33%]
5. XYZ Ltd. expects earnings before interest and tax of Rs
6,00,000 and belongs to risk class of 10%. You are
required to calculate the value of the firm and cost of
equity capital (according to the NOI approach) if it
employs 8% debt to the extent of 20%, 40% or 60% of
the total financial requirement of Rs 30,00,000.
[Ans: (a) 20% Debt: Value of Firm Rs 60,00,000; Cost of
Equity 10.222%.
(b) 40% Debt: Value of Firm Rs 60,00,000; Cost of Equity
10.50%
(c) 60% Debt: Value of Firm Rs 60,00,000; Cost of Equity
10.857%].
6. The following is the data regarding two Companies 'X'
and 'Y' belonging to the same equivalent risk class:
Company X Company Y
Number of ordinary shares 90,000 1,50,000
Market price per share Rs 1.20 Re.1.00
6% Debentures 60,000 --
Profit before interest Rs 18,000 Rs 18,000
All profits after debenture interest are distributed as dividends.
You are required to explain how under Modigliani & Miller
approach, an investor holding 10% of shares in Company 'X'

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will be better off in switching his holding to Company 'Y'.

[Ans: Present Income = 1440
Income after switching holdings - Rs 1656].
7. Firms X and Y identical are except that firm X is not
levered while Firm Y is levered. The following data relate
to them:
Firm X Rs Firm Y Rs
Assets 5,00,000 5,00,000
Debt capital 2,50,000 (9% int.)
Equity share capital 5,00,000 2,50,000
No. of shares (50,000) (25,000)
Rate of Return on assets 20% 20%
Calculate EPS for both firms, assuming tax rate of 50%. Will it
be advantageous to firm Y to raise the level of debt capital to
75%?
[Ans: EPS: Firm X Re.1.00; Firm Y Rs 1.55. Advantageous
for firm Y to raise level of debt to 75%, as EPS increases to Rs
2.65].
8. A Company Ltd., has a share capital of Rs 1,00,000
dividend into shares of Rs 10 each. It has major
expansion programme requiring an investment of another
Rs 50,000. The management is considering the following
alternatives for raising this amount:
(i) Issue of 5,000 shares of Rs 10 each.
(ii) Issue of 5,000, 12% preference shares of Rs 10 each.
(iii) Issue of 10% debentures of Rs 50,000.
he company's present earnings before interest and Tax (EBIT)
is Rs 30,000 p.a.
You are required to calculate the effect of each of the above

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modes of financing on the earnings per share (EPS),

presuming.
(a) EBIT continues to be the same even after expansion.
(b) EBIT increases by Rs 10,000.
(c) Assume tax liability at 50%.
[Ans: (a) E.P.S. : Plan I Re.1.00; Plan II Re.0.90; Plan III Rs
1.25
(b) E.P.S. : Plan I Rs 1.33; Plan II Rs 1.40; Plan III Rs 1.75].
9. Paramount Produces Ltd. wants to raise Rs 100 lakhs for
a diversification project. Current estimate of earnings
before interest and taxes (EBIT) from the new project is
Rs 22 lakhs per annum.
Cost of debt will be 1.5% for amounts upto and including Rs
40 lakhs, 16% for additional amounts up to and including Rs
50 lakhs and 18% for additional amounts above Rs 50 lakhs.
The equity shares (face value Rs 10) of the company have a
current market value of Rs 40. This is expected to fall to Rs 32
if debts exceeding Rs 50 lakhs are raised.
The following options are under consideration of the company:
Option Equity Debt
I 50% 50%
II 60% 40%
III 40% 60%

Determine the earning per share (EPS) for each option and
state which option the company should exercise. Tax rate
applicable to the company is 50%.
[Ans: EPS: Option 1 Rs 5.76; Option II Rs 5.33; Option III Rs
5.04; First Option should be exercised].

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UNIT-11
DIVIDEND POLICY

Learning Objectives
 Mechanics and practice of dividend payment
 Factors affecting dividend policy
 Legal framework of payment of dividend
 Dividend theories
 Determinants of dividend policy
INTRODUCTION
The term dividend refers to that part of profits of a
company which is distributed among its shareholders. It is a
reward to the shareholders for their investments in the shares
of the company. The investors are interested in earning the
maximum return on their investments and to maximise their
wealth. A company, on the other hand, needs to provide funds
to finance its long-term growth. The firm‘s decision to pay
dividends must be reached in such a manner so as to equitably
apportion the distributed profits and retained earnings.
Dividend Decision and Valuation of Firms
The value of the firm can be maximised if the
shareholders‘ wealth is maximised. There are conflicting
views regarding the impact of dividend decision on the
valuation of the firm. According to one school of thought,
dividend decision does not affect the share-holders‘ wealth
and hence the valuation of the firm. On the other hand,
according to the other school of thought, dividend decision
materially affects the shareholders‘ wealth and also the
valuation of the firm. The views of the two schools of
thought are discussed below under two groups:

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1. The Irrelevance Concept of Dividend or the Theory of

Irrelevance, and
2. The Relevance Concept of Dividend or the Theory of
Relevance.
1. The Irrelevance Concept of Dividend or the Theory of
Irrelevance:
A. Residual Approach
According to this theory, dividend decision has no effect
on the wealth of the shareholders or the prices of the shares,
and hence it is irrelevant so far as the valuation of the firm is
concerned. The decision to pay dividends or retain the earnings
may be taken as a residual decision. This theory assumes that
investors do not differentiate between dividends and retentions
by the firm. Their basic desire is to earn higher return on
their investment. Thus, a firm should retain the earnings if it
has profitable investment opportunities otherwise it should pay
them as dividends.
B. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most
comprehensive manner in support of the theory of irrelevance.
They maintain that dividend policy has no effect on the
market price of the shares and the value of the firm is
determined by the earning capacity of the firm or its
investment policy. The splitting of earnings between retentions
and dividends, may be in any manner the firm likes, does not
affect the value of the firm.
Assumptions of MM Hypothesis
The argument given by MM in support of their
hypothesis is that whatever increase in the value of the firm
results from the payment of dividend, will be exactly off set
by the decline in the market price of shares because of external

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financing and there will be no change in the total wealth of the

shareholders, it will have to raise additional funds from
external sources. This will result in the increase in number of
shares or payment of interest charges, resulting in fall in the
earnings per share in the future. Thus whatever a shareholder
gains on account of dividend payment is neutralised
completely by the fall in the market price of shares due to
decline in expected future earnings per share. To be more
specific, the market price of a share in the beginning of a
period is equal to the present value of dividends paid at the
end of the period plus the market price of the shares at the end
of the period. This can be put in the form of the following
formula:

Where P0 = Market price per share at the beginning of the

period, or prevailing market price of a share
D1 = Dividend to be received at the end of the period.
P1 = Market price per share at the end of the period.
ke = Cost of equity capital or rate of capitalisation.
The value of P1 can be derived by the above equation as under:
P1 = P0(1+ke)-D1
The MM hypothesis can be explained in another form also
presuming that investment required by the firm on account of
payment of dividends is financed out of the new issue of equity
shares.
In such a case, the number of shares to be issued can be
compared with the help of the following equation:

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Further, the value of the firm can be ascertained with the help
of the following formula:

Where, m = number of shares to be issued

I = Investment required
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period
Ke = Cost of equity capital.
n = number of shares outstanding at the beginning of the
period.
D1 = Dividend to be paid at the end of the period
nP0 = Value of the firm

Let us take the following problem to show MM

hypothesis of irrelevance of dividend to the valuation of firm.
Problem 1. ABC Ltd. belongs to a risk class for which
the appropriate capitalisation rate is 10%. It currently has
outstanding 5,000 shares selling at Rs.100 each. The firm is
contemplating the declaration of dividend of Rs.6 per share at
the end of the current financial year. The company expects to
have a net income of Rs.50,000 and has a proposal for making
new investment of Rs.1,00,000. Show that under the MM
hypothesis, the payment of dividend does not affect the value
of the firm.

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Hence, whether dividends are paid or not, the value of the firm
remains the same Rs.5,00,000
Criticism of MM Approach
MM hypothesis has been criticised on account of various
unrealistic assumptions as given below.
1. Perfect capital market does not exist in reality
2. Information about the company is not available to all the
persons.
3. The firms have to incur flotation costs while issuing
securities
4. Taxes do exit and there is normally different tax treatment

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for dividends and capital gains.

5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees, etc. while
doing any transaction.
7. Shareholders may prefer current income as compared to
further gains.
2. The Relevance Concept of Dividend or the Theory of
Relevance
The other school of thought on dividend decision holds
that the dividend decisions considerably affect the value of the
firm. The advocates of this school of thought include Myron
Gordon, Jone Lintner, James Walter and Richardson.
According to them dividends communicate information to the
investors about the firms‘ profitability and hence dividend
decision becomes relevant. Those firms which pay higher
dividends will have greater value as compared to those which
do not pay dividends or have a lower dividend payout ratio.
(i) Walter‘s Approach and (ii) Gordon‘s Approach
(i) Walter’s Approach
Prof. Walter‘s approach supports the doctrine that
dividend decisions are relevant and affect the value of the
firm. The relationship between the internal rate of return
earned by the firm and its cost of capital is very significant in
determining the dividend policy to sub serve the ultimate goal
of maximising the wealth of the shareholders. Prof. Walter‘s
model is based on the relationship between the firm‘s (i) return
on investment, i.e., r, and (ii) the cost of capital or the required
rate of return, i.e., k.
According to Prof. Walter, If r > k, i.e., if the firm earns a
higher rate of return on its investment than the required rate of
return, the firm should retain the earnings. Such firms are

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termed as growth firms and the optimum pay-out would be

zero in their case. This would maximise the value of shares.
In case of declining firms which do not have profitable
investments, i.e., where r < k, the shareholders would stand to
gain if the firm distributes its earnings. For such firms, the
optimum pay-out would be 100% and the firms should
distribute the entire earnings as dividends.
In case of normal firms where r = k, the dividend policy
will not affect the market value of shares as the shareholders
will get the same return from the firm as expected by them. For
such firms, there is no optimum dividend pay-out and the value
of the firm would not change with the change in dividend rate.
Assumption of Walter’s Model
(i) The investments of the firm are financed through retained
earnings only and the firm does not use external sources
of funds.
(ii) The internal rate (r) and the cost of capital (k) of the firm
are constant.
(iii) Earnings and dividends do not change while determining
the value.
(iv) The firm has a very long life.
Walter’s Formula for Determining the Value of a Share
Walter has developed a mathematical equation to
ascertain the market price of a share which enables a firm to
arrive at the appropriate dividend decision. His equation is
based on the following share valuation model:

Where, P = Price of equity share

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D = Initial dividend per share

ke = Cost of equity capital
g = Expected growth rate of earnings/dividend
Prof. Walter has given the following formula to ascertain the
market price of a share:

P = Market price per share

D = Dividend per share
r = Internal rate of return
E = Earnings per share
ke = Cost of equity capital
Let us take the following problem to understand the above
equation
Problem 2. The following information is available for Awadh
Corporation:
Earnings per share Rs. 4.00
Rate of return on investments 18 %
Rate of return required by shareholder 15 %
What will be the price per share as per the Walter‘s Model if
the pay-out ratio is 40%?, 50%? and 60%?
Solution:

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Problem 3. The following information is available in respect

of a firm:
Capitalisation rate = 10%

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Earnings per share = Rs. 50

Assumed rate of return on investments:
(i) 12%
(ii) 8%
(iii) 10%
Show the effect of divided policy on market price of shares
applying Walter‘s formula when dividend pay-out ratio is
(a) 0% (b) 20% (c) 40% (d) 80% (e) 100%
Solution:

Effect of dividend policy on market price of shares

(i) r = 12% (ii) r = 8% (iii) r = 10%
(a) When dividend pay-out ratio is 0%

(b) When dividend pay-out is 20%

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(c) When dividend pay-out is 40%

(d) When dividend pay-out is 80%

(e) When dividend pay-out is 100%

Conclusion: From the above analysis we can draw the

conclusion that when,
(i) r > k, the company should retain the profits, i.e., when
r = 12%, ke = 10%
(ii) r is 8%, i.e., r < k, the pay-out should be high; and
(iii) r is 10%, i.e., r = k; the dividend pay-out does not affect
the price of the share.
GORDON’S APPROACH
Myron Gordon has also developed a model on the lines of
Prof. Walter suggesting that dividends are relevant and the

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dividend decision of the firm affects its value. His basic

valuation model is based on the following assumptions:
(i) The firm is an all equity firm
(ii) No external financing is available or used. Retained
earnings represent the only source of financing
investment programmes.
(iii) The rate of return on the firm‘s investment r, is constant.
(iv) The retention ratio, b, once decided upon is constant,
thus, the growth rate of the firm g = br, is also constant.
(v) The cost of capital for the firm remains constant and it is
greater than the growth rate, i.e., k > br.
(vi) The firm has perpetual life.
(vii) Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to
the present value of future stream of dividends. Thus,

Gordon‘s basic valuation formula can be simplified as under:

where,
P = Price of shares
E = Earnings per share b = retention ratio

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ke = Cost of equity capital

br = g = Growth rate in r, i.e., rate of return on investment of
an all-equity firm
D0 = Dividend per share
D1= Expected dividend at the end of year 1.
The implications of Gordon‘s basic valuation model may be
summarised as below:
1. When the rate of return of firm on its investment is greater
than the required rate of return, i.e., when r > k, the price
per share increases as the dividend pay-out ratio
decreases. Thus, growth firm should distribute smaller
dividends and should retain maximum earnings.
2. When the rate of return is equal to the required rate of
return, i.e., when r=k, the price per share remains
unchanged and is not affected by dividend policy. Thus,
for a normal firm there is no optimum dividend pay-out.
3. When the rate of return is less than the required rate of
return, i.e., when r < k, the price per share increases as the
dividend pay-out ratio increases. Thus, the shareholders of
declining firm stand to gain, if the firm distributes its
earnings. For such firms, the optimum payout would be
100%.
Problem 4. The following information is available in respect
of the rate of return on investment, the cost of capital (k) and
earnings per share (E) of ABC Ltd.
Rate of return on investment (r) = (i) 15%; (ii) 12%;
and (iii) 10%
Cost of capital (k) = 12%
Earnings per share (E) = Rs.10
Determine the value of its shares using Gordon‘s Model

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assuming the following:

D/p ratio (1-b) Retention ratio (b)
(a) 100 0
(b) 80 20
(c) 40 60

Solution:

Dividend Policy and the Value of Shares

i) R = 15% (r > k) (ii) r=12% (r=k) (iii) r=10% (r<k)
(a) When D/p ratio is 100% or b =0

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= Rs.133.33 = Rs.83.33 = Rs.66.68

Gordon’s Revised Model
The basic assumption in Gordon‘s Basic Valuation
Model that cost of capital (k) remains constant for a firm is not
true in practice. Thus, Gordon revised his basic model to
consider risk and uncertainly. In the revised model, he
suggested that even when r=k, dividend policy affects the
value of shares on account of uncertainty of future,
shareholders discount future dividends at a higher rate than
they discount near dividends.
Problem 5. The following information is available in
respect of return on investment (r), the cost of capital (ke) and
earnings per share (E) of XYZ Ltd.
r = 10 %
E = Rs.40
Determine the value of its shares using Gordon‘s Model,
assuming the following:

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Retention ratio Cost of equity

D/p ratio (1-b)
(b) (ke)%
(a) 20 80 20
(b) 40 60 18
(c) 60 40 16
(d) 80 20 14

Solution:

Where P = Price of shares

E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br =g=growth rate in r, i.e., rate of return on investment of an
all-equity firm
Dividend Policy and Value of Shares of XYZ Ltd.

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= Rs.66.67 = Rs.133.33 = Rs.200 = Rs.266.67

Problem 6. A Company is expected to pay a dividend of Rs.6
per share next year. The dividends are expected to grow
perpetually at a rate of 9 %. What is the value of its share if
the required rate of return is 15%?
Solution:

Problem 7. The current price of a company‘s share is Rs.75

and dividend per share is Rs.5. Calculate the dividend growth
rate, if its capitalisation rate is 12 %.
Solution:

Problem 8. The current price of a company‘s share is Rs.200.

The company is expected to pay a dividend of Rs.5 per share
next year with an annual growth rate of 10 %. If an

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investor‘s required rate of return is 12% should he buy the

share?
Solution:

As the value of share is more than its current price of Rs. 200,
the investor should buy the share.
Problem 9. The book value per share of a company is
Rs.145.50 and its rate of return on equity is 10 %. The
company follows a dividend policy of 60% pay-out. What is
the price of its share if the capitalisation rate is 12 %?
Solution:

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DETERMINANTS OF DIVIDEND POLICY

The following are the important factors which
determine the dividend policy of a firm:
1. Legal Restrictions. Legal provisions relating to dividends
as laid down in sections 93, 205, 205A, 206 and 207 of the
Companies Act, 1956 are significant because they lay down a
framework within which dividend policy is formulated.
2. Magnitude and Trend of Earnings. The amount and
trend of earnings is an important aspect of dividend policy. It
is rather the starting point of the dividend policy.
3. Desire and Type of Shareholders. The directors should
give the importance to the desires of shareholders in the
declaration of dividends as they are the representatives of
shareholders. Desires of shareholders for dividends depend
upon their economic status.
4. Nature of Industry. Nature of industry to which the
company is engaged also considerably affects the dividend
policy. Certain industries have a comparatively steady and
stable demand irrespective of the prevailing economic
conditions.
5. Age of the Company. The age of the company also
influences the dividend decision of a company. A newly
established concern has to limit payment of dividend and retain
substantial part of earnings for financing its future growth and
development, while older companies which have established
sufficient reserves can afford to pay liberal dividends.
6. Future Financial Requirements. It is not only the
desires of the shareholders but also future financial
requirements of the company that have to be taken into
consideration while making a dividend decision.
7. Government’s Economic Policy. The dividend policy of

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a firm has also to be adjusted to the economic policy of the

Government as was the case when the Temporary Restriction
of Payment of Dividend Ordinance was in force. In 1974 and
1975, companies were allowed to pay dividends not more than
33 % of their profits or 12 % on the paid-up value of the
shares, whichever was lower.
8. Taxation Policy. The taxation policy of the Government
also affects the dividend decision of a firm. A high or low rate
of business taxation affects the net earnings of company (after
tax) and thereby its dividend policy.
9. Inflation. Inflation acts as a constraint in the payment of
dividends. Profits as arrived from the profit and loss account
on the basis of historical cost have a tendency to be overstated
in times of rise in prices due to over valuation of stock-in-trade
and writing off depreciation of fixed assets at lower rates.
10. Control Objectives. When a company pays high
dividends out of its earnings, it may result in the dilution of
both control and earnings for the existing shareholders.
11. Requirements of Institutional Investors. Dividend
policy of a company can be affected by the requirements of
institutional investors such as financial institutions, banks
insurance corporations, etc.
12. Stability of Dividends. Stability of dividends is another
important guiding principle in the formulation of a dividend
policy. Stability of dividend simply refers to the payment of
dividend regularly and shareholders, generally, prefer payment
of such regular dividends.
DETERMINANTS OF DIVIDEND POLICY
1. Legal Restrictions
2. Magnitude and Trend of Earnings
3. Desire and Type of Shareholders

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4. Nature of Industry
5. Age of the Company
6. Future Financial Requirements
7. Government‘s Economic Policy
8. Taxation Policy
9. Inflation
10. Control Objectives
11. Requirements of Institutional Investors
12. Stability of Dividends
13. Liquid Resources

13. Liquid Resources. The dividend policy of a firm is

also influenced by the availability of liquid resources.
Although, a firm may have sufficient profits to declare
dividends, yet it may not be desirable to pay dividends if it
does not have sufficient liquid resources. The company may
resort to declare stock dividend in such cases.
TYPES OF DIVIDEND POLICY
The various types of dividend policies are discussed as
follows:
(a) Regular Dividend Policy
Payment of dividend at the usual rate is termed as
regular dividend. The investors such as retired persons,
widows and other economically weaker persons prefer to get
regular dividends. A regular dividend policy offers the
following advantages:
(a) It establishes a profitable record of the company.
(b) It creates confidence amongst the shareholders.
(c) It aids in long-term financing and renders financing easier.

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(d) It stabilises the market value of shares.

(e) The ordinary shareholders view dividends as a source of
funds to meet their day-to-day living expenses.
(f) If profits are not distributed regularly and are retained, the
shareholders may have to pay a higher rate of tax in the
year when accumulated profits are distributed.
2. Stable Dividend Policy
The term ‗Stability of dividends‘ means consistency or
lack of variability in the stream of dividend payments. In more
precise terms, it means payment of certain minimum amount
of dividend regularly. A stable dividend policy may be
established in any of the following three forms:
(a) Constant dividend per share. Some companies
follow a policy of paying fixed dividend per share
irrespective of the level of earnings year after year.
(b) Constant payout ratio. Constant pay-out ratio means
payment of a fixed percentage of net earnings as dividends
every year.
(c) Stable rupee dividend plus extra dividend. Some
companies follow a policy of paying constant low dividend
per share plus an extra dividend in the years of high profits.
Such a policy is most suitable to the firm having fluctuating
earnings from year to year.
3. Irregular Dividend Policy
Some companies follow irregular dividend payments on
account of the following:
(a) Uncertainty of earnings
(b) Unsuccessful business operations
(c) Lack of liquid resources

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(d) Fear of adverse effects of regular dividends on the

financial standing of the company.
4. No Dividend Policy. A company may follow a policy of
paying no dividends presently because of its unfavourable
working capital position or on account of requirements of
funds for future expansion and growth.
DIVIDEND POLICY IN PRACTICE
We have observed earlier that the main consideration in
determining the dividend policy is the objective of
maximisation of wealth of shareholders. Thus, a firm should
retain the earnings if it has profitable investment opportunities,
giving a higher rate of return than the most of retained
earnings, otherwise it should pay them as dividends. It
implies that a firm should treat retained earnings as the active
decision variable, and the dividends as the passive residual.
In actual practice, however, we find that most firms
determine the amount of dividends first, as an active decision
variable, and the residue constitutes the retained earnings. In
fact, there is no choice with the companies between paying
dividends and not paying dividends. Most of the companies
believe that by following a stable dividend policy with a high
pay-out ratio, they can maximise the market value of shares.
Moreover, the image of such companies is also improved in
the market and the investors also favour such companies. The
firms following this policy can, thus, successfully approach the
market for raising additional funds for future expansion and
growth, as and when required. It has, therefore, been rightly
said that theoretically, retained earnings should be treated as
the active decision variable, and dividends as passive residual,
but the practice does not conform to this in most cases.
It has been observed that the managements of Indian
firms believe that dividend policy conveys information about

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the current and future prospects of the firm and thus affects its
market value. They do consider the investor‘s preference for
dividends and shareholder profile while designing the dividend
policy. They also have a target dividend payout ratio but want
to pay stable dividends with growth.
Problem 10. The earnings per share of company are Rs.8
and the rate of capitalisation applicable to the company is 10%.
The company has before it an option of adopting a payout
ratio of 25% or 50% or 75%. Using Walter‘s formula of
dividend payout, compute the market value of the company‘s
share if the productivity of retained earnings is (i) 15% (ii)
10% and (iii) 5%
According to Walter‘s formula

where, P = Market price per share

D = dividend per share
r = Internal rate of return
E = Earnings per share
ke = Cost of equity capital
Computation of Market Value of Company’s Shares

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Problem 11. The following information relates to XYZ Ltd.:

Rs.
Paid-up equity capital 20,00,000
Earnings of the company 2,00,000
Dividend paid 1,60,000
Price-earnings ratio 12.5
Number of shares outstanding 20,000

You are required to find out whether the company‘s

dividend payout ratio is optimal, using Walter‘s Model.
Solution:
As per Walter‘s Model, the market price of the share is

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Thus, the firm can increase the market price of the share up to
Rs. 156.25 by increasing the retention ratio to 100%, the
optimal pay-out ratio for the firm is zero.

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Problem 12. ABC Ltd. has a capital of Rs. 10 lakhs in equity

shares of Rs. 100 each. The shares are quoted at par. The
company proposes to declare a dividend of Rs. 10 per share
at the end of current financial year. The capitalisation rate for
the risk class to which the company belongs is 12%. What will
be the market price of the share at the end of the year, if:
1) dividend is not declared
2) dividend is declared
3) Assuming that the company pays the dividend and has
net profits of Rs. 5,00,000 and makes new investments
of Rs. 10 lakhs during the period, how many new shares
must be issued? Use the MM model.
Solution:
According to the MM model, the price of the share at the end
of the current financial year can be calculated as below:
P1 = Po (1 + ke ) - D1
where,
Po = Prevailing Market Price of the Share
P1 = Market Price per share at the end of the year
D1 = Dividend to be received at the end of the year
ke = Cost of equity capital
Substituting the values in the above equation:
a) When a dividend is not declared
P1 = Po (1 + ke ) - D1
P1 = 100(1+ 0.12)- 0
P1 = 100(1+ 0.12) = Rs.112
b) When a dividend is declared (Rs. 10 per share)

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P1 = Po (1 + ke ) - D1
P1 = 100 (1+ 0.12)-10

= 112—10 = Rs. 102

Number of shares to be issued assuming that the company
pays the dividend:

Where
m = Number of shares to be
issued
I = Investment required
E = Total earnings of the firm during the period
n = Number of shares outstanding at the beginning of
the period.
D = Dividend to be paid at the end of the period.
P1= Market price per share at the end of the period.
Substituting values

FORMS OF DIVIDEND
Dividends may also be classified on the basis of medium in
which they are paid:
(a) Cash Dividend. A cash dividend is a usual method of
paying dividends. Payment of dividend in cash results in
outflow of funds and reduces the company‘s net worth, though

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the shareholders get an opportunity to invest the cash in any

manner they desire. This is why the ordinary shareholders
prefer to receive dividends in cash. But the firm must have
adequate liquid resources at its disposal or provide for such
resources so that its liquidity position is not adversely affected
on account of cash dividends.
(b) Scrip or Bond Dividend. A scrip dividend promises to
pay the shareholders at a future specific date. In case a
company does not have sufficient funds to pay dividends in
cash, it may issue notes or bonds for amounts due to the
shareholders. The objective of scrip dividend is to postpone
the immediate payment of cash. A scrip dividend bears interest
and is accepted as a collateral security.
(c) Property Dividend. Property dividends are paid in the
form of some assets other than cash. They are distributed
under exceptional circumstances and are not popular in India.
(d) Stock Dividend. Stock dividend means the issue of bonus
shares to the existing shareholders. If a company does not
have liquid resources it is better to declare stock dividend.
BONUS ISSUE
A company can pay bonus to its shareholders either in
cash or in the form of shares. Many a times, a company is not
in a position to pay bonus in cash inspite of sufficient profits
because of unsatisfactory cash position or because of its
adverse effects on the working capital of the company. In such
cases, if the company so desires and the articles of
association of the company provide, it can pay bonus to its
shareholder in the form of shares by making partly paid shares
as fully paid or by the issue of fully paid bonus shares.
The following circumstances warrant the issue of bonus
shares
(1) When a company has accumulated huge profits and

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reserves and it desires to capitalise these profits so as use

them on permanent basis in the business.
(2) When the company is not able to declare higher rate of
dividend on its capital, in spite of sufficient profits, due
to restrictions imposed by the Government in regard to
payment of dividend.
(3) When higher rate of dividend is not advisable for the
reason that the shareholder may expect the same higher
rate of dividend in future also.
(4) When the company cannot declare a cash bonus because
of unsatisfactory cash position and its adverse effects on
the working capital of the company.
(5) When there is a large difference in the nominal value and
market value of the shares of the company.
Hence, the bonus issue is made to achieve the following
objects:
(1) To bring the amount of issued and paid up capital in line
with the capital employed so as to depict more realistic
earning capacity of the company.
(2) To bring down the abnormally high rate of dividend on its
capital so as to avoid labour problems such as demand for
higher wages and to restrict the entry of new
entrepreneurs due to the attraction of abnormal profits, as
illustrated below:
Balance Sheet of X Co. (Prior to bonus issue)
Liabilities Rs. Assts Rs.
Share capital 5,00,000 Fixed Assets 15,00,000
Reserve 15,00,000 Current Assets 7,00,000
Creditors 2,00,000
22,00,000 22,00,000

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Assume that the company earns a profit of Rs.4,00,000

in the year. It will mean

i.e., 80% returns on its capital and it may attract many new
entrepreneurs into the business and may also create other
problems from labour. But in reality the profit of
Rs.4,00,000 has been earned not on capital of Rs.5,00,000 but
on the actual investment of Rs.20,00,00 i.e., Rs.5,00,000
capital plus Rs.15,00,000 Reserves, making a return on its
actual investments to

Hence, to bring down abnormally high rate of dividend, it

is advisable that the company should issue shares.
(3) To pay bonus to the shareholders of the company without
affecting its liquidity and the earning capacity of the
company
(4) To make the nominal value and the market value of the
shares of the company comparable.
(5) To correct the balance sheet so as to give a realistic view
of the capital structure of the company.
GUIDELINES FOR THE ISSUE OF BONUS SHARES
The following regulations have been provided by the
SEBI (Issue of Capital and Disclosure Requirements)
Regulations, 2009 for issue of bonus shares:
1. Conditions for bonus issue
Subject to the provisions of the Companies Act, 1956 or
any other applicable law for the time being in force, a listed
issuer may issue bonus shares to its members if:

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(a) it is authorised by its articles of association for issue of

bonus shares, capitalisation of reserves, etc:
Provided that if there is no such provision in the articles of
association, the issuer shall pass a resolution at its general
body meeting making provisions in the articles of
associations for capitalisation of reserve;
(b) it has not defaulted in payment of interest or principal in
respect of fixed deposits or debt securities issued by it;
(c) it has sufficient reasons to believe that it has not defaulted
in respect of the payment of statutory dues of the
employees such as contribution to provident fund, gratuity
and bonus;
(d) the partly paid shares, if any outstanding on the date of
allotment, are made fully paid up.
2. Restriction on bonus issue
(1) No issuer shall make a bonus issue of equity shares if it
has outstanding fully or partly convertible debt
instruments at the time of making the bonus issue, unless
it has made reservation of equity shares of the same class
in favour of the holders of such outstanding convertible
debt instruments in proportion to the convertible part
thereof.
(2) The equity shares reserved for the holders of fully or
partly convertible debt instruments shall be issued at the
time of conversion of such convertible debt instruments
on the same terms or same proportion on which the bonus
shares were issued.
3. Bonus shares only against reserves, etc. if capitalised
in cash
(1) The bonus issues shall be made out of free reserves built
out of the genuine profits or securities premium collected

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in cash only and reserves created by revaluation of fixed

assets shall not be capitalised for the purpose of issuing
bonus shares.
(2) Without prejudice to the provisions of sub-regulation (1),
the bonus share shall not be issued in lieu of dividend.
4. Completion of bonus issue
(1) An issuer, announcing a bonus issue after the approval of
its board of directors and not requiring shareholders
approval for capitalisation of profits or reserves for
making the bonus issue, shall implement the bonus issue
within fifteen days from the date of approval of the issue
by its board of directors:
Provided that where the issuer is required to seek
shareholders‘ approval for capitalisation of profits or
reserves for making the bonus issue, the bonus issue shall
be implemented within two months from the date of the
meeting of its board of directors where in the decision to
announce the bonus issue was taken subject to
shareholders‘ approval.
(2) Once the decision to make a bonus issue is announced, the
issue cannot be withdrawn.
REVIEW QUESTIONS
A. Short Answer Type Questions
1. Name the two main theories of dividend
2. Enlist the factors that influence the dividend policy of a
firm.
3. What is the significance of stable dividends?
4. What is dividend pay-out ratio?
5. What do you mean by bonus issue?
6. Write a note on dividend policy in practice.

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B. Essay Type Questions

1. Explain the various factors which influence the dividend
decision of a firm.
2. What do you understand by a stable dividend policy? Why
should it be followed?
3. Discuss the various forms of dividends.
4. Do you agree with the proposition that dividends are
irrelevant? Discuss the main determinants of the dividend
policy of a corporate enterprise.
EXERCISE
Ex.1 The Agro-Chemicals Company belongs to a risk class for
which the appropriate capitalisation rate is 10%. It currently
has 1,00,000 shares selling at Rs.100 each. The firm is
contemplating the declaration of Rs.5 as dividend at the end of
the current financial year which has just begun. What will be
the price of the share at the end of the year, if a dividend is not
declared? What will be the price if it is declared? Answer this
on the basis of MM model and assume no taxes.
(Ans. (i) Rs.110: (ii) Rs.105)
Ex.2. The earnings per share of a company are Rs.16. The
market rate of discount applicable to the company is 12.5%.
Retained earnings can be employed to yield a return of 10%.
The company is considering a payout of 25%, 50% and 75%.
Which of these would maximise the wealth of share holders?
(Ans.75%)
Ex.3. The earnings per share of a company are Rs.10 and the
rate of capitalisation applicable to it is 10%. The company has
before it the options of adopting a payout of 20% or 40% or
80%. Using Walter‘s formula, compute the market value of the
company‘s share if the productivity of retained earnings is (i)
20%, (ii) 10%, and (ii) 8%.

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What inference can be drawn from the above exercise.

(Ans.Rs.180. 160. and 120, Rs.100, 100, and 100, Rs.84, 88
and Rs.96)
Ex.4. A company is expected to pay a dividend of Rs.2 per
equity share. The dividends are expected to grow at the rate
of 10%. Find out the share price today, if market capitalises
dividend at 30%.
(Ans. Rs.10)
Ex.5. A company presently pays a dividend of Re.1.00 per
share and has a share price of Rs.25.00. If the dividend is
expected to grow at a rate of 15% p.a forever, what is the
firm‘s expected or required return on equity using a dividend
discount model approach?
(Ans. 19.6%).
Ex. 6. A company has a total investment of Rs. 5,00,000 in
assets, and 50,000 outstanding ordinary shares at Rs. 10 per
share (par value). It earns a rate of 15% on its investment, and
has a policy of retaining 50% of the earnings. If the
appropriate discount rate of the firm is 10%, determine the
price of its share using Gordon‘s Model. What shall happen
to the price of the share if the company has a pay-out of 80%.
(Ans. Rs. 30 and Rs. 17.14)

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