FINANCIAL MANAGEMENT

MCO-07
MCOM (IGNOU) STUDY MATERIALS
(NUMERICALS INCLUDED)

Santosh Sharma
(MCOM / BED / MBA)
 Contents

Units Topics Page No.

1 Financial Management: An Overview 2

2 Time Value of Money 4
3 Valuation of Securities 5
4 Risk & Return 7
5 Cost of Capital 10
6 Capital Budgeting - I 11
7 Capital Budgeting – II 13
8 Sources of Long-Term Finance 15
9 Capital Market 17
10 Lease Financing 20
11 Project Financing 22
12 International Business Finance 24
13 Leverage: Operating, Financial and Total 29
14 Capital Structure Decision 31
15 Dividend Policy Decision 34
16 Working Capital 36
17 Cash Management 39
18 Inventory Management 40
19 Receivables Management 43
20 Numericals 46

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 MCO-07: Financial Management (Numericals included)
Unit-1: Financial Management, An Overview
Meaning of Financial management
Financial management simply means management of finance or funds. Finance is said to be the lifeblood of business.
Financial management is also called as managerial finance or corporate finance. Financial management is the process
of planning, organising, directing and controlling the financial activities of a firm.
It answers the following questions:
• How to procure funds?
• What are the sources of raising funds?
• Where to invest?
• How to manage and control funds?

Nature of Financial Management

The nature of financial management can be understood by the financial decisions taken by it. We can divide the
financial decisions into three categories such as:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
1. Investment decisions: It relates to decisions regarding investments in different assets like securities, fixed
assets, instruments, bonds etc. Investment decisions generally involve the following decisions:
• Management of working capital.
• Buying of fixed assets.
• Capital budgeting decisions.
• Analysis of securities.
• Managing these investments and merger.
2. Financing decisions: It relates to raising finance through equity and debt capital. The important decisions
relating to financing are:
• Identifying the sources of finance.
• Cost of raising finance.
• Analysis of interest rates, taxes and depreciation.
• Requirement of funds.
• Amount of working and fixed capital required.
3. Dividend decisions: It relates to how much dividend should be paid to the shareholders out of the profits
earned. The important decisions relating to dividends are:
• How much dividend should be paid to the shareholders?
• How much funds are to be taken out of profits?
• Determining the market value of present equity shares.

A short note on Risk-Return Trade-off.

The risk return trade-off is the principle of investment. It states that higher the risk, higher will be the reward. Risk
is directly proportional to reward. By using this principle, an investor takes his financial decisions. It helps him to
compare the amount of risk associated with investments. It depends on factors like how much risk an investor can
sustain and which stocks can be replaced? A proper balance between risk and return should be maintained to
maximise the market value of the investments.

Goals of Financial Management

1. Maximization of profit.

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 2. Maximization of return on capital.
3. Growth in the market value of shares.
4. Identification of the sources of finance at minimum cost.
5. Minimum cost of capital
1. Maximization of shareholders wealth: When the value of shares of a firm increase, it results in maximization
of shareholders wealth. The economic value of the shareholders wealth is the market price of the shares which
is the present value of all future dividends and benefits expected from the firm. Wealth and profit maximization
is also possible through proper financial management.
2. Maximization of return on capital: Every investor expects maximum return on his investment. The
shareholders of a company also expect good return on their investment. Therefore, the main object of financial
management is to maximise the return on capital employed by the investors. So that, they would invest more
with confidence in future.
3. Market value of shares: The growth of a company is reflected by the market value of its shares. If the market
value of the shares is increasing that means the company is making a steady growth. It increases the goodwill
and credit-worthiness of a company. Therefore, a firm aims at growing the market value of shares.
4. Optimum level of leverage: There are different types of leverages like financial leverages, operating leverage
and mixed leverages. In simple words, it is the earning per share. The amount of return on investment is termed
as leverage. Therefore, a company always tries to maximise the leverage.
5. Minimum cost of capital: A company can raise funds through debt capital or equity capital. A firm should
consider the cost of capital before raising funds through various sources. Cost of capital is the cost of raising
funds. A firm has to take decision on the sources of raising capital at the minimum cost.

Role of a Financial Manager

1. To estimate the funds required by the company.
2. To prepare appropriate capital structure of the company.
3. To take investment decisions.
4. To take financing decisions.
5. To take dividend decisions.
6. To look after the allocation of funds in the organization.
7. To evaluate ROI (Return on Capital)
8. To do financial negotiations with banks and financial institutions regarding raising funds.
9. To maintain good relationship with stock exchanges.
10. To increase profit of the firm and wealth of the shareholders.
Challenges for Financial Manager
Financial management is not easy task. There are many problems encountered by a financial manager while carrying
out his functions. Some of them are:
1. Shareholders value creation: Shareholders are more satisfied with increasing sales and profits. They want
growth of return on investment. Therefore, the financial manager has to concentrate not only on earning per
share but also on increasing market value of its shares.
2. Psychology of investors: It is a challenge for a financial manager to have a good understanding of the
psychology of the investors. These investors may be individual or institutional. For example, nowadays,
investors have shifted their focus more on mutual funds the rather than equity. So, he has to prepare the
different types of market securities which attract investor’s attention.
3. Increasing risk: The market has been increasingly risky nowadays with the onset of liberalisation,
privatisation and globalization. A financial manager should have sound interpersonal and communication
skills and overall organizational knowledge to deal with such risks.

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 Unit-2: Time value of money

Meaning of Time value of money

The time value of money is a basic financial concept that holds that money in the present is worth more than the
same sum of money to be received in the future. This is true because money that we have now can be invested to
earn a good return and thus creating a larger amount of money in the future. The time value of money is sometimes
referred to as the net present value (NPV) of money. Investors are willing to spend their money now only if they
expect a favourable return on their investment in the future. Time value of money problems involve the net value of
cash flows at different points in time.
For example, if we deposit ₹1000 in a bank at 10% interest rate per year. After one year, we will get ₹1,100. This is
equal to the principal amount of ₹1000 and interest of ₹100 which we have earned during the year. Hence ₹1,100 is
the future value of ₹1000 invested for one year at 10%. It means that ₹1000 today is worth ₹1,100 in one year, given
that 10% is the interest rate.
The formula used to calculate the future value open single amount for a single period:
FV = PV (𝟏 + 𝐢)𝒏
Whereas,
FV = Future value
PV = Cash flow
I = Rate of interest
n = Number of years

Question: What will be the future value of Rs.1000, invested for 5 years @10%?
Here, PV = 1000, i = 10%, n= 5 years, FV =?
FV = 1000 X 1.611 {(1 + 10)5 = 1.611, see Annuity Table)
FV = 1611

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 Unit-3: Valuation of Securities

Basic Valuation Model of valuation of securities.

Any investor would take two steps before making an investment decision such as risk and return of the security. An
investor also considers factors like cost, benefit and uncertainty of securities before making an investment.
According to basic valuation model, an asset derives its value from the cash flow associated with it. The value of an
asset is equal to the present value of its expected cash flows. The formula used to calculate the value of an asset in
this model is:
𝑐𝑓1 𝑐𝑓2 𝑐𝑓3 𝑐𝑓𝑛
𝑉0 = 1 + 2 + 3 + ⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
Whereas,
𝑉0 = Value at time 0
Cf = cash flow during a year
I =rate of interest
n= no of years

Factors that affect the valuation of securities

The important factors that affect the valuation of securities are:
1. Nature of business.
2. Demand of shares.
3. Past performance of the company.
4. Growth prospects of the company.
5. Management of the company.
6. Accumulated reserves.
7. Dividend declared.
8. Government policies.

Approaches for valuation of Equity Shares

Valuation of equity shares is rather difficult as the cash flows are not stable and measurable. The two important
methods to value equity shares are:
1. Dividend Capitalization Approach.
2. Earning Capitalization Approach

1. Dividend Capitalization Approach

This approach assumes that dividends do not grow in futures rather dividends grow at a constant rate or
multiple rates in future. This approach can again be subdivided into two parts such as single period and
multiple periods.
𝐷1 +𝑃1
Single period valuation assumes as one year and the formula is: 𝑃0 = 1+𝑟
P0 = = current price of shares,
D1 == Expected dividends
P1 == Expected price after one year
r= required rate of return

In multiple period valuation, it is assumed that equity shares have no maturity period. They are paid
dividend for an indefinite period of time. therefore, the formula is:
𝐷1 𝐷2 𝐷3 𝐷𝑛
𝑃0 = (1+𝑟)1 + (1+𝑟)2 + (1+𝑟)3 +……………..+ (1+𝑟)𝑛

2. Earning Capital Approach:

In this approach three factors are considered such as future earnings, growth rate and P/E ratio.

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 P/E is the ratio between price and earning per share. The greater the expected growth rates, higher will be the
P/E ratio. If normal price earnings ratio exceeds P/E ratio, then shares are under-priced and vice versa.
Average P/E ratio should be less than 20 which provides good investment opportunities. Lower the PE ratio
better will be the investment. The formula to calculate P/E ratio is:
P/E Ratio = Price per share / Earning per share

Valuation of Bonds
Bonds are the debts of a company. Its face value is also known as power value. It has a certain rate of interest called
coupon rate. Its maturity varies from 5 to 20 years. Realizable value or economic value of a bond is equal to the
present value of the expected cash flows. The formula to find the value of a bond is:
I TV
PV = + whereas,
(1+r)t (1+r)n
PV= Present value at time 0.
I= Interest or Coupon rate
TV= Terminal value at maturity
R= Required rate of return
N= Number of years

• If rate of return = Coupon rate (Bond value = Par value)

• If rate of return > Coupon rate (Bond value < Par value)
• If rate of return < Coupon rate (Bond value > Par value)

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 Unit-4: Risk and Return

Concept of Risk and Return

Risk is the possibility of adverse happening. If a situation is deviated largely from the expectation, risk arises. There
are three states of possibilities such as certainty, uncertainty and risk.
Certainty is a happening of an event with zero deviation. Uncertainty is the happening of an event with large
deviation. Risk lies between certainty and uncertainty.
There are some statistical tools to measure risks such as:
1. Standard deviation,
2. Variance,
3. Coefficient of variation,
4. Skewness
5. Probability distribution.

Different types of Risks

No risk, no gain. Risk may be of two types such as:
1. Systematic risk
2. Unsystematic risk

1) Systematic Risk
This type of risk is caused by external factors such as change in economic conditions, political uncertainty and
social conditions. It affects the whole economy and is also known as market risk. Systematic risks can be
classified into four categories such as:
a. Interest rate risk: In this type of risk, the government changes the rate of interests. These risks are not
under the control of a firm. These risks are applied to the whole economy.
b. Market risk: This type of risk is associated with stock market. It arises due to the change in attitude of
the investors. In other words, this risk arises due to change in demand and supply of securities,
international environment, domestic conditions, etc.
c. Exchange rate risk: This type of risk arises due to devaluation of domestic currency in the international
market. There are many reasons for devaluation like unfavourable balance of payment, depression of the
domestic economy, etc. Those firms which are engaged in foreign trade are prone to such risks.
d. Political risk: This type of risk arises due to instable government, riots, wars, frequent elections and
instable government. This type of risk is quite common in India and badly affect the working of business
enterprises.

2) Unsystematic Risk
This type of risk arises due to internal events in the organization. The firm has control over such risks. Examples
of unsystematic risks are equipment failure, power cut, labour problem, change in top management etc. A
systematic planning of procedures can reduce the effect of such risks.

Systematic Risk Unsystematic Risk

These risks arise due to external factors. These risks rise due to internal factors.
External factors include change in economic Internal factors include labour problems,
conditions, political conditions and social equipment failure, over management etc.
conditions.
The main components of systematic risk are These risks are also known as specific risk.
market risk, interest rate risk and income risk.

Concept of Return
Return is something which is received back. The amount of benefit received by an investor from his investments is
known as returns. There are different types of returns such as:

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 1) Book Return & Market Return
2) Single Period Return & Multi-period Return
3) Ex-ante Return & Ex-post Return
4) Security Return & Portfolio Return

1. Book Return and Market Return: Book return is calculated from the accounting books. It is also known as
return on assets. Calculations are made by using various variables like capital employed, earnings per share,
dividends per share etc. On the other hand, market return refers to the returns calculated on the basis of market
values of the assets of a company. The market value of assets generally fluctuates from time to time.

2. Single period Return and multi period Return: Single period returns are calculated for a particular period
of time. These are calculated for only a year. On the other hand, multi period returns are calculated for different
periods.

3. Ex-ante (expected) Return and Ex-post (realised) Return: Ex-ante return is the one that an investor hopes
to get from his investment. There is no guarantee that what the investor has hoped for would come true. It is
calculated by adding anticipated dividend and anticipated market price divided by initial investment. Whereas,
the Ex-post return is the actual or realised return. It is calculated by adding actual dividend received and actual
market price divided by initial investment.

4. Security Return and Portfolio Return: Security return refers to the return received from single investment
made in capital market. Whereas, portfolio return refers to the returns received from multiple investments or
different shares.

Relationship between Risk & Return

The relation between risk & return can be understood by the following models:
1. Capital Asset Pricing Model
2. Arbitrage Pricing Model

Capital Asset Pricing Model (CAPM)

This model tells us the relationship between risk and return. According to this model greater the risk of a security,
greater will be the return. There is an implied equilibrium relationship between risk and return. More the
unavoidable risk more will be the return on investment. Returns is directly proportional to risk. The risk averse
investors will not hold risky assets, unless they are adequately compensated for the risks, they bear. This model can
be used for pricing of the securities. It also helps to assess whether a security is over-priced, under-priced or
correctly priced. This model has two basic components such as:
a. Risk-free Rate
b. Risk Premium
The formula to find the relation between risk and expected return is: 𝐄𝐑 𝐢 = 𝐑 𝐟 + 𝛃𝐢 [ 𝐄(𝐑 𝐦 ) − 𝐑𝐟 ]
Whereas, ER i = Expected rate of return on asset i
R f = Risk free rate
βi = beta co-efficient of stock i
E(R m ) = Expected return of the market

Assumptions of the CAPM model

1. Investors make their decisions only on the basis of expected return and risk associated with the security.
2. An investor cannot influence the price of the stock in the market.
3. Investors can lend or borrow funds add the riskless rate of interest.
4. There are no transaction costs involved in buying and selling of stocks.
5. There is no personal income tax.

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Arbitrage Pricing Theory
• This model was developed by Stephen Ross.
• Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset.
• This process generates riskless profit.
• According to this model, security should be sold at a high price and simultaneously we should purchase the
security at relatively lower prices.
• The difference between the high price and low price gives us the maximum return on investment.
• According to this model, profit can be earned through arbitrage or riskless process.
• According to this model, returns on the securities are influenced by a number of macro economic factors such
as industrial growth rate, rate of inflation, interest rates etc.

Assumptions
• The investors have homogeneous expectations.
• The investors are risk takers and want to maximise returns.
• There is perfect competition in the market.
• There is no transaction cost.

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 Unit-5: Cost of Capital

Meaning of Cost of Capital

As we know, a firm needs capital to grow and expand its business. The cost of raising funds is known as cost of capital.
Cost of capital is the minimum rate of return the firm must earn from investment so that the market value of equity
shares does not fall. It is the weighted average cost of their different sources of financing. In simple words, the
minimum rate of return required from investment is known as cost of capital.
Cost of capital is defined as “the rate of return the firm requires from investment in order to increase the value of the
firm in the market place.”
Some of the characteristics of cost of capital are:
i) Cost of capital is a rate of return; it is not a cost as such.
ii) Return is calculated on the basis of actual cost of different components of capital.
iii) It refers to minimum rate of return on investment.
iv) It is related to long-term capital funds.
v) Cost of capital consists of three main components, such as:
a. Return at Zero Risk Level.
b. Premium for Business Risk
c. Premium for Financial Risk

Importance of Cost of Capital

1. It helps to evaluate new investment proposals.
2. It helps to determine the optimal capital structure.
3. It helps to formulate appropriate dividend policy.
4. It helps to frame appropriate working capital policy.
5. It helps to evaluate the financial decisions of the management.

Types of Cost of Capital

1. Explicit cost of capital & Implicit cost of capital: Explicit cost of capital is the present value of the funds
received by the firm. In simple words, explicit cost refers to raising of funds. On the other hand, implicit cost
refers to the rate of return associated with the best investment opportunity for the firm. In simple words,
implicit cost refers to the usage of funds.

2. Specific cost of capital and combined cost: Specific cost of capital refers to the individual component of capital
whereas, combined cost of capital is the average cost of capital. Combined cost of capital is mostly used by a
company while taking decisions regarding accepting or rejecting a proposal.

3. Average cost and Marginal cost: The average cost is the weighted average of the cost of each component of
funds. On the other hand, marginal cost of capital is the weighted average cost of new funds raised by a firm.

4. Future cost and historical cost future cost is also known as expected cost of funds to finance a project. It
includes all the expected costs associated with the project. On the other hand, historical cost refers to the past
costs which were incurred while executing a project.

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 Unit-6: Capital Budgeting-I

Meaning of Capital budgeting

• It is a process of making capital investment decisions.
• Capital investment expenditures include expenditures on plant and machinery, equipment, land and building,
and all other fixed assets.
• These expenses are generally of higher amounts.
• The decisions taken on capital expenditures are not reversible.
• These decisions are generally long-term decisions taken by the company.
• Capital budgeting decisions are taken after analysing the initial outflow of funds compensated by future inflow
of funds.
• This is a very complex and critical decision taken by the finance manager because future is uncertain.
• It is very difficult to predict the cost and benefit associated with a given project.

Processes of Capital Budgeting

1. Generation of idea: The whole process of capital budgeting decision starts with an idea. The owner or the top
executive of a company identifies the business opportunity and then ask their subordinates to gather
information about the opportunity.
2. Estimating cash flows: The next step is to estimate the cash flows of the project. In this step the cost of the
whole project including different types of costs are calculated and estimated.
3. Evaluating cash flows: Then evaluation of cash flows is done carefully. It is done to find out the certainty and
future value of the project. This is one of the most complex functions of the finance manager.
4. Selecting a project: The next step is to select the appropriate project or the most suitable project among the
various alternatives. Pros and cons of the projects are properly analysed before taking the final decision.
5. Execution of the project: Finally, the execution of the project it has to be started by a team of engineers,
financial experts, marketing experts under the leadership of the owner or the executive. Proper monitoring of
the implementation process is very important to avoid time and cost vestige.

Types of Capital Budgeting Decision or Projects Investment

1. New project: It refers to expenditure on creation of new assets. For example, setting up a new factory or
building. These projects are generally of big size and takes a long time for completion.
2. Expansion of existing project: In this type of project the existing project is expanded and developed. More
investment is done on the existing project rather than new project.
3. Renewal project: It refers to the renovation of the projects. Here expenditure is done to replace old
machineries and plants. New machinery is installed and new technology is adopted.
4. Research and development project: Research and development projects are those projects in which present
expenditure is being incurred to get a new product or design in future. this type of project takes a long time for
completion and there is a degree of uncertainty too.
5. Exploration Projects: Those projects in which new resources are explored are known as exploration projects.
Expenditure incurred on these projects are capital in nature which means the benefits will be available in
future. For example, oil exploration, mining, etc.

Requisites of a good Investment Appraisal.

• It should be based on cash flows rather than on profits or expenditure.
• Cash should be covered for the entire expected life of the asset rather than few years only.
• It should give the absolute value of gain or loss.
• It should consider time value of money.
• It should show relative profitability between different alternative projects to make a better comparison
analysis.
• It should indicate the degree of risk associated with the investment.

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Methods of Capital Budgeting
The following are the different methods of capital budgeting
1. Payback Period
2. Accounting Rate of Return (ARR)
3. Discounted Payback

1) Payback Period
It is the time duration required to recover the initial cash outflows or expenditures. This is also known as pay
off or capital recovery period method. Payback. Is calculated by initial cash outflow / annual cash inflow. For
example, if a company spends ₹50,000 on any project and expects that within two years it will get back the
amount, then the payback. Is 2 years. Shorter the payback, higher will be the ranking of the investment proposal.
Advantages
a. This method is easy to understand and use.
b. This is one of the most popular methods widely used for initial screening of the project.
c. The risk associated with the project can be easily calculated.
d. This method is quite suitable for small projects.
Limitations
a. It takes into account only early cash flows and ignores the future cash outflows.
b. This method ignores time value of money.
c. This method is considered only a measure of capital recovery and it is not a perfect measure for
profitability.

2) Accounting Rate of Return (ARR)

It is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the
Net Profit After Tax (PAT) and initial investment.
Advantages of ARR
a. It is a simple method involving the calculation of averages.
b. It is easy to understand because easy accounting information like EBIT, PAT, depreciation, investment etc.
are considered.
Disadvantages of ARR
a. It is not properly defined because we do not know whether to use EBIT or PAT.
b. Accounting information itself are not very accurate and subject to many assumptions.
c. It ignores time value of money and hence not suitable for scientific decision making.

3) Discounted Payback
In this method, the discounted cash flows of different years are considered to calculate the payback period. In
other words, the number of periods taken to recover the investment is calculated on the basis of present value
of the cash outflows. Obviously, this method takes a longer time to calculate payback.
Advantages
a. This method is more accurate and reliable.
b. It considers the time value of money.
Limitations
a. This method is too lengthy and takes a lot of time to calculate payback period.
b. This method is not very popular because it is a very complex method and involves a lot of mathematical
calculations.

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 Unit-7: Capital Budgeting-II

Methods of investment appraisal

There are basically three scientific methods of investment appraisal. These are:
1. Net present Value Method.
2. Profitability Index Method.
3. Internal Rate of Return Method.

1. Net Present Value Method (NPV)

NPV is the net present value of all cash flows that occur during the entire life span of a project. The total cash
flows occurred during the completion of a project is called Net Present Value. The outflows will have negative
values while the inflows will have positive values. If the cash inflow is greater than outflow, then NPV is
positive. If cash inflow is less than cash outflow, there is a negative NPV.

Advantages of NPV
a. It is quite scientific technique of capital budgeting.
b. It considers time value of money.
c. It is an absolute value.
d. NPV of two or more projects can be added up.

Limitations of NPV
a. Comparison of two or more different projects is a complex process.
b. NPV is not applicable in case of change in rate of interest.

2. Profitability Index Method

It is a ratio between present value of inflows and present value of outflows. If profitability index is greater than
1, the project should be accepted. If the profitability index is less than 1, the project should be rejected. This
method is also known as benefit-cost ratio method.

Advantages
a. It is a more scientific method and reliable.
b. It considers the time value of money.
c. It gives a relative measure of a project’s profitability.

3. Internal Rate of Return Method (IRR)

IRR is the rate of discount at which NPV is zero. It shows the relationship between the rate of discount and the
NPV. There is always an inverse relationship between NPV and discount rate. If discount rate increases, NPV
decreases and vice versa. Therefore, IRR is the rate when NPV is zero. It is also known as marginal rate of
return. If IRR is greater than the discount rate or cost of capital, the project should be accepted. A project with
higher IRR should be ranked higher than other projects.

Advantages of IRR
a. It considers the entire cash flows of a project. Therefore, it is more reliable and accurate.
b. It takes into account time value of money.
c. It is useful in ranking of projects because it is a rate and not any absolute value.
d. It is not dependent of any external rate.
e. It is useful to assess the margin of safety in a project.
f. It is more scientific in terms of cost and return.

Distinguish between NPV and IRR

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 NPV IRR
NPV discounts the stream of expected cash flows IRR calculates the percentage rate of return at
associated with a proposed project to their current which cash flows will result in a net present value of
value, which presents a cash surplus or loss for the zero. IRR is defined as that discount rate that
project. equates the PV of projects expected cash inflows
with its initial cost or the present value of the
outflow.
Here cash inflows are conventional. Here cash inflows are unconventional.
The cost of capital is considered discount rate at the The discount rate is calculated by trial-and-error
NPV method. method.
It is easy than IRR. It is difficult than NPV.
It is the absolute value of a gain or loss. It is the rate of return from a given investment and
thus, more accurate for project appraisal.

A short note on Capital Rationing

• It is a process of imposing restrictions on the number of new investments or projects undertaken by a company.
• The project is to ensure that capital has been used properly and there will not be any shortage of funds.
• It is a management function of allocating funds to various investment projects.
• It helps to achieve optimal use of available capital. It is a situation when there is some ceiling of funds.
• A firm has to choose the best project due to limited availability of funds.

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 Unit-8: Sources of Long-Term Finance

Meaning of Long-term Finance.

Long-term finance can be defined as any financial instrument with maturity exceeding one year. For example, bank
loans, bonds, lease finance, etc.

Sources of long-term finance

1. Retained earnings
2. Equity capital
3. Preference capital
4. Debentures and bonds
5. Term loans
6. Venture capital

i) Retained Earnings
These are the earnings of a company for the current accounting year after distribution of dividends. It also
includes accumulated profits of the past periods like reserve fund. Retained earnings are those earnings that
are kept as reserves in the form of various reserve accounts. They are shareholders’ funds and are used for the
purpose of capital or revenue expenditure of the company. They may be distributed as bonus shares to the
existing equity shareholders. Have retained earnings can be used for buying back shares, have reinvesting for
growth, paying off the debts, etc. It is one of the best sources of long-term finance for a company.

ii) Equity Capital

The stock or shares of a company issued to investors is called equity capital. It is of two types such as equity
shares and preference shares. Equity capital is divided into a number of equal parts known as shares having a
specified nominal value. Dividends on equity shares is paid after paying dividends to the preference
shareholders. Whenever a company needs finance, it can issue equity capital to raise money. It is one of the
major sources of long-term finance. It has no maturity and as long as the company exists its equity capital also
exists.

iii) Preference Capital

Preference shares have preferential rights to receive dividends at fixed rate and repayment of capital at the
time of winding up of a company. They carry a fixed rate of dividend. Preference shares may be of different
types such as cumulative and non-cumulative preference shares, redeemable and irredeemable preference
shares, convertible and non-convertible preference shares. Preference shareholders are less risky. They don’t
have voting rights in the management of a company.

iv) Debentures or Bonds

Debenture is a document acknowledging a loan made by a company. A fixed rate of interest is paid on
debentures. Debentures are also transferable like equity shares. These are also of different types such as
transferable and non-transferable debentures, redeemable and irredeemable debentures. It is also one of the
major sources of raising funds buyer company.

v) Term Loans
These are loans taken from banks and financial institutions to purchase fixed assets. The period of loan may
vary from 3 years to 10 years. The borrower has to pay a fixed amount at regular intervals of time. Term loans
carry a fixed or floating interest rate. These loans are generally taken by small business organisations. The
borrower may need to pay down payment or keep mortgage to avail such loans. These are the primary sources
of income for banks and financial institutions. Term loans may be of 3 types such as short-term loans, medium
term loans and long-term loans. Short term loans are generally for less than one year. Medium term loans are
generally between 1 to 3 years. Long term loans are taken up to 30 years.

SANTOSH SHARMA 15
vi) Venture Capital
It is an equity capital seeking investment in new companies, new ideas, new production, new processes or new
services that offer the potential of high returns on investment. Venture capital is used to finance high risk
ventures. The ventures are generally new and sunshine industries but may also be old and risky ones. These
enterprises have a high mortality rate and therefore do not find finance from banks or private sector
companies. It does not look into current income but returns off future expectations. Venture capitalists finance
new, young and rapidly growing or changing companies. They help to invent or produce new products and
services. They take high risks with the expectation of higher rewards. They have a long-term investment plan.
Venture capitalist also work actively with the management of the company and frames strategy.

SANTOSH SHARMA 16
 Unit-9: Capital Market

Meaning of Capital Market

Capital markets are a part of financial markets where financial assets are purchased or sold. The main participants
in these markets are households, business firms, governments etc. In other words, it is a marketplace for investments
that have a lock-in period greater than a year, or their maturity period is at least more than one year. The capital
market involves the sale and purchase of both equity and debt instruments, including equity shares, debentures,
preference shares, secured premium notes, and zero-coupon bonds. Capital market maybe of 2 types such as primary
capital market and secondary capital market.

Functions of Capital Markets

1) Mobilize savings: Financial market helps to utilize the savings of the people. The investors can invest their
hard-earned savings to earn healthy returns. Their investment is put in the productive work which may yield
heavy profits.
2) Price fixing: Financial market helps to determine the prices of financial securities. In other words, the exchange
rates of shares and debentures are automatically fixed due to interaction of suppliers of funds and demand of
funds.
3) Liquidity of financial assets: Financial market acts as a place for buying and selling of securities. Thus,
financial assets can be converted into cash as and when required.
4) Economical: It helps to save time, effort and money of both buyers and sellers of assets. It provides a platform
where they can interact with each other to do a transaction.

Differences between Capital Market and Money Market

Capital Market Money Market

The main participants are companies, banks and The main participants are RBI, commercial banks
public. and no public.
The main instruments traded are shares, debentures The main instruments trade is Treasury Bills,
and bonds. Commercial Paper, Certificate of Deposits, etc.
Investments can be made in small amounts. Investment is made in huge amounts.
It deals in long term securities. It deals in short term securities.
This market is risky for the investors. This market is safe for the investors as the duration
is short.
Return on investment is generally very high. Return on investment is low.

Differences between Primary Markets and Secondary Markets

Primary Market Secondary Market

It is a place where new securities of the companies It is a place where existing securities of the companies
are bought & sold. are bought and sold.
Securities are traded between companies and Securities are exchanged between investors only.
investors directly.
Prices are determined by the management of the Prices are determined by the action of demand &
companies. supply of securities in the market.
Here securities are only bought. Securities are bought & sold.
These markets do not have fixed geographical These markets have fixed geographical locations.
location.

Managing New issues of Shares / Different ways of issuing IPO

A company can raise cash by placing their securities for sale in a number of ways such as:
1. Direct sale
SANTOSH SHARMA 17
 2. Sale through firms
3. Secondary Stock issue
4. Securities Auction
5. Transfer of shares

a) Direct Sale
Companies can directly sell their securities to the existing shareholders or to the new shareholders. It is done
when company offers IPO (Initial Public Offering) for the first time. The firms must provide detailed information
about its financial condition to the shareholders because the company is new to the shareholders.
b) Sale through firms
Normally, a company planning to issue an IPO will hire a professional firm to sell their stocks. These hiring firms
are called underwriters who help the company to issue new shares by extending their certification which is
more acceptable to the public. Since they go to the market frequently, they need to protect their reputations.
They may also buy the shares at discounted issue prices and takes the risk of selling them later to the investors
at a higher price. The underwriter undertakes an analysis of the company and then estimates the price range
for the stock.
c) Secondary Stock Issue
In this case, a company hires is security firm to sell its shares. Because the company already has shares in the
market. It can monitor the market price to anticipate the price at which it should sell new shares. Companies
are more willing to issue new stock when the market price of their outstanding shares is relatively high.
d) Securities Auction
In auctions of securities, the participants are often required to submit sealed bids. The two most common
auction mechanisms are, i) discriminatory auction and ii) uniform price auction. In uniform price auctions the
winning bidders pay the same price equal to the lowest winning bid. In the discriminatory auction the winning
bidders pay the prices the bid.
e) Transfer of Shares
As we know, the ownership of shares is transferable from one person to another. Thus, a company can transfer
its new shares to the existing shareholders, if they agree. It is done through the stock broker and transfer agent
who brings the buyer and seller together.
Stock Exchange
Stock Exchange is a place or institution where securities are bought and sold. It controls, regulates and helps in
trading of securities.
Functions or role of a Stock Exchange
1) Provides liquidity
Liquidity here means buying and selling of securities. A stock exchange helps to buy and sell securities. This is
the place where people can invest their savings in buying share and debentures of the companies. There are
authorised brokers who guide the investors in buying or selling securities.
2) Pricing of securities
The prices of shares are determined by the action of demand and supply forces in a stock exchange. It is the
place where people can get immediate information about the prices of securities. Prices of securities fluctuate
every hour on a stock exchange.
3) Safety
Stock exchanges are regulated and controlled by SEBI, which is a government department. So, there is very less
possibility of fraud and cheating in a stock exchange. Public money is safe and all the transactions are genuine.
4) Economic growth
A stock exchange helps to mobilize the savings of the people into the most productive uses. This helps to
multiply the savings of the people. They can earn more and have high purchasing power. All these things lead
to overall economic growth of the economy.
5) Speculation
A stock exchange encourages healthy speculation within the controlled limits. All the speculative activities are
done within the provisions of law.

SANTOSH SHARMA 18
Regulation of Stock Exchanges in India
Indian Capital Markets are regulated and monitored by the Ministry of Finance.
The Ministry of Finance regulates through the Department of Economic Affairs - Capital Markets Division. The
division is responsible for formulating the policies related to the orderly growth and development of the securities
markets as well as protecting the interest of the investors. The important functions of these institutions are:
1. Institutional reforms in the securities markets,
2. Building regulatory and market institutions,
3. Strengthening investor protection mechanism, and
4. Providing efficient legislative framework for securities markets.
The Division administers legislations and rules made under the
• Depositories Act, 1996,
• Securities Contracts (Regulation) Act, 1956 and
• Securities and Exchange Board of India Act, 1992.
The main institutions that regulate stock exchanges in India are:
A. SEBI (The Securities and Exchange Board of India)
B. The RBI (The Reserve Bank of India).
C. NSE (National Stock Exchange)

A. Securities & Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is the regulatory authority established under the SEBI Act,
1992 and is the principal regulator for Stock Exchanges in India. SEBI’s primary functions include protecting
investor interests, promoting and regulating the Indian securities markets. All financial intermediaries
permitted by their respective regulators to participate in the Indian securities markets are governed by SEBI
regulations, whether domestic or foreign. The important functions of SEBI are:
1. The SEBI has been empowered to conduct inspection of stock exchanges. The SEBI has been inspecting
the stock exchanges once every year since 1995-96.
2. During these inspections, a review of the market operations, organisational structure and administrative
control of the exchange is made.
3. It ensures that the exchange provides a fair, equitable and growing market to investors.
4. It should also ensure that the exchange’s organisation, systems and practices are in accordance with the
Securities Contract Act.
5. The SEBI should see that the exchange has implemented the directions, guidelines and instructions issued
by it from time to time.
6. The exchange has complied with the conditions, if any, imposed on it at the time of renewal/
grant of its recognition.

B. Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is governed by the Reserve Bank of India Act, 1934. The RBI is responsible for
implementing monetary and credit policies, issuing currency notes, being banker to the government, regulator
of the banking system, manager of foreign exchange, and regulator of payment & settlement systems while
continuously working towards the development of Indian financial markets. The RBI also regulates financial
markets and systems through different legislations. It regulates the foreign exchange markets through the
Foreign Exchange Management Act, 1999.

C. National Stock Exchange (NSE) – Rules and Regulations

In the role of a securities market participant, NSE is required to set out and implement rules and regulations to
govern the securities market. These rules and regulations extend to member registration, securities listing,
transaction monitoring, compliance by members to SEBI / RBI regulations, investor protection etc. NSE has a
set of Rules and Regulations specifically applicable to each of its trading segments. NSE as an entity regulated
by SEBI undergoes regular inspections by them to ensure compliance.

SANTOSH SHARMA 19
 Unit-10: Lease Financing

Meaning of Lease financing

A lease is a contract whereby the owner of the asset grants to another party the exclusive right to use the asset,
usually for an agreed period of time, in return for the payment of rent. The lease contract may vary from few hours
to the entire life of an asset. The lessee pays fixed rent in instalments over period of time. In the lease agreement,
options may be given to lessee to renew the lease for another lease period or to purchase the asset after the
termination of the agreement. The owner of the asset is called lessor and the user is known as lessee.

Difference between Leasing and Hire Purchase

Leasing Hire Purchase

The user of the asset or lessee is not the owner The hirer is deemed to be the owner of the asset.
of the asset.
A lessee cannot claim depreciation on asset. Depreciation can be claimed by the hirer.
Lessee cannot charge depreciation to profit andA hirer may charge depreciation to profit and loss
loss account. account.
The rent paid by lessee is a tax-deductible In hire purchase, the interest paid on loan is
expense. considered as a revenue expenditure and hence tax
deductible.
The asset is not shown in the balance sheet of The asset is shown in the balance sheet of the hirer.
the lessee.
It is done usually for industrial equipment. It is generally done for vehicles.

Forms of Lease Finance

Generally, leases are classified into:
1. Financial lease
2. Operating lease
3. Direct leasing
4. Sale and leaseback
5. Leveraged leasing

1. Financial lease
In this type of lease, the lease period is generally equal to the expected economic life of the assets. The lease
agreement cannot be cancelled. The lessee has to pay fixed rents until the lease period expires. The lessee has
the exclusive right to use the asset for a period of time. The lessee may purchase the equipment after the expiry
of the agreement. This type of lease is more popular in costly equipment like locomotives, earthmoving
equipment, office equipment, plant and machinery, textile machinery, etc.
2. Operating lease
In this type of lease, the lease period is less than the expected economic life of the assets. The lease contract
can be cancelled with proper prior notice. The lessor is expected to maintain the assets in good working
conditions. It is also known as short term or maintenance lease because the lease period is usually for a short
period which may stretch from one day to 5 years. The lease rent is generally higher. This type of leases is more
suitable for highly sensitive equipment like computers, automobiles, office equipment, etc.
3. Direct leasing
In this type of leasing, accompany acquires the right to use an asset which it did not own previously. The
manufacturers sell the asset to the lessor, who in turn, leases it to the lessee. The lessee firm may also lease the
asset from the manufacturer directly. The important lessor may be manufacturers, finance companies, banks,
etc.
4. Sale and leaseback

SANTOSH SHARMA 20
 In this type of lease, a firm, that owns a given asset sells it to the leasing company and gets it back on lease.
Usually, the asset is sold at the market value. The lessee receives the sale price in cash and the economic use of
the asset. The lessee has to pay lease rent periodically. The lessee pays all the maintenance expenses, property
taxes, insurance, etc. The lessee may purchase the property after the termination of the agreement. This type
of leasing is more popular in retail stores, office buildings, multipurpose industrial buildings, etc.
5. Leveraged leasing
This type of leasing has been popular in recent years. There are 3 parties involved in leveraged leasing such as
the lessee, the lessor and the lender. The lessor acquires the asset and finances the asset in part by an equity
investment. The remaining part is financed by a long-term lender. The lessor is the borrower in this type of
lease. This loan is secured by a mortgage on the asset. This type of leasing is more popular in aircraft, railroad,
coal mining, electric power plants, pipeline, ships, etc.

Benefits of Lease Financing.

1. Risk of ownership of asset is avoided: When a firm purchases machinery, it has to bear the risk that the
machinery may become obsolete before the completion of its service life. However, this risk can be avoided by
taking the machinery on lease.
2. Convenience of payment: Leasing enables the lessee firm to make full use of the asset without making
immediate payments of the purchase price which it would otherwise have been required to pay.
3. Tax advantage: Leasing can provide the tax advantages to the lessee. When a company acquires an asset on
lease, the full amount of the lease payments is deductible for tax purposes.

Disadvantages / Problems in lease financing

1. Expensive: Leasing may prove to be costlier than a straight purchase particularly in the case of leveraged
leasing where the lessor is only the financial intermediary who has obtained finance from banks and has added
to the cost his own profit.
2. Strict actions against defaulters. If the lessee fails to pay the lease rent regularly strict actions are taken
against him. The asset may be taken back from him. He is always in a pressure situation to pay the rent on
regular intervals of time.
3. Lessor loses the economic value: The asset may be useless and obsolete at the end of lease term. The lessee
may not maintain the asset properly and thereby the value of the asset decreases rapidly.
4. Risk of obsolescence: After the expiry of the lease agreement, the equipment may be obsolete and not usable
anymore. therefore, the asset loses its economic value add utility. Because technology is rapidly changing and
the asset may prove to be a useful.
5. Competition: With rising competition, the major players are diverting their activities to other activities. It has
been reported that the rate of interest is 13% to 14% only which is below the average cost of capital.
6. Lack of qualified personnel: In India, the concept of leasing business is a recent one and naturally it is very
difficult to get the right person to deal with the problems of this new business. The leasing companies have to
develop expertise in handling new types of business.

SANTOSH SHARMA 21
 Unit-11: Project Financing
Meaning of Project financing
Project financing is the most popular form of financing large infrastructure projects. Project financing is financing of
a project as an independent economic unit. Cash flows from the project is used to recover the investments made by
the sponsors. It is a source of raising funds through loans for mega projects in power, telecommunication, roads,
railways, oil and gas etc. A special purpose vehicle (SPV) is created for the project. For example, the construction of
Konkan railways project, Konkan Railway Corporation limited was created as SPV. The funding of long-term
infrastructure, projects and public services is known as project financing arrangements. The loan is repaid from cash
flows after the completion of the project. There are two types of financing arrangements such as debt financing and
equity financing. Funds are arranged from public and private companies.

Requirements of Project financing

1. Environmentally friendly technology: The technology used for the project should be latest and
environmentally friendly which is the demand of the day. For this purpose, the opinions of consultants and
engineering firms should be taken.
2. The project should have economic value: The project should be completed within the stipulated date. It
should start generating cash immediately after the completion of the project. It is very important to recover the
investments which has been done on the project. This is possible only when the project has economic value.
3. Availability of factors of production: It should be ensured that raw materials and labour should be available
near the site of the project. This will help to save transportation and other costs. Factors of production include
raw-materials, labour, machinery, power, etc.
4. Professional management: The project must have competent management in order to ensure successful
execution of the project. It should be properly designed by engineers and the task of completion can be given to
Special Purpose Vehicle (SPV) who are specialised in the project.

Risks associated with Project Financing

There are different types of risks associated with project financing. These are as follows:
1. Completion risk
2. Technological risk
3. Raw material risk
4. Maintenance risk
5. Economic value risk
6. Financial risk
7. Political risk
8. Environmental risk

1) Completion Risk: It refers to the risk of completing the project within stipulated time. If the project does not
get completed in time, it will affect the lenders the most. Because they expect return on their investments as
quickly as possible. There are many factors which may cause delays in completing the project such as
availability of raw-materials, labour, environmental factors, etc.
2) Technological Risk: As we know, technology has been changing very fast. There is every chance of change in
technology during the completion of the project. The project may not meet the desired quality specifications if
it fails to use latest technology.
3) Raw-material Risks: The quality and quantity of resources availability is critical to the project success.
Availability of resources ensures smooth operation of the project and results in completion within the stipulated
time period.
4) Maintenance Risk: The ability of the management of the SPV who successfully operate and maintain the plant
after its implementation is important for the project to be successful. The economic value of the project depends
on the management and maintenance by the SPV.

SANTOSH SHARMA 22
5) Economic value Risk: The economic risks refer to the market demand for the project output and its market
price. The demand for the project may not be sufficient in order to recover the investments of the sponsors. The
prices may be very competitive making the project margins very low.
6) Financial Risk: Generally, there is a very high debt ratio in case of project finance. If the debt carries floating
rate of interest, there is a possibility of rising interest rates which may affect the profitability of the project.
7) Political Risk: There may be a change in the government policies towards the execution of the project. If there
are frequent elections in the country and has an environment of political instability, it will badly affect the
execution of the project. Because every government has its own ideologies.
8) Environmental Risk: When the environmental impact causes a delay in the completion of the project it creates
environmental risk. Therefore, a proper assessment of the environment must be made before the start of the
project.

Distinguish between Corporate Finance and Project Finance.

Corporate finance Project Finance

The board of directors monitors and control the The special purpose vehicle is appointed to manage
overall performance of corporate finance. project finance.
The debt ratio is generally very low. The debt ratio is generally very high.
A company can raise finance quickly in case of In case of project financing, it is highly structural and
corporate finance. involve a lot of transaction costs.
The company is a going concern that means it has The SPV has a specific life and comes to an end once the
perpetual succession. concession period is over.
The board of directors take decisions regarding The SPV cannot take such decisions regarding
cash flows to be paid as dividends and distribution of profits and cash flows.
reinvestment.
The lenders have interest in the balance sheet of a
The lenders decide on the strength of the project assets
company. and future cash flows expected to be generated by the
project.
All the projects undertaken buy a corporate are Each project has a separate legal entity and therefore
reported together in the balance sheet. have separate balance sheet.

SANTOSH SHARMA 23
 Unit-12: International Business Finance

Foreign Exchange Markets (FOREX)

Foreign exchange market is a market where foreign currencies are bought and sold. The traders include firms,
foreign exchange brokers, banks, financial institutions, etc. In other words, the foreign exchange market is a financial
institution that facilitates the exchange of one country’s currency for that of another. Foreign exchange markets are
the oldest and most traditional financial marketplaces. Banks, dealers, commercial companies, investment
management firms, and hedge funds make up the foreign exchange markets. The currency market is open five days
a week, 24 hours a day. In the forex market, currency trading entails the simultaneous buying and selling of two
currencies. The foreign exchange rate is the price at which one currency may be exchanged for another currency.
The forex market has no physical address. It is an electronically linked network.

Function of Foreign Exchange Market

1. Transfer of money: The primary purpose of the foreign exchange market is to make it easier to convert one
currency into another or to make buying power transfers between nations. A number of credit instruments,
such as telegraphic transfers, bank draughts, and foreign bills, are used to transmit purchasing power. The
foreign exchange market performs the transfer function by making international payments by clearing debts
in both directions at the same time, similar to domestic clearings.

2. Provides credit: Another important role of the foreign exchange market is to facilitate international trade by
providing credit, both domestic and international. When foreign bills of exchange are used in overseas
payments, a credit of around three months is necessary before they mature. The FOREX provides importers
with short-term loans in order to promote the flow of goods and services between countries. The importer can
fund international imports with his own credit.

3. Hedging Function: Hedging foreign exchange risks is a third function of the foreign exchange market. Hedging
is the process of avoiding foreign currency risk. When the exchange rate, or the price of one currency in terms
of another currency changes in a free exchange market, the party involved may earn or lose money. If there are
large amounts of net claims or net liabilities that must be satisfied in foreign currency, a person or a company
takes on a significant exchange risk.

Advantages of Foreign Exchange Market

i) Flexibility: The forex market offers traders a great deal of freedom. This is due to the fact that the quantity
of money that may be traded is unlimited. Moreover, market regulation is essentially non-existent.
ii) Transparency: The Forex market is enormous in size and spans many time zones. Despite this, information
about the Forex market is freely available. Additionally, neither government nor the central bank has the
authority to corner the market or set prices for an extended period of time. The magnitude of the Forex
market makes it fair and efficient.
iii) Options Trading: Traders can choose from a wide range of trading alternatives on the forex markets.
Traders have lots of different currency pairs to select from. Investors can also choose between spot trading
and signing a long-term contract. As a consequence, the Forex market has a remedy for any budgetary and
investor’s risk appetite.

Features of Foreign Exchange Market in India

1. Low Transaction Costs: Because of the lower online FOREX trading costs, even small investors will make
good money. Unlike other investment options, FOREX traders only charge a small fee. The spread, or the
difference between buying and selling prices for a currency pair, is where the FOREX commission is limited.

2. Elevated Leverage: In the FOREX market, you can sell on margins, which are technically borrowed funds.
The return on your investment is rising exponentially, so the value of your investment is high. Since the

SANTOSH SHARMA 24
 FOREX market is so unpredictable, trading with leverage (borrowed money) will result in significant losses
if the market goes against you.

3. Extremely Transparent: The foreign exchange market in India is a transparent market in which traders
have complete access to market data and information necessary for successful transactions. Traders who
operate on open markets have more leverage over their investments.

4. FOREX Market Accessibility: If you have an internet connection, you can access your foreign currency
trading account from anywhere. You can trade at any time and from any place.

Types of Foreign Exchange Market in India

1. Spot Market: In this market, transactions involving currency pairs happen quickly. In the spot market,
transactions require immediate payment at the current exchange rate, also known as the 'spot rate.' The
traders on the spot market are not exposed to the FOREX market's uncertainty, which increases or lowers the
price between trade and agreement.

2. Futures Market: Future market transactions, as the name implies, require future payment and distribution
at a previously negotiated exchange rate, also known as the future rate. These agreements and transactions
are formal, which ensures that the terms of the agreement or transaction are set in stone and cannot be
changed. Traders who conduct major FOREX transactions and pursue a consistent return on their assets
prefer future market transactions.

3. Forward Market: Forward market deals are identical to future market transactions. The main difference is
that in a forward market, the parties will negotiate the terms. The terms of the agreement can be negotiated
and adapted to the needs of the parties concerned. Flexibility is provided by the forward market.

Risks which an exporter faces while dealing in foreign currency.

Foreign exchange risks refer to a situation where a trader is affected due to fluctuations of the exchange rates. These
risks can be divided into 3 categories:
1. Transaction Risks
2. Economic Risks
3. Translation Risks

1. Transaction Risks
These types of risks arise when there is a change in exchange rate before the settlement of the transaction.
Transaction Risk is the exposure to uncertainty factors that may impact the expected return from a deal or
transaction. It can include but is not limited to foreign exchange risk, commodity, and time risk. It essentially
encompasses all negative events that can prevent a deal from happening. A deal with a high transaction risk
will typically require a higher return. Therefore, it is important to consider such risk when evaluating a
prospective investment. Some of the most common transaction risks that can affect the deal or transaction
value include the following:
a. Foreign Exchange Risk: Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which
can affect the expected transaction value. This risk is especially important to consider for cross-border
transactions or deals with countries that have relatively high currency volatility. Foreign Exchange Risk
is also called economic exposure.
b. Commodity Risk: Similar to foreign exchange, commodity risk considers the unexpected fluctuation of
commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in the Oil
& Gas and Mining sectors.
c. Interest Rate Risk: It examines how interest rate fluctuation can affect transaction value. Depending on
the changes in rates, this risk can affect the ability of the purchasing party to raise the necessary
capital for the transaction and can impact the debt obligations of the selling party. For companies that

SANTOSH SHARMA 25
 engage in debt covenant agreements with financial institutions, interest rate fluctuation can impact the
company’s ability to meet its obligations established in the covenant.
d. Time Risk: As market conditions and companies change with time, there is a higher probability that the
initial transaction agreement conditions will become unfavourable the longer the negotiation process is
extended. As a result, deals can fall through due to the favourable conditions no longer being present for
both parties. The longer a deal takes to finalize, the longer the transaction is exposed to the other risks.
e. Counterparty Risk: When engaging in transactions, there is a risk that the counterparty will not
complete their contractual obligations agreed upon in the transaction. In instances where counterparties
default on their contractual obligations, it is often due to the effects of the previously stated transaction
risks.

2. Economic Risk
These types of risks arise when there is a change in market value of product due to change in its demand and
supply. These risks can be of three types:
i) Sovereign Risk: This type of economic risk is one of the most critical risks that can have a direct impact
on the investment. Sovereign Risk arises when a government cannot repay its debt and default on its
payments. When a government becomes bankrupt, it directly impacts the businesses in the country.
Sovereign Risk is not limited to a government defaulting but also includes the political unrest and change
in the policies made by the government.
ii) Unexpected swing in exchange rate: This can be due to speculation or the news that can cause a fall in
demand for a particular product or currency. Oil prices can significantly impact the market movement of
other traded products. Change in inflation, interest rates, import-export duties, and taxes also impact the
exchange rate. Since this directly impacts trade, exchange rates risk seeming to be a significant economic
risk.
iii) Credit risk: This type of sovereign risk is the risk that the counterparty will default in making the
obligation it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness to
pay its debts. The counterparty’s business activities need to be monitored on a timely basis so that the
business transactions are closed at the right time without the risk of counterparty default to make it
payments.

3. Translation Risks
These risks occur when a company does business outside the country but its financial performance is measured
in domestic currency. Translation risk arises when foreign financial statements of a company is converted into
domestic currency. This risk may adversely affect firm’s reported financial statements, or related financial
ratios or borrowing covenant compliance, resulting from changes in the rates at which foreign currency
denominated assets and liabilities are translated into the reporting currency. Translation risk commonly
applies to the translation of monetary assets and liabilities. This risk may also apply to the consolidation of
overseas subsidiaries into group financial statements.

Techniques of managing Transaction Exposure or Risks

An exporter can manage the transaction exposure risks in the following ways:
1. Hedging: Companies will engage in hedging arrangements to reduce the level of potential risk from the price
movement of various assets. Hedging provides companies with protection against adverse changes to asset
prices that can negatively affect investment. Within the context of transactions, companies will often
complete hedging arrangements to reduce the effects of Foreign Exchange and Commodity Risk associated
with the deal.
2. Refinancing: In a fluctuating interest rate environment, companies often look to refinance their debt when
interest rates are declining. Debt refinancing allows companies to reduce their debt obligations and to
borrow at more attractive rates. To ensure that a party is eligible for refinancing, the borrowing party can
include renegotiation clauses in their contracts that allow for refinancing adjustments when notable interest
rate changes.

SANTOSH SHARMA 26
 3. Due Diligence: To reduce the possibility of the counterparty defaulting on their contractual obligations,
parties will undergo an extensive due diligence process to assess various components of the transaction
before coming to an agreement. In situations where the counterparty has a higher risk of defaulting, the
purchasing party may place a default risk premium into the transaction agreement to create an incentive for
taking on more risk.

Relation between transaction exposure, translation exposure and economic exposure or risk.
Transaction exposure
• It is the simplest type of foreign currency exposure.
• It deals with actual foreign currency transactions.
• It occurs due to foreign currency Gators of sale, payment of imported goods or services, receipts or payments
of dividends, payment of EMI, etc.
• For example, if you have bought goods from a foreign country to be paid after 3 months. but the value of
foreign currency rises in between that, you end up paying higher than your actual dept.
Translation exposure
• It is also known as accounting exposure.
• It occurs due to translation of books of accounts into the home currency.
• It affects the valuation of assets and liabilities.
• It is equivalent to comparing cash flow accounting treatment with accounting book treatment.
Economic exposure
• It deals with the whole economic system of a country.
• It is not applicable to a single firm rather it affects all the forms of a country.
• The impact of this higher than the other exposures.
• It directly affects the market value of a firm.
• It affects the cash flows and also the assets and liabilities of a firm.

International Bonds
International bonds are bonds issued by a country or company that is not domestic for the investor. The international
bond market is quickly expanding as companies continue to look for the cheapest way to borrow money. By issuing
debt on an international scale, a company can reach more investors. It also potentially helps decrease regulatory
constraints.

Types of International Bonds

There are three general categories for international bonds: domestic, euro, and foreign. The categories are based on
the country (domicile) of the issuer, the country of the investor, and the currencies used.
1. Domestic bonds: As the name implies, these bonds are traded in the domestic markets. These are issued,
underwritten and then traded with the currency and regulations of the borrower’s country.
2. Eurobonds: A Eurobond is a long-term bond. It is issued and sold outside the country where it has been
denominated. Although the implication from the name indicates that Europe is involved, any country can create
a Eurobond. If an organization is based in the United States, it can issue a bond that is denominated in dollars,
then sold to the investors in the United Kingdom, then it would be qualified as a Eurobond. The same would be
true if that company sold that bond to South-Korean investors. Multi-national companies often issue
Eurobonds as a way to finance their global operations. It is very common to issue a Eurobond from one country
where they have a presence, then sell it to another country where there are offices as well.
3. Foreign bonds: Issued in a domestic country by a foreign company, using the regulations and currency of the
domestic country. A foreign bond is a long-term bond that can be issued by governments or companies which
are outside of their home country. If a U.S. company were to issue a bond that was denominated in Canadian
dollars, then sold to investors in Canada, then a foreign bond would be issued. It is usually denominated in the
currency of where it is expected to be sold. Many companies issue foreign bonds in the U.S. Dollar because they

SANTOSH SHARMA 27
 seek out investors from the United States to fuel their operations. Foreign bonds may be subject to disclosure
requirements, trading regulations, and securities regulations as they are traded on national markets.

Instruments traded in International Financial Market

1. Foreign Exchange: In international financial market, currencies of various countries are bought and sold
against each other. The foreign exchange market is an over-the-counter market. It is one of the largest
markets in the world.
2. Derivative Products: A derivative is a financial instrument whose value depends on other more basic,
underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold
or copper. Derivatives have become increasingly important in the field of finance.
3. International Currency Market: Since the 1960s various banks started forming international syndicates.
Multinational banks are responsible for huge international transfers of capital not only for investment
purposes but also for hedging and speculating against exchange rate changes.
4. Eurocurrency Market: This represents the money market in which Eurocurrency, that is currency held in
banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe.
5. Money Market Instruments: The money market is the securities market dealing in short-term debt and
monetary instruments. Money market instruments are forms of debt that mature in less than one year and
are very liquid and relatively risk free. The important instruments traded here are:
i) Treasury bills make up the bulk of the money market instruments.
ii) Commercial Paper: This is an unsecured, short-term instrument issued by a corporation, typically
for financing accounts receivables and inventories. It is usually issued at a discount reflecting
prevailing market interest rates. Maturities on commercial paper are usually up to a maximum
maturity 270 days.
iii) Euro commercial Paper: This is an unsecured, short-term paper issued by a bank or corporation in
the international money market, denominated in a currency that differs from the corporation’s
domestic currency.
iv) Certificate of Deposit: This is a savings certificate entitling the bearer to receive interest. A
Certificate of Deposit bears a maturity date, a specified interest rate and can be issued in any
denomination. CDs are generally issued by commercial banks.
v) Banker’s Acceptance: This is a short-term credit investment created by a non-financial firm and
guaranteed by a bank. Such acceptances are traded at a discount from face value on the secondary
market.
vi) Bond and Note Issues A note is a debt security, usually maturing in one to 10 years. In comparison,
bills mature in less than one year and bonds typically mature in more than 10 years. Often the terms
‘notes’ and ‘bonds’ are used interchangeably.

SANTOSH SHARMA 28
 Unit-13: Leverage- Operating, Financial and Total

Meaning of Leverage
The term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or funds to increase the return to
its equity shareholders. In other words, leverage is the employment of fixed assets or funds for which a firm has to
meet fixed costs or fixed rate of interest obligation—irrespective of the level of activities attained, or the level of
operating profit earned.
Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the risk involved in meeting
fixed payment obligations i.e., operating fixed costs and cost of debt capital. But, at the same time, higher risk profile
increases the possibility of higher rate of return to the shareholders.

Types of Leverage
Leverage are the three types:
1. Operating leverage
2. Financial leverage
3. Total or Combined leverage

1) Operating Leverage
Operating leverage may be defined as the “firm’s ability to use fixed operating cost to magnify effects of changes
in sales on its earnings before interest and taxes”. Operating leverage refers to the use of fixed operating costs
such as depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the operations of a
firm. But it does not include interest on debt capital. Higher the proportion of fixed operating cost as compared
to variable cost, higher is the operating leverage, and vice versa. It is calculated by the following formula:
Contribution
O.L = , whereas, Contribution = Sales Revenue – Variable Cost, EBIT = Earning before Interest & Tax
EBIT

The importance of Operating Leverage:

i) It gives an idea about the impact of changes in sales on the operating income of the firm.
ii) High degree of operating leverage magnifies the effect on EBIT for a small change in the sales volume.
iii) High degree of operating leverage indicates increase in operating profit or EBIT.
iv) High operating leverage results from the existence of a higher amount of fixed costs in the total cost structure
of a firm which makes the margin of safety low.
v) High operating leverage indicates higher number of sales required to reach break-even point.
vi) Higher fixed operating cost in the total cost structure of a firm promotes higher operating leverage and its
operating risk.
vii) A lower operating leverage gives enough cushion to the firm by providing a high margin of safety against
variation in sales.
viii) Proper analysis of operating leverage of a firm is useful to the finance manager.

2) Financial Leverage
Financial leverage is a technique of using debt instead of equity to acquire assets and projects. It is also known
as trading on equity. Companies should maintain a proper balance between debt and equity. They must generate
a higher rate of return than the rate of interest to be paid on debts. Financial leverage is suitable for companies
which are in profits. There are many types of leverage ratios to determine the financial health of a firm such as
debt-capital ratio, debt-equity ratio etc. Financial leverage can be found out by using the following formula:
EBIT
F.L = , whereas, EBT = Earning before Tax
EBT

The importance of Financial Leverage

SANTOSH SHARMA 29
 i) It helps the financial manager to design an optimum capital structure. The optimum capital structure
implies that combination of debt and equity at which overall cost of capital is minimum and value of the
firm is maximum.
ii) It increases earning per share (EPS) as well as financial risk.
iii) A high financial leverage indicates existence of high financial fixed costs and high financial risk.
iv) It helps to bring balance between financial risk and return in the capital structure.
v) It shows the excess of return on investment over the fixed cost.
vi) It is an important tool in the hands of the finance manager while determining the amount of debt in the
capital structure of the firm.

3) Total or Combined Leverage

Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to
percentage change in sales. The financial leverage shows the financial risk and is measured by the percentage
change in EPS due to percentage change in EBIT. Both operating and financial leverages are closely concerned
with ascertaining the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine them,
the result is total leverage and the risk associated with combined leverage is known as total risk. It measures
the effect of a percentage change in sales on percentage change in EPS. The combined leverage can be measured
with the help of the following formula:
Combined Leverage = Operating leverage x financial leverage

The importance of combined leverage is:

a) It indicates the effect change in sales on EPS.
b) It shows the combined effect of operating leverage and financial leverage.
c) A combination of high operating leverage and a high financial leverage is very risky situation because the
combined effect of the two leverages is a multiple of these two leverages.
d) A combination of high operating leverage and a low financial leverage indicates that the management
should be careful as the high risk involved in the former is balanced by the later.
e) A combination of low operating leverage and a high financial leverage gives a better situation for
maximising return and minimising risk factor, because keeping the operating leverage at low-rate full
advantage of debt financing can be taken to maximise return. In this situation the firm reaches its BEP
(Breakeven point) at a low level of sales with minimum business risk.
f) A combination of low operating leverage and low financial leverage indicates that the firm losses
profitable opportunities.

SANTOSH SHARMA 30
 Unit-14: Capital Structure Decision

Meaning of Capital Structure

The composition of capital with equity, preference, debenture, bonds, etc. is termed as capital structure. There are
two main sources of raising capital, such equity capital and debt capital. Equity is one the major sources of raising
capital because the cost of capital is less. On the other hand, debt capital is raised in the form of debentures and loans.
A business enterprise must maintain a proper balance between equity and debt capital.
The capital structure in which the equity-debt capital is maximum and cost of capital is minimum is called
appropriate capital structures. In appropriate capital structure, market value of equity debt capital is maximum.
Market value of cost of capital is minimum.

Features of Appropriate Capital Structure

1. Flexibility
2. Profitability
3. Solvency
4. Control

1) Flexibility: The capital structure of the firm should be flexible and dynamic. That means it can be changed
according to time and situation. If new growth opportunity comes in future, the company should be capable of
getting easy finance for the same.
2) Profitability: The main object of the firm is to have the capital structure which ensures maximum returns to
the shareholders. Therefore, the amount of capital structure and its size should be properly designed.
3) Solvency: An appropriate capital structure should have the features of solvency. A firm should have proper
control over its capital structure. Its size should be big enough to create market value in the market so that a
company can easily raise money from the public.
4) Control: The choice of capital structure should consider that it should not result in dilution of control of the
existing management. Therefore, the firm should raise more debt capital for an appropriate capital structure.

Theories of Capital Structure

The most commonly used capital structure theories are:
1. Net Operating Income Approach (NOI)
2. Traditional Approach
3. Net Income Approach (NI)
4. Modigliani and Miller Approach

1) Net Operating Income Approach (NOI)

Durand proposed the theory of the Net Income Approach. According to this theory, a firm can increase its
value by decreasing the overall cost of capital which is measured in terms of the (WACC) Weighted Average
Cost of Capital. This can be done by raising more of debt capital than equity capital. Because debt capital is a
cheaper source of capital. Weighted Average Cost of Capital (WACC) is the weighted average costs of equity
and debts, where the weights are the amount of capital raised from each source.
According to Net Income Approach, a change in the financial leverage of a firm will lead to a corresponding
change in the Weighted Average Cost of Capital (WACC) and the company’s value. The Net Income Approach
suggests that with the increase in leverage (proportion of debt), the WACC decreases, and the firm’s value
increases. On the other hand, if there is a decrease in the leverage, the WACC increases, thereby decreasing the
firm’s value. For example, the equity-debt mix of a firm is 50:50, if the equity-debt mix changes to 20: 80, it
would positively impact the value of the business and increase the value per share.
Cost of capital can be calculated by the method of WACC using the following formula:
SANTOSH SHARMA 31
 ROI x Equity+Debt
WACC =
Equity+Debt

Assumptions of Net Operating Income Approach

The Net Income Approach makes certain assumptions which are as follows.
a. The increase in debt will not affect the confidence levels of the investors.
b. There are only two sources of finance; debt and equity. There are no other sources of finance like Preference
Share Capital and Retained Earnings.
c. All companies have a uniform dividend pay-out ratio; it is 1.
d. There is no flotation cost, no transaction cost, and corporate dividend tax.
e. The capital market is perfect; it means information about all companies is available to all investors, and there
are no chances of overpricing or under-pricing of security. Further.
f. All investors are rational and want to maximize their return by minimizing risk.
g. All sources of finance are for infinity. There are no redeemable sources of finance.

2) Traditional Approach
The traditional approach to capital structure advocates that there should be a right combination of equity and
debt in the capital structure. As per this approach, debt capital should exist in the capital structure but only up
to a specific point, beyond which any increase in leverage would result in a reduction in the value of the firm.
It means that there exists an optimum value of debt-to-equity ratio at which the WACC is the lowest and the
firm’s market value is the highest. Once the firm crosses that optimum value of debt-to-equity ratio, the cost of
equity rises to give a negative effect on the WACC.

Assumptions of Traditional Approach

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

3) The Net Income (NI) Approach of Capital Structure.

Net income approach was introduced by Durant. According to this theory, the market value of a company can
be increased by decreasing the cost of capital and increasing the debt capital. Cost of capital is measured by
weighted average cost of capital (WACC). Debt capital is a cheaper source of capital as compared to equity
capital.

Assumptions of Net Income Approach

1. There are only two sources of capital such as debt capital and equity capital.
2. The market value of a firm is not affected by an increase or decrease of debt capital.
3. All companies have uniform dividend pay-out ratio of 1:1.
4. There are no transaction costs, taxes etc.
5. There is perfect competition in the market which means all the companies are known to investors.
6. Investors are rational that means they want maximum returns on their investments.

4) Modigliani and Miller Proposition or Approach (MM Proposition)

Both Franco Modigliani and Merton Miller received the Nobel Prize in 1950 for their important contributions
to understanding the relationship between a firm's capital structure, value, and cost of capital. The main idea
of them is that the capital structure of a company doesn’t affect its overall value. According to them, in the
absence of taxes, firm capital structure is irrelevant and with taxes, a firm's cost of capital can be lowered

SANTOSH SHARMA 32
through issuing debt. There are two parts of this theory. The first proposition is without taxes and suffered
from a lot of limitations. But the second proposition was with taxes, transaction costs and bankruptcy costs.
Assumptions of MM Proposition
a. There are no taxes.
b. There are no transaction costs.
c. Both individuals and corporations can borrow at the same rate.

1. MM Proposition I
According to this proposition, the company’s capital structure doesn’t impact its value. Since the value of a
company is calculated as the present value of future cash flows, the capital structure cannot affect it. The
value of levered firm is equal to value of unlevered firm plus present value of infinite stream of tax
advantage of interest on debt. It assumes that companies operating in perfectly efficient market do not pay
any taxes and transaction costs.

2. MM Proposition II
According to this proposition, the company’s cost of capital is directly proportional to the company’s
leverage level. It assumes that the company pay taxes and transaction costs. This proposition is widely
accepted and more practical than the first proposition. The cost of debt is generally less than the cost of
equity. If a company increases borrowing to get the cheaper rate, it will also increase the amount it will
have to pay on equity. So, in effect, you cannot lower your cost of capital by exchanging debt for equity.

SANTOSH SHARMA 33
 Unit-15: Dividend Policy Decision

Why do firms pay dividends?

Dividend is the return on investment made by shareholders. In simple words, it is the income of shareholders
received for taking risks. A company can only pay dividends when it makes sufficient profits during the year.
Moreover, it depends on the policy of the company whether to distribute a part of profit among the shareholders or
not. It may not issue dividends if it wants to reinvest the profits in a profitable venture. But there are many companies
that pay dividends due to the following reasons:
Advantages of paying dividends
1. Investors like dividends: Number of investors in India prefer dividends for behavioural reasons. The
payment of dividends resolves uncertainty about the firm’s performance in the minds of the investors. If the
firm is continuously paying growing dividend per share, it builds confidence amongst the investors.
2. Information signal: Dividend decision of the management conveys information to the market as to how the
company is likely to perform in the future competitive environment.
3. A tool for changing firms financing mix: The firm used dividend policy to change its debt to total capital
ratio. If the firm increases dividend payments, it will result in increase in debt ratio and increased use of
financial leverage. The management can use dividends as a vehicle to shift the value to shareholders from
lenders. the lenders generally put a condition at the time of granting loans that dividend payments cannot
exceed their particular level. if management wants to pay more dividends it has to first retire the debt and then
it can pay more dividends.
4. Reduces management discretion: The management of firm may pursue a goal of maximising sales and
investing in assets but this growth may not be profitable to the shareholders. This growth may have a required
rate of return greater than the rate of return it generates.
5. It builds confidence among shareholders that the firm has good financial position.
6. It increases the demands for their stocks.
7. It increases the market value of their shares.
8. The company has stable growth.
9. It increases the market worthiness and the company can get loans from the market easily.
10. Regular dividend acts as a source of income for few shareholders.

Factors that determine the Dividend Pay-out Ratio

1. Availability of growth opportunities
2. Liquidity position of the firm
3. Debt market conditions
4. Control considerations
5. Other considerations

1) Availability of growth opportunities: Generally, matured firms pay most of their earnings as dividends. Their
pay-out ratio is high. The dividend pay-out ratio of growing firm is low because the firm has opportunities
available.
2) Liquidity position of the firm: The payment of dividends involved cash outflows. Hence the liquidity position
of the firm has an impact on the firm’s dividend policy. The firm may be profitable but may not have adequate
cash available to pay dividends as the profits are reinvested or used for paying debts hence may have low
dividend pay-out ratio. This is possible in case of highly profitable but rapidly growing firms.
3) Debt market conditions: If the debt market is flushed with the funds and firm has financial flexibility, the firm
may like to distribute its earnings as dividends and raise resources in the debt market to encash the growth
opportunity. On the other hand, if the firm has not so good credit ratings it will be compelled to use internally
generated funds for growth and we will have low dividend pay-out ratio.
SANTOSH SHARMA 34
 4) Control considerations: If a firm pays dividends and raises fresh equity to invest in the growth opportunity,
it incurs transaction cost and results in dilution of control. The dilution of control means the managements
controlling stake is reduced by fresh equity and firm becomes vulnerable to takeover.
5) Other considerations: The other considerations for determining dividend pay-out ratio may be cost and
availability of alternative forms of financing, legal rules, inflation, access to capital market, tax policy and desire
of the shareholders.

Dividend Policy
Generally, a firm can have two types of dividend policy such as:
1. Stable Dividend Policy
2. Residual Dividend Policy

1) Stable Dividend Policy

In this type of dividend policy, the investors receive dividends consistently, although the amount of dividend
may vary from year to year. Basically, the companies decide to distribute a certain portion of the profit to the
shareholders every year in the form of dividends. These companies are mostly matured and don’t intend to
pursue any strong growth strategy. Further, the policy is best suited for investors for whom a steady source of
income today is more important than capital appreciation.
2) Residual Dividend Policy
According to residual dividend policy, the equity earnings of the firm are first applied to provide for its
investment needs. The surplus if any, left after the meeting of the investment needs is distributed as dividend
to the shareholders. In other words, dividends are only to be paid out of residual profit.
Residual dividend policy has approaches such as pure residual dividend policy approach, fixed dividend pay-
out approach and smooth residual dividend approach.
In this type of dividend distribution, the company pays dividend based on the amount of left-over earnings. In
residual dividend policy, a company pays dividends only after ensuring that all the planned investments have
been done. This policy reduces the need for raising external funds to a large extent.

Buyback of Shares
Buyback of shares refers to repurchase of shares by a company which it had issued earlier to the shareholders. It is
done by paying the shareholders back at market values either in the open market or directly.

Advantages of Buyback of Shares

1. It helps to reduce excess share capital not required by the company at present.
2. It helps to increase the reserves of a company.
3. It helps to protect against unfriendly takeovers from other companies.
4. It increases earning per share and P/E ratio.
5. It increases the market value of shares of the company.
6. If a company thinks that its share prices are low as expected it can go for buyback of shares.
7. It results in saving taxes.
8. It boosts the prices of shares.
9. A company can use excess amount of cash for its growth and expansion of business.

SANTOSH SHARMA 35
 Unit-16: Working Capital

Meaning of Working capital

Working capital refers to the capital used to meet day to day operations of a company. Working capital is the
difference of current assets and current liabilities.

Objectives of working capital

1. To strengthen the liquidity position of the firm.
2. To smoothen operating cycle.
3. To manage cash flows.
4. Optimal return on investments.

Factors influencing Working Capital requirement

1) Nature of business: A manufacturing company needs more working capital than a trading company. Because
it has to keep a stock of raw-materials, payment of wages to labourers, factory rent, warehousing charges, etc.
whereas, a trading company just needs to have a stock of inventory according to the orders.
2) Scale of the unit: If the size or scale of business is large, it requires large amount of fixed capital. Because its
large economies of scale and capable of producing goods at lower cost. So, large companies may not require
huge amount of working capital.
3) Method of production: A capital intensive organisation requires more working capital than labour intensive
organisation. A capital-intensive firm uses latest methods of production and technology for which it has to incur
a large amount of capital for procuring them. On the other hand, a labour-intensive firm uses more of labour
and less of machines, so they need less working capital comparatively.
4) Technology: If an organisation uses modern technology, it needs more working capital. Whereas if an
organisation uses old technology, it needs less capital. To operate new technology, it needs services of expert
persons, for which it needs have sufficient amount of working capital.
5) Growth prospects: Higher growth of an organisation generally requires higher investment in fixed assets. If a
firm wants to grow and expand its business, it needs more and more of capital.

Discuss the methods available to finance Working Capital requirements.

There are two methods to finance working capital requirements such as:
A. Informal Credit
B. Formal Credit

A. Informal Credit: These sources of credit include:

1. Trade credit
2. Stretching accounts payable
3. Accrued expenses and deferred income
1) Trade credit: When firms purchase goods and services on credit terms, it is known as trade credit. It is
generally given on open account basis. The supplier evaluates the creditworthiness of the buyer before giving
trade credit. This method is more attractive and not very difficult and therefore firms prefer this method of
credit.
2) Stretching accounts payable: It is also a very attractive source of credit. The firm may have to pay interest
on the extra credit period.
3) Accrued expenses at deferred income: Expenses which are due but not paid are called accrued expenses.
Deferred income consists of payment received from customers for goods and services yet to be delivered.

B. Formal Credit: These credit sources include:

1. Commercial paper
2. Bank credit
3. Line of credit
4. unsecured and secured borrowing
SANTOSH SHARMA 36
 5. Inventory loans
1) Commercial paper: It is a short term unsecured promissory note issued by large corporations. The maturity
could range from days to months. Commercial paper is typically bought by large corporations and banks with
surplus funds to invest. This is not very reliable form of funding and may not be available to corporations at
all points of time because they are dependent on external market conditions.
2) Bank credit arrangements: It is available in several different forms such as working capital term loan, cash
credit, overdraft, bill discounting, etc. each of these options have interest and maturity.
3) Line of credit: It is an agreement between the bank and the borrower wherein, the bank promises a certain
line of credit permitting the company to borrow up to that limit during a specified period. It is available when
the company needs it and it is quite flexible.
4) Unsecured and secured borrowing: These unsecured borrowings refer to the borrowings in which there
is no mortgage or security kept by a company. This source of credit has high rate of interest and requires
creditworthiness of the borrower. Whereas, secured borrowings can be undertaken by keeping assets
mortgage for security.
5) Inventory loans: These loans can be taken from financial institutions and banks on the basis of stocks or
inventory they have. These inventories act as collateral or mortgage for short term borrowings.

Meaning of Money Market

Money Market is a financial market where short-term financial assets having liquidity of one year or less are traded
on stock exchanges. The securities or trading bills are highly liquid. Also, these facilitate the participant’s short-term
borrowing needs through trading bills. The participants in this financial market are usually banks, large institutional
investors, and individual investors.
There are a variety of instruments traded in the money market in both the stock exchanges, NSE and BSE. These
include treasury bills, certificates of deposit, commercial paper, repurchase agreements, etc. Since
the securities being traded are highly liquid in nature, the money market is considered as a safe place for investment.
The Reserve Bank controls the interest rate of various instruments in the money market. The degree of risk is smaller
in the money market. This is because most of the instruments have a maturity of one year or less.

Objectives of Money Market

1. Providing borrowers such as individual investors, government, etc. with short-term funds at a reasonable
price.
2. Lenders will also have the advantage of liquidity as the securities in the money market are short-term.
3. It also enables lenders to turn their idle funds into an effective investment. In this way, both the lender and
borrower are at a benefit.
4. RBI regulates the money market. Therefore, in turn, helps to regulate the level of liquidity in the economy.
5. Since most organizations are short on their working capital requirements. The money market helps such
organizations to have the necessary funds to meet their working capital requirements.
6. It is an important source of finance for the government sector for both national and international trade. And
hence, provides an opportunity for the banks to park their surplus funds.

Characteristics of Money Market

1. It is a financial market and has no fixed geographical location.
2. It is a market for short term financial needs, for example, working capital needs.
3. Its primary players are the Reserve Bank of India (RBI), commercial banks and financial institutions like LIC,
etc.,
4. The main money market instruments are Treasury bills, commercial papers, certificate of deposits, and call
money.
5. It is highly liquid as it has instruments that have a maturity below one year.
6. Most of the money market instruments provide fixed returns.

SANTOSH SHARMA 37
Types Of Money Market Instruments
The important instruments traded in money market are:
1. Treasury Bills
2. Certificate of Deposits
3. Commercial Paper
4. Repo & Reverse Repo Transactions
5. Banker’s Acceptance

1) Treasury Bills (T-Bills)

Issued by the Central Government, Treasury Bills are known to be one of the safest money market instruments
available. However, treasury bills are zero risk instruments. Therefore, the returns one gets on them are not
attractive. Treasury bills come with different maturity periods like 3-month, 6-month and 1 year and are
circulated by primary and secondary markets. Treasury bills are issued by the Central government at a lesser
price than their face value. The interest earned by the buyer will be the difference of the maturity value of the
instrument and the buying price of the bill, which is decided with the help of bidding done via auctions.
Currently, there are 3 types of treasury bills issued by the Government of India via auctions, which are 91-day,
182-day and 364-day treasury bills.
2) Certificate of Deposits (CDs)
A Certificate of Deposit or CD, functions as a deposit receipt for money which is deposited with a financial
organization or bank. However, a Certificate of Deposit is different from a Fixed Deposit Receipt in two aspects.
The first aspect of difference is that a CD is only issued for a larger sum of money. Secondly, a Certificate of
Deposit is freely negotiable. First announced in 1989 by RBI, Certificate of Deposits have become a preferred
investment choice for organizations in terms of short-term surplus investment as they carry low risk while
providing interest rates which are higher than those provided by Treasury bills and term deposits. Certificate
of Deposits are also relatively liquid, which is an added advantage, especially for issuing banks. Like treasury
bills, CDs are also issued at a discounted price and their tenor ranges between a span of 7 days up to 1 year.
However, banks issue Certificates of Deposits for durations ranging from 3 months, 6 months and 12 months.
They can be issued to individuals (except minors), trusts, companies, corporations, associations, funds, non-
resident Indians, etc.
3) Commercial Papers (CPs)
Commercial Papers can be compared to an unsecured short-term promissory note which is issued by highly
rated companies with the purpose of raising capital to meet requirements directly from the market. CPs usually
feature a fixed maturity period which can range anywhere from 1 day up to 270 days. Highly popular in
countries like Japan, UK, USA, Australia and many others, Commercial Papers promise higher returns as
compared to treasury bills and are automatically not as secure in comparison. Commercial papers are actively
traded in secondary market.
4) Repo & Reverse Repo Transactions
Repurchase Agreements, also known as Reverse Repo or simply as Repo, loans of a short duration which are
agreed upon by buyers and sellers for the purpose of selling and repurchasing. These transactions can only be
carried out between RBI approved parties Repo / Reverse Repo transactions can be done only between the
parties approved by RBI. Transactions are only permitted between securities approved by the RBI like treasury
bills, central or state government securities, corporate bonds and PSU bonds.
5) Banker's Acceptance (BA)
Banker's Acceptance or BA is basically a document promising future payment which is guaranteed by a
commercial bank. Similar to a treasury bill, Banker's Acceptance is often used in money market funds and
specifies the details of the repayment like the amount to be repaid, date of repayment and the details of the
individual to which the repayment is due. Banker's Acceptance features maturity periods ranging between 30
days up to 180 days.

SANTOSH SHARMA 38
 Unit-17: Cash Management
Meaning of Cash management
Cash Management refers to the collection, handling, control and investment of the organizational cash and cash
equivalents, to ensure optimum utilization of the firm’s liquid resources. Money is the lifeline of the business, and
therefore it is essential to maintain a sound cash flow position in the organization.

Objectives of Cash Management

i) Fulfil Working Capital Requirement: The organization needs to maintain ample liquid cash to meet its
routine expenses which possible only through effective cash management.
ii) Planning Capital Expenditure: It helps in planning the capital expenditure and determining the ratio of debt
and equity to acquire finance for this purpose.
iii) Handling Unorganized Costs: There are times when the company encounters unexpected circumstances like
the breakdown of machinery. These are unforeseen expenses to cope up with; cash surplus is a lifesaver in
such conditions.
iv) Initiates Investment: The other aim of cash management is to invest the idle funds in the right opportunity
and the correct proportion.
v) Better Utilization of Funds: It ensures the optimum utilization of the available funds by creating a proper
balance between the cash in hand
vi) Avoiding Insolvency: If the business does not plan for efficient cash management, the situation of insolvency
may arise. It is either due to lack of liquid cash or not making a profit out of the money available.

Functions of Cash Management

Cash management is required by all kinds of organizations irrespective of their size, type and location. Following are
the multiple managerial functions related to cash management:
1. Investing Idle Cash: The company needs to look for various short-term investment alternatives to utilize
surplus funds.
2. Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is an essential function
of the business.
3. Planning of Cash: Cash management is all about planning and decision making in terms of maintaining
sufficient cash in hand and making wise investments.
4. Managing Cash Flows: Maintaining the proper flow of cash in the organization through cost-cutting and
profit generation from investments is necessary to attain a positive cash flow.
5. Optimizing Cash Level: The organization should continuously function to maintain the required level of
liquidity and cash for business operations.

Techniques of Cash Management

The various techniques or tools used by the managers to practice cash flow management are as follows:
1. Accelerating Collection of Accounts Receivable: One of the best ways to improve cash inflow and increase
liquid cash by collecting the debts and dues from the debtors readily.
2. Stretching of Accounts Payable: In this technique, the company try to extend the payment of dues by
acquiring an extended credit period from the creditors.
3. Cost Cutting: The company must look for the ways of reducing its operating cost to main a good cash flow in
the business and improve profitability.
4. Regular Cash Flow Monitoring: In this method, a firm keeps an eye on the cash inflow and outflow,
prioritizing the expenses and reducing the debts to be recovered, makes the organization’s financial position
sound.
5. Wisely Using Banking Services: The services such as a business line of credit, cash deposits, lockbox
account and sweep account should be used efficiently and intelligently.
6. Upgrading with Technology: Digitalization makes it convenient for the company to use the cash flows
wisely.

SANTOSH SHARMA 39
 Unit-18: Inventory Management

What is Inventory Management?

Inventory management is the process of ordering, storing and using inventory. The main object is to avoid
overstocking and understocking of inventory.
Objectives of Inventory Management
1. To ensure continuous supply of raw materials.
2. To avoid overstocking and understocking of inventory.
3. To maintain minimum working capital.
4. To reduce order costs, holding cost and transport cost.
5. It reduces wastages.
6. It helps to maintain systematic record of inventories.

Cost of holding inventory / Different types of costs associated with inventory

The different types of costs associated with inventory are: material cost, ordering cost, carrying cost and opportunity
costs. These costs are discussed below:

1. Material Cost: These are the costs of purchasing or procuring the goods for the purpose of production or
trading. These costs also include transportation and handling costs.

2. Ordering Cost: The ordering costs refer to the costs associated with the preparation of purchase order.
Manufacturing firms have to purchase raw materials for production. these costs include preparation of
purchase order, transportation of materials ordered, inspection and handling at the warehouse. These are
inversely related to the size of inventory. Lesser the size of the inventory lesser will be the ordering costs.

3. Carrying Cost: These are the expenses related to storage of goods. these costs include insurance, rent,
depreciation of warehouse, salaries of store keeper and security personnel, spoilage, labour and accounting
costs. Carrying costs increase with the size of the inventory.

4. Opportunity cost: It is a part of carrying cost. Whenever a firm commits its resources to inventory it is using
funds that otherwise might be available for other purposes. The firm has lost the use of funds for other profit-
making purposes. This is known as opportunity cost.

Inventory management Techniques

The important techniques and methods of inventory management are:
1. Economic Order Quantity (EOQ)
2. Re-Order level (ROL)
3. ABC Analysis
4. Just-in-time Inventory Control (JIT)

Economic Order Quantity (EOQ)

The economic order quantity is that quantity where the total cost of inventory management is the minimum. The
cost of inventory management includes the carrying cost and the ordering cost. The order quantity should be such
that the firm has economy of order cost and the number of orders will be less during the year. Thus, the trade-off is
between the ordering cost and the carrying cost. The firm generally gets quantity discount if it places an order for
large quantity.
For example, if the annual production of motor bikes is 1,00,000 units, then the tires and tubes required will be
2,00,000. If a company places an order for 50,000 tires and tubes at a time, it has to place four orders during the year.
However, the inventory carrying cost of 50,000 tires and tubes will be very high.
EOQ is calculated by the following formula

SANTOSH SHARMA 40
 2 x Annual Material requirement quantity x Ordering Cost per order 0.5
EOQ = [ ]
Material Cost per unit x Carrying Cost %

Carrying cost = Average order quantity into cost per unit into carrying cost percent per annum = Q/2 × C × i%
Ordering cost = Number of orders placed during the year x Ordering cost per order = A/Q × O

Assumptions of EOQ Model

i) The ordering cost per order and carrying cost per unit per annum are fixed.
ii) The material cost per unit is constant.
iii) The material consumption level during the year is known in advance and is even throughout the year.
iv) No stock out occurs.

Re-Order level (ROL)

The reorder level lies between the minimum stock level and the maximum stock level. The reorder level is that stock
level on reaching the same, the firm places and order for the economic order quantity. It ensures that there is enough
quantity available during the lead time to meet the normal production requirements and minimum stock level. Lead
time is the time taken to replenish the inventory levels. In other words, lead time refers to the how long it will take
the order to arrive. The firm places an order for fixed order quantity or economic order quantity, once the reorder
level is reached.
Reorder level = Minimum Stock Level + (Normal Lead Time × Normal Level of raw material consumption per unit of
time) or
Reorder level = Maximum Lead Time × Maximum Level of raw material consumption per unit of time

Safety Stock Level

Safety stock is the inventory held by the firm during all the times irrespective of the order size. The safety stock is
that stock level where the total cost of inventory management is the minimum. The firm carries safety stock levels
to meet the contingencies of lead time. It is a cushion to avoid stock out situation. It is also called as minimum stock
level. It includes the expected stock out cost besides carrying cost and ordering cost. The maintenance of safety stock
has the benefit of avoiding loss of profits by meeting delivery schedules.
The formula to calculate safety stock level is:
Safety Stock Level = Reorder level (Normal Lead Time × Normal level of material consumption per unit of time)

Maximum stock level

It is the maximum level of inventory maintained by the firm at any point of time. The firms with conservative
approach will maintain the maximum stock level. It is to be ensured that the firm has necessary storage facilities and
funds to maintain this level. The formula to calculate maximum stock level is:
Reorder level + reorder quantity – (Minimum consumption × Minimum Lead Time)

ABC Analysis of inventory control

ABC stands for “Always Best Control”. As the name implies, the management should classify its inventories into three
main categories such as, A, B and C
Category-A: Low volume but high value
Category-B: Moderate volume and moderate value
Category-C: High volume but low value
The management should focus on low volume but high value items as far as application of inventory management
tools. The tools such as reorder level, economic order quantity and safety stock levels are applied to A-Category
items. The firm should order most of its requirement in respect of C-Category items to avail the benefit of quantity
discount.

SANTOSH SHARMA 41
 Category-A Category-B Category-C
Stocks included in category A are These items are less important and These items are not risky
the most important and risky to risky.
handle.
Nearly about 70% of the value of These inventories cover only 20% of Value of inventory is about 10%
consumption is from category-A. the value of consumption.
Nearly 13% of the inventory is Nearly 30% of the inventory is Volume of inventory used is about
consumed from this category. consumed from this category. 57%
Strict control is required on these These items do not require strict They do not require much control.
stocks. control.
The items in category-A are These items are moderately This category contains items of
generally expensive. expensive. least value.

Just-In-Time technique of inventory control.

• According to this technique, goods are ordered only when they are needed.
• The main object is to control stocks of goods.
• It helps to reduce inventory wastage.
• It helps the producer to concentrate more on production rather than handling stocks.
• It helps producers to produce good quality of products.
• Producers are burden free.
• It needs small investments.
• This model is suitable for computer appliances, electronics producing companies.
• Producers must have good relationship with the suppliers so that purchasing can be done in time.
• There is no risk of overproduction.
• A firm can concentrate more on consumers satisfaction.

What is Safety stock?

It is the additional inventory held by a company to avoid the risk of stock out due to fluctuations in demand and
supply. It is also known as emergency stocks or buffer stock.

Role and importance of Safety Stocks

a. It helps to meet uncertain demand of stocks.
b. It helps to carry out smooth production process.
c. It avoids stock outs.

SANTOSH SHARMA 42
 Unit-19: Receivables Management

Meaning of Credit Policy

Credit policy refers to the decisions on the maximum amount of credit that will be allowed to customers. In simple
words, amount of risk a firm is willing to undertake in its sales activities is called its credit policy. A credit policy may
be of two types such as liberal credit policy and rigid credit policy.
In liberal credit policy, a firm allows credit facilities freely without much hesitation. On the other hand, in rigid credit
policy, limited amount of credit is allowed to customers.

Objectives of Credit Policy

1. To increase sales: The most important object of a credit policy is to increase the sales and profits of a
company. some customers are unable to pay immediate cash so they opt for credit.
2. To increase profits: Profits are directly linked to sales. More the sales more will be the profit. A firm can earn
high profits in credit sales.
3. To maintain liquidity: Here, liquidity means converting stocks into cash immediately. There is no chance of
deadstock. A firm can dispose of with old stocks by selling them on credit.
4. To meet competition: A sound credit policy can challenge the competitors of the firm. A firm should have a
lucrative credit policy to beat its competitors.

Variables of Credit Policy

The financial manager must consider the following variables before framing credit policy:
1. Credit Standard
2. Credit Period
3. Cash Discount
4. Collection efforts

i) Credit Standard
This is the most important base to decide credit policy. Credit policy should be designed according to the
standard of customers. It should be well balanced. The factors that affect credit standard are:
a. Creditworthiness of a customer.
b. Capacity to pay.
c. Character of the customer.
d. Capital invested by the customer.
e. Collateral or security offered by the customers.
ii) Credit Period
The time period allowed to customers to pay for their purchases is known as credit. It directly affects
investments. Longer the credit period, longer will be the investments. Long credit periods increase the chances
of bad debts. Some factors should be considered while framing a proper credit period:
1. Buyers stock turnover.
2. Nature of commodity.
3. Profit margin.
4. Availability of funds.
5. Competitors policies.
iii) Cash Discount
The creditor grants cash discount to a debtor if he makes payment in or before credit. It is not a compensation
but a premium on payment of debts. Cash discount is beneficial to both creditor and debtor. It increases the
turnover rate of working capital and the firm can do higher volume of business with less investment in working
capital. Cash discount prevents debtors from using trade credit as a source of working capital.

SANTOSH SHARMA 43
 iv) Collection efforts: The collection policy should be speedy while collecting dues. If the speed is slow, additional
finance will be needed to sustain the production and sales. The objective should be to collect dues and not to
offend the customer. The firm may take efforts like sending a reminder or personal request on phone or
personal visits to customer or through collection agencies. Some of the firms employ muscle men to recover
payments which is absolutely a wrong policy. Court cases of recovery should be avoided as far as possible
because of court delays and expenses in India.

A short note on Factoring

• It is a financial transaction in which a firm sells its accounts receivables or invoices to a 3rd party or factor at
a discount.
• It is done to meet immediate cash requirements of a business enterprise.
• There are 3 parties involved in factoring such as seller, factor and debtor.
• A factor gets the right to collect from the debtors.
• It is also known as invoice discounting.
• Factoring is more popular method used by exporters in international trade.
• Factoring provides quick and convenient funding to growing companies who need capital to expand their
business.
• The factor enters into an agreement with the company for factoring receivables and the terms under which it
is ready to advance funds.
• The firms send the customer purchase order to the factor to do a credit verification and approval.
• The factor confirms the willingness to advance funds based on the credit risk evaluation.
• Based on the confirmation, the customer is informed that the receivables have been sold and that the payment
must be made directly to the factor.
• Factoring allows the firm to create cash flow for the growth and expansion of business.

A short note on Securitization

• It is a process of converting debts or illiquid assets into securities which are traded to raise money.
• Securitization is a process by which the future cash inflows of an entity are converted and sold as debt
instrument through certificates carrying a fixed rate of return to the holders.
• The originator of a typical securitization transfers a portfolio of potential assets to a special purpose vehicle
(SPV) commonly a trust.
• The SPV is basically funded by investors.
• In return for the transfer, the originator gets cash up front on the basis of the mutually agreed valuation of the
receivables.
• The transfer value of the receivables is done in such a manner so as to give the lenders a reasonable rate of
return.
• It helps to raise funds easily for working capital and in liquidity of assets.
• It also assures good return to investors.
• The cash inflow from financial assets such as mortgage loans, trade receivables, credit card receivables, etc.
become the security against which borrowings are raised.
• Since the lender is assured of regular cash inflows there is an advanced element of credit
• This process involves 3 parties such as originator, special purpose vehicle (SPV) and investors.

Merits of Securitization
a. It helps to raise funds easily to meet the working capital requirements.
b. The assets can be liquidated into cash immediately
c. Investors can earn good amount of profit from securitization.
d. It increases the total financial resources available to the firm without disturbing the traditional lines of credit.

Demerits of Securitization

SANTOSH SHARMA 44
 a. The true picture of the originators financial position is not clear merely from the balance sheet.
b. The best assets of the company may be transferred to the SPV and the company may be left with substandard
assets on its books.
c. A company may have taken huge liabilities but that may not be apparent from the balance sheet of the
company.
d. If the receivables become bad the SPV will have the right to recover the dues from the originator.

Process of Securitization
1. The originated determines which assets he wants to securitize for raising funds.
2. Then the SPV is formed.
3. The SPV is funded by investors and issues securities to the investors.
4. The SPV acquires the receivables under agreement at their discounted value.
5. The servicer for the transaction is appointed, who is normally the originator.
6. The servicer collects the receivables usually and pays off the collection to the SPV.
7. The SPV either passes the collection to the investors or reinvest the same to pay off the investors.
8. In case of default the servicer takes action against the debtors as the SPV agent.
9. At the end of the transaction the originators profit or laws is paid to the originator

A short note on Special Purpose Vehicle (SPV)

An SPV is an entity specially created for doing the securitization deal. It invites investment from investors, uses the
invested funds to acquire the receivables of the originator and then uses the realizations to pay the investors thereby
giving them a reasonable rate of return. The SPV may be a trust, corporation or any other legal entity.
The Important functions of SPV are:
1. Holding title to transfer financial assets.
2. Issuing beneficial interest in the form of debt securities or equity securities.
3. Collecting cash proceeds from assets held and reinvesting proceeds.
4. Distributing proceeds to the holders of the beneficial interests.

SANTOSH SHARMA 45
 Few important Numericals

1. A company issued 10% debentures of Rs.10000. The company is in 50% tax bracket. Find the cost of
debt capital i) at par, ii) 10% discount and iii) 10% premium.
Solution:
I (1−T)
Cost of Debt Capital (Kd) = , Kd = Cost of capital, I = Interest, np = Net proceeds, t = tax
np
I = 10% of 10,000 = 1,000
np = 10,000
T = 50% = 0.5
1000 (1−0.5)
i) Kd (at par) = 𝑥 100% = 5%
10000

1000 (1−0.5)
ii) Kd (at discount) = 𝑥 100% = 5.56%
9000

1000 (1−0.5)
iii) Kd (at premium) = 𝑥 100% = 4.54%
11000

2. A company issued Rs.100 face value Preference shares with 12% dividend repayable after 10 years.
The net amount realised is Rs.92. Find the cost of preference capital.
Solution:
(F−P)
D+
Formula to find Cost of preference share: Kp = P+F
n

2
Kp = Cost of preference capital
D = Dividend = 12
P = Redemption price = 92
n = no. of years = 10
F = Face Value = 100
(𝟏𝟎𝟎−𝟗𝟐)
𝟏𝟐+ 12+0.8
Kp = 𝟏𝟎
𝟗𝟐+𝟏𝟎𝟎 = = 0.133 x 100% = 13.3%
96
𝟐

3. Sales=7,50,000, Variable cost= 4,20,000, Fixed cost= 60,000, Debt= 4,50,000, Interest on debt= 9%,
Equity capital= 5,50,000, Find:
i) Operating Leverage
ii) Financial Leverage
iii) Total Leverage
iv) Rate of Return on investment
Solution:
Contribution = Sales – V.C = 7,50,000 – 4,20,000 = 3,30,000

EBIT (Earnings before interest & tax) = Contribution – F.C = 3,30,000 – 60,000 = 2,70,000

EBT (Earning before tax) = EBIT – Interest = 2,70,000 – 9% of 4,50,000 = 2,29,500

Contribution 3,30,000
i) Operating Leverage = = 2,70,000 = 1.22
EBIT

EBIT 2,70,000
ii) Financial Leverage = == = 1.17
EBT 2,29,500

iii) Total Leverage = O.L X F.L = 1.22 X 1.17 = 1.43

SANTOSH SHARMA 46
 EBIT 2,70,000
iv) Rate of Return = = 5,50,000+4,50,000 = 0.27 x 100% = 27%
Total share capital+Debt capital

4. Given that Discount rate is 10%, Present value of Rs.1 for 1st & 2nd year is 0.893 & 0.797, Find the NPV
for each project. Which project is to be selected and why?

Cash flows Project-A Project-B Project-C

𝐂𝟎 -25,000 -25,000 -25,000
𝐂𝟏 0 15,400 28,700
𝐂𝟐 33,050 15,400 0

Solution:
NPV of Project-A = (-25,000) + (0 X 0.893) + (33,050 X 0.797) = Rs.1,340.85

NPV of Project-B = (-25,000) + (0.893 x 15,400) + (0.797 x 15,400) = Rs. 1,026

NPV of Project-C = (-25,000) + (0.893 x 28,750) + (0.797 x 0) = Rs. 673.75

NPV of project-A is more profitable as its NPV is highest.

5. A company needs Rs. 5,00,000 for a new plant. The company issues 50,000 equity shares @ Rs.10. If
the company’s earnings before interest and tax are Rs.10,000, Rs.20,000, Rs.40,000, Rs.60,000 and
Rs.1,00,000 for 5 years. What is the earning per share? (Assuming that corporate tax is 50%)

Items 1st year 2nd year 3rd year 4th year 5th year
EBIT 10,000 20,000 40,000 60,000 1,00,000
Tax (50%) (5,000) (10,000) (20,000) (30,000) (50,000)
Total earning 5,000 10,000 20,000 30,000 50,000
No. of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.1 0.2 0.4 0.6 1.0

SANTOSH SHARMA 47