FINANCIAL MANAGEMENT

SOMB2001
Dr. Shallu Sehgal
Associate Professor
 FINANCIAL MANGEMENT

EDITORIAL BOARD

Dr. Pankaj Vaidya Dr. Pooja Verma

Head of School and Professor PhD & UGC-NET (Management)

Yogananda School of AI, Computer, Associate Professor

and Data Sciences
Faculty of Management Sciences

Dr. Purnima Bali Mr. Vipin Pubby

Associate Professor Director and Professor

Chitrakoot School of Liberal Arts Director of School of Journalism and New

media

Shoolini University Centre for Distance and Online Education

Shoolini University
Solan (HP)
Copyright © 2022 Shoolini University Center of Online and Distance Education (SCODE)

All rights reserved. This book or any portion thereof may not be reproduced or used in
any manner whatsoever without the express written permission of the publisher except
for the use of brief quotations in a book review.

Printed by Shoolini University Center of Online and Distance Education (SCODE)

First printing, 2022.

Shoolini University

Bajhol, Solan, Himachal Pradesh

173229.
 Contents

UNIT 1: INTRODUCTION TO FINANCIAL MANAGEMENT __________________ 1

UNIT 2: FINANCIAL PLANNING _____________________________________ 19

UNIT 3: TIME VALUE OF MONEY____________________________________ 33

UNIT 4: RISK AND RETURN ________________________________________ 50

UNIT 5: CAPITAL BUDGETING - I ____________________________________ 60

UNIT 6: CAPITAL BUDGETING EVALUATION TECHNIQUES _______________ 70

UNIT 7: CAPITAL BUDGETING – MODERN TECHNIQUES _________________ 78

UNIT 8: COST OF CAPITAL _________________________________________ 89

UNIT 9: CAPITALISATION _________________________________________ 103

UNIT 10: SOURCES OF SHORT-TERM FINANCE________________________ 109

UNIT 11: SOURCES OF LONG-TERM FINANCE_________________________ 118

UNIT 12: LEVERAGE ANALYSIS ____________________________________ 130

UNIT 13: CAPITAL STRUCTURE DECISION ____________________________ 138

UNIT 14: WORKING CAPITAL MANAGEMENT ________________________ 155

1 SHOOLINI UNIVERSITY

UNIT-1: INTRODUCTION TO FINANCIAL

MANANGEMENT

CONTENT:
▪ Objectives
1.0 Introduction
1.1 Scope of Finance
1.2 Evolution of Financial Management
1.3 Interface of Financial Management with other Functional Areas
1.4 Approaches to the Financial Management
1.5 Financial Decisions in a Firm
1.6 Objectives/Goals of Financial Management
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:
• Describe the scope of finance and its interaction with other functional areas.
• Highlight the different approaches to finance function.
• Describe on the shareholders' wealth maximisation.
• Finance decision criterion.
2 FINANCIAL MANAGEMENT

1.0 INTRODUCTION
The topic of financial management is very important to both academics and people who work in
the field. Academics are very interested in it because the subject is still changing and there are still
many areas where people disagree, and no clear answers have been found yet. Practitioners are
interested in this topic because financial decisions are some of the most important ones a business
can make, and understanding financial management gives them the theoretical and logical
background they need to make these decisions.

1.1 SCOPE OF FINANCE

Production, obtaining capital, and selling products or services are the three most important aspects
of every organisation. Finance activity refers to the process by which a company acquires the
necessary capital and then invests that capital in endeavors that produce a return on the capital
invested (known as production and marketing activities).

To maintain its commercial operations, a business has to have assets in its possession. These assets
may take the form of either tangible or intangible possessions. Examples of tangible assets include
things like plant and machinery, an office, a factory, furniture, and fixture, as well as land and
buildings. Intangible assets, on the other hand, include things like technological collaborations,
technical know-how, and patents. In order to procure financial resources from the capital market,
the company solicits buyers of its financial securities, which may take the form of shares, bonds,
or debentures.

Borrowing money from commercial banks and other kind of financial institutions are financial
assets. Investment or capital expenditure refers to the process by which a company uses funds to
acquire or improve its assets. The company projects that it will earn returns on investment and then
give a portion of those returns to investors through dividends.

These terms "raising capital money," "using those funds to generate returns," and "paying returns
to the suppliers of funds" are all examples of what are referred to as "financial functions" of a
company. A corporation can raise not one but two distinct kinds of cash: stock funds and borrowed
funds. In addition to this, a company can accumulate funds by setting aside a portion of its income
3 SHOOLINI UNIVERSITY

for future use. Because retained earnings represent returns on equity capital that have not been
released, they should be considered a legitimate component of equity capital. The practise of
keeping a portion of a company's profits for operational expenses can be viewed as a kind of fresh
capital formation. If a corporation gives all its profits to its shareholders, it is then permitted to
request further funding from the same investors by means of the issuance of new shares.

The funds that are raised by a company will be invested in the various investment possibilities that
are accessible to the firm. Each investment opportunity that is offered to a company is referred to
as an investment project or just a project. A project necessitates the expenditure of money in the
here and now to realise advantages in the foreseeable future.

There is a possibility that the company is currently working on some projects. It's possible that
(ongoing initiatives) will require cash outlays to keep their profitabilities the same or perhaps grow
them. The realisation that the generation of revenue, which is a production activity, is only possible
when money is invested in projects would come to be known.

1.2 EVOLUTION OF FINANCIAL MANAGEMENT

In this century, the study of Financial management emerged for the first time as its own distinct
academic area. There are three distinct phases that may be distinguished in the development of
financial management:

1. The traditional phase

2. The transitional phase

3. The modern phase.

Approximately forty years comprise the conventional phase of development. The following is a
list of notable qualities that were present throughout the traditional phase:

• The approach to financial management was primarily vivid and institutional.

• The primary focus of financial management was on definite sporadic events that occurred during
the life period of the company.
4 FINANCIAL MANAGEMENT

These events include the formation of the company, the issuance of share capital, major expansion,
merger, reorganization, and liquidation.

The financial management system's core was formed by the capital market's financial instruments,
financial institutions, and diverse trading methods. Starting of 1940s of this century, the
transitional period of Financial Management continued up to 1950s. This phase lasted roughly a
decade. The nature of financial management remained the same throughout this phase as it had
been throughout the previous phase, which was known as the traditional phase of financial
management.

During the 1950s, the Modern Phase of financial management began to grow rapidly, with the
incorporation of ideas from economic theory and the application of quantitative methods.

The most important choices that need to be taken throughout the contemporary period are as
follows:

(a) Investment Decisions

(b) Financial Decisions

(c) Dividend Decisions.

1.3 INTERFACE OF FINANCIAL MANAGEMENT WITH OTHER FUNCTIONAL AREA

Most essential facets of financial management are sound financial planning. The study of closely
related areas and disciplines such as Economics, Accounting, Marketing, Quantitative Models,
Production and Human Resource Management are among those that are drawn to the field of
financial management.

There are significant differences between each of these fields; however, they are interrelated. The
acquisition of funds and their subsequent use are essential components of virtually every kind of
commercial enterprise, whether directly or indirectly. For instance, it is the responsibility of the
Human Resource department to hire new people to work in the marketing department; and then
the finance department is responsible for paying salaries and providing other financial benefits. In
a similar vein, the transfer of funds is required to purchase of a brand-new machinery or to replace
an older machinery. The movement of money is involved in marketing activities like sales
5 SHOOLINI UNIVERSITY

promotion activities, which fall under the umbrella of marketing. Therefore, where is the line
drawn between the functions of production, marketing and finance. It is imperative that the finance
department has enough money to pay the costs of manufacturing and marketing activities. Where
does the function of production end, where does the function of marketing begin, and where does
the function of finance begin? These questions do not have straight forward responses available.
A company's whole operations can be affected by the finance function, but this doesn't mean that
other functions can't run at full capacity. This is even though the finance function raises and uses
money. if the company is in a precarious financial position, it will give financial considerations a
greater amount of importance and will formulate its marketing, production, and human resource
plans with the financial resources at its disposal as a primary consideration. However, if the
commercial enterprise has a typical supply of finances, it will be flexible in the formulation of its
many policies, regardless of whether those policies relate to the manufacturing of goods, the
management of human resources, or the promotion of those goods. Actually, a company
organization's decisions on production, human resources, and marketing can be tailored to fit
within the parameters of its financial policies.

1.3.1 RELATIONSHIP TO ECONOMICS

There are important connections to be made between economics and finance. The macroeconomic
context that a company operates within is referred to as the setting, while the microeconomics that
is studied provides a theoretical perspective on the different financial management instruments.

The major macroeconomic factors include the following:

● The growth rate of the economy,

● The GDP,

● The domestic savings rate,

● The involvement of the government in economic affairs,

● The tax structure,

● The extent of external economic relations,

6 FINANCIAL MANAGEMENT

● The availability of funds to the industry,

● The rate of inflation,

● The real rate of interest, and

● The terms under which the firm can raise funds.

Because all these factors have a direct influence on the company's operations, it is impossible for
a financial controller or management to have sufficient funds to ignore the developments in these
macroeconomic aspects.

In the same way that familiarity with macroeconomic issues makes every financial manager more
attuned to the opportunities and dangers present in their surrounds, familiarity with the
microeconomic environment helps a company become more adept at analyzing the impact of its
various choices.

The core of finance can be understood as the application of microeconomics.

1.3.2 RELATIONSHIP TO ACCOUNTING

The accounting and finance functions are intimately connected. There is a myth that accounting,
and finance are identical or at least considerably overlap with each other. But what are the
similarities and differences between the two will be clearer from the following:

1. Keeping Score vs. Maximizing Value- Accounting is Worried About Keeping Score While
finance is meant to maximize value. Accounting's primary purpose is to evaluate the performance
of a company or other type of business organisation by determining its level of financial health
and determining its tax liability.

Financial management, on the other hand, aims to maximise shareholder wealth by replicating
initiatives with a positive Net Present Value while also minimising the cost of capital. This is
accomplished by replicating projects. Therefore, one could say that accounting is the source of the
input that goes into financial management.
7 SHOOLINI UNIVERSITY

2. The Accrual Method vs. the Cash Flow Method- The accrual method of accounting is the one
that is used to prepare the books of accounts. The accrual method of accounting recognises
revenues when the sales have occurred or been made regardless of the fact of timing of realisation
of the cash (immediately or later) and matches expenses to sales regardless of the fact of timing of
payment of cash.

3. The difference between certainty and ambiguity- Accounting is concerned with the past and
records the transactions that have already taken place. As a result, one might make the argument
that accounting is more objective and certain. The art of decision-making in the face of uncertain
conditions and limited knowledge is central to the study of finance.

As a result, the mischaracterization brought on by a greater quantity of prejudice sharpens its study
of various decisions.

1.4 APPROACHES TO FINANCIAL MANAGEMENT

There are two ways to handle the Finance functions-

● The traditional way

● The modern way.

The old way of doing things or the traditional way of looking at how finance works is to compare
it to the early days of financial management. This word, "finance," used to mean what we now call
"Financial Management."

This more traditional way of handling money lasted for about 40 years (upto 1950). In the past,
financial management was mostly about how business organisations got their money. In simple
terms, the traditional approach to the finance function used a narrow definition that included
business organisations getting funds to meet their own financing needs.

So, the field of study called "financial management" was about getting money from outside sources
and managing it. The emphasis of Financial Management was on certain events that happened on
a regular basis, such as the sale of stock, the growth of a business, mergers, modernization,
reorganisation, and the closing down of a business.
8 FINANCIAL MANAGEMENT

This approach was mostly about explaining things and setting up systems. The most important
parts of financial management were the financial institutions, the tools for getting money. The
outsider's point of view was the most important. In the traditional approach, financial management
was looked at from the points of view of lenders, investment bankers, and other groups. The
traditional way is criticised today because of the following: The first thing that goes against the
traditional approach is how business organisations get money.

Because the finance function was linked to questions about getting and spending money, the theme
was built around the outsiders' points of view, and the internal decision-making process was
completely ignored.

The traditional way of doing things was also criticised because it only looked at the financial
problems of business organisations and not those of non-business organisations. The next thing
that people didn't like about the traditional approach was that it treated things like promotion,
incorporation, consolidation, merger, and reorganisation as one-time events. Financial
management was limited to these rare events in the life of a business. Day-to-day financial
problems were not given much thought.

Last but not least, the company was slammed for spending too much time focusing on financing.
It gave the impression that concerns about how to manage working capital were not in the scope.
These problems with the traditional way of managing money were more fundamental.

The biggest problem with the traditional approach was that it only focused on getting money from
outside sources and didn't think about how the money would be spent. If this part wasn't covered,
the traditional approach to financial management was very limited. This weakness can be fixed by
using a modern approach to managing money.

1.4.1 MODERN APPROACH

Since the mid-1950s, the traditional approach, which was based on theory, hasn't been useful in
the fast-changing business world. During and after the middle of the 1950s, several economic and
non-economic factors, such as the growing speed of industrialization, the invention of new
technologies, the growing involvement of the government, fierce competition, population growth,
and wider markets, made it necessary for the firm to use its resources in the best way possible.
9 SHOOLINI UNIVERSITY

Luckily, the development of several management skills and ways to make decisions led to the
creation of a system that helps a company use its resources in the best way possible. Conceptual
and analytical theories are built into the new method.

This new way of looking at a business's money problems is a logical way to look at the situation.
Financial management is seen as a basic and essential part of management. Making excellent use
of money in this larger context is the most essential component of financial policy and the most
important part of making good use of money is balancing returns from conceivable uses with the
expenses of other available sources so that a corporation can achieve its major financial goals. So,
the main job of finance in a modern business is to decide what to spend money on and how much
money to ask for to pay for it. In other words, the person in charge of money is worried about how
well these funds will be used. The problem of how to spend money is not new, though. It used to

be there, but it wasn't thought to be important to the company's long-term goals.

The financial manager's new job is to make good use of money, so he or she needs to find a good
excuse to respond to the following questions:

1. How big should a business be and how fast should it grow?

2. How should it use things it has?

3. What must the liabilities be made up of?

The questions above are about three big areas of financial management decisions: making
investments, getting money, and deciding whether to pay out dividends. The person in charge of
money must make these decisions in a mostly logical way. All these decisions should be made so
that the firm's money is used in the best way possible.

All these financial decisions have a huge effect on everything else the business does.

A financial manager's main job is to raise money, but he or she also needs to set the direction of
growth, figure out how profitable and risky the business is, and choose the best mix of assets and
financing. This new way of managing money can be expanded to include planning for making
money. The term "profit-planning" refers to business decisions about how much to make, how
10 FINANCIAL MANAGEMENT

much to charge, and which products to sell. Planning for profits is a must for making the best
financing and investment decisions.

1.5 FINANCIAL DECISIONS IN A FIRM

1. Investment decisions-long term asset mix Decision

2. Financing Decisions/Capital Mix Decisions

3. Dividend Decision /Profit allocation Decision

4. Liquidity decision-short term asset mix Decisions

For finance functions to work, business activities need to be planned, controlled, and carried out.
We know that a financial management decision that raises the value of shareholders' wealth is
good for them. As a result, the financial manager should strive to raise the value of the company's
stock as much as possible while completing these financial obligations.

Here is a short summary of the financial decisions:

1.5.1 INVESTMENT DECISIONS-LONG TERM ASSET MIX DECISION

The first important decision that a business must make is what kind of business it wants to be in.
The decision about investments has a big effect on how the organisation spends its money. Once
the manager of a business organisation chooses the business they want to start or grow, they must
plan to invest in buildings, equipment, research and development, machines, showrooms,
information infrastructure, brands, distribution networks, and other assets. This is called budgeting
for capital.

1.5.2 FINANCING DECISIONS/CAPITAL MIX DECISIONS

The financial manager also must decide about how to pay for things. When a company has decided
on a set of investment projects, it needs to find ways to pay for them.

When making decisions about capital structure, the most important questions to answer are: What
is the best debt-to-equity ratio? Which specific financial tools should the company use, and which
11 SHOOLINI UNIVERSITY

capital markets should it go to? When should the company raise money, and at what price should
its securities be sold to the public?

The goal of financing decisions should be to keep costs as low as possible.

1.5.3 DIVIDEND DECISION /PROFIT ALLOCATION DECISION

The decision about a dividend is another important financial choice. All earnings should be
distributed to shareholders, but the company's financial managers must decide how much should
be distributed. They can either distribute all profits equally or keep a portion for themselves while
giving the remainder to shareholders. When it comes to dividends, the optimal strategy is one that
increases the value of the stock. In order for a company's shareholders to care about its dividend
policy, the financial manager must choose the appropriate dividend-payment ratio.

The financial manager should also think about how cash dividends work in practise, how stable
dividends are, and how bonus shares are given out. Most of the time, companies that make money
give cash dividends to their shareholders on a regular basis. In addition to the cash dividend, some
companies also give their existing shareholders bonus shares at regular intervals.

Figure 1.1
12 FINANCIAL MANAGEMENT

1.6 OBJECTIVES / GOALS OF FINANCIAL MANAGEMENT

For the company to make smart financial decisions, it needs to have a goal. In theory, most people
agree that the financial goals of a company should be to maximise the economic well-being of its
owner There are two different approaches that have been talked about a lot that can be used to
decide how to make the most money for the owners:

1. Profit Maximisation

2. Wealth Maximisation

In the present section, we will discuss about these approaches. The profit maximization approach
says that you should do things that make you more money and avoid things that make you less
money.

With this approach, a company's decisions about investments, financing, and dividends should all
be made with the goal of making as much money as possible. Profit maximisation means getting
as much money as possible from firms, whether in rupees, dollars, pounds, or euros.

Product and services that are in high-level demand can charge higher prices, which gives the
companies more money. Others want to make these goods and services because they can make
more money from them.

As competition gets tougher, there will eventually be a price where demand and supply are equal.
If people don't need these goods and services, their prices will go down, and in the end, so will
their profits.

But when it comes to the price system, people often ask if the price system in a free-market
economy would be in the best interests of society. Adam Smith has already answered this question.
He said, "The businessman, by guiding industry in a way that makes its products more valuable,
can make more money." wants only to help himself, but in this case, as in many others, he is led
by an invisible hand to help a goal that was not part of his plan.

"In pursuing his own interests, he often promotes the interests of society more effectively than he
intends to." Profit maximisation is used to judge how a company runs its business.
13 SHOOLINI UNIVERSITY

1.6.1 PROFIT MAXIMISATION HAS SOME CRITICS

Pople have said a lot of bad things about the profit maximisation criterion. First, it is said that
maximising profits requires perfect competition, and since markets aren't always perfect, this can't
be a firm's goal. At the beginning of the 19th century, when business organisations were based on
private property, self-financing, and single entrepreneurship, making as much money as possible
became the goal of financial management.

The modern business has limited liability, and there is a split between the owners and the people
who run the business. Today, shareholders and lenders provide the money for business
organisations, but they are run and managed by professionals. There is also the idea that people
who try to make the more money in a market, companies may tend to make goods and services
that society doesn't really need.

Because of this, government tends to get involved in business. Because of flaws in the real world,
the price system and, by extension, the idea of making the most money may not work. Because of
the problems listed above, profit maximisation doesn't work to make sure that the owners' finances
are as good as they can be.

The limitations with the profit maximisation criterion are its vagueness, the timing of its benefits,

the quality of its benefits.

1.6.1.1 VAGUENESS

The term "profit" is the first operational problem with the profit maximisation approach. This
word, "profit," is vague and hard to understand because it doesn't mean anything clear.

Different people have different ideas about what it means. To some people Profit may be total
profit or rate of profit; it may be profit before-tax or profit after-tax; and so on.

If profit Maximisation is taken to be the objective, then which of these variants of profit should a
business Organisation try to maximise?

Clearly, a free expression of profit cannot form the basis of effective decisive factor for financial
management.
14 FINANCIAL MANAGEMENT

1.6.1.2 TIMINGS OF BENEFITS

Profit Maximisation criteria also ignores the timing of investment benefits.

Let us have a look at Table 1.1

From the table, Total earnings are the same for both X and Y. Based on profit maximisation
criterion, both options are evaluated equally high. There are, however, significant differences in
the financial benefits of each of these options. Alternative X offers better returns in the early years
than in the later years, whereas alternative Y's returns are greater in the latter years than in the
early years.

Alternative X So, these two options aren't the same. That saying "money obtained today is worth
more than money received tomorrow" contributes to this. The "time value of money" refers to this.
The profit maximisation strategy considers all returns to be identical regardless of their timing and
does not differentiate between returns received at various times. Benefits gained at a young age
are more valuable than those received later in life, although this is not always the case in practice
received in later yea₹

Profit maximization's third major technical shortcoming is its failure to consider the quality of the
advantages that go along with the returns. "Quality" refers to the degree of certainty with which
benefits can be anticipated.

It is believed that the quality of the advantages is higher when the expected return is more assured.
15 SHOOLINI UNIVERSITY

On the other hand, returns that fluctuate and are unclear, are risky. After-Tax Profitability: One
can readily show that maximising profit after taxes does not maximise the economic well-being of
the business's owner(s) profits after taxes can be increased by trading additional shares and
investing the money in low-income assets. A company's profit after taxes would rise, but its
earnings per share would fall. If a corporation has 500 shares and a post-tax profit of ₹ 10,000,
then each share is worth ₹ 5,000. In other words, it has a yearly profit per share of Rs 20. Adding
500 new shares at ₹ 100 per share and investing the funds at a 5% after-tax rate results in a profit
of ₹ 12500. As a result, each share will be worth ₹ 12.5 in earnings.

A company's financial goal of maximising earnings per share cannot guarantee the economic well-
being of its shareholders (EPS). Furthermore, it neglects the timing and danger of the projected
advantages, which are already identified as drawbacks. Aside from that, aiming for the maximum
potential EPS has disadvantages. Maximizing the company's EPS does not inevitably lead to the
company's greatest possible share price if market value is not linked to EPS. It is imperative that
companies hold off on paying dividends until they can reinvest the money at a profit within the
company in order to maximise earnings per share (EPS).

1.6.2 MAXIMIZATION OF WEALTH FOR SHAREHOLDERS

The term "value maximisation" or "Net Present Worth Maximisation" is also used to describe the
goal of increasing shareholder wealth. According to academic research, the best operational
decision criteria for financial management decisions are those that maximise value. Its operational
qualities meet all three operational. Distinguished financial economists and practitioners have
argued in favour of this goal. Here are a few examples to support their claims: Businesses have
only one social obligation in a market economy that recognises the rights of private property: to
produce value and do so lawfully and ethically. Increases in the market worth of a corporation
should worry everyone, not just the shareholder Stock price increases reflect a company's
improved competitiveness, which is important to everyone with an interest in the business or
economy. Is it better for a company to prioritise the interests of its workers, customers, or
creditors? These are all fictitious inquiries. What should a company do in order to maximise its
impact on society? Maximizing a company's worth is the best way to make a positive impact on
16 FINANCIAL MANAGEMENT

society. It's a mistake to think that shareholder wealth maximisation is morally or ethically wrong,
because shareholders are not only the beneficiaries of a company's financial success, but they are
also the referees who determine the power of management. Shareholders' Wealth Maximization
(SWM): What does it imply? Maximizing the value of shareholders' wealth is referred to as
"Shareholders' Wealth Maximization". A company's net present value (NPV) is the difference
between its inflows and outflows. Here is a clear definition of NPV in terms of the following:

Where:

A1, A2:the benefits expected to occur

Co” the cost of the action

K: the appropriate discount rate to measure quality of A’s

K reflects both timings and risk of benefits

W: Net Present Value

Only when W is positive, i.e. when the firm's wealth increases, may a company take action. The
wealth maximisation principle can be expressed in a very basic way using this model. In the case
of long-term capital investments, the model can predict that k will shift. Positive NPV activities
are beneficial to shareholders, while negative NPV actions are detrimental to shareholders and
should be avoided. The action with the highest net present value (NPV) should be chosen in a
situation where there are no other options. When making financial decisions, this approach can
help you maximise your wealth. The goal of shareholder wealth maximisation considers the timing
of the anticipated benefits and the accompanying risks. An adequate discount rate for the
anticipated flow of benefits can address these concerns.

Cash flow is the standard unit of accounting for benefits. In investment and finance decisions, cash
flow is more essential than accounting profits.
17 SHOOLINI UNIVERSITY

In time, increasing the long-term utility of shareholders' consumption is equivalent to increasing

their economic well-being. Customers can modify their cash flow to maximise their spending when
owners' wealth is maximised. The rise in the share price of the comapny represents to shareholders
the wealth created by the company's operations. That's why the wealth maximisation principle
asserts that the main goal of a firm’s equity is to maximise its market value. The market price of a
firm's stock represents the worth of its shares.So, the market value of a company's stock serves as
an indicator of the company's performance.

SUMMARY

At the turn of the 20th century, financial management, also known as corporate finance or
managerial finance, emerged as a distinct subject of study. Macroeconomics, financial accounting,
marketing, and production are all aspects of financial management that are intertwined.
Investment, including the management of working capital, financing, and dividend policy all fall
under the current. It is the responsibility of every financial management to make these judgments
in light of the goals of the company. Instead of focusing just on increasing profits, which ignores
the timing of benefits and the nature (uncertainty) of those benefits, financial managers should aim
to increase wealth, as measured by share market prices.

REVIEW QUESTIONS

1. Define the Scope of Financial Management. What role should the Financial Manger play in a
modern enterprise

2. "The profit maximisation is not an operationally feasible criterion". Do you agree? Illustrate
your views.

3. What are the basic Financial Decisions? How do they involve risk free trade- off.

4. What is the rebuttal provided by the advocates of maximising shareholder wealth?159

18 FINANCIAL MANAGEMENT

FURTHER READINGS

Books

Solomon, Ezra and Pringle John J.: An Introduction to Financial Management, Prentice-Hall of
India.

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra : Financial Management, Tata McGraw Hill

I.M. Pandey : Financial Management, Vikas Publishing House

19 SHOOLINI UNIVERSITY

UNIT-2: FINANCIAL PLANNING

CONTENT:
▪ Objectives
2.1 Introduction
2.2 Financial Plan
2.3 Steps in Financial Planning
2.4 Understanding long-term and short-term Financial Requirements
2.5 Fixed Capital: meaning and definition of Fixed Capital
2.6 Assessment of Fixed Capital Requirement
2.7 Limitations of Financial Planning
Review Questions
Further Reading

OBJECTIVES

After Completing this Unit, You Should be able to understand:

● Meaning of financial planning

● Importance of fixed capital

● Objectives Of Financial Plan

● Fixed capital: meaning and definition of fixed capital

● Estimation of intangible assets requirements

20 FINANCIAL MANAGEMENT

2.1 INTRODUCTION

The management of one's company's financial resources is an essential function. Planning as it

relates to the management of one's finances is known as financial planning. This function's primary
focus is on securing funds in the most cost-effective manner possible and maximizing their return
on investment. It entails the decision-making process of objectives, policies, and processes in
connection with the financial function. When it comes to the acquisition, management, and
distribution of cash, the financial policy and procedures serve as the overarching guides. Planning
finances is one of the most crucial responsibilities of Financial Management. This function needs
to be carried out regardless of the size of the company in question. In a similar vein, both an
established company and a startup are required to consider the planning of this activity. Not only
will a well-prepared financial plan enable the acquisition of sufficient finances, but it will also
ensure that those monies are used properly. This duty is under the purview of the company's
promoter when the business is just getting off the ground, but it is eventually handed off to the
financial manager.

The formulation of a financial plan ought to consider both the current situation and those that are
still to come.

First, an estimation of the requirements for acquiring fixed assets and the needs for Working
Capital should be performed. It is important to keep in mind that there will likely be a requirement
for additional funding in the not-too-distant future to finance business growth and diversification.
Another essential component of financial planning is making a choice regarding the kinds of
securities that will be distributed to investo₹ It is important to make an informed decision on the
quantity of capital that is to be issued, the kind of loans that are to be raised, and the cost of
obtaining cash from a variety of sources.

Cohen and Robbins Define financial planning should:

1. Figure out how much money is needed to carry out the company's operating plan.

2. Predict how much of this money will come from the company itself and how much will come
from outside sources.
21 SHOOLINI UNIVERSITY

3. Come up with the best plans for getting the outside money you need.

4. Set up and keep up a system of financial control that will control how money is distributed and
used.

5. Make plans to get the best profit, volume, and cost relationships

6. Look at the business’s financial reults.

7. Give the top management facts and your ideas about how the company should run in the future.

2.2 FINANCIAL PLAN

A financial plan estimates how much money will be available and describes how it will be used.
How much money is needed will depend on how many assets the business needs? Care should be
taken to figure out when the money will be needed so that money can be raised at the right time.
The next part of a financial plan is to figure out how the money will be paid for. There are different
ways to raise money. Care should be taken when choosing between different securities. The money
can be raised in several ways, such as by selling stock and bonds, getting loans, etc.

It is critical to know how much money is needed and where it should come from. Changing a
finance pattern is extremely difficult after it has been established. A financial strategy also includes
policies for the introduction of various company securities, including when they should be
launched.

2.2.1 OBJECTIVES OF FINANCIAL PLAN

Main goals of a financial plan:

1. Adequate Funds- A financial plan would make sure that the business has enough money to reach
its goals.

2. Keeping costs and risks in check- Costs and risks should be balanced so that investors are
protected.

3. Being flexible. A financial plan should be flexible so that it can be changed as needed. It should
be able to be changed to fit the changing circumstances.
22 FINANCIAL MANAGEMENT

4. Ease of use. Putting out different securities should not make the financial structure more
complicated. There should be less security so that it is easy to understand.

5. Looking ahead. A financial plan should look at the big picture. When choosing a pattern of
financing, you should think about how much money you will need right away and how much you
will need over a longer time.

6. Liquidity. When making a financial plan, you should always think about how quickly money
can be used. During times of depression, a business can stay in business because it has enough
cash on hand.

7. Optimum use. A financial plan should make sure that there are enough funds to cover real needs.
Plans shouldn't be hurt by a lack of money, and those funds shouldn't be thrown away either. The
money should be used in the best way possible.

8. Economy. The cost of getting the money should be as low as possible. It shouldn't put an unfair
amount of stress on the company. It can be made sure of with the right mix of debt and equity.

2.2.2 CHARACTERISTICS/PRINCIPLES OF A SOUND FINANCIAL PLAN

Financial management should examine the following things while finalizing a financial strategy:

1. Simplicity- A financial plan should be so simple that even a person who doesn't know much
about money can understand it. A complicated way of handling money leads to problems and
confusion.

2. Based on Clear-cut Objectives. When a company plans its finances, it should keep the
company's overall goals in mind. For the sake of profit, it should aim to achieve the lowest feasible
price.

3. Having less reliance on external resources- The goal of a long-term financial strategy is to
reduce your reliance on outside sources of income. It's possible to do this by reinvesting some of
the company's earnings. Making your own money is the only way to carry out financial
transactions. There are times when outside funding is required, but you should organise your
finances such that you don't need it as much in the long run.
23 SHOOLINI UNIVERSITY

4. Flexibility. The plan for money shouldn't be set in stone. It should leave room for changes when
new circumstances come up. There may be a chance to get more money if new opportunities come
up. Also, funds that aren't being used could be put into short-term securities with low risk. Plans
that are flexible will help people deal with the needs of the future.

5. Solvency and Liquidity: Financial planning should make sure that the business is solvent and
has enough cash on hand. Both short-term and long-term payments must be made on time in order
for a company to be considered solvent. As a result, the company will gain credibility and credit.
When assets are kept liquid, it will be possible to be solvent. When payments need to be made,
there should be enough money on hand. Getting a good idea of what payments will be coming up
will help with planning liquidity.

6. Cost. When choosing a financial plan, it's important to think about how much it will cost to get
money. The different sources should be chosen so that the costs are kept to a minimum. Interest-
bearing securities should be returned as often as possible to ease this burden.

7. Profitability. A financial plan should change the different securities in a way that doesn't hurt
the business's ability to make money. Interest-bearing securities and other liabilities should be
changed in a way that helps the business make more money.

2.2.3 CONSIDERATIONS IN FORMULATING FINANCIAL PLAN

1. Kind of the Industry: When it comes to money, each industry has a unique set of requirements.
Asset structure, seasonality, and earnings stability are not uniform among businesses. These
considerations will influence how much money is needed and how it is spent.

2. Standing of the Concern. The status of a business will affect how a financial plan is made.
Financial plans take into account the current situation of the business, its credit rating in the market,
its prior success, and the management's attitude.

3. Future Plans. When making a financial plan, a business should think about what it wants to do
in the future. Shortly, the plans to grow and change will need a flexible financial plan. The sources
of funds should make it easy to get the money that is needed.

4. Availability of Sources. Money can be raised from many different places.

24 FINANCIAL MANAGEMENT

Consider the advantages and disadvantages of each source before making a final decision. The
sources should be able to give enough money regularly to meet different needs at different times.
When choosing a financial plan, you should think about how reliable the different sources are.

5. General Economic Conditions. The national and international economies will be taken into
account when deciding on a financial plan. Before deciding where to get money from, you should
think about these things. If the economy is doing well, it will be easy to get the money you need.
On the flip side, an uncertain economy could make it hard for even a good business to get enough
money.

6. Government Control. A financial plan will be affected by how the government decides to issue
shares and debentures, pay dividends and interest rates, work with other countries, etc. It will be
hard to get money because of the laws that make it hard to use certain sources, limit dividend and
interest rates, etc. So, when choosing a financial plan, you should think about how the government
controls it.

2.3 STEPS IN FINANCIAL PLANNING

The following are the various steps involved in Financial Planning:

1. Establishing Financial Objectives- The financial goals of a corporation should be clearly

defined. Short-term and long-term goals should be carefully considered. In order to get the most
of your financial resources, it is essential to conduct thorough financial planning. There should be
the best possible use of money. The business should take advantage of the way the economy is
right now.

2. Developing Financial Policies- The Financial Policies of a business make sure that the company
gets, manages, and spends its money in the best way possible. There should be clear plans for how
to get the money needed and what it could be used for. When making financial policies, it's
important to think about which funds are required now and in the future.

3. Formulating Procedures. Procedures are made to make sure that actions are always the same.
25 SHOOLINI UNIVERSITY

After policies are made, the procedures come next. If the plan is to get short-term money from
banks, there should be a way to get in touch with the lenders and the people who are allowed to do
that.

4. Providing for Flexibility. Financial planning should make sure that the goals, policies, and
procedures are flexible enough to change as the economy does. A rigid plan for money won't let
the business take advantage of new opportunities.

2.4 IDENTIFICATION OF LONG AND SHORT-TERM FINANCIAL NEEDS

It's critical to identify your immediate and long-term financial goals before turning to outside
sources of funding. Having the wrong amount of capital can be disastrous for a company. Because
of a lack of money, this will continue its struggle to survive. If a person has more money than he
or she needs, it will merely sit there and may not bring in as much money as investing. to ensure
that all of the necessary funds are covered, accurate estimations must be provided.

The money a business needs can be roughly categorized into:

1.Fixed Capital

2. Working Capital

2.5 FIXED CAPITAL: MEANING OF FIXED CAPITAL

Long-term investments like machinery, land, buildings, and furniture require a large amount of
"fixed capital," which is money set aside for this purpose.

These assets comprise a firm’s capital that is permanently blocked. Fixed capital is also called
"Block Capital" because the business has no plans to sell these assets.

The value of the fixed assets is not always stable, and they are not always tied to a specific location.
Moreover, they are not always fixed. They are fixed assets despite the fact that their value may go
up or down over the course of time.

This is since they are required to be kept in the company to carry out routine operations; without
these operations, the concern would be not able to conduct business.
26 FINANCIAL MANAGEMENT

2.5.1 IMPORTANCE OF FIXED CAPITAL

Capital is what keeps a business alive and makes it run. Just as blood flow is important to live, so
is capital to the smooth running of a business.

We can't say enough about how important fixed capital is. Every business needs a certain amount
of money to buy fixed or non-current assets that can be used for production or other business
needs.

There is no way to start a business without enough fixed capital. From the very start, when you
first have an idea for a business, you need money to promote or start the business, buy fixed assets,
do research like market surveys, etc.

Even a business that is already up and running may need fixed capital to make improvements or
grow. So, it is very important for a business to have enough fixed capital.

2.6 ASSESSMENT OF FIXED CAPITAL REQUIREMENTS

A company will require fixed capital to purchase long-term assets such as real estate, construction
materials, machinery, and equipment. Intangible assets, including advertising, organizational
expenditures, operating losses, finance costs, patents, copyrights, and goodwill, must also be paid
for with the money earned from the sale of tangible assets.

So, to figure out how much-fixed capital a business needs in total, you have to:

A. Estimate Fixed Assets Requirement

B. Estimate Intangible Assets Requirement.

2.6.1 FIXED ASSETS REQUIREMENTS

Generally, the needs for fixed assets are estimated when a new business is put on the market.

But existing businesses may also need it when they want to grow, replace, or improve their current
facilities. It's critical to estimate not only the amount of money but also the duration of time
required to invest in these assets.
27 SHOOLINI UNIVERSITY

The business's owners and managers can figure out what fixed assets they need by studying similar
units, interacting with technical experts and also by their own experience in the business. They
could get an idea of how much these assets would cost by talking to the companies that made or
sold them. In most cases, the cost of land and the cost of construction may be easily calculated
with the assistance of building experts and contractors. Also, you should figure out how much it
will cost to set up the plant, machinery, and other equipment. To meet the needs, though, there
should be enough room for non-firm costs.

Every business has different needs when it comes to fixed assets. There are a number of things that
affect how many fixed assets a business needs.

2.6.2 FACTORS AFFECTING THE ESTIMATION OF FIXED ASSETS REQUIREMENTS

There are two broad categories of elements to consider when estimating a company's need for fixed
assets:

1) Internal Factors (2) External Factor

2.6.2.1. INTERNAL FACTORS

(a) Nature of Business.

A business's needs for fixed assets mostly depend on what kind of business it is. Investing a lot of
money in fixed assets is needed for public utilities like electricity, water, and trains. Alternately,
trading and financial firms don't need many fixed assets, but they do need to invest a lot in current
assets.

Manufacturing businesses also need a lot of fixed capital because they must set up production
facilities and spend a lot of money on fixed assets like land, buildings, equipment, etc. So, the type
of business has a big impact on how much-fixed assets and capital are needed.

(b) Size of Business.

A company’s needs for fixed capital are affected by its size, in general, bigger units need more
fixed capital.
28 FINANCIAL MANAGEMENT

(c) Scope of Business.

A company's fixed-capital needs are influenced by the scope of its products or services. For
example, a business that makes and sells its own products needs more fixed capital than a business
that only makes or only sells.

(d) Production Techniques.

A company's fixed capital requirements are influenced by a variety of factors, including the
production process. For instance, using automatic machinery requires more money to be spent on
fixed assets.

On the other hand, a smaller amount of fixed capital will be required if the production methods are
simple and don't need these kinds of tools.

(e) Mode of Acquisition of Fixed Assets (extent of Lease or Hire).

Fixed Assets can be bought outright, or they can be rented or leased. If fixed assets are bought
outright, a larger amount of fixed capital is needed than if they are rented or leased.

So, it is important to decide ahead of time which assets will be bought on a leasehold basis and
which will be bought outright. In the same way, if some of the fixed assets can be rented or leased,
a decision must be made about whether to buy these assets or rent them.

(f) Procurement of old Equipment and Plant.

In some industries, you may be able to buy old equipment and machinery for a lot less than you
would pay for new equipment and machinery. If old plans and machines could be used efficiently
in production, it could cut the amount of money needed to be spent on fixed asstes.

(g) Ancillary Units.

In some industries, some processes can be done by auxiliary units or subcontractors without
affecting the quality or price of the product. If that's the case, the need for fixed assets could go
down.
29 SHOOLINI UNIVERSITY

(h) Availability of Fixed Assets at Concessional Rates.

In some cases, the government provides subsidies for land or facilities in order to encourage the
development of various businesses across the country in an equitable manner. Plants and machines
could also be made available in parts.

2.6.2.2 EXTERNAL FACTORS

Investing in fixed assets means spending a lot of money and making decisions that can't be
changed. These kinds of decisions have a big impact on how profitable a business is in the long
run. Such decisions need to be made after considering the factors affecting them:

(a) International Conditions and Economic outlook: Investing in fixed assets, especially in
large firms, requires consideration of the national economy and the global economy. For example,
if business activity is expected to go up, the company will need more fixed assets and more money
to buy them. In the same way, companies that think there will be war may make big investments
in fixed assets before there aren't enough of them.

(b) Demographic Trends: If a company wants to sell its products all over the country, it needs to
look at national population trends when figuring out how many fixed assets it will need. In India,
people who want to start businesses are encouraged to do so because the population is growing
quickly. For some businesses, the age and gender of the population may also be important.

(c) Changes in Consumer Preferences: Changes in consumer tastes are another thing that affects
how much-fixed assets will be needed in the future. The needs for fixed assets should be planned
so that goods or services can be made that consumers will buy.

(d) Competitive Factor: The competition also affects how decisions are made about how much-
fixed assets will be needed in the future. If, for example, an existing company decides to change
its business focus, other businesses may follow suit.

(e) Technological Shift: When deciding how many fixed assets will be needed in the future, it is
also important to think about how technology will change and improve in the future. When new
conditions arise, the financial strategy should allow for adjustments.
30 FINANCIAL MANAGEMENT

(f) Government Regulations. There may be rules set by the government that affect how big a
business is and where it goes. So, these should also be considered when figuring out how many
fixed assets are needed. Even though it might not be possible to predict how government policies
will change, a buffer should be built into account for them.

2.6.3. ESTIMATION OF INTANGIBLE ASSETS REQUIREMENTS

Fixed capital includes the costs of promoting, incorporating, organizing, or setting up a business.
Intangible assets, such as goodwill, patents, and copyrights, have a significant impact on the
amount of fixed capital a company requires.

For intangible assets, other than organisational expenses like legal fees and taxes, it is difficult to
estimate the amount of money needed to maintain them and it depends on various factors:

1. Promotional Expenses: In order to conduct preliminary research, investigate marketing

alternatives, inquire about the technical elements of production processes, and put together the
components of the firm, the promoter must incur promotional expenditures. These are to be paid
to the promoter as payment for the work he did to get the business started.

Even though it's hard to figure out how much the promoter should be paid for his time, effort, and
skill in promoting the business, this should be taken into account when estimating the needs for
intangible assets in order to figure out how much is fixed capital a business needs.

2. Incorporation and Organisation Expenses: Incorporation or organizational costs include

things like legal advice, stamp duty, registration fees, filing fees, incorporation taxes, printing, etc.,
that are needed to set up a business. When figuring out how much-fixed capital a business needs,
it is very important to estimate these kinds of costs.

3. Costs of Financing: Costs of financing are the costs that a business has to pay to get the money
it needs. Underwriters, brokers, and investment bankers are paid in addition to the costs of
preparing a registration statement and prospectus for raising capital. These expenses would be
factored in when assessing the requirements for fixed capital intangibles.

4. Initial Operating Losses: It takes time for a firm to get to a position where it can pay for itself
and steady production. Until then, it loses a certain amount of money and money flows out of the
31 SHOOLINI UNIVERSITY

business. Such losses last the longest in businesses that have to make a big initial investment, use
complicated production methods, and market or create a new product. It's critical to factor in
operating losses like this while making capital investment decisions.

5. Cost of Acquisition of Patents, Copyrights, Goodwill, etc: Patents, copyrights, and goodwill
are all examples of "intangible assets" that need to be factored into a company's overall fixed
capital requirements before they can be purchased.

After figuring out how much money is needed for fixed assets and intangible assets separately, we
can find out how much-fixed capital an enterprise needs by adding up how much money is needed
for fixed assets and intangible assets.

2.7 LIMITATIONS OF FINANCIAL PLANNING

Some of the limitations of financial planning are discussed as follows:

1. Difficulty in Forecasting. People make financial plans based on their expectations of what will
happen in the future. When things don't always go as to plan, financial planning has little value.
There is a lot of uncertainty and doubt about how reliable financial plants are.

2. Difficulty in Change. Once a financial plan has been made, it is hard to change it. If a situation
changes, the financial plan may need to change, but the people in charge may not want to do that.
Even if they hadn't, they might have bought assets and paid for raw materials and labour anyway.
When this happens, it's hard to make changes to a financial plan.

3. Problem of Coordination. The most important of all of the functions is the financial one. A
decision about a financial plan is affected by other things. When figuring out how much money is
needed, product policy, staffing needs, and marketing options are all considered. If all the functions
don't work together well, it's hard to put together a financial plan. Often, different functions don't
work together as well as they could. Financial planning can be messed up by people who can't
make up their minds.

4. Rapid Changes. The increasing use of machines in the industry is causing quick changes in
how things are done in the industry. Demand is always made by how things are made, how they
32 FINANCIAL MANAGEMENT

are sold, and what people want. Every time there are new changes, the financial plan needs to be
changed.

Once investments have been made in fixed assets, they cannot be taken back. When things change
quickly, it's hard to change a financial plan to keep up with them. If a financial tool doesn't help
people use new techniques, it has limited use.

REVIEW QUESTIONS

1. What is financial planning?

2. How is financial planning concerned with the future?

3. Name the factors influencing financial requirements?

4. What do you mean by fixed capital.

5. Write a short note on the importance of fixed capital.

FURTHER READING

Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

https://drive.google.com/file/d/1MWRnLmEZ1ES04wfiETlVWlBBM8BFtjwC/view.pdf
33 SHOOLINI UNIVERSITY

UNIT-3: TIME VALUE OF MONEY

CONTENT:

▪ Objectives
3.1 Introduction
3.2 Future Value of Single Cash Flow
3.3 Future Value of Annuity
3.4 Future Value of Annuity Due
3.5 Present Value of Single Cash Flow
3.6 Present Value of Series of Cash Flows
Summary
Review Questions
Further Reading

OBJECTIVES

After completing this unit, you will be able to understand

● Future value and present value concepts.

● Compound interest and discount.

● Calculate present and future value of a single amount and annuity

34 FINANCIAL MANAGEMENT

3.1 INTRODUCTION

You should all be aware that the current market value of a rupee is higher than the future market
worth of a rupee. Did it ever occur to you why it is that way? Permit me to illustrate what I mean
with an example. Amar's father offered to give him one lakh (1,00,000) rupees at the end of five
years as a present, but he also gave him the option of receiving 75,000 rupees right now. What
decision would you have made if you were in his shoes? Which sum of money—a lakh rupees
after five years or seventy-five thousand rupees right now—would you have preferred to receive?
75,000 rupees right now is a lot better option than one hundred thousand rupees after five years,
since the future is less certain than the present. You might be able to earn something out of a ₹
75,000 investment in the market today. Because of inflation, one lakh rupees (₹ 1,000,000), due to
inflation will definitely have less purchasing power at the end of five year. Hope, the above
illustration rightly elucidates that the value of one rupee today is greater than future value.
However, the complexities of financial problems cannot be ignored.

The principles of time worth of money will remove the mystique around such decisions, which are
ones that each of us must make on a regular basis. Ninety percent of excellent financial sense can
be attributed to a knowledge of the time value of money. Cash flow at various moments in time is
taken into consideration while making investment decisions. Therefore, it is extremely crucial to
take into account the temporal worth of money. This section will teach you how to calculate the
future value of a single amount and an annuity, as well as the present value of a single amount and
an annuity, using compound interest and discount. Let's begin with the worth in the future of a
single amount over the course of a single period or across multiple periods.

3.2 FUTURE VALUE OF A SINGLE CASH FLOW

The amount by which an investment's future value (FV) increases over time at a specific interest
rate is referred to as future value (FV). Alternatively, the monetary value of an investment at some
point in the future is referred to as its "future value."

Future Value of a Single Amount for Single Period: If ₹ 1000 is deposited in a fixed account of
your bank at 10% interest per year, how much you will get after one year? You will get ₹ 1100,
which is equal to the principal amount ₹ 1000 and the interest earned in an year i.e., ₹ 100. Hence,
35 SHOOLINI UNIVERSITY

₹ 1100 amounts to the future value of ₹ 1000 deposited (invested) for one year at 10 per cent.
Alternately, it means that ₹ 1000 in the present is worth ₹ 1100 after one year, given the rate of
interest being 10 per cent. Thus, if you invest for one period at an interest rate of i, your investment
will grow to (I+i) per rupee invested. In the above Example is 10 percent.

Future Value of a Single Amount for more than One Period:

Continuing with the pprevious example, if you invest the samee amount for a period of two years
assuming the same rate of interest, what will you earn? You will earn ₹ 10 + ₹ 100 during the
second year, besides ₹ 1100 in the first year; so you will have total of ₹ 1210 (1100+ 110). This is
future value of ₹ 1000 for two years at 10 per cent.

As you can see in this ₹ 1210 has four components. First is ₹1000 which is the principal amount;
second is ₹100 as interest earned in first year; third, is another ₹100 earned as interest in second
year, and lastly, fourth, is ₹ 10 which is the interest earnedd in second year on interest paid in first
year ₹ 100 @ 10% = ₹ 10. So, the total interest earned is ₹210. Hence, the future value in this case
is ₹1210.

Compounding is the process of keeping your money and any accrued interest on an investment for
an extended length of time and reinvested the interest. Compound interest is obtained when interest
is earned on interest as opposed to simple interest, which is earned on the original principle only
and is referred to as interest on interest.

Future value of a single cash flow can be calculated by the following formula :

FVn = PV (1+i)n

FVn = future value for n years

PV = cash flow

i = rate of interest per year

n = total number of years

36 FINANCIAL MANAGEMENT

Table 3.1

The equation that can be seen in the table above is an example of a fundamental equation in
compounding analysis. The component that is represented by (1 + i)n is referred to as the
compounding factor or the Future Value Interest Factor (FVIF). Because the computations get
more complicated as the number of years increases, there are now published tables that are referred
to as future value tables. These tables indicate the value of (l+i)n for a variety of possible
combinations of the variables I and n. If you need to determine the future value factor at a rate of
ten percent over a period of five years, locate the column that is labelled "ten percent," then move
down the rows until you reach the section labelled "five yea₹" This is how we arrived at the
conclusion that the future value Factor for the example provided below should be 1.611.

What will your ₹ 1,000 be worth to you after five years if you invest it at a rate of 10%?

FVn = PV (1+i)n

= 1000 X 1.611

= ₹ 1611

The total interest earned on ₹ I000 in five years is ₹ 611.

37 SHOOLINI UNIVERSITY

In five years the total simple interest earned is ₹500, i.e., ₹ 100 per year at 10% and ₹ 111 (₹ 611-
500) is from compounding. Table given below shows the simple interest, compound interest and
total amount earned each year and at the end of five year.

Table 3.2

This gives an idea about the future value of a lumpsum (single) amount for a number of yea₹ Now
let us try our hand at future value of multiple cash flows.

Let us take up another illustration. Suppose, you deposit ₹ 1000 today in a bank at an interest rate
of 10%. After one year, you again deposit ₹ 1000. How much will you have in two years? At the
end of the first year you will have ₹ 2100. i.e., (₹ 1100 + second deposit ₹ 1000). Since you have
left this deposit for another year at l0%, therefore, at the end of the second year you will have ₹
2100 x 1.10 = ₹ 2310.00 Let us depict this with the help of a timeline

Figure 3.1
38 FINANCIAL MANAGEMENT

There is another method of finding out future value of two deposits of ₹ 1000. Firstly, ₹ 1000 is
deposited for two years at 10%, therefore, its future value is ₹ 1000 x 1.102 = I000 x 1.2100 = ₹
1210. Secondly, ₹ 1000 is deposited for one year at 10%, so its future value is ₹ I000 x l.l0 = ₹
1100.

The total value is = 1210 + 1100 = ₹ 2310.

To sum up, there are two ways of calculating future value for multiple cash flows.

1) One year at a time, carry the accrued debt forward in a compounding fashion.

2) Calculate the future value of each cash flow first and then add them.

Both methods will give you the same answer, and you can use either of them.

Effect of Compounding:

Going back to the example of Amar in the very beginning, suppose his great grand father had
invested ₹ 100, 60 years ago at 10% interest rate. How much it would have grown till today? Let
us find out the future value Factor.

FVIF = (1 +. l)60= l.l60 = 304.48

FV = 100 X 304.48 = ₹ 30,448.00

In this case simple interest amounts to ₹ 600, whereas the balance ₹ 29,848 (30,448-600) is from
compounding. Therefore, there is significantly greater effect of compounding over long periods
as compared to short periods.’

3.3 FUTURE VALUE OF AN ANNUITY

For example, a life insurance premium or a home loan payment is an annuity because it is a fixed-
amount payment. There are two kinds of annuities:

(a) a regular or ordinary annuity

(b) an annuity due.

39 SHOOLINI UNIVERSITY

Having a regular annuity implies you'll be paid at the conclusion of each period. At the beginning
of each period, an annuity payable is paid or received.

3.3.1 VALUE OF REGULAR (ORDINARY) ANNUITY

The amount a person would have at the conclusion of annuity period if their money was invested
and held until that time at an agreed-upon rate of interest. For example, a 5 year annuity is a
promise to pay ₹ 1000 every year for 5 yea₹

Example 1: If you deposit ₹ 5,000 in a bank at the end of every year for 5 years and the bank pays
10% interest, this annuity will be worth ₹ 30,525.5 in the future.

₹ 5000(1.10) 4 + ₹5,000 (1.10)3 + Rs,5000(1.10)2 + ₹5000(1.10) + ₹5,000 Or ₹5000 (1.4641) +

₹5,000(1.3310) + ₹5000(1.2100) + ₹5,000(1.10) + ₹5,000 = ₹ 30,525.5

The above steps can be expressed in the following way:

Future Value of An Annuity

FVA = A(1+i)n-1

A = Periodic cash flow

i = Interest rate

n = number of years

Taking the figures from illustration 1

FVA = 5000[(1+.10)5-1]

.10

FVA = 5000[1.6105-1]
40 FINANCIAL MANAGEMENT

.10

FVA = 5000 X .6105

0.10

FVA = 5000 X 6.105

FVA = ₹ 30,525

In the formula A(1+i)n-1 is called future value of interest factor of ‘i’ an annuity. You can find
out the FVIFAA from the table, see the table for 10% for 5 years it is 6.105. You can directly
multiply 5000 by 6.105 and will get ₹ 30525 as future value of annuity.

Example 2: A person plans to contribute ₹ 2,000 every year to a retirement account which is
paying 8% interest. If the person retires in 30 years, what is the future value of this amount?

FVA = A [(l+i)n- 1/i]

FVIA = (1 = 0.08)30-1/0.08

= 10.063-1/0.08

= 113.28

The future value annuity table shows an FVIFA of 113.28 for an annuity with an 8 % interest rate
over a 30-year period.

Future value of annuity is = 2,000 x 1 13.28 = ₹ 2,26560

Finding the interest rate (i)

Example 3 : Suppose you receive a 1umpsum of ₹ 94,000 at the end of 8 years after paying annuity
₹ 8,000 for 8 yea₹ What is the interest rate (i) in this?
41 SHOOLINI UNIVERSITY

First of all find FVIFAin

96000 = 8000 FVIFAi8

FVIFAi8 = 96000/8000

= 12

Look at the future value annuity table and see the row corresponding to 8 years until we find value
close to 12, it is 12.300 and is below the column of 12%. Hence interest rate is below 12 per cent.

3.3.2 FINDING THE ANNUAL ANNUITY

We can use this example to illustrate how interest rates and periods might affect annuity future
values (received or paid). You need to figure out how much you'll get in annuities each year. How
much money should you put into a bank each year to earn a total of 1,50,000 over the course of 10
years?

Annul Annuity = 1,50,000 X 1/FVIFAin

= 1,50,000 X 1/FVIA10,10

= 1,50,000 X 1/15.937

= ₹ 9,412.05

So, you should deposit ₹ 9,412.05 in a bank every year for 10 years in order to get ₹ 1,50,000 at
the end of 10 yea₹

Note: The FVIFAin is called sinking fund factor, when used as a denominator.

Example 4: How much a person should save annually to accumulate ₹ 1,00,000 for his daughter's
marriage by the end of 10 years, at the interest rate of 8%.

Annual Annuity = 1,00,000 X 1/FVIFAin

= 1,00,000 X 1/14.487
42 FINANCIAL MANAGEMENT

= 1,00,000 X 0.073

= ₹ 6,903

A person should save ₹ 6,903 annually for 10 years to get ₹ 1,00,000.

3.4 FUTURE VALUE OF ANNUITY DUE

The term "annuity due" refers to an annuity that makes payments at the beginning of each period.
An example of annuity due is a lease or payment plan.

To figure out annuity due, the same methods, which were used to figure out an ordinary annuity,
will be used, albeit with a few changes.

Let's start by figuring out the future value of a ₹ 1,000 ordinary annuity for 3 years at 8% and
compare it to the future value of a ₹ 1,000 annuity due for 3 years at 8%.

Note that the cash flows for the ordinary annuity happen at the end of periods 1, 2, and 3,

while the cash flows for the annuity due happen at the beginning of periods 2, 3, and 4.

So, the future value (FV) is found by taking the difference between the future value of an ordinary
annuity and the annuity due.

FV is figured out based on the last cash flow for an ordinary annuity. FV is calculated one period
after the last cash flow for an annuity due.

The future value of the 3-year annuity due is just the future value of a 3-year ordinary annuity
compounded for one more period.

How do you figure out the future value of an annuity due:

FVADn = ordinary annuity future value X (1 + i)

43 SHOOLINI UNIVERSITY

Figure 3.2

(₹ 1,000) (FVIFA8%3) (₹ 1.08) = (₹ 3,246)(1.08) = ₹ 3,506

Future value of an annuity due of 8% for 3 years (FVAD) = ₹ 3,506

3.5 PRESENT VALUE OF A SINGLE CASH FLOW

₹ 1.10 is what ₹1 will be worth in a year if you add 10% to it. Alternately we can ask how much
do you have to put away today at 10% to get ₹1 back in a year? Here, it is given that, this will be
worth 1 rupee in the future, but what is it worth at present?

Since you need Re.1 at the end of the year, the present value will be:

PV (1 + i)n = FVn

PV = 1/ (1 + 0.1)1
44 FINANCIAL MANAGEMENT

= 1/(1.1)

= Re. 0.909

Present value of Re.1 is Re.0.909.

Let us see the discount factor here

𝐹𝑉
PV = (1+𝑖)𝑛 𝑛

𝐹𝑉 ×1
𝑛
= (1+𝑖)𝑛

In this equation 1/(1 + i) is the present value interest factor or discount factor.

Suppose you want to earn ₹1500 in three years at 7% rate of interest. How much should you invest
today to get ₹1,500 in three years?

1
PV=1500 (1.07)3

= 1500 X 0.8163

= ₹ 1224

There is no such thing as a future value. Compounding is a feature of future worth. We discount
back to the present under the present value idea. Discounting refers to the practise of reducing
future income payments to their current value before making a decision to invest in them. The
value today, of the sum received in the future, is called its present value. If you want to know PV
of ₹500 in one year at 8%, then:

PV X 1.08 = ₹ 500

1
PV = 5001 X 1.08

= ₹ 462.5

There isn't a lot of math involved. Calculating the present value of future cash flows is made easier
with the aid of present value tables. Add the present value interest factor to the amount to get the
45 SHOOLINI UNIVERSITY

interest rate. So, ₹500 x 0.925 = ₹ 462.5. (See P.V. factor at 8% for one year in present value table,
it is 0.925).

3.6 PRESENT VALUE OF SERIES OF CASH FLOWS

The series of cash flows may be

a) Even series of cash flows i.e., annuity

b) Uneven series of cash flows

1/(l+i)n is known as the discount factor or present value factor, and the rate utilised is referred to
as the discount rate in this equation. Discounted Cash Flow (DCF) valuation is a method for
determining the present value of future cash flows.

3.6.1 PRESENT VALUE OF AN ANNUITY

You want to have ₹ 800 at the end of each of three yea₹ If the discount rate is 10%. What is the
present value of ₹2,400?

There are two methods to find out present value.

Under the first technique, the annuity's present value is the sum of all of the annuity's inflows. It
can be expressed as follows:

1 1 1
PVA = ₹ 800( 1.10)1 + 800( 1.10)2 + 800( 1.10)3

= ₹ 800 X 0.909 + ₹ 800 X 0.8264 + ₹ 800 X 0.7513

= ₹ 727.28 + 661.12 + 601.04

= ₹ 1989.44
46 FINANCIAL MANAGEMENT

The above can be arrived by the formula

𝐴 𝐴 𝐴 𝐴 𝐴
PVA = (1+𝑖) + (1+𝑖)2 + (1+𝑖)3 + ….. + (1+𝑖)𝑛−1 + (1+𝑖)𝑛

(1+𝑖)𝑛 −1
PVA = A 𝑖(1+𝑖)𝑛

(1+𝑖)𝑛 −1
[ ] is present value interest factor for annuity (PVIFAin)
𝑖(1+𝑖)𝑛

A = Annuity Amount

i = Discount Rate

n = Number of years

PVA = Present Value of Annuity

Alternate Method

Instead of calculating present value for each year we can multiply annuity amount by annuity
present value interest factor. See annuity P.V. interest factor table, it is 2.48685 at 10% for 3 yea₹
So ₹ 800 x 2.48685 = ₹1989.44 is the present value of an annuity.

Note: If present value annuity table is not available the PVIFA call be calculated as follows:-

1 1
Present Value Interest Factor = (1.1)3 - 1.331

= 0.75131

1−𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟
Present Value of Interest Factor = 𝑖

for annuity

1−0.75131
= 0.10

0.248685
= 0.10

= 2.48685
47 SHOOLINI UNIVERSITY

3.6.2 PRESENT VALUE OF UNEVEN CASH FLOW

You may have to deal with a variety of cash inflows at any given time. The example is dividend
on equity shares.

Illustration 5: Aman makes an investment in a mutual fund which promises following cash flows
for five year The discount rate is 10%. Find the present value.

Year Cash flow (₹)

1 1,000

2 2,000

3 2,000

4 3,000

5 3,000

First, see present value table to find present value factor.

Perpetuities: A cash flow that lasts for an indefinite amount of time is called a CONSOLS or
perpetuity. It is a type of annuity that is unique. You can find its present value by dividing its cash
flow by the discount rate. For example, if you get an offer for a steady cash flow of ₹ 1,000 every
year and the required rate of return is 16%, you might decide to take the offer. The value of the
perpetual will be ₹ 6250 (1000/0.16)

It means that if ₹ 6250 were invested at an interest rate of 16%, it would bring in ₹ 1,000 each
year.

Value of an annuity as of today

Let's look at how to figure out the present value of an annuity that is due. We will figure out both
the present value of a ₹1,000 ordinary annuity at 8% for 3 years (PVA3) and the present value of
a ₹1,000 annuity due at 8% for 3 years (PVAD).
48 FINANCIAL MANAGEMENT

3 year annuity payments are equal to the present value of a 2 year regular annuity + one non-
discounted period receipt or payment. First calculate the annuity's present value for two years, and
then add the annuity amount to it. It can be calculated as given below:

PVADn = A (PVIFAin-1+ 1)

The present value of an annuity due could be compared to the present value of an ordinary annuity
that has been pushed back one period too far. In other words, you want the present value to be one
period later than the usual annuity value, and then to compound one period forward. The formula
for computing PVADn is:

PVADn = Ordinary annuity present value x (l+i)

Figure 3.3

₹ 2783 = (1000) (PVIFA8%,2+1)

(1.08) (₹1,000) (PVIFA8%,3) = ₹(2783) = (₹1,000) (PVIFA8%,2+1) (1.O8) (₹1,000) (2.577) =

₹2,783 = (₹1.000) (2.783)

An annuity's future and present value can be calculated using the formula above.

So two steps are involved here.

49 SHOOLINI UNIVERSITY

i) Calculate the future/present value of annuity and

ii) Multiply your figure by (l+i)

REVIEW QUESTIONS
1) What do you mean by Future value?

2) What is compounding? What is the difference between regular annuity and annuity due?

2) You have deposited ₹ 10,000 in a fixed deposit in a bank at 6% rate of interest. How much
will you get after 5 years?

3) How much Rakesh will get after 12 years if he deposits ₹2,500 today in a fixed desposit at
10%?

FURTHER READING
Books

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra : Financial Management, Tata McGraw Hill

I.M. Pandey : Financial Management, Vikas Publishing House

https://drive.google.com/file/d/1MWRnLmEZ1ES04wfiETlVWlBBM8BFtjwC/iew
50 FINANCIAL MANAGEMENT

UNIT-4: RISK AND RETURN

CONTENT:
▪ Objectives
4.1 Introduction
4.2 Return
4.3 Risk
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:

• Meaning of Return

• Measuring Expected Return

• Concept of Risk

• Causes of Risk in Investment

• Types of Risks
51 SHOOLINI UNIVERSITY

4.1 INTRODUCTION
Every person who puts money into something wants to get something back. This return is the
difference between what the investment will be worth in the future and what it is worth right now.
Investors always worry that their money may not be returned at all or may only be returned in part.
Risk is the word for this fear. In the financial world, there is a close link between risk and return.
They are linked together. When an investor buys a risky asset, he does so to make more money. If
an investor doesn't like taking risks, he will put his money in a safe security that pays less. The
level of risk depends on what kind of security the money will be put into. So, it makes sense for
an investor to keep a close eye on both the risk and the return of his investment. Before he does
that, he should have a good idea of both the risk and the return.

Individuals and businesses make investment decisions for different reasons. Firms make
investment decisions to gain control, grow, etc. People make investment decisions to protect their
finances, make more money, etc.

The firms look at how much money a project can make. When figuring out the return, the risk of
the project must be considered. Even though return on investment is very important, it can't be the
only reason to invest. This is clear because most businesspeople don't put their money into just
one business. Instead, they put their money into many kinds of businesses.

4.1 RETURN
Return is what you get in exchange for making an investment. To figure out how much of a return
an investment gave, you must think about both how the asset's price changed and how much cash
it brought in while you owned it. Actual (historical) return needs to be measured so that investors
can figure out how well they have done. As the name suggests, the realised (historical) return is
the return that was earned or could have been earned in the past.

For example, if you put ₹ 100 in a bank on January 1, 2022, and the annual interest rate is 8%, that
₹100 will be worth ₹108 a year later. So, the actual or realised, return for 2022 is 8 percent, or
8/100.

The expected return is the amount of money that investors think they will get back from their
investment. It is a predicted return that is uncertain and could happen or not. Investors are willing
52 FINANCIAL MANAGEMENT

to buy an asset if they think it will give them a good return, but they know that their expectations
may not come true.

𝑖𝑛𝑐𝑜𝑚𝑒 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑+𝑃𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

% Return= × 100
𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

In the context of an investment, return is the amount of money you gain or lose over time. It is
usually shown in percentage of the initial investment. It keeps the investor interested in what he or
she is investing in. Return in financial management is the amount of money an investor will get
back after a certain amount of time. The investor has the option of putting their money into a single
asset or a portfolio, which is a collection of several different types of investments. There will be
two kinds of returns based on this.

1. Return on a single Asset

2. Return on a portfolio

4.1.1 RETURN ON A SINGLE ASSET

When an investor buys a share of a single company, his return will be the sum of dividends and
the difference between what he paid for the share and what he could sell it for after a certain amount
of time. The return can either be positive or negative, which shows a profit or loss. It can be
explained using the following equation:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

Return ={ 𝑃𝑢𝑟𝑐𝑎ℎ𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 × }×100
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

Illustration 1

veena has purchased 500 shares (face value 100) of Canara bank of India at ₹ 110. she

gets 10% dividend on face value during the year. Find his rate of return if he sells her share at

(a) ₹ 120

(b) ₹ 90
53 SHOOLINI UNIVERSITY

Solution:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

(a) Return ={ 𝑃𝑢𝑟𝑐𝑎ℎ𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 × }×100
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

10 120−110
={ 110+ }×100
110

= (.09+.09) ×100 =18.18% profit

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

(b) Return ={ 𝑃𝑢𝑟𝑐𝑎ℎ𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 × }×100
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

10 90−110
={ 110+ }×100
110

= (.09-.1818) ×100

4.2 RISK
Risk is the second part of investing. Investors have a natural sense of the idea of risk. In simple
the risk is the possibility that the real result will be different from what was expected. If we know
for sure that something will happen, there is no risk involved. We are supposed to come up with a
way to measure risk. When someone makes an investment, they hope to get something back from
that investment in the future. But because the future is unknown, the expected return is uncertain.
Because of this, getting a return on an investment is risky.

The gap between an investment's predicted return and its actual return can be discerned. An
investor's expected return is the uncertain return they hope to receive in the future from an
investment. Investment returns are known for certain when an investment is sold at the conclusion
of its holding period. This is the "realised return." The investor chooses whether to put money into
something based on how much money they expect to get back from it. The real return on an
investment may not be the same as what was expected. If the predicted return turns out to be lower
than expected, then there is a risk involved. There is no risk when the actual return is equal to the
predicted return. Risk happens when there is difference between expected return and actual return.

So, risk can be defined as the difference between returns. A high-risk investment is one where the
return on the investment changes a lot.
54 FINANCIAL MANAGEMENT

4.2.1 CAUSES OF RISK IN INVESTMENT

The factors which cause risk in an investment are given below:

1. Change in the Macro-economic factors like Interest rate, Inflation rate and GDP growth rate,
etc.

2. International factors.

3. Natural calamities.

4. Reputation of Issuer of security.

5. Wrong timing of investment.

6. Over expected return.

7. Wrong assessment of company performance.

4.2.2 TYPES OF RISKS

Several things, like those listed above, cause the difference in return. There are two ways to group
this risk. The first group is made up of things outside of the company that affect many securities.
The company can't do anything about these things. The second group of factors is made up of
things that are inside of a company and only affect that company. The company has a lot of control
over most of these factors.

When comparing systematic and unsystematic risk, it is important to understand the difference
between them. Systemic and non-systemic risk are the two components of total risk. Therefore,

Total risk = Systematic risk + Unsystematic risk

4.2.2.1 SYSTEMATIC RISK

Systematic risk is also known as Market risk or Undiversifiable risk. It influences the whole
economy, a system, or a class of assets. It can't be planned for. Uncertainty is a risk that you don't
know what will happen with. War, inflation, a slowing economy, and changes in interest rates are
all examples of this type of risk. Even if a business or investor buys different types of assets to
reduce the risk on the portfolio investment, even then they can’t avoid systematic risk.
55 SHOOLINI UNIVERSITY

Systematic risk can be caused by the following: -

(a) Government Policy: Government policy has a big effect on all businesses and the economy.
In most economies, the government has full control over both fiscal and monetary policy. Both
fiscal policy and monetary policy have a big effect on the business.

(i) Fiscal Policy or Tax rate risk: Fiscal policy is the policy that affects the amount of taxes, how
they are set up, and how they are paid for. Any change in the tax rate has a big effect on how a
business works and how much money it makes. If taxes go up, businesses will make less money.

(ii) Monetary Policy or Interest rate risk: Money supply and the direction of money supply in
an economy are controlled by Monetary Policy. The central bank of the country oversees it. It has
a direct effect on the interest rates that are being used in the economy. Which will affect the price
of bonds and debentures in the economy. The price of stocks, bonds, government securities,
commodities, or investments will change in the future if interest rates go up or down quickly.

Changes happen in the economy, government, and social life. Stock prices change because of these
changes. But these changes have different effects on each company and each security. Investors
won't buy debentures with a coupon interest rate of 8% unless the holder of the debentures lowers
the price to R80.

When the price goes down to 80, the person who buys the debentures gets 8 in interest on an
investment of 80, which is the same as an 8% return on an investment of 100.

Changes in interest rates also affect the price of stock on the market. If the market interest rate
goes up, firms' profits tend to go down, and if the market interest rate goes down, firms' profits
tend to go up.

(b) Economic forces: Economic forces are things that influence the whole economy. They decide
how competitive a business is. The amount of supply and demand in the economy is affected by
these forces.

(i) Market risk: Market risk is when the share prices of a company change because of changes in
the overall financial market. It could happen if people's moods change because of big changes in
56 FINANCIAL MANAGEMENT

the national and international economies. For example, when there is a war, a terrorist attack, or
political instability, the financial market will move around a lot.

(ii) Purchase Power Risk: Both inflation and deflation change how much an investor can spend.
Purchase power risks mean that unplanned changes in prices will hurt the real value of an investor's
investments. Let's say you have invested ₹1000/- in 10 percent debentures. Here's how it works:
Let's say the rate of inflation is 4% per year. This means that you will get ₹1000/- at the end of the
year, but its real value is ₹1000 - 4% of ₹1000 = ₹960.

(c) Acts of Nature: Natural disasters always pose a risk to business. No one can stop things like
earthquakes, tsunamis, and hurricanes from happening. It changes not only how resources are
shared, but also how many resources there are in total. No one can avoid this kind of risk.

(iv) Interest Rate Risk: This type of risk is systematic risk that has different effects on debt
securities and stock shares. Most of the time, when the interest rate goes up or down, the price of
a security fluctuates. The interest rate on a debenture is set at a fixed coupon rate, which is the
same as the market rate at the time it is issued.

The market interest rate may change after the bond is issued, but the coupon rate stays the same
until the bond matures.

A debenture having a face value of ₹100 issued at coupon rate of 8% when interest rate is also 8%
will have a market price of ₹100. After the issue, the market interest rate moves to 10%,

i.e., 1080 - 108 = ₹972.

Although the investor has earned an interest income of & 80 despite that the purchasing power of
₹1,000 has reduced to ₹972. In an inflationary economy, the investor should consider the rate of
inflation in the economy while estimating the expected rate of return from an investment.

4.2.2.2 UNSYSTEMATIC RISK

An unsystematic risk is one in which the returns fluctuate due of factors that are specific to a given
company rather than general factors affecting all companies. Unsystematic risk could be caused
by things like a strike, a lack of raw materials, too much competition, or bad management, among
other things. The unique risk is another name for the unsystematic risk.
57 SHOOLINI UNIVERSITY

The factors affecting Unsystematic risk can be divided into three parts: -

1) Business Risk

2) Financial Risk

3) Liquidity Risk

(i) Business Risk: A company must work in two types of environments: its own and the world
around it. The cost of running the business shows how these operating conditions affect the
business. Costs of doing business can be broken up into fixed costs and costs that change over
time. If a company's share of fixed costs is more than it would be bad for the business. If there is
a bad change in the operating conditions that causes sales revenue to go down, the profit will go
down more than proportionally because the company can't change the fixed costs. This kind of
company faces a big business risk.

(ii) Financial Risk: If a business doesn't have any debt, it doesn't have any financial risk. The
degree of financial risk will depend upon how much financial leverage a company has in their
capital structure. The potential financial risk goes up as the amount of financial leverage goes up.
When debt (also called "fixed cost-bearing capital") is part of a company's capital structure, it
creates fixed payments in the form of interest, which must be made whether the company makes a
profit. This interest payment makes it more difficult for equity shareholders to predict how much
money they will make. So, equity shareholders face this kind of risk, which is called financial risk.

Let’s take an example, a share is currently selling at ₹100. The Investor anticipates the price at the
end of a year would be 140 and company will pay a divided of ₹10 during the year. The expected
₹10+₹140
return from this investment would be -1 =50%
100

Investor will expect a return of 50% if he or she decides to make investment into these shares. But
future is uncertain. Company may not declare a dividend of ₹10 during the year or price of this
share after a year may not be ₹140. In both the situations actual return may differ from expected
return. The actual return may be 30%, 40%, 50% or may be 60% or any other. So the investor
would be required to consider all these probabilities of returns.

As discussed, for the purpose of taking an investment decision risk along with return is observed.
58 FINANCIAL MANAGEMENT

(c) Liquidity Risk: The liquidity risk is the chance that a company won't have enough cash when
it needs it. Liquidity risk has two parts. One is not being able to get money when you need it, and
the other is not being able to sell assets for close to what they are worth.

SUMMARY
The return on an investment is the amount of money you make or lose over a specified period of
time. The return on investment (ROI) is typically expressed as a percentage of the original
investment. Actual (historical) return is the return that was earned or could have been earned in
the past. When an investor buys a share of a single company, his return will be the sum of dividends
and the difference between what he paid for the share and what he could sell it for after a certain
amount of time. The return can either be positive or negative, which shows a profit or loss.

Systematic risk can be caused by any of the following:

War, inflation, a slowing economy, and changes in interest rates are all examples of this type of
risk. (i) Monetary Policy or Interest rate risk: Money supply and direction of money supply in an
economy are controlled by monetary policy. (ii) Purchase Power Risk: Both inflation and deflation
change how much an investor can buy. Market Risk: Unplanned changes in prices will hurt the
real value of an investor's investments. Unsystematic risk is caused by things that are unique to a
firm and not because of things that affect all firms.

REVIEW QUESTIONS
1. What is Risk

2. What is return

3. Return on a portfolio

4. Risk vs Uncertainty

5. Systematic Risk

6. Un-systematic Risk
59 SHOOLINI UNIVERSITY

FURTHER READING
Books:

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

60 FINANCIAL MANAGEMENT

UNIT-5: CAPITAL BUDGETING -1

CONTENT

▪ Objectives
5.1 Introduction
5.2 Capital Budgeting Process
5.3 Nature and Types of Investment Decisions
5.4 Investment Evaluation Criteria
5.5 Limitations of Capital Budgeting
Summary
Review Questions
Further Readings

OBJECTIVES
After completing this unit you will be able to understand:

● The nature and importance of investment decisions.

● The type of investment decisions.

● The capital budgeting and investment process, including planning and control.
61 SHOOLINI UNIVERSITY

5.1 INTRODUCTION
To determine whether an organization's long-term investments like the purchase of new machines,
replacements for old machines and new plants and product development projects are worth funding
through the firm's capitalization structure is done through the process of capital budgeting, also
known as investment appraisal.

Examples of such investments include purchasing new machinery and replacing machinery (debt,
equity or retained earnings). Capital budgeting is the process of allocating resources for significant
capital or investment expenditures. Increasing the value of the company to its shareholders is one
of the key purposes of the investments that are funded by the capital budget. The most crucial
aspect of contemporary finance is the effective distribution of available resources, especially
capital. It involves making decisions about where to invest the company's money in long-term
investments. Investment and capital budgeting decisions have a significant impact on a company's
value since they affect the company's pace of growth, profitability, and risk.

This decision-making process is known as capital budgeting or capital expenditure decision-

making in the business world. When a corporation decides to invest its current cash in long-term
assets that they believe will provide the greatest return over the course of a year, this is referred to
as capital budgeting decision. This type of asset is defined as one that has an impact on the
company for more than one year. The long-term assets of the company should be considered while
making investment decisions, whether it be for expansion, acquisition, modernization, or even
replacement. The sale of a firm or division can also be part of an investment decision (also known
as a divestment). An investment decision should also take into account decisions that have long-
term consequences for the company's expenditures and returns, such as a change in sales,
distribution, advertising, or a research and development programme. The long-term investments
involve the tying up of considerable sums in current assets, such as inventories and receivables,
thus it is vital to be aware of this fact. Investment in both fixed and current assets, therefore,
comprises a single, unified process. The characteristics of investment choices are:

• The process of exchanging present resources for potential future gains.

• Investing in long-term assets is a priority.

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• The company will reap the benefits over a period.

It is important to underline that an investment's expenditures and benefits should appropriately be

measured in cash. When examining investments; cash flow, rather than accounting profit, should
be the primary focus. It is also possible to mention that the company’s worth is affected by the
decisions that are made about investments. If investments produce a profit and contribute to the
wealth of the owners, then the value of the company will go up. Therefore, investments ought to
be evaluated based on the criteria that are compatible with the goal of increasing the wealth of the
owner. The wealth of shareholders will rise as a result of an investment if the returns are larger
than the opportunity cost of capital's minimum benefits requirement. This section assumes that the
investment project's opportunity cost of capital is already determined. In addition, we presume that
the costs of the investment as well as the advantages derived from it are completely clear. In
subsequent sections, both presumptions are discarded.

5.3 THE CAPITAL BUDGETING PROCESS

A capital budgeting decision involves

1. Project identification and generation:

In most cases, it is the initial step in the process of budgeting for capital expenditures. To begin, it
is vital to have an awareness of the reasons behind the necessity of a capital budgeting decision
for a company. There are several reasons why it could be necessary for a company to make
investments. It's possible that they want to add a new product line to their portfolio or extend the
one they already have. If there is sufficient cash on hand at the company, then a wide variety of
initiatives can be carried out. As a result, the first stage is to determine whether or not an adequate
number of business possibilities are now available to a business firm and to determine what these
opportunities are.

2. Project Screening and Evaluation:

The projects that were found in the prior stage are screened and reviewed utilising a variety of the
tools that are accessible in this step. At this point, it will be determined whether it is prudent for a
company to invest some of its cash resources in other projects. To put it another way, it establishes
whether the projects are appropriate. In addition to this, the project needs to contribute to the
63 SHOOLINI UNIVERSITY

overall goal of the company to maximise its profits. The projects are evaluated using a variety of
methodologies, including risk assessment, cost-benefit analysis, and the value of money over time
among othe₹

Project identification
and generation

Project Screening and

Evaluation

Project Rankin

Project Selection

Implementation

Performance review

Figure 5.1

3. Project Ranking:

The projects that were identified previously are then sorted according to the preferences that the
company has for each of them. This is done in order to construct a list of the projects in order of
the benefits they provide, with the most beneficial project listed first.

It means that the project that will have the most benefits should be prioritized over the other
projects that will have advantages that are on average less significant. It gives the company the
ability to choose various projects if its resources allow for this.
64 FINANCIAL MANAGEMENT

4. Project Selection:

Next, the capital budget is utilised to evaluate the projects in order to ascertain exactly how many
the company is capable of completing at one time. Only projects with a better rate of return than
the cost of acquiring the cash required for the project can be chosen by the company. Before
moving on to the final level of certification, there are a number of protections that need to be
satisfied, such as testing for profitability and feasibility, among other things.

5. Implementation:

The implementation of the project proposal is the next step that needs to be taken. The financial
resources are made available, and a comprehensive breakdown of tasks and timetables is
performed. Additionally, the management is responsible for performing routine monitoring of the
project as well as checking for deviations and working to minimise them to the greatest extent
possible.

6. Performance review:

The comparison of the expected results with the actual ones is part of the final phase of the process
of capital budgeting. This assists in gaining an understanding of the constraints placed on the
planning process and makes it possible to include these constraints in order to enhance the manner
in which future projects are carried out.

5.3.1 IMPORTANCE OF INVESTMENT DECISIONS

The company's long-term growth and risk are directly influenced by investment decisions. They
involve committing a lot of money; they can't be changed or can only be changed at a big cost; and
they can't be changed back. The most difficult decisions to make in life are those involving
investments. The following criteria are important for consideration;

Growth: The implications of investment decisions today, need to be dealt with in the future also.
The rate and course of a company's expansion are both significantly impacted by its choice of
whether to make long-term investments in its business. A poor choice can have a catastrophic
implications on the company’s existence; the addition of assets that are either unproductive or
unwelcome will result in significant increases in the running costs of the company. On the other
65 SHOOLINI UNIVERSITY

hand, if the company did not make sufficient investments in its assets, it would be difficult for the
company to successfully compete with its rivals and to keep its current level of market share.

Risk: The commitment of funds over prolonged time periods may potentially alter the risk profile
of the company. If a company makes an investment that raises its average gain but creates
significant swings in its earnings, the company will take on additional risk as a result of the
investment. Consequently, investment choices determine the fundamental makeup of a company.

Funding: As most investment decisions require significant amounts of money, they require
meticulous planning and advance arrangements of funds from within or outside the company.

Irreversibility: Most investments are non-reversible. Once you've bought these big-ticket
products, finding a buyer might be a real challenge. If these assets are disposed of, the company
will suffer significant financial harm.

Complexity: When it comes to business, investment decisions are some of the most difficult ones
to make. Future events are difficult to anticipate, thus they are an appraisal of what might happen.
Accurately estimating an investment's future cash flows is a difficult task. Uncertainty in cash flow
estimation may result from economic, political, social, and technological influences.

5.3.2 EXPANSION AND DIVERSIFICATION

Increasing the capacity of an existing product line is one way that a business might expand its
current activities. For example, the Gujrat State Fertilizer Company (GSFC) could increase its
plant capacity to generate more urea. This may be considered Linked Diversification . A
company's operations can be broadened by entering a new industry. It is necessary to invest in new
products and newer types of industrial activities in order for a new business to grow. It is an
example of new business development or Unrelated Diversification.

There are many examples of companies making investments in new facilities and machinery to
produce new products that they have never done before. When a corporation wants to expand its
operations, it may buy other businesses. Regardless of the outcome, the company invests in the
hope of bringing in more money. Revenue-expansion investments may also be referred to as
investments in existing or new product development.
66 FINANCIAL MANAGEMENT

5.3.3 REPLACEMENT AND MODERNIZATION

Modernization and replacement increases operational efficiency and reduces costs. Profits rise
because of reduced costs, but the company's revenue may not change. With technological
advancements, assets become obsolete and ineffective. These outdated assets must be retired and

replaced with newer, more energy-efficient ones by the company. When it comes to the
modernisation and replacement of equipment, a cement industry is a good illustration of this. A
cost-reduction investment is one that helps bring in more efficient and cost-effective assets using
replacement decisions. More money can be made, however, by making decisions that include
major modernization and technological development while also increasing revenues and
decreasing costs.

Investments may also be classified as follows:

● Mutually Exclusive Investments

● Independent Investments

● Contingent Investments

5.3.4 MUTUALLY EXCLUSIVE

Mutually exclusive investments compete for the same rate of return. Investments must be
sacrificed if one is made. If a corporation wants to produce a product, it can either utilise a labor-
intensive machine or a capital-intensive, highly automated equipment. If you go with the semi-
automatic machine, you have to say no to the fully automatic one.

5.3.5 INDEPENDENT INVESTMENTS

Investments that are separate from one another have diverse goals and are not in competition with
one another. If a heavy engineering company wants to manufacture more excavators, it might
expand its plant capacity and add more production facilities. Another possibility is to make light
commercial vehicles at the same time. The corporation has the option to make either of these
investments, based on their performance and financial resources.
67 SHOOLINI UNIVERSITY

5.3.6 CONTINGENT INVESTMENTS

It's called a Contingent Investment when making a decision about one investment requires the
decision to be made about another or even more investments. Contingent investments are
dependent initiatives. Consider the case when an enterprise intends to develop a factory in a
backward location and must make investments in housing, roads, health care facilities and
educational institutions to lure workers to the area. Construction of a plant therefore necessitates
the purchase of workspace for its employees. It will be handled as though the entire amount was
invested in a single transaction.

5.4 INVESTMENT EVALUATION CRITERIA

Steps involved in evaluation of an investment:

1. Estimation of cash flows.

2. Estimation of the required rate of return (the opportunity cost of capital).

3. Application of a decision rule for making the choice.

5.4.1 INVESTMENT DECISION RULE

It is possible to refer to the investment choice guidelines as capital budgeting strategies or
investment criteria. Investing money in a project should be evaluated using a reputable method.
A sound strategy should aim to increase shareholder wealth to the greatest extent possible. A
robust investment evaluation criterion should also have the following characteristics:

• It should consider all cash flows to figure out the profitability of the project.

• It should give a clear and objective way to tell the difference between good and bad projects.

• It should help rank projects based on how profitable they really are.

• It should know that bigger cash flows are better than small flows, and that early cash flows are
better than the ones come later.

• It should help decide between projects that can't work together which project will make the most
money for the shareholder.
68 FINANCIAL MANAGEMENT

• It should be a standard that can be used for any investment project, no matter what others are
doing.

5.4.2 EVALUATION CRITERIA

Investment criteria of capital budgeting techniques may be grouped in the following two
categories:

1. Non Discounted Cash Flow

Payback period (PB)

Discounted payback period

Accounting rate of return (ARR)

2. Discounted Cash Flow (DCF)

Net present Value (NPV)

Internal Rate of Return (IRR)

Profitablity Index (PI)

5.5 LIMITATIONS OF CAPITAL BUDGETING

1. Estimating Cash Inflows: To use the capital budgeting techniques, you have to estimate how
much money will come in and go out in the future. The future is always hard to predict, and the
information we gather for it may not be correct. Obviously, the results may not be good if they are
based on bad information.

2. Factors that can't be measured: Some things, like the morale of the employees, the reputation
of the company, etc., can't be accurately measured, but they still have a big impact on the capital
decision.

3. Government policies have an effect: It is difficult to predict the impact of government policies
like taxation because cash flows are spread out over a longer period of time.
69 SHOOLINI UNIVERSITY

4. Figure out the Cost of Capital: Making judgments on the capital budget necessitates an
understanding of the cost of capital. Several assumptions are used to figure out the cost of capital.
So, it's not easy to figure out the cost of capital.

5. Different Results: The results of different ways to evaluate are different. It is a very difficult
task to choose the best method.

SUMMARY
To put it another way, capital budgeting is the formal process by which a corporation plans for the
acquisition and investment of capital. When evaluating capital expenditures, classic methods
include payback period, payback equivalent, and accounting rate of return (ARR). There are three
discounting cash flow methods: the Net Present Value (NPV), the Profitability Index or
Desirability Factor, and the Internal Rate of Return.

REVIEW QUESTION
1) What is a budget for capital? How should the amount of money put into capital projects be
decided?

2) Explain what capital budgeting is for and how it works.

3) Why is a company's capital budget important?

4) How should sunk costs and working capital be treated when looking at investments and business
opportunities? Explain using the right examples.

FURTHER READING
Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Chandra, P., Financial Management—Theory and Practice, New Delhi, Tata McGraw Hill
Publishing Company Ltd., 2002, p. 3

Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi,
Prentice Hall of India Pvt. Ltd., 1996, p. 2.
70 FINANCIAL MANAGEMENT

UNIT-6: CAPITAL BUDGETING

EVALUATION TECHNIQUES -
TRADITIONAL NON-DISCOUNTED
TECHNIQUES

CONTENT:

▪ Objectives
6.1 Non-Discounted Techniques of Evaluation

Summary

Review Questions

Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:

● Non-Discounted evaluation criterion

● Payback Period

● Average rate of Return

71 SHOOLINI UNIVERSITY

6.1 NON-DISCOUNTED TECHNIQUES OF EVALUATION

6.1.1 PAYBACK PERIOD
Sometimes referred to as the payout method, this approach to project evaluation is computationally
straightforward and has been utilized for a significant amount of time. The first step is to calculate
how long it will take for a project to produce the profits which will be equal or greater than the
initial investment.

Case 1: When Cash inflows are consistent & constant

Illustration:1

Assume that a Project requires an outlay of ₹200000 and yields annual cash inflow of ₹40000 for
9 years. The Payback period for the Project is:

Payback = (200000/40000)

= 5.0 years

Case 2: When Cash inflows are not same or constant:

There can be the case that cash inflows for every year will not be the same. In this situation, we
would say that the annual cash inflows will be uneven. It is possible to compute the payback period
by summing the cash inflows, which include profits before depreciation and after tax, until they
are equal to the project's initial cash outlay or the total cost of the asset. This method works even
if annual earnings aren't constant.

This process continues until the annual earnings are equal.

The payback period of a project or asset is the amount of years that pass until the total cumulative
inflows catch up to the whole cost of what was invested in the endeavor.
72 FINANCIAL MANAGEMENT

Illustration 2.

Find the payback period of a Project where the initial outlay is ₹50,000. The cash inflows for the
same are ₹10,000, ₹20,000, ₹15,000, and ₹15,000 in the first, second, third and fourth year
respectively.

Solution:

Cash Outlay = ₹ 50,000

Year Cash Inflow (₹) Total Cash Inflows

1 10,000 10,000

2 20,000 30,000

3 15,000 45,000

4 15,000 60,000

In the fourth year, the total cash inflows are 60,000 which is 10,000 more be de cash outlay.
So the payback period is between third and fourth year. We assume that 15,000 (the cash inflow
of fourth year) occurs evenly throughout the year.

The time needed to recover the amount of 5,000 will be ( 5,000 ÷ 15,000) × 12 = 4 months.

So, here the payback period will be 3 yrs. and 4 months.

A) Ranking / Selection of a project:

The management must decide about the investment to be made in a project. If more than one
alternative is available, then selection of a project is to be made. If this selection depends on the
payback period method, the project whose payback period is the least is considered or ranked first.

Case 3: Post Payback Profitability

Sometimes, the projects generate some profits even after the payback period. In the above two
cases, this concept of post payback profitability is ignored which is again very important in the
73 SHOOLINI UNIVERSITY

selection of the project. The returns or cash inflows after the payback period are known as post
payback profits. The projects with higher post payback profitability should be ranked first.

The Post Payback Profitability Index is to be calculated as under:

Post payback profitability Index = (Post payback profits / Initial Investment) x100

Case 4. Discounted Payback Period

The time value of money is not taken into account in any of the three scenarios above. Rather,
annual inflows are taken into account.

In contrast, "money earned today is of greater value than the money obtained a year from now."
Payback Period, Post Payback Profitability Index Method evaluates projects based on total cash
inflows over more than one year, not taking into account the worth of money one year afterwards.
This method can be used to find the present value of money or cash inflows after discounting them
at a specific cut-off rate.

Present Value of all cash withdrawals and inflows is calculated. Discounted payback period is the
point at which the total present value of cash inflows equals the total present value of cash
outflows.

Illustration 3

Compute Discounted Payback Period:

Cost of the Project 700000

Annual Cash Inflows 200000

Life of Project 5 years

Cut off Rate/ Discount factor is 10%

Solution:
74 FINANCIAL MANAGEMENT

Table 6.1

Year Inflows PV at 10% Present value Cumulative present value

1 200000 .909 1,81,800 1,81,800

2 200000 .826 1,65,200 3,47,000

3 200000 .751 1,50,200 4,97,200

4 200000 .683 1,36,600 6,33,800

5 200000 .621 1,24,200 7,58,000

From the cumulative present values, it is clear that the total cash outlay of 7,00,000 is recovered
back somewhere between 4th and 5th year. So, the Discounted Payback Period is 4 yrs. and some
months which may be calculated as under

Discounted payback period = 4 years +(7,00,000 - 6,33,800/1,24,200) x12

= 4 years+(66200/1,24,200) x12

= 4 years + 6 months (approx.)

The discounted payback period method is better than simple payback period as it considered the
time value of money.

6.1.1.1 MERITS AND DEMERITS

Due to its simplicity and ease of use, the Payback Method is a popular choice. It also takes into
account the project's total lifetime earnings. But it established on a rough average of how much
money will be made in the coming future years. It doesn't consider how profits change from year
75 SHOOLINI UNIVERSITY

to year. Capital Budgeting decisions must take into account time worth of money, which is not
taken into account by this method.

Suppose someone gives you the choice of getting ₹ 100 now or in 4 year You would probably
prefer to get the money right away, since you can make further investment through that amount
like you will put it in your bank account and get back about ₹ 147/- after 4 years if the bank gives
you interest at the rate of 10% per year.

This flaw can be fixed, though, by using information about cash flows instead of accounting data.
We've found that none of the investing decision-making strategies we've looked at so far take into
consideration the present value of future capital inflows and outflows.

The timing of cash flows is considered by the next three methods

● The Net Present Value Method

● The Internal Rate of Return Method

● The Profitability Index Method

These techniques are referred to as discounted cash flow. While there are other ways to assess a
project's performance, these techniques more than make up for the shortcomings of the other
approaches.

Present value of future cash flow streams and cash flows over the capital project's complete
operating life.

6.1.2 AVERAGE RATE OF RETURN

The average rate of return method is yet another time-tested approach that may be used to evaluate
various investment options. A different name for this procedure is the Accounting Rate of Return
(ARR) method.

When determining whether a project is profitable using this approach, accounting data, rather than
cash coming into the business, is used.
76 FINANCIAL MANAGEMENT

According to the accounting concept known as "net profit after tax and depreciation," we calculate
the net earnings for the period in question. To determine the rate of return, first take the average
earnings and divide those numbers by the average investment.

ARR= (Average earnings after tax/ Average investment) x100

Illustration 4.

A project costs 2,00,000 with a life of 5 year. Its earnings before interest, depreciation and tax
are expected to be 50,000, 60,000, 80,000, 85,000 and 1,00,000 respectively. The
straight-line method of depreciation is to be used. If the tax rate is 40%, determine the accounting
rate of return.

Solution:

Table 6.2

Year EBIT Depreciation EBT Tax Earnings after

s Depreciation &
Tax (EADT)

1 50000 40,000 10,000 4000 6000

2 60000 40,000 20,000 8000 12000

3 80000 40,000 40,000 16000 24000

4 85000 40,000 45,000 18000 27000

5 100000 40,000 60,000 24000 36000

Total earnings = 1,05,000

77 SHOOLINI UNIVERSITY

Average Earnings = 1,05,000/5 = 21000

Average Investment = 2,00,000/2 = 1,00,000

ARR= (Average earnings after tax/ Average investment) x100

(21,000/ 1,00.000) x100 = 21 percent

As a result of the ARR approach, it's a simple calculation. Regardless of the Payback Period, the
Project's overall earnings are taken into account.

However, like with the payback period method, it also ignores the time value of money, which is
critical for calculating the actual profitability of any enterprise.

SUMMARY
When using the discounted payback period method, you must take into account the time value of
money or discount factor. How much money is expected to be made in the next year is taken into
account. All other ways of judging a project's success have flaws, but these methods make up for
them. Accounting data, rather than cash coming into the business, is used to determine whether a
project is profitable. When a project has a higher rate of return, it gets prioritised above a lower-
rate one.

REVIEW QUESTIONS
1. Explain the nature of Capital investment decisions. Why such decisions are important for a
business Enterprises.

2. What do you understand by accounting Rate of Return ? Discuss its limitations.

FURTHER READING
Solomon, Ezra and Pringle John J: An Introduction to Financial Management, Prentice-Hall of
India.

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

78 FINANCIAL MANAGEMENT

UNIT-7: CAPITAL BUDGETING - MODERN

TECHNIQUES

CONTENT:
▪ Objectives
7.0 Discounted Cash Flow Techniques
7.1 Present Value Method
7.2 Net Present Value (NPV)
7.3 Profitability Index (PI)
7.4 Internal Rate of Return (IRR)
7.5 Difference of NPV and IRR
7.6 Points of Difference in NPV And IRR
7.7 Recommendation
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:

● Capital Budgeting Techniques

● Discounted Cash flow Techniques

● Comparison of Net Present Value and Internal Rate of Return

79 SHOOLINI UNIVERSITY

7.0 DISCOUNTED CASHFLOW TECHNIQUES

It is also known as the Discounted cash flow method by the term "Time adjusted". These are
superior to the Payback and Average rate of return approaches because they take into account both
the return following the payback period and the worth of money over time. Lately, these methods
have become known as the best way to make decisions about money.

7.1 PRESENT VALUE METHOD

In the Present Value Method, cashflows at various points in time are valued differently. This
method is made up of the following steps:

1. Figure out how much money will come in and go out, including the initial investment and other
payments.

2. Figuring out how much money will come in over different time periods.

3. Figure out the discounting rate, also known as the cut-off rate. Most people think it equals the
Cost of Capital.

4. Use the Discounting rate to figure out the Present Value Factor (PVF).

5. Add up the present value of all the cashflows from different time periods.

6. Salvage value is also cash inflows discounted to the present value at the end of a project's
economic life.

Note: When calculating the present value of future cash flows, the initial amount is
discounted by a factor equal to the present value of future cash outflows. However, future
cash outflows are not discounted.

Computation of Present Value Factor (P.V.F.)

The present value of cash inflows can be calculated with the help of following formula:

1
P.V.F. = (1+𝐼)𝑛

P.V.F. = Present value factor of rupee one

80 FINANCIAL MANAGEMENT

r = Required earning rate or discounting rate

n = Number of years

7.2 NET PRESENT VALUE (NPV) METHOD

The Discounted benefit-cost ratio Technique of Capital Budgeting, often known as the Net Present
Value (NPV) method, is based on an assessment of the Present Values of investment outflows and
cash inflows.

Investment proposals have traditionally been evaluated using the net present value method. It is a
discounted cash flow method that takes into account the ephemeral nature of money. By default,
it assumes that cash flows occurring at different times have varying values and may only be
compared to their equivalents, or current values.

"It is a present value of the cost of the investment," says Ezra Soloman.

The formula for the net present value can be written as:

As,

C=Annual Cash Inflows

Cn = Cash inflow in the year n

K=Cost of Capital

I=Initial Investment

The Acceptance criterion is

NPV >0 Accept the project

NPV< 0 Reject the Project

NPV=0 May accept or reject the project

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7.2.1 MERITS
Let’s read the following merits of NPV method

(i) Consideration to the total cash inflows- Instead than focusing on the payback period, the NPV
approaches look at investment opportunities' total cash flows over their lifetimes.

(ii) Recognition to the time value of money- In order to make important financial decisions, it is
crucial to know the temporal value of money, which this approach does.

(iii) Changing Discount Rate: Depending on how the investor's risk profile shifts over time,
various discount rates may be appropriate to use.

(iv) The Best decision criterion for Mutually Exclusive Projects- In this method is especially
helpful when it comes to selecting projects that are incompatible with one another. It is the most
appropriate criterion for making a selection when considering alternatives that are incompatible
with one another.

(v) Maximization of the Shareholders Wealth: In conclusion, the NPV approach plays a
considerable role in the achievement of the goal of optimizing the wealth that is distributed to
shareholder. To maximise shareholder wealth, this method is not only consistent with the
company's purpose of maximising market value for its shares. However, it is logically correct for
investment proposal selections.

7.2.2 DEMERITS
(i) Both comprehending it and making use of it are challenging.

(ii) The discount rate used to calculate Net Present Value is the Cost of Capital.

(iii) However, it fails to address the problem of projects that call for varying amounts of
funding, as well.

(iv) In the context of other projects with limited finances and unequal lifestyles, it does not
provide the correct answer to a question.
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7.3 PROFITABILITY INDEX (PI)

This method is also known as Benefit Cost Ration Method. The profitability Index of a project is
“the ratio of the present value of future net cash inflows to the present value of cash outflows”.

Profitability Index = (Present value of cash inflow)/ (Present value of cash outflow)

Decision criteria: PI ≥ 1, only then the project will be accepted otherwise rejected.

MERITS

(i) It considers the Time Value of money

(ii) As a result of the Index's Value, it is easier to approve or reject investment proposals.

(iii) It is important to rank the suggestions since the highest/lowest Value of the Index can be used
as a basis for comparison.

(iv) It takes into account all of the project's future financial flows.

DEMERITS

(1) It is difficult to compute.

(vi) Due to Profitability Index, it is difficult to analyse the decision.

7.4 INTERNAL RATE OF RETURN

The time value of money is taken into account when using the IRR Method. To calculate an
investment's Internal Rate of Return, take the present value of predicted future cash inflows and
multiply it by the amount of money invested.

The pace at which NPV equals 0, then, is what we're talking about.

The IRR must be calculated whenever a project report is created to determine the project's viability.
In addition, financial institutions and investors benefit greatly from this.
83 SHOOLINI UNIVERSITY

As,

C = Initial Capital outlay.

A1,A2,A3, etc =Future cash inflows

R=Rate of return

N=Number of years of the project

7.4.1 CALCULATION OF INTERNAL RATE OF RETURN

The hit-and-trail approach will be used to calculate the Internal Rate of Return. It can be calculated
as:

(i) The present value of future cash flows from an investment can be calculated using a
randomly chosen interest rate I.

(ii) The next phase in the process is to compare the present value with the capital outlay.

(iii) Present value of inflows is calculated by applying an increased rate if present value
exceeds cost.

(iv) This process should be repeated until the investment's current inflows and outflows are
roughly equal.

(v) The interest rate that equalises is known as the internal rate of return.

The following formula can be used to get the exact IRR between two rates that are close to each
other.

Where,

L = Lower rate of interest

P1 = Present value at lower rate of interest

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P2 = Present value at higher rate of interest

Co = Cash outlay

D = Difference in rate of interest

Acceptance Rule

Internal rate of return must meet or above the required rate of return for a project to be accepted.
Projects that fail to meet the required return on investment (IRR) should be rejected. The IRR
method is frequently employed while evaluating proposals. When comparing projects with the
highest and lowest rates of return, the highest-returning initiatives will take the top spot.

Thus, the IRR acceptance rules are

Accept if IRR > k

Reject if IRR < k

May accept or reject if IRR = k

Where

K is the cost of capital

7.4.2 MERITS
The following are the merits of the IRR method:

(i) Consideration of Time of Money: It takes into account the worth of money over time.

(ii) Consideration of total Cash Flows: It took into account all of the asset's cash flows over its
useful life.

(iii) Maximizing of shareholders’ wealth: It is in line with the company's goal of promoting the
welfare of its shareholders.

(iv) Provision for risk and uncertainty: The more recent the money value, the greater the weight
assigned to it by this technique. There are two techniques to calculating payback periods and
accounting rates of return in which all money units are given identical weight, which is not a
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practical approach. There's a better method for evaluating projects, however: the Internal Rate of
Return (IRR). Estimate quality is enhanced, and uncertainty is reduced to a bare minimum, using
this technique.

(v) Elimination of pre-determined discount rate: A set rate of return is used in the IRR method,
rather than discounting future cash flows depending on the cost of capital as is the case with the
NPV technique. The IRR, on the other hand, is a more accurate indicator of a project's profitability.

7.4.3 DEMERITS
The following are the Demerits of the IRR:

(i) It is extremely difficult to comprehend and use.

(ii) it requires a great deal of computational effort,

(iii) it may not always provide a unique response in all cases.

(iv) In practice, it is probable that the assumption of reinvestment of cash flows is not feasible.

(v) There is no way to find the most profitable project consistent with the goal of making
shareholders rich by examining the mutually exclusive concepts.

7.5 COMPARISON OF NET PRESENT VALUE AND INTERNAL RATE OF RETURN

However, there are certain basic difference between these two methods of capital budgeting:

Table 7.1
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7.6 POINTS OF DIFFERENCE IN NPV AND IRR

i) The interest rate used by NPV is the company's cost of capital. It's impossible to utilise the NPV
approach unless you know the cost of capital. To figure out IRR, you don't need to figure out the
cost of capital.

ii) It might be difficult to understand Net Present Value when dealing with multiple projects or
limited cash in a world where people lead quite varied lives. IRR lets you compare projects that
have different lifespans and cash flows at different times.

iii) The Internal Rate of Return may rank complex projects differently from the Net Present Value
technique.

iv) In the case of Net Present Value, the firm's cost of capital is assumed to be ploughed back into
the project, whereas in the case of Internal Rate of Return, the project's internal rate of return is
assumed.
87 SHOOLINI UNIVERSITY

(v) The IRR method is better for short-term projects that promise to return more than the cut-off
rate. The NPV method, on the other hand, is better for long-term projects.

(vi) The IRR can sometimes give a negative rate or more than one rate. NPV is not limited by the
fact that there are more than two rates.

Note: This method's result may not be the same as the NPV method's result if the projects are
different in

(a) how long they are expected to last,

(b) how much they cost, or

(c) when they bring in cash.

SUMMARY
Capital budgeting involves the selection of projects which will make the optimum contribution to
corporate objectives, and one of the most important corporate objectives is to maximize the
profitability of the enterprise. Capital budgeting is broader in scope than investment decisions. It
includes not only investment decisions but also the exploration of profitable investment
opportunities, and investigation of potential opportunities. Capital budgeting decisions are top
management decisions. Capital investment projects may be initiated at any level of management,
but they are processed through various levels including the head of the operating division
concerned, financial controller, investment or finance committee, general manager, and the board.
The most widely accepted criterion of investment decision is the estimated net worth or present
value of the project. Major investment decision methods are:

(i) Payback period

(ii) Average rate of return method

(iii) Net present value

(iv) Profitability index,

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(v) Internal rate of return

REVIEW QUESTIONS
1. To begin with, what did you say exactly about "Capital Budgeting"? Illustrate the significance
of this.

2. Describe several Methods of Discounting Capital expenditures.

3. Make a few brief comments about:

(a) Internal Rate of Return (IRR)

(b) IRR vs. NPV

FURTHER READING
Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

89 SHOOLINI UNIVERSITY

UNIT-8: COST OF CAPITAL

CONTENT:

▪ Objectives
8.1. Introduction
8.2. Meaning
8.3 Definition
8.4. Significance of Cost of Capital
8.5. Classification of Cost of Capital
8.6. Determining Cost of Capital
8.7 Estimation of Cost of Capital
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:

● Concept of Cost of Capital

● Importance and Types of Cost of Capital

● Computation of Cost of Capital

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8.1 INTRODUCTION
There are a wide range of business tasks that necessitate financing. Each supply, however, comes
at a cost. Any financial decision must take into account the cost of capital. Capital costs are an
important consideration in financial management. Though tough to learn and put into action, this
is an essential skill to have. To estimate the present or future value of cash flows, one must apply
a discount rate. The discount rate is another name for the cost of capital. Financial sources for non-
corporate enterprises are mostly derived from either internal (savings, investments in current and
non-current assets, etc.) or external borrowings (loan from financial institutions, local borrowings
etc.). For example, a company can raise money through the sale of debt securities like debentures
and bonds. Raising capital for a corporation can be accomplished through the sale of equity shares,
preference shares, or even retained earnings.

8.2 MEANING
Capital expenditures refer to short-term investments in long-term assets. Investors' expected or
required minimum rate of return. Financial institutions (like banks) lend money to companies in
the form of preferred stock, debt instruments (such as debentures), equity, and sometimes even
retained earnings. How quickly anything is regarded successful or failed. A company's share price
stays the same if it does not reach its cut-off, target, or hurdle rate. In order to maximise wealth, a
company's rate of return must be higher than its cost of capital. The larger the potential loss, the
more expensive it is to borrow money. The higher the risk, the higher the cost of capital for a
corporation. When making a final choice on a capital project, the cut-off rate, or the company's
cost of capital, is well-known. This rate represents the least return necessary on investment
initiatives. A fee must be paid in addition to the principal when a company receives finance from
any source. This additional sum of money is referred to as "the cost of capital," and it represents
the price that must be paid in order to make use of capital. The cost of capital, stated as a rate, is
used for discounting or compounding a cash flow or series of cash flows. In addition to "cut-off"
rate and "hurdle" rate, other terms for cost of capital include "minimum return rate" and "cut-off
rate."

8.3 DEFINITIONS
The following are a few main definitions of cost of capital given by eminent scholars:
91 SHOOLINI UNIVERSITY

1. According to James C. Van Horne: ―The cost of capital is ―a cut-off rate for the allocation
of capital to investments of projects. It is the rate of return on a project that will leave unchanged
the market price of the stock‖.

2. According to Soloman Ezra: ―Cost of Capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure‖. It is the discount rate /minimum rate of return/opportunity
cost of an investment.

3. According to Milton H. Spencer-Cost of Capital‖ is the minimum rate of return which a firm
requires as a condition for undertaking an investment."

8.4 IMPORTANCE AND SIGNIFICANCE OF COST OF CAPITAL

Capital providers (shareholders, lenders, and debt holders) anticipate a return on their investment
as a recompense for their contribution to the overall capital. Management primarily relies on the
concept of cost of capital in order to make an informed decision. The ability to accurately calculate
one's cost of capital simplifies the process of making decisions. It is critical to consider the cost of
capital in financial management since it impacts the following areas:

1. Proposals for capital budgeting: The Net Present Value (NPV) technique is used in investment
proposals to discount future cash flows based on the cost of capital. As a result, it's a valuable tool
for capital budgeting. Present value is calculated by discounting future cash flows from investment
opportunities (such as a company or a project) by the relevant cost of capital. A project must have
a present value greater than or equal to the investment's cost in order to be accepted. If this is the
case, it must be returned to the sender. The predicted cash inflows are discounted at the cost of
capital, which is the discount rate, to arrive at the current value of expected returns. It's important
to remember that the cost of capital for each investment option can vary, so you must utilise the
cost of capital that applies to your options.

2. Helpful in Performance Appraisal: The cost of capital is an important metric to consider when
assessing a project or business. The performance of a project or business in relation to the cost of
capital is measured as the cut-off rate or hurdle rate.
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When evaluating the financial performance of a company's top executives, one can also look at the
company's cost of capital. Profits are compared to the expected and actual cost of capital in order
to establish if a company's performance is sufficient.

3. Making the most of credit policy design: It is extremely helpful in developing a credit policy
that is acceptable for the company. The expense of permitting a credit duration is contrasted to the
benefit/profit gained by providing credit to a segment of consumers while evaluating the credit
period. Calculating the current value of the costs and benefits is done using the cost of capital.

4. Making it possible to achieve the best possible results: It's critical to consider the cost of
capital while constructing a company's capital structure. Maximizing the firm's value while
lowering its cost of capital is the goal of the ideal capital structure. The cost of capital principle
can be used to design an optimal capital structure.

Capital costs have a significant impact on the appropriateness and balance of a company's capital
structure. A well-balanced mix of debt and equity capital is vital when funding a company's assets.
In order to maximise the value of a company while minimising the cost of capital, the management
of a company must keep these objectives in mind.

Weighted average cost is an essential part of planning and building a company's capital structure.

5. Useful in other financial decisions: There are many more ways to use the cost of capital in
addition to capitalising gains and issuing rights. Using the cost of capital, an organisation can
determine the most effective way to allocate the money provided by owners and creditors to
various investment initiatives.

An organisation can utilise the current cost of capital to help decide how to fund itself in the future.
Choosing between leasing versus borrowing, for example, may be based on cost. Of course, control
and risk are also significant factors.

Additionally, the cost of capital can be used as a factor in deciding whether to pay dividends or

invest in the stock market.

93 SHOOLINI UNIVERSITY

8.5 CLASSIFICATION OF COST OF CAPITAL

Cost of capital classified in different ways as described below:

8.5.1. HISTORICAL COST AND FUTURE COST

For a project, the historical cost is the amount of money that has already been spent on it. It is
based on previous data that has been gathered. The expense of financing a project in the future is
referred to as future cost. which is important. Future costs are more important than past costs when
making financial decisions.

8.5.2 EXPLICIT COST AND IMPLICIT COST

There are two ways to calculate the cost of capital: explicitly or implicitly. As the name implies,
explicit cost of capital refers to a company's outgoing cash flow that is directly related to the use
of capital. Outflows include, but are not limited to, interest payments to debenture holders,
principal repayments to financial institutions, and dividend payments to shareholders. It's a
measure of a company's profit margin. Other costs are known as "implied costs," which are the
costs that aren't actually monetary but rather the opportunity costs of not taking advantage of a
more lucrative choice. It's also called the opportunity cost because it represents the opportunity
lost as a result of starting a new project. The rate of return shareholders can earn by investing the
money elsewhere is a hidden cost of retaining earrings as an example. A corporation's "explicit"
cost is the return on investment it receives on the money it invests. The implicit cost refers to the
potential return on investment that can be earned by placing funds into other assets.

8.5.3. SPECIFIC COST AND COMPOSITE COST

Debentures, preferred stock, and common stock can all be used by a corporation to raise the capital
it needs. Funds are made up of these various sources. The corporation bears a price for each of
these sources of funding. Each of the various financial components has a unique cost of capital,
which we refer to as "funding costs." When the individual costs of capital are totaled up, the total
cost of capital is referred to as the composite cost of capital, the combined cost of capital, or the
weighted cost of capital. The "specific" or "mixed" cost of capital and the "combined" or
"combined" cost of capital are two forms of capital costs. Based on the average, it's a calculation.
The term "total cost of capital" can also be referred to as "cost of capital." When making business
94 FINANCIAL MANAGEMENT

decisions, it is critical to take into account the entire cost of capital rather than the cost of a single
form of capital.

8.5.4 AVERAGE COST AND MARGINAL COST

Average cost of capital is referred to as Weighted Average Cost, based on the cost of each Capital
fund source. An organisation must pay an average capital cost in order to get additional capital.
The marginal cost of capital is a term used to describe this. The Marginal Cost of Capital is more
important than the Cost of Capital when it comes to capital planning and financing decisions.

8.6 DETERMINATION OF COST OF CAPITAL

The only factor that affects the Cost of long-term funds raised by a company at distinct points in
time is the risk-free cost of the specific type of financing. As a result, the cost of capital may not
be the same for any two businesses. In the same way, neither of these businesses carries the same
degree of risk. The following are a few examples of such factors:

Country's Economic Climate: At various points in time, a country is confronted with a variety
of economic conditions. Economic growth and inflation are directly impacted by this factor in a
significant way. Risk-free rates of return are a common metric for most businesses, and they reflect
this.

The state of the stock market: The financial markets are affected by a variety of factors. When
an investor wants to sell a security, it may not be readily marketable or, if it is, the price may
fluctuate significantly. This phenomenon has a significant impact on the cost of capital as well.

Level of risk: There is a direct correlation between the level of risk and the amount of money you
make. The decisions made by the company also pose a risk. Business and financial risk are two of
the most common categories of risk. These threats also affect the company's capacity to raise
money from the market at a certain price.

Amount of finance required: As finance requirements increase, the cost of capital increases.
There are a variety of reasons why this could occur. For investors, a higher rate of return may be
demanded if management approaches the capital markets with big sums of capital relative to the
95 SHOOLINI UNIVERSITY

company size. Financial institutions are reluctant to provide relatively big sums of money without
proof that management can absorb this cash into the business due to an increase in the degree of
risk.

8.7 ESTIMATION OF COST OF CAPITAL

Making financial decisions necessitates a thorough understanding of the concept of "Cost of
Capital." The appropriate technique to measure the cost of capital continues to be a source of
disagreement among financial experts. The cost of capital is influenced by a company's individual
sources of financing. As the majority of funds used to fund Fixed Assets, long-term sources of
funding must be taken into account when making capital budget decisions.

In Calculating the Cost of Capital, Components includes: -

1. Long Term Debt

2. Preference Capital

3. Equity Capital

4. Retained Earnings

5. Weighted average Cost of Capital

6. Marginal Cost of capital

These categories have been discussed in detail as below:

8.7.1. COST OF DEBT

The price of debt can be estimated with a fair amount of simplicity. The rate of interest that must
be paid on debt constitutes the cost of the debt. The issuance of debentures is the method by which
debt capital is raised. There are a variety of floatation charges that are associated with the issuance
of debentures. Some examples of these expenses include publishing the prospectus, advertising,
underwriting, and brokerage fees. Again, debentures can be issued at par, at times below par (at
96 FINANCIAL MANAGEMENT

discount), or at times over par when the market conditions warrant it (at premium). The total cost
of debt capital is significantly impacted by factors such as floatation charges as well as modalities
of issue.

Illustration

(a) ABC Ltd. issues ₹2,00,000, 9% debentures at par. The tax rate applicable to the company

is 50%. You are required to compute the cost of debt to the company

b) XYZ Ltd. issues ₹3,00,000, 6% debentures at a premium of 10%. The tax rate applicable to the
company is 50%. You are required to compute the cost of debt to the company capital.

(c) BETA Ltd. Issues ₹ 2,00,000, 7% debentures at a discount of 5%. The tax rate applicable is
50%. You are required to compute the cost of debt to the company.

(d) PVC Ltd. issues ₹ 5,00,000, 8% debentures at a premium of 10%. The costs of floatation are
₹.30,000. The tax rate applicable is 50%. You are required to compute the cost of debt to the
company.

Solution:

(a) Kd =I/ NP *(1-t)

= 18,000/2,00,000*(1-0.5) = 4.5 %

(b) Kd =I/ NP *(1-t)

= 18,000/3,30,000*(1-0.5) = 2.73 %

(c) Kd =I/ NP *(1-t)

= 14,000/1,90,000*(1-0.5) = 3.68 %

(d) Kd =I/ NP *(1-t)

= 40,000/5,20,000*(1-0.5) = 3.84 %
97 SHOOLINI UNIVERSITY

8.7.2 COST OF PREFERENCE SHARE CAPITAL

There is no predetermined dividend payment schedule for equity shares. On the other hand, in
most cases, a firm will pay its preferred shareholders a dividend at a predetermined rate. The
dividend that is anticipated by the shareholders of preference shares serves as the capital's cost. In
addition, preference shareholders are given payment of dividends before equity owners are given
payment of dividends when it comes to concerns over the distribution of dividends. In the event
that preference shareholders are not paid dividends, the company's ability to raise capital may be
negatively impacted as a result. Therefore, dividends are often paid on preference shares on a
regular basis, except for times when there are insufficient revenues to fund dividend payments.

Illustration: Majra Ltd. issues Rs. 2,00,000, 9% preference shares at par. You are required to
compute the cost of preference shares to the company.

Solution: Kp =D/ P = 18,000/2,00,000 = 9%

Here the tax rate is irrelevant.

Kp =D/ NP = 18,000/3,30,000 = 5.45%

Redeemable Preference is in effect. A firm issues shares, which can be redeemed or cancelled at
the end of their term. The cost of redeemable preference share capital can be calculated as:

𝐷 + 1/𝑛 (𝑀𝑉 − 𝑁𝑃)

Kpr = ½ (𝑀𝑉 + 𝑁𝑃)

8.7.3. COST OF EQUITY SHARE CAPITAL

When it comes to the corporate form of organisation, this is the source of capital that is considered
to be the most significant. The payment of dividends on equity shares is not a requirement, nor is
the rate of dividends set in stone. This is crucial to keep in mind. Therefore, the corporation may
choose not to declare and pay dividends to equity owners even if there are adequate earnings
available. Because shareholders invest their spare cash in equity shares in the hope of receiving
dividends, and because the business must maintain a certain minimum rate of return to keep the
market price of its shares consistent, this is not always viable for a corporation. Equity capital costs
98 FINANCIAL MANAGEMENT

are therefore defined by the needed rate of return, which is equal to the present value of expected
dividends and the market value of the company's stock. Accurately estimating the cost of stock in
the real world is nearly impossible. In large part, this is because it is difficult to predict the
dividends that equity shareholders expect to receive. Earnings and dividends distributed on equity
share capital are also expected to expand in the future. In most cases, the following strategies are
utilised in order to determine the cost of equity capital:

a) Dividend Yield Method: The discount rate used to calculate the cost of equity capital is equal
to the present value of expected future dividends divided by the net proceeds (or current market
price) of a share.

‘In other words, it denotes the relationship between dividend and net proceeds/market price.

The fundamental premises on which this approach is based are that the investor places a high value
on dividends and that the level of risk posed by the company remains unchanged.

Actually, it is only appropriate when a company has maintained a consistent dividend policy over
a long period of time and has consistently earned steady profits. The dividend price ratio method
has a few drawbacks that need to be considered. To begin, it does not consider the increase in
dividends, nor does it take into account future earnings or any earnings that have already been
retained.

Illustration

XYZ Ltd. issues 25,000 equity shares of ₹100 each at a premium of 10%. The company

has been paying 10% dividend to equity shareholders for the 5 years and expects to

maintain the same in the future also. Compute the cost of equity capital. Will it make any

difference if the market price of equity share is ₹180?

Solution:

Ke = D/NP

= 10/110 × 100 = 9.09%

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if the market price of a equity share is Rs. 180.

Ke =D/MP

= 10/180× 100 = 5.55%

(b) Dividend Yield plus growth method: This approach considers increases in dividends as they
occur. However, this strategy is only applicable in situations in which it is anticipated that the
company's dividends will continue to rise at the same rate over time and the dividend payout ratio
would not change.

Under this method,the calculations are made as under:

Ke = D/ NP + G

where, Ke = Cost of Equity Share Capital

D = Expected Dividend per share

NP = Net Proceeds per share

G = Rate of Growth in dividends.

The Market Price per share can also be used in this technique. Existing equity share capital costs
are therefore computed using the MP (market price per share) rather than the NP (net present value)
method.

Ke = D/ MP + G

Illustration

Dhiraj Industries Ltd. Issues 20000 New Equity shares of ₹100 each at par. The floatation costs
are expected to be 5% of the share price. The company gives a Dividend of ₹20 per share initially
and the growth in dividends is expected to be 5%.

Calculate the Cost of new issue equity share. Further, if the current market price of an equity share
is ₹190, what will be the Cost of Equity Share Capital.
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Solution:

(a) Ke = D/ NP + G =20/95 + 5% = 26.05%

(b) Ke = D/ MP + G= 20/190 + 5% = 15.53%

8.7.4 COST OF RETAINED EARNINGS

The term "retained earnings" refers to the company's unshared profits. Retained earnings don't
come free, as some claim. As a result, the opportunity cost of dividends in alternative investments
is added to retained earnings, making them more expensive to keep. As a result, shareholders
demand at the very least a return on retained earnings. The shareholders, on the other hand, demand
a return on their investments. Income tax and brokerage costs must be considered when
determining cost of retained earnings.

Therefore, after these adjustments,

Cost of Retained Earnings is calculated as under:

Illustration: A firm‗s cost of equity (Ke) is 15%, the average income tax rate of shareholders is
50% and brokerage cost of 2% is excepted to be incurred while investing their dividends in
alternative securities. Compute the cost of retained earnings.

Solution:

Cost of Retained Earnings=

Kr = Ke (1-t)(1-b)

15(1-0.50) (1-0.02) =15x.5x.98 =7.35%

8.7.5. WEIGHTED AVERAGE COST OF CAPITAL

The word "cost of capital" should also be used as a composite term because of the significant
connection between how you finance something and how much it costs. As a result, the weighted
average of the costs of the various sources of funding is the composite cost or overall cost of
capital. The weights show the contribution of each source of funds to the capital structure.
Weighted averages are more accurate than basic averages when it comes to figuring out the total
101 SHOOLINI UNIVERSITY

cost of capital. The simple average cost of capital isn't an effective technique to determine the
capital structure because enterprises don't employ diverse sources of money in the same manner.

To figure out the weighted average cost of capital, you need to do the following:

i) To figure out how much each source of money costs on its own.

ii) Multiplying the cost of each source by how much of the capital structure it makes up, and

iii) Add up the weighted costs of all sources of funds to get the weighted cost of capital.

So, the Weighted Average Cost of Capital was calculated using the component costs.

SUMMARY
For investors, Cost of Capital is the rate at which they may expect their money to be returned.
Alternatively, it can be viewed of as the rate of return on investments if the price of a company's
equity share does not change over time. The cost of capital should include all of the types of capital
that the company uses, such as debt, preferred shares, and equity. How much of a company's
money each source of capital brings in should determine how important it is. Management may be
tempted to utilise the cost of a single source of capital as the hurdle rate if the investment is paid
for fully with debt. Costs of capital can be divided into two categories: operational and
nonoperational. There are many various ways to calculate an average cost, and each method has
its own advantages and disadvantages. It is the marginal cost of capital that a company pays for
fresh or additional funds. The marginal cost is what you should look at when deciding where to
put your money. Then, they went into detail about the different ways to figure out the cost of
capital.

REVIEW QUESTIONS
1. Define the term ‘Cost of Capital ‘. What is its importance?

2. How is Cost of debt computed?

3. "The equity cost is free." Do you agree? Elaborate in detail.

4. "Debt is the cheapest source of funds". Comment.

102 FINANCIAL MANAGEMENT

FURTHER READING
Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

103 SHOOLINI UNIVERSITY

UNIT-9: CAPITALISATION

CONTENT:

▪ Objectives
9.1 What is Capitalisation?
9.2 Overcapitalisation
9.3 Undercapitalisation
9.4 Effects of not Capitalising enough
Summary
Review Questions
Further Reading

OBJECTIVES
After reading this unit, you’ll be able to understand:

● Capitalisation

● Overcapitalization

● Undercapitalization
104 FINANCIAL MANAGEMENT

9.1 WHAT IS CAPITALISATION?

Share capital, debentures, loans, free reserves, etc., are all parts of capitalization. Capitalization is
the amount of money that is permanently invested in a company, minus long-term loans.
Capitalization and capital structure are two different things. Capital structure is a broad term that
refers to the way money is spent. Capitalization, on the other hand, is a narrow term that deals with
numbers.

Capitalization is generally found to be of following types-

● Normal Capitalization

● Over Capitalization

● Under Capitalization

9.2 OVERCAPITALISATION
The term "overcapitalization" refers to a circumstance in which a business's actual profits are
insufficient to meet the company's ongoing financial obligations, including the payment of interest
on debentures and loans as well as the distribution of dividends on shares of stock. When a
corporation successfully raises more money than it needs, they find themselves in this predicament.
There is always some portion of capital that is not being used. As a direct consequence of this, the
rate of return exhibits a pattern of decreasing returns.

The causes can be-

1. High promotion cost- Over-capitalization occurs when a business spends a lot of money
promoting itself, such as on contracts, canvassing, underwriting commissions, document drafting,
and the like, but doesn't get enough money back to cover the costs.

2. Purchase of assets at higher prices- In the end, the book value of assets is greater than the real
returns on assets when a company purchases them at an artificially inflated price. As a result of
this, the company has an abundance of cash on hand.

The floatation of a firm during a boom period: There are times when a corporation needs to ensure
that it is solvent to float during boom periods. That is the point at which the rate of return is lower
105 SHOOLINI UNIVERSITY

than the amount of capital being consumed. There are both positive and bad consequences to this,
which include a fall in actual earnings and earnings per share. Lack of enough depreciation
provision: When assets need to be replaced or become obsolete, the company will lack sufficient
finances since the finance manager has failed to provide an adequate rate of depreciation. It's
necessary to spend a lot of money on new assets, and that's pricey.

3. Liberal dividend policy: When a firm's board of directors distributes a significant amount of
its profits to shareholders in the form of dividends, it leaves the company with insufficient retained
profits, an essential component of robust profitability. The end outcome is a lack of progress in the
company. To make up for the shortfall, more capital is sought, which ends up being a more
expensive endeavor and results in the company having more money than it needs.

4. Over-estimation of earnings: Inadequate financial planning can lead to overly optimistic

projections of a company's future revenues, which can force the company to take out loans that it
will have difficulty paying back and prevent it from using its capital in a way that will generate a
profit. As a direct consequence of this, earnings per share will fall as a direct result.

9.2.1 EFFECTS OF OVERCAPITALISATION

On the Shareholders: The over capitalized companies have following disadvantages to
shareholders:

1. As a result of the decline in profitability, the rate of earnings that shareholders take home
is also on the decline.

2. The low profitability of the company leads to a decline in the market price of the shares.

3. The stockholders are being impacted because of the declining profitability. Their income
starts to be a question mark.

4. As the company's goodwill depreciates, so does the stock price. This means that shares
cannot be traded on the capital market as a result.

On Company

1. The company's reputation has suffered as a direct result of its low profitability.
106 FINANCIAL MANAGEMENT

2. The company's shares are difficult to sell off on the market.

3. When a firm's profits fall down, the goodwill of the company goes down with them. When
this happens, it becomes more difficult to obtain new loans because the company's reputation has
been damaged.

4. In order to protect its reputation, the corporation engages in unethical business methods
such as manipulating its financial statements to provide the appearance of great profits.

5. The corporation decreases the amount of money it spends on upkeep, asset replacement,
sufficient depreciation, and other related activities.

On Public: An overcapitalized company has got many adverse effects on the public:

1. The management will resort to underhanded strategies such as jacking up prices or cutting
corners on quality in order to conceal the company's true earning potential.

2. The return on capital utilized is not very high. The public may get the idea, as a result of
this, that their financial resources are not being employed effectively.

3. The company's inability to make timely payments to its debtors hurts its credibility, which
in turn hurts the company's ability to attract new investors.

4. This element has a detrimental impact on both the quality of working conditions and the
payment of wages and salary.

9.3 UNDERCAPITALISATION
When compared to the profits generated by other companies operating in the same industry, a
corporation is said to be undercapitalized if those earnings are significantly higher than average.
The term "undercapitalization" refers to the situation that arises when a company's actual profits
are much lower than the earnings that were anticipated for the business. As a consequence of this,
the outcome is higher levels of cash on hand, increased profits, high levels of goodwill, high
earnings, and a trend toward an increasing return on capital.

The causes can be-

1. Low costs to market

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2. Buying assets at prices that have gone down

3. Conservative dividend policy

4. Flotation of a company during a recession

5. Directors who do their jobs well

6. the right amount of depreciation

7. There are kept large secret reserves.

9.4 EFFECTS OF NOT CAPITALISING ENOUGH

On Shareholders

1. The company makes more money. Earnings go up because of this.

2. The share's market value goes up.

3. The same is true for the financial reputation.

4. The dividend is likely to be high.

On company

1. When you make more money, your reputation gets stronger.

2. When earnings are high, there is more competition in the market.

3. Due to high profits, there may be more need for workers.

4. Customers are less interested in a company that makes a lot of money because they think
it charges too much for its products.

On Society

1. There can be unhealthy speculation in the stock market when earnings, profits, and share
prices are all high.
108 FINANCIAL MANAGEMENT

2. "Most of the people become restless when they link up high profits with high prices of
goods.

3. The company keeps secret reserves, which can help them pay less tax to the government.

4. The general public has high hopes for these companies because they can bring in new ideas,
high-tech products, and the best quality products.

SUMMARY
Capitalization is the amount of money that is permanently invested in a company, minus long-term
loans. The term "overcapitalization" refers to a circumstance in which a business's actual profits
are insufficient to meet its ongoing financial obligations. Inadequate financial planning can lead
to overly optimistic projections of a company's future revenues, which can force the company to
take out loans that it will have difficulty paying back. An over-capitalized company has got many
adverse effects on the public and shareholders. Corporations are said to be undercapitalized if their
actual profits are much lower than the earnings that were anticipated for the business. The
company's inability to make timely payments to its debtors hurts its credibility, which in turn hurts
its ability to attract new investors.

REVIEW QUESTIONS
1.Write about capitalization

2. Write about undercapitalization and overcapitalization

3. Effect of undercapitalization on society

FURTHER READING
Books:

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

https://drive.google.com/file/d/1MWRnLmEZ1ES04wfiETlVWlBBM8BFtjwC/view.pdf
109 SHOOLINI UNIVERSITY

UNIT-10: SOURCES OF SHORT-TERM

FINANCE

CONTENT:

▪ Objectives
10.1 Introduction
10.2 Characteristics of Short-Term Financing
10.3 Trade Credit
10.4 Accured Expenses, provisions and Deferred Income
10.5 Bills of Exchange
10.6 Public Deposit
10.7 Commercial Papers
10.8 Inter-Corporate Deposits (ICDs)
10.9 Short-term Unsecured Debentures
10.10 Bank Finance
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand

● Knowledge about source of finances

110 FINANCIAL MANAGEMENT

● Short term sources of finance

● Its benefits and limitations

10.1 INTRODUCTION
A year or less is considered short-term in the world of finance. The next year's financial needs are
included in this list. Short-term loans are the primary source of working capital. Raw supplies,
salaries, taxes, and rent are all paid for with short-term funds. In most cases, short-term sources of
financing include trade credit, bank credit and native bankers, public deposits, advances from
consumers, personal loans, retained earnings, expenses already paid, and a tax and depreciation
fund. Sources that come up on their own and sources that are negotiated are the most common
types of short-term finance. While a business is operating, "spontaneous sources" of money are
referred to as such. A variety of sources of credit can be utilised to illustrate this point, including
trade credit, employee credit, service provider credit, and so on. These sources are those that must
be discussed with lenders, such as commercial banks and financial institutions. Financiers need to
exercise extreme caution when deciding how to finance working capital. Before making any
judgments, it is critical to consider the following criteria. A company's short-term funding needs
can be met by hedging or matching their strategy, which implies obtaining short-term funds with
the same maturity as the company's short-term funding demands.

10.2 CHARACTERISTICS OF SHORT-TERM FINANCING

In the next paragraphs, we'll discuss what sets the short-term apart. Short-term loans are typically
less expensive than long-term loans. For short-term financing, the banking system is the most
common source, with overdrafts or loans being quick and inexpensive to get. Long-term investing
necessitates hiring a slew of experts, including lawyers, auditors, and other professionals whose
services might be prohibitively expensive when selling stock to the general public. Negotiating an
overdraft with a bank doesn't require this expertise, but the bank may impose a fee for the overdraft
facility and interest on the overdraft when it is used.

Borrowing or lending money for a short time, like a year or less, is called short-term financing. In
almost every type of business, small businesses are more likely to use short-term financing, while
large businesses are less likely to do so. This is probably because it's hard for a small business to
111 SHOOLINI UNIVERSITY

get long-term funding because the average credit score is low and many small units don't last very
long. Short-term financing includes loans from the commercial bank, trade credit, and other places
that must be paid back in less than a year. Trade credit is when a business lets a customer put off
paying for goods they've bought, sometimes for a month or more. Most of the time, short-term
financing is used to pay for business assets that come up often and are used up or consumed during
operations. These kinds of assets are also called "working assets" or "current assets." When
customers make advances on contracts, they can sometimes help with short-term cash flow. In
essence, they pay for the goods before they are sent to them. Customers might give money to the
manufacturer ahead of time if the order is big enough for the manufacturer to have to spend more
money on raw materials or goods than he or she can afford.

10.3 TRADE CREDIT

Trade credit is a type of working capital that comes from suppliers of goods during normal business
transactions. Trade credit is the credit given to a retailer to buy goods to resell or to a manufacturer
for raw materials used to make products. So, trade credit can be thought of as the credit that can
be used to buy goods and services to sell again. Trade credit is different from other sources because
it can be "resold." Using an example, it can be demonstrated that fixed assets can be purchased on
credit, but since they are used in the production process and not for resale, this type of credit
purchase of fixed assets is not considered trade credit. It is possible that a corporation does not
have to pay for its purchases straight away. While payment is not yet due, buyers nevertheless owe
their sellers money during this time period. On the buyer's balance sheet, this debt is listed as a
creditor, whereas the supplier's account is listed as a debtor. Normal commercial transactions
provide the company with short-term funding because of the time lag between receiving goods
and services and being paid for them (called trade credit). The amount of this kind of financing
depends on how much is being bought and when the payments are due. Small and new businesses
often depend more on trade credit because it's hard for them to get money from other sources.

10.3.1 BENEFITS OF TRADE CREDIT

Trade Credit is an improvised way to get money. When the amount of business goes up, the amount
of credit goes up automatically, too. Let's say that a buyer is used to getting credit for 30 days and
spends ₹10,000 every day. If his business grows and he spends ₹3,00,000 (30 x 10,000) to
112 FINANCIAL MANAGEMENT

₹4,50,000 on purchases (30 x 15,000). Informally, the buyer gets extra credit because he paid on
time after 30 days.

10.4 ACCURED EXPENSES, PROVISIONS & DEFERRED INCOME

10.4.1 ACCRUED EXPENSES
The expenses that have already been paid or are still owed are another source of short-term
financing. The firm has used services for which it hasn't yet paid. This is what is meant by "accrued
expenses." Staff salaries are the best example of this. When employees work for salaries and
wages, the company gets the benefit of their work right away, but they don't get paid until the end
of the month. This means that employees are also a source of short-term cash for the company they
are employed for. It's not just electricity and phone services that fall into this category: You get
the service first and pay at the end of the month. Corporate taxes are paid every three months,
while profits are made whenever a sale is made. Even the government has given credit to
businesses for their cash sales in this way. It is necessary to make a provision for accrued expenses
when invoices are not paid and the accounts need to be closed so that profit and financial position
are correctly reported on the balance sheets. When a service is rendered, it is often paid for at the
end of the term. Accrued expenses are an unexpected and interest-free way to get money. Accrued
expenses don't have any explicit or implicit costs, and the company can save cash by letting them
build up. The more time there is between payments, the more money the company makes. But
because of laws and other problems, the firm can't put off paying for as long as they want. Short-
term financing helps the company until they pay it back.

10.4.2. PROVISIONS AND FUNDS GENERATED FROM OPERATIONS

Profit after Tax, the estimated costs of future expenses like dividends, bonuses, etc. are subtracted.
Since these provisions don't require cash right away, they give the company money it can use right
away. But the company will have to pay for these costs out of the money it makes in the future.

During an accounting period, the amount of working capital goes up by the same amount as the
amount of money made from operations. Profit and depreciation are the two main parts of money
made from operations. Working capital will grow based on how much money is made from
operations.
113 SHOOLINI UNIVERSITY

10.4.3 DEFERRED INCOME

Deferred Income is money that was paid up front for services that will be done in the future. The
firm has more money after getting the money. Deferred income, on the other hand, can only benefit
enterprises with significant demand for their products and services and a strong market position.
When it comes to pricey goods that require a long time to develop or build, manufacturers and
contractors often demand money in advance. When a project is "turn-key" or when goods need to
be made for a specific need, a down payment is required. This keeps the sale from being cancelled
after the order has already begun to be carried out. Most contracts have a clause that says any
payments made in advance will be lost if the contract is cancelled. When goods and services are
given, these advances are changed. The amount is a liability in the books of the recipient until the
service is provided. This is a great way to get money for your business with no cost.

10.5 BILLS OF EXCHANGE

Using bills of exchange, it's simple to issue trade credit. The buyer is given a bill of exchange as
documentation of the transaction by the selling when the seller is uncertain about getting paid on
time. Bill of exchange accepted and timely payment received by buyer. It is a record of a trade
credit, in other words. Bulk merchants call them "bills receivable," whereas small retailers refer to
their bills as "bills payable," respectively. The term "bills receivable" is used instead of "different
debtors" in wholesalers' financial statements. In the accounts of retailers, various creditors are
replaced by bills that need to be paid.

As an additional source of working capital, a vendor might negotiate with his banker to have past
due accounts discounted. Even if the buyer's creditworthiness is unquestioned, a seller who wants
to be able to resell the bill of exchange for money may opt for this payment option. If the supplier
and buyer don't sign the bill of exchange, the supplier can get money from the bank by putting the
book debts up as collateral. In other words, there are different ways to meet working capital needs,
such as discounting bills of exchange and hypothecation of book debts.

The biggest benefit of a bill of exchange is that it pays for itself. The due date is set, and the buyer
can't avoid paying, which is not the case with book debt. Suppliers can also use his banker to
discount their receivables and obtain working capital.
114 FINANCIAL MANAGEMENT

10.6 PUBLIC DEPOSIT

A deposit from the public is one of the most important ways for big, well-known companies with
a lot of capital to get money for the short and medium term. By giving a high rate of interest, the
company could get short-term money from the public. The deposits that non-financial
manufacturing companies get from the public are called "public deposits" or "fixed deposits."
Companies' amendment rules, which are now referred to as company law, govern public deposit
rules. Nevertheless, a firm that wishes to accept public deposits can only receive 10% of its paid-
up share capital and free reserves.

Every three months, the rate of interest on a public deposit is computed at 15%. The registrar of
companies must be informed of a company's name, registration date, profits, and other relevant
details before it may begin advertising in order to raise money through a public deposit.

10.7 COMMERCIAL PAPER

The term "Commercial Paper" refers to a promissory note that is short-term and unsecured. These
notes are issued by companies that have a credit rating that is fairly high. It was initially distributed
in the United States, which went on to become a significant money market instrument. Following
the recommendations made by the Vaghul Working Group on the Money Market, the Reserve
Bank of India implemented CP in the country of India. Only large companies in a healthy financial
position are eligible to receive short-term financing through CP.

a) The maturity of Commercial Paper can be changed to fit the needs of the company that issues
it.

b) Even when the money market is tight, Commercial Paper can be issued as a way to get money.

c) Most of the time, Commercial Paper costs less for the company that gives it out than commercial
bank loans.

10.8 INTER-CORPORATE DEPOSITS (ICDS)

Inter-corporate Deposits are payments made by one company to another company and are referred
to by that name (ICDs).
115 SHOOLINI UNIVERSITY

These deposits are often made for a period ranging from one month to six months at a time. These
deposits can be one of three diverse types:

1. Deposits for Calls: Deposits are expected to be paid when the call is made. With just one day's
notice, whenever it's owed. But in reality, the lender would have to wait at least two or three days
before they can get their money back from the borrower. A yearly interest rate of 12 percent is
normal for deposits made between businesses.

2. Deposits for a period of three months: Businesses wishing to invest their surplus income
choose this form of deposit the most. This type of deposit is used by the borrower to cover a
shortage in accessible money for a limited period of time. The annual percentage rate of return on
these types of deposits is around 14%.

3. Deposits for a Maximum of Six Months: Inter-company deposits are typically made for six
months or less in most circumstances. Borrowers in the 'A' category commonly have access to
these types of deposits, which typically have an annual interest rate of roughly 16 percent.

10.9 SHORT-TERM UNSECURED DEBENTURES

Companies have used unsecured debentures with terms of up to 17 months and 29 days to get
money for short-term needs. These debentures may have a higher rate of interest than secured long-
term debentures. It's important to note that these debentures don't need a credit rating because,
according to SEBI rules, credit ratings are only needed for debentures with a maturity of 18 months
or more. The capital market in the economy determines whether or not unsecured debentures can
be used as a source of short-term financing. When business is slow, the companies might not be
able to give out these debentures. Debentures can also only be given out by well-known companies,
since investors won't be interested in a new company. Another problem with this source is that the
company doesn't get a lump sum from just one source. Instead, it gets money from individual
investors. Also, issuing securities on the capital market is a time-consuming process that needs to
be carefully planned.

10.10. BANK FINANCE

There are different kinds of short-term loans that a bank can give to businesses. It might give
money in a direct or indirect way. You don't get any money from the bank when you use a letter
116 FINANCIAL MANAGEMENT

of credit, for example. Direct financing, such as cash credit, overdraft, note lending, and
discounting of bills, involves a bank providing funds and taking on the associated risk. This is
known as "risk-free" financing. It's the company's responsibility to tell the bank how much working
capital it will need. In response to this request, the bank extends a line of credit to the company.
An additional sum is added to the amount of money that the corporation has already borrowed. A
condition of a loan is that the borrower's operational accounts must constantly have a minimum
amount. This is called a "compensatory balance."

SUMMARY
There are several ways to raise short-term cash include accumulated expenses, provisions, trade
credit and bank finance, public deposit, commercial papers, treasury bills, factory and
Eurocurrency, etc. Trade credit is a significant short-term funding source. When a company
acquires goods on credit, this problem occurs. If the firm accepts trade credit, it must also consider
the cost of not taking advantage of the supplier's cash discount. Delayed payments and liabilities
lead to accrued expenses and deferred payments. In turn, the company gains the ability to put off
payments, resulting in extra cash. Short-term loans are almost exclusively obtained through banks.
Bank borrowing includes cash credit, bank overdraft, payment discounting, short-term loans, and
letter of credit. A company's demand for operational capital dictates how much money a bank is
willing to lend.

The provision of bank credit is governed by several RBI regulations. In the money market,
commercial paper is a vital tool. Commercial paper is issued by the highly rated, blue-chip
corporation for short-term financing. It is customary for commercial papers in India to be issued
with maturities of 91 and 180 days.

REVIEW QUESTION
1 What Are the Various Sources of Short-Term Credit Available to an Enterprise In India.

2. Describe Public deposits as a method of financing Working Capital in India.

3. Write about Bills of Exchange

4. Write about Bank Loan.

117 SHOOLINI UNIVERSITY

FURTHER READING
Bhalla V.K. (2006); ‘Management of Financial Services’ Third Revised and Enlarged Edition,
Anmol Publications Pvt. Ltd., New Delhi.

Kulkarni P.V., Satyaprasad B.G.(2007); ‘Financial Management’, Himalaya Publishing House,

Mumbai

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Chandra, P., Financial Management—Theory and Practice, New Delhi, Tata McGraw

Hill Publishing Company Ltd., 2002, p. 3.

I.M. Pandey, Financial Management, 8th Edn., Vikas Publishing House Pvt. Ltd.
118 FINANCIAL MANAGEMENT

UNIT-11: SOURCES OF LONG-TERM

FINANCE

CONTENT:

▪ Objectives
11.1 Introduction
11.2 Financial Needs and Sources of Finance of a Business
11.3 Share Capital
11.4 Debentures/Bonds
11.5 Difference between Shares and Debentures
11.6 Retained Earnings
11.7 Term Loan
11.8 External Commercial Papers
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you will be able to understand:

● Long term sources of finance

119 SHOOLINI UNIVERSITY

● Purpose of raining long term finances

● Share capital, preferences share, debentures

11.1 INTRODUCTION
For funds to work well, the company needs to keep enough money on hand. Just like there should
be enough blood in the body, there should be enough money in a business. Fixed capital, non-
movable capital, or long-term capital are all synonyms for long-term finance. Firms require long-
term capital for the acquisition of fixed assets, expansion/improvement, diversification, and the
acquisition of other businesses, among other things.

There are two things about long-term finance. 1. It's used to pay for the company's long-term
financial needs. 2. It's a fixed amount of money that can't be changed at will. At the time of firm
inspection, long-term finances are used to buy fixed assets like land and buildings, machines,
furniture, fittings, and patents.

One of the most important aspects of initiating a new project or undertaking growth,
diversification, modernisation, or rehabilitation is determining the project's cost and available
finance. Any company can obtain funding from a variety of sources.

An efficient process is needed to assess the risk, term, and cost of each source of funding that a
corporation has access to. The choice of the source of funding depends on the firm's financial
strategy, the level of leverage it intends to use, the state of the economy's finances, and the risk
tolerance of both the company and the sector it works in. Every funding source has some benefits
and drawbacks.

11.2 FINANCIAL NEEDS AND SOURCES OF FINANCE OF A BUSINESS

If financial requirements are expressed in terms of time/period, then requirements/needs for fund
may be grouped into three categories:

To raise money for their operations, all firms rely on several kinds of financing. Business funds
are the resources needed to carry out daily operations. A firm cannot function correctly without
sufficient finances; it can only operate smoothly when it has sufficient funds.
120 FINANCIAL MANAGEMENT

Businesses constantly need money, and they raise it through a variety of forms of funding. These
financial resources can be divided into groups according to their generational sources, ownership
and control, and time.

For individuals who are starting a new business or already running an existing business, choosing
the appropriate sources of money is one of the most challenging tasks. Therefore, before choosing
from which source to acquire funds, every institution should consider all factors pertaining to
various resources of funding.

Further classified in to three categories:

11.2.1. BASED ON PERIOD

The period basis is further divided into three dub-division.

Long Term Source of Finance – Over a five-year period, this long-term money is used. The fund
is gathered from the capital market and is organised through preference, equity, and debentures,
among other instruments.

Finances for the long term are not liquid in nature.

Equity Shares, Preference Shares, Retained Earnings, Debentures, and Long-term debts, among
other things, are all long-term sources of money.

Medium Term Source of Finance – These short-term investments have a duration of more than
a year but less than five years. The funding comes from a variety of sources, such as loans from
financial institutions, commercial banks, commercial paper, and lease finance.

Short Term Source of Finance – These funds are only needed for the upcoming year. These
sources include trade credit, working capital loans from commercial banks, and others.

11.3 SHARE CAPITAL

The law says that the company can sell shares to get money. The money you get from selling
shares is called "ownership capital." Justice Lindle said, "Share is the proportional amount of profit
that a holder is entitled to."

There are two kinds of shares that the company can give out:
121 SHOOLINI UNIVERSITY

Equity Shares and Preference Shares.

11.3.1 EQUITY SHARES

Equity Shares are the Owner’s Equity that doesn't expire. It is also called "ordinary shares" or
"common shares." These are the real owners of the company because they can vote and make
important decisions about the company. Without these shares, investors won't be willing to give
the company money in the form of Debt or Preference Shares. The return for Equity Shareholders
comes in the form of dividends. How much they get back depends on how much money the
company makes and how much they gain or lose when they sell their shares. The Indian Company's
Act says that when a company gives out shares for the first time, they must do so at their par value.
But more shares can be given out at a higher price.

11.3.1.1 FEATURES OF EQUITY SHARES

Maturity- They give the company access to capital on a permanent basis, and there is no
predetermined expiration date for such funds. After paying off all of the company's debts, the
shareholders will only be entitled to their share of the profits in the case that the company is forced
into liquidation. If, on the other hand, shareholders feel the need to liquidate their investments,
they have the option of selling their shares on the secondary market.

Claim on Income: All of the company's remaining revenue and assets belong to the company's
shareholders. Preference shareholders receive dividend payments after operational revenues are
used to fulfil all of the company's costs and commitments. If there is still a profit after all the
conditions have been met, then that profit is paid out as a dividend to the equity shareholders.

Claim on Assets- Owners of the company's equity share have the right to a residual claim on the
company's assets. During the process of the company's winding down, the assets are liquidated
and utilised to pay off any remaining liabilities as well as expenses. After then, the equity
stockholders have the right to stake a claim on any remaining assets, assuming there are any.

Right to Control or Voting Rights- In the annual general meeting, the equity shareholders can
vote on any motion that is brought up for consideration. It is determined by the amount of each
shareholder's paid-in capital. The equity shareholders choose who will serve on the boards of
directors, and those same shareholders also choose who will be the company's managers. The
122 FINANCIAL MANAGEMENT

equity shareholders are in the position to exercise the utmost and complete control over the
operations of the organisation.

Pre-emptive Rights- In order for a corporation to issue additional equity shares, it must first offer
those shares to its existing owners. The pre-emptive right is the name given to this notion. The
goal is to allow shareholders to retain a proportionate share of the company's equity. – As an
illustration, a firm is required to offer 5% of newly issued shares to a shareholder who holds 5%
of the company.

Limited Liability- The possible legal duties of equity investors are capped at the value of their
shares. Even if the company goes bankrupt and its liabilities exceed its assets because of the
shareholder's full payment of the face value, he or she has no further responsibilities.

No Cash Outflow: Considering that Equity Financing is a consistent way to acquire capital. The
concern that the corporation will lose money due to redemption or cash flow is unfounded. The
funds will remain accessible within the firm up until the point that the company is put into
liquidation.

Borrowing Base: Because the company has sufficient capital, providing money to it makes the
lenders feel secure. In most cases, they make loans based on a percentage of the firm’s Equity
Capital.

No Compulsion for Payment of Dividend: The equity shareholders are the company's residual
claimant, and paying the dividend isn't a requirement. dividend payments may be put on hold if
the company has financial issues.

Real Owners and Gainers: The Equity Shareholders are the ones in charge of the company's
operations; as a result, they are the true owners of the business, and in the event of a profit, they
are the ones who benefit the most, both in terms of increased dividends and an increase in the
stock's value on the market.

11.3.1.2 DEMERITS OF EQUITY FINANCE

Cost of Equity: When compared to the costs of other sources of financing, the cost of financing
via equities results in the highest overall cost because dividends are not tax deductible. In addition
123 SHOOLINI UNIVERSITY

to this, floatation costs are incurred, which are significantly higher than the loan. Floatation costs
are expenses that are spent incidentally by the company in conjunction with the issuance of shares.

Trading on Equity: Only when debt is issued in addition to the stock share is it possible for the
company to meet all of its financial obligations. Rather, it is only achievable when both types of
capital are issued together. The earnings of stock shares can be increased through trading on equity.

Risk: When opposed to debt, the stock carries a higher level of risk for investors because there is
no assurance that they will receive a return on their investment. Obtaining the capital through the
sale of equity is not only more complex but also more expensive.

Dilution of Earnings: If a firm issues extra shares but does not correspondingly raise its
profitability, the earnings per share will be diluted because of the company's actions.

Ownership Dilution: To keep the proportionate ownership structure intact, the firm decides to
issue additional shares to the shareholders it already has. If there is a problem with finances, the
current management is likely going to be forfeited. The risk associated with a corporation that is
closely held.

11.3.2 PREFERENCE SHARES

Preference shares, as the name suggests, are preferable to equity shares in some respects. Preferred
shareholders receive dividends and their principal restored first in the event of liquidation. In
contrast to equity owners, whose dividends are paid once their investment is repaid, non-equity
stockholders do not receive dividends. Equity shares and debentures can be found in preference
share capital, which is a hybrid security. After the Finance Bill of 1997, preference shares have
become more important because dividends are no longer taxed for individual investors but are still
taxed for the company because a flat tax rate is applied to all distributed profits. Now, a domestic
company that pays dividends must pay a dividend distribution tax of 12.5%, a surcharge of 10%,
and an education cess of 2%. (Total 14.025 percent)

11.3.2.1 FEATURES OF PREFERENCE SHARES

Maturity- Preference shares will always be there. Like equity shares, they don't have to be paid
back over time. If the company goes out of business, they get their money back after debenture
124 FINANCIAL MANAGEMENT

holders are paid. But unlike equity, it may have a call back feature or a way to get out of it. If the
shares are redeemable or can be called, they can be redeemed at maturity.

Claim on Income Assets- This type of security is more significant than equity shares. To put it
another way, the preference The rights of shareholders over the company's profits and dividend
payments are superior to those of equity holders. If the company goes out of business, the people
who own the preference shares get their money back before the people who own equity shares.

Nature of Preference Dividends- The dividend on preference shares is set, and even if the
company makes more money than expected, preference shareholders don't get any extra dividends.
If the company's bylaws allow it, any dividends that were not paid because the company lost money
that year will be carried over to the next period and paid when the company makes money.

Controlling Power- Preference shareholders don't get to vote on how the company is run. They
do, however, have the ability to vote on issues that have an impact on them personally. The board
of directors of a company can be filled by preferred shareholders if dividends are not paid for two
years in a row.

Hybrid form of Security: The preference share capital is a hybrid type of security because it has
some features of both equity shares and debentures. When dividends aren't paid, a company doesn't
have to go out of business if it has preference shares. Not everyone has to pay dividends. But you
can't get a tax break for dividends. The dividend rate on a preference share is fixed, just like the
interest rate on a debenture. They have no right to any of the company's future profits.

Not Tax Deductible: Since the company pays preference dividends after it has paid taxes on its
income, they are not tax deductible. Interest paid on debt is taken out before taxes are paid, which
is different from preferred dividends. This is called a "interest tax shield" because it makes paying
taxes less expensive. So, preferred capital costs more than debt that a business has to pay back.

Participation: Company sometimes gives out "participating preference shares." When this
happens, the preference shareholders get the same right as equity shareholders to share in the rest
of any extra profits, but in a different amount. A fixed dividend and a variable payout are both
available to preference shareholders, thus they receive both fixed and variable dividends.
125 SHOOLINI UNIVERSITY

11.4 DEBENTURE /BONDS

A promise to give a loan for a longer duration is called a debenture. It could be safe, or it could
not be safe. Debenture or Bond is a security for a creditor that has a fixed interest rate and a fixed
date when it will be paid off. Debentures are a way for a company to get money with little risk.
People who have money in debentures are called "debt holders

11.4.1 FEATURES OF DEBENTURES/BONDS

Maturity: Debentures are long-term investments that are issued for a specific period of time.
Debentures are issued for a period of seven to ten years and must be repaid on a specific date.

Fixed Interest Rate: No matter how much or how little money the company produces, the interest
rate on a debenture is fixed and cannot be changed. The interest is calculated using the debenture's
face value. The person who owns the debenture can deduct the interest from their taxable income.
This means that the person who owns the debenture must pay taxes on it.

Claim on Income: Even if a company loses money, it still must pay the interest it owes. If an
interest payment isn't made on time, the person who owns the debenture can ask a court to close
down the company.

Claim on Assets: When a company goes bankrupt, debenture holders get their money first, before
any other investors.

Callable Features: Using the call option, the corporation can purchase back the debentures ahead
of schedule. If the interest rate the firm will have to pay is higher than the present interest rate, the
company is usually able to do so. The debentures are paid off ahead of schedule by the company.
This saves you money. To call is generally more expensive than to buy. Keeping in mind that the
company is producing money, it's not an issue to distribute some of that cash to the holders of
debentures.

Treaty or Trust Deed: The firm that issues the debentures and the trustees who represent the
debenture holders have entered into a legally binding contract. Debenture holders, the issuing
corporation, and the trustees all have rights and responsibilities that are explained in full in the
trust deed. The role of the trustees is to ensure that the corporation that issued the debentures lives
126 FINANCIAL MANAGEMENT

up to its promises to the holders of the debentures. Most of the time, a trustee is selected from
among banks or insurance companies.

Controlling Power: A person who owns Debentures doesn't have the right to vote, so they don't
have control over the company and can't take part in running it. They only have a right to get paid
back before equity and preference shareholders.

11.5 DIFFERENCE BETWEEN SHARES AND DEBENTURES

The interest rate on the Debentures is flat fixed and the company has to pay it no matter how much
money it makes.

Usually, debentures are backed by something. Companies give debenture holders collateral
security to make them feel safe from a security point of view. Debenture holders are not likely to
lose money if the company goes bankrupt, as long as they are safe, and enough money is made
when they are sold.

Table 11.1
127 SHOOLINI UNIVERSITY

11.6 RETAINED EARNINGS

Profits that are left over after the distribution of interest and dividend in the business are called
"retained earnings." Later on these retained earnings used to buy permanent fixed assets that are
needed for growth, diversification, or a merger or takeover. Some people think that the company's
retained earnings are a free source of money, but this is not always the case. It is not at all right.
But the cost of money that comes from retained earnings is less than the cost of money that comes
from new equity capital. The company needs to think about how much money the shareholders
could get if the profits were shared instead of kept. It's clear that it should give these funds back to
the shareholders if it can't make at least the same amount of money from them. Some people think
that all the company's profits should be given to the shareholders as dividends, so they can reinvest
them as they see fit. But it might be expensive to give out all of the profits and then ask stockholders
to buy new shares. So, the Company should remember that it should only keep earnings if it makes
sense to do so after looking at the different costs.

11.7 TERM LOAN

In addition to stock capital and debentures, companies can obtain long-term financing in the form
of term loans. Commercial banks, development financial institutions, state-level financial
institutions, and investment organisations in India all give term loans to the industrial sector in
support of the expansion of India's manufacturing sector.

They are use as a method of payment for large projects that may involve

● Modernization

● Expansion

● Diversification.

The term "project financing" can also refer to financing in the form of term loans. The fact that a
term loan is just for a predetermined period is one of its most attractive features. Profits from the
company could be used to make payments in instalments rather than all at once. In addition, the
interest liability is set and cannot be altered in any way. This ensures that the profitability of the
project will remain stable for a considerable amount of time.
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11.8 EXTERNAL COMMERCIAL BORROWINGS

It is possible for Indian entrepreneurs to borrow money directly from foreign organisations, such
as the World Bank or other international development banks. Foreign Currency Term Loans are
another name for it. Financial assistance in the form of loans in a foreign currency is provided by
international institutions. The foreign currency is used to pay the interest on these loans. On the
date of payment, the amount of interest is changed into the local currency at the current foreign
exchange rate. The project's cash flow can be used to decide how much to borrow, how much to
pay back, and how much to pay in interest. This is done with the help of restrictions that are written
into the agreement when a term loan is given.

SUMMARY
Long-term funds are used, among other things, to buy fixed assets, expand or improve
programmes, diversify, buy, take overs and mergers, and form alliances. Long-term funds can
come from many places, such as stock capital, debentures, bonds, retained earnings, foreign loans,
term loans, venture capital, leasing, etc. Equity capital is money that comes from the company's
owners and stays there forever.

Permanent capital also includes preference capital, but equity investors have more power and
voting rights than preference investors. People who own preference shares get their share of the
investment and profits before those who own equity shares. Debentures are long-lasting
promissory notes that can be secured or not. Debentures always have the same rate of interest.
Bond and debenture holders are paid first, before equity and preference shareholders.

REVIEW QUESTION
1. "From an investor's point of view, debentures are the least risky, preference shares are slightly
riskier, and equity shares are the riskiest." Talk about and point out the differences between any
two long-term financial tools.

2) How do term loans work? What do they look like?

3) Tell me about the different kinds of deposit slips.

129 SHOOLINI UNIVERSITY

FURTHER READING
Books

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

https://drive.google.com/file/d/1MWRnLmEZ1ES04wfiETlVWlBBM8BFtjwC/view.pdf
130 FINANCIAL MANAGEMENT

UNIT-12: LEVERAGE ANALYSIS

CONTENT:
▪ Objectives
12.1 Introduction
12.2 Financial Leverage
12.3 Operating Leverage
12.4 Combined Leverage
12.5 Difference between operating leverage and financial leverage
12.6 Advantages and Disadvantages of Leverage
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this Unit, you will be able to understand

● Leverage

● Different type of leverage.

● Operating Leverage, Financial Leverage and Combined Leverage.

131 SHOOLINI UNIVERSITY

12.1 INTRODUCTION
Leverage refers to use of borrowed money to invest in a business so that the owners/shareholders
can make as much money as possible. Levered is the term for a business that has borrowed money
as part of its capital structure. Un-levered refers to a business entity or firm that has no debt funds.
In general, the word "leverage" refers to the relationship between two things that affect each other.
In financial analysis, leverage shows how one financial variable affects another financial variable
that is related to it, for example, the variable can be cost, output, earnings before interest, and taxes
etc.

It is the quantity of fixed income securities, such debt and preferred stock, that a firm utilises that
determines its level of financial leverage. Financial leverage increases as a result of more debt
borrowing. The higher the company's financial leverage, the more interest it must pay, which in
turn reduces its bottom-line earnings per share. When a corporation has greater debt and preferred
stock, it poses a financial risk to its shareholders. When a company takes on more debt and
preferred shares, interest payments go up, which lowers EPS. Because of this, the risk to the return
of stockholders is increased. Consider your company's best capital structure while making
financing decisions.

Any increase in debt and preferred stock will have a positive impact on the company's valuation.
A company has to decide how to pay for its capital projects based on how it budgets for its capital.
Every time the company decides to invest, it also decides how to pay for the investment. When
you decide to build a new plant or buy a new machine, you have to find a way to pay for it. Should
a business use debt or equity? What does the mi of debt and equity mean? How much debt and
how much equity is right?This unit will teach you how to measure financial leverage and how
operating and financial leverage affect profit. You will also learn about the MM hypothesis and
the capital structure theories

12.2 FINANCIAL LEVERAGE

Financial leverage is a type of leverage that a company gets from the debt part of its capital
structure. The more debt you have, the more financial leverage you have, because you have to pay
more interest on more debt. Leverages can help or hurt a business, depending on the circumstances.
Leverage can boost a company's return to shareholders if it can generate a better ROI than the
132 FINANCIAL MANAGEMENT

interest rate it is paying. As a result of this, significant leverage can lead to a company's downfall,
such as bankruptcy.

The use of financial leverage is a measure of the associated financial risks. The ratio of a
company’s earnings before interest (EBIT) to its earnings before taxes (EBT) is known as its
financial leverage. The existence of interest expenses has an either positive or negative effect on
the degree of operating leverage. When a company's financing costs (interest charges) are high, it
will be more likely to go bankrupt, and the inverse is also true. A company's capacity to employ
fixed financial costs to boost the effects of EBIT/operating profits on its earnings per share is
known as financial leverage.

A company’s income statement depicts two fixed financial costs:

1. Interest on loans and 2. Dividends on preferred shares.

These fees must be paid no matter how much EBIT is available to pay them.

12.2.1 SIGNIFICANCE OF FINANCIAL LEVERAGE

Leverage may be a blessing and a curse. Increasing earnings per share while also increasing
financial risk are two sides to this equation. A high degree of financial leverage entails both a
higher level of fixed costs and a higher level of risk. Financial leverage and financial risk (i.e., the
likelihood of a bankruptcies) rise in lockstep with an increase in the capital structure's debt
component.

12.2.2 DEGREE OF FINANCING LEVERAGE

Measurement of changes in operating profit or earnings before interest, taxes and depreciation
(EBIT) on the earnings per share (EPS). It is calculated as:
133 SHOOLINI UNIVERSITY

12.2.3 THE IMPORTANCE OF FINANCIAL LEVERAGE

1. Using this tool, financial managers can create the most efficient capital structure feasible.
"Optimal Capital Structure" refers to the combination of debt and equity that results in the lowest
total cost of capital while at the same time maximising the value of the company.

2. It enhances both the earnings per share (EPS) and the risk of company’s finances.

3. High financial leverage results in high fixed expenses and high financial risk.

4. A proper balance between risk and reward is maintained in the Capital Structure through this.

5. It illustrates the surplus of return on investment over the fixed cost of using the funds.

6. It is a handy tool for determining how much debt to incorporate in a company's capital structure.

12.3 OPERATING LEVERAGE

Fixed operational expenditures such as depreciation, insurance, asset repairs, property taxes, etc.
can be leveraged in a firm's operations to increase profitability. However, this does not cover the
cost of borrowing money. A company's operating leverage is determined by the percentage of fixed
operating costs compared to variable operating costs.
134 FINANCIAL MANAGEMENT

12.3.1 DEGREE OF OPERATING LEVERAGE

Operating profit is a measure of the impact of changes in sales on the profitability. As a percentage
change in EBIT (operating profit) to sales change, the degree of operating leverage is stated.

12.4 COMBINED LEVERAGE

Combined Leverage is a type of leverage that refers to high profits as a result of fixed costs. It
combines fixed operating and fixed financial expenses. It represents fixed quantity leverage
benefits and risks.

12.4.1 SIGNIFICANCE OF COMBINED LEVERAGE

How important is combined leverage?

It is very risky to have both a lot of operating leverage and a lot of financial leverage.

If the company is making and selling a lot of things, its shareholders will make a lot of money.

But even a small drop in the amount of business would cause earnings per share to drop by a lot.

Because of this, a company must strike the right balance between these two leverages.

High operating leverage has been tempered by low financial leverage, indicating that management
is being prudent, as evidenced by the low financial leverage.

In contrast, having a low operating leverage and high financial leverage would be preferable.
135 SHOOLINI UNIVERSITY

12.5 DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

• Financial leverage is connected to the firms capital structure, whereas operating leverage is
related to the company’s operating cost structure.

• The risk a company confronts in its business operations can be measured using operating
leverage, whereas the risk a company has in its financial operations can be measured using
financial leverage.

• The link between a company's Sales revenue and its EBIT (Operating Income) is what
determines a company's Operating Leverage, whereas the relationship between a company's EBIT
(Operating Income) and its EPS (Earnings Per Share) is what determines the Financial Leverage
of a company.

• If the company has a larger degree of operating leverage (DOL) than financial leverage (DFL),
it means it is more vulnerable to business risk than it is to financial risk, and vice versa.

12.6 ADVANTAGES AND DISADVANTAGES OF LEVERAGE

12.6.1 ADVANTAGES OF LEVERAGE
Overall, using Leverage has some benefits when the economy is doing well, but it also has some
drawbacks. Advantages of using more debt: e.g. operating leverage . With a small change in sales,
operating profits can go up by a lot because most of the costs stay the same and can't go up any
more. Also, if we think about financial leverage, if operating profits go up, each shareholder's share
of the earnings will go up a lot. Here, the operating profits and earnings per share will go up by a
bigger percentage the more leverage there is.

12.6.2 DISADVANTAGES OF HIGHER LEVERAGE

When you use debt, you run the risk of going bankrupt. In operating leverage, fixed costs push
back the point at which a business breaks even. The lowest level of activity (sales) required to
avoid any losses or gains is known as break even. Financial leverage necessitates a higher level of
operational income to cover interest payments. If the required level of activity isn't met, the
company will go out of business or suffer a loss of funds.
136 FINANCIAL MANAGEMENT

There is a need for a balance between the advantages and disadvantages of leverage when
considering the pros and cons. When it comes to leverage, you don't want to go overboard and risk
bankruptcy, but you also don't want to go too low and miss out on the benefits. Financial leverage
refers to the extent to which a firm utilises fixed-income products such as debt and preferred stock.
When you use a lot of borrowed money, you have to pay a lot of interest. Because of this, interest
payments have a bad effect on the bottom line earnings per share. As interest payments go up
because of more debt, earnings per share (EPS) go down.

As we've already said, financial risk is the risk to stockholders that comes from a company's capital
structure having more debt and preferred stocks. When a company takes on more debt and
preferred shares, interest payments go up, which lowers EPS. Because of this, the risk to the return
of stockholders is increased. An organisation must think about its optimal capital structure while
making decisions about financing. As a result, debt and preferred stock rises will have a positive
impact on the company's valuation.

SUMMARY
● In financial analysis, leverage shows how one financial variable affects another financial
variable that is related to it. The amount of leverage in a company’s capital structure can
have a significant effect on the value by changing the returns and risks of the company.
Operating leverage shows how a company’s sales revenue compares to its EBIT.

● The company uses break even analysis, also called cost volume profit analysis, to figure
out how much it needs to make to cover all its operating costs. High operating leverageis
good when sales are going up; but it is bad when sales are going down.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

● Financial leverage = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

REVIEW QUESTIONS
1. Define leverage. Mention different types of Leverage.

2. What do you mean by operating Leverage?

3. Discuss the concept of Financial Leverage.?

137 SHOOLINI UNIVERSITY

FURTHER READING
Solomon, Ezra and Pringle John J.: An Introduction to Financial Management, Prentice-Hall of
India.

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra : Financial Management, Tata McGraw Hill

I.M. Pandey : Financial Management, Vikas Publishing House

138 FINANCIAL MANAGEMENT

UNIT-13: CAPITAL STRUCTURE DECISION

CONTENT:

▪ Objectives
13.1 Introduction
13.2 Meaning of Capital Structure
13.3 Major Considerations in Capital Structure Planning
13.4 Value of the Firm and Capital Structure
13.5 Capital Structure Theories
13.6 Arbitrage Process
Summary
Review Questions
Further Reading

OBJECTIVES
After completing this Unit, you will be able to understand

● Capital Structure

● Recognise the Concept of Optimum Capital Structure

● Theories of Capital Structure

139 SHOOLINI UNIVERSITY

13.1 INTRODUCTION
Companies require money to operate and maintain their operations. To have the right balance of
fixed and current assets in its portfolio. Short-term, long-term, or a combination of both sources
of money can be used to raise the necessary funds. Short-term sources are used to fund current
assets to a considerable extent. A conservative financial policy is typically followed by businesses,
as seen by the preservation of net current assets. It is necessary to find long-term funding for this
net positive current asset.

As a result, financing from long-term sources is needed for

(a) Long-term assets (fixed assets) and

(b) Networking capital (positive current assets).

A company's financial structure has an impact on both its long-term financial stability and
profitability. The phrase "financial structure" refers to the "total liabilities" on the left side of the
balance sheet, which include current obligations, long-term debt, preference shares, and equity
share capital.

13.2 MEANING OF CAPITAL STRUCTURE

It is the primary objective of Financial Management to increase the wealth of the owners. Financial
decisions in any organisation should be based on this principle. Financing long-term capital
requires the use of a variety of different sources. maximisation of the firm's worth and of the wealth
of its shareholders) Long-term and short-term sources of finance are referred to as "capital
structure" in the financial industry.

13.2.1 OPTIMUM CAPITAL STRUCTURE

A company's capital structure is optimal if it maximises the wealth of the company's owners
through a combination of debt and equity. With this capital structure, both the share price and the
cost of capital are at their maximum. The optimal debt-to-equity ratio in a company's capital
structure can't be calculated because a company's market value for an equity share can fall because
of an increase in risk caused by a high level of debt in the structure. Thus, "appropriate capital
structure" rather than "optimum capital structure" is a more pragmatic expression in practise.
140 FINANCIAL MANAGEMENT

13.2.2. FEATURES OF CAPITAL STRUCTURE

1. Profitability- The Capital Structure that tends to reduce financing costs while maximising
earnings per Equity share is the most profitable.

2. Flexibility: The capital structure ought to allow the company to raise money as needed.

3. Conservation: The maximum amount of debt that can be supported by the company should not
be included in the capital structure.

4. Solvency: The capital structure needs to be set up so that the company doesn't face the risk of
going bankrupt.

5. Control: The company's control loss risk should be kept to a minimum by designing the capital
structure accordingly.

13.3 MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE PLANNING

One should keep in mind that there is no specific model that can be recommended or employed as
the ideal for all commercial endeavors, when establishing the capital structure. This is due to the
diverse nature of corporate activities. Therefore, it is crucial to comprehend those various financial
structures will be needed for various commercial endeavours.

The Capital Structure depends, primarily on number of factors like:-

• The type of business

• How long it will take for the business to start making money

• How certain it is that the business will make money once it starts making money for real

• How much money the business is likely to make back on its investment.

But when planning the capital structure, the finance manager should think about the following
things:

1. Risk: There are two types of risk:

1) Business Risk
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2) Financial Risk

Financial Risk is of two Kinds:

1) Chance of running out of capital: A company's risk of going bankrupt due to cash flow rises
as more debt is raised. There are two causes for this. First off, a higher % of debt in the capital
structure raises the organization’s obligations in terms of fixed costs. This indicates that a business
is obligated to pay a higher interest rate regardless of whether it has cash on hand or not. Second,
there's always a chance that the money's source could take the money out at any time. Thus, even
if there isn't enough money to pay off the long-term creditors all at once, it can still be necessary
to do so. With equity shares, there is no risk involved.

(b) Risk of variant in the estimated earnings available to Equity Shareholders: The Risk of
changes in estimated earnings accessible to equity owners will increase if a firm's capital structure
has a larger debt component. This is a result of trading on equity. Financial leverage has a
bidirectional effect. it either rapidly increases or sharply decreases the shareholders return.

2. Cost of Capital: Cost is a crucial factor in Capital Structure decisions, and it goes without
saying that a company should at the very least be able to generate enough income to cover its cost
of capital.

3. Control: Control is a crucial issue when building the Capital Structure along with cost and risk
factors. The controlling interest of the current owners is inevitably diluted when a corporation
issues more equity shares. Like ordinary shareholders, preference shareholders may exercise their
right to vote and so influence the makeup of the Board of Directors if dividends on their shares are
not paid for two years in a row. Financial institutions typically state that the Board of Directors
must consist of one or more directors.

4. Trading on Equity: Borrowing money or issuing stock is one way to raise money for a business.
There is a fixed interest rate that must be paid regardless of whether or not the borrower makes a
profit. Preference For the company to pay a dividend, shareholders must be entitled to a set
dividend rate. The company is said to be trading on equity if the ROI on the entire capital
employed, which includes the cash of shareholders and long-term borrowings, is higher than the
interest rate on borrowed money or the dividend rate on preferred shares. Increasing the overall
142 FINANCIAL MANAGEMENT

wealth and return on common stock of a company is a top priority for any financial manager. A
new source of financing must be chosen with this in mind, and any possible impact on earnings
per share must be carefully addressed.

Determines whether or not to employ internal equity or borrowings as a means of raising finances.

5. Corporate Taxation: Dividends on stock are not deductible under income tax laws, but interest
on borrowed money is, and can be deducted for determining taxable income. It must be capitalised
if it occurs within the pre-commencement stage. The cost of issuing shares is deductible. Because
of these provisions, choosing between various sources of finance is significantly influenced by
corporate taxation.

6. Government Policies: A key aspect of capital structure is determined by governmental policies.

Similar to this, the Rules and Regulations established by SEBI have a significant impact on the
capital issue strategy of different companies. Government fiscal and monetary policies have an
impact on capital structure choices as well.

7. Legal Requirements: Law consideration is also must.

8. Marketability: The organisation's capacity to market corporate securities must taken while
deciding the capital structure.

9. Maneuverability: It needs flexibility to have as many options as feasible when increasing or

decreasing the amount of money needed.

10. Flexibility: Flexibility refers to an organization's and its management's ability to change course
in response to anticipated and unforeseen changes in circumstances.

In other words, management wants a capital structure that always allows for the most flexibility
possible.

11. Timings: Flexibility of securities issuance are strongly recommended. Due to the erratic nature
of the capital markets, timing a security issue successfully frequently yields large savings.

Intelligent management aims to forecast the capital market situation to lower the cost of capital
rising and the reduction caused by the release of new common shares.
143 SHOOLINI UNIVERSITY

12 Size of the company: Small businesses mainly depend on owner ‘capital, whereas big
businesses can issue a variety of securities because they are typically seen as less hazardous by
investors.

13 Purpose of Financing: The financial Structure of the company is somewhat influenced by the
objective of the funding. If money is needed for manufacturing or other productive reasons, the
corporation may raise money from long term sources of finances. On the other side, the business
may only rely on internal resources if money is needed for non-productive objectives like
employee welfare facilities like schools, hospitals, etc.

14. Period of Finance: The capital structure is also impacted by the duration of the financing
requirement. Borrowing money would be sensible if these funds were needed for long-term
obligations. However, if the money is needed for Notes, it will be fair to obtain capital by issuing
equity shares.

15. Nature of Enterprise: The financial structure or the firm is significantly impacted by the
nature of the business as well. Businesses that consistently generate a profit or have a monopoly
on a certain market segment may choose to borrow money or purchase preference shares because
they generate enough revenue to cover interest and other fixed costs. Contrarily, businesses
without guaranteed revenue should preferentially rely heavily on their own internal resources.

16. Requirement of Investors: Depending on the needs of the investors, different classes are
issued with different types of securities.

17.Provision for the Future: The provision for potential capital needs must be considered when
planning capital structure.

13.4 VALUE OF THE FIRM AND CAPITAL STRUCTURE

Value of the company is based on how much money it makes, and how much money it makes is
based on how it invests its money. How big the EBIT is depending on what investments are made.
There are three main claimants to the EBIT:

1. The people who own the debt and get their share as interest.

2. The part of the money that goes to the government through Taxes.
144 FINANCIAL MANAGEMENT

3. The Shareholders, who get the money left over.

So, the size of the EBIT pool is determined by the firm's investment decisions, while its capital
structure mix determines how it is split up. The company’ total value is the sum up of what its debt
holders and shareholders think it's worth. So, investment decisions can make the firm's value go
up by making the EBIT bigger.

13.5 CAPITAL STRUCTURE THEORIES

These methods examine the connection in between Leverage, Cost of Capital, and company in
many ways. However, to fully understand these relationships, the subsequent presumptions are
made.

1. There are two possible sources of funding: Equity and Debt.

2. The firm's total assets are listed.

3. No retain earning concept. It suggests that distribute all profits are divided equally among
stockholders.

4. The choice of the funding mix is believed to have no impact on the business risk.

5. Neither corporate nor individual taxes are levied.

6. The investors' subjective expectation of earnings is distributed similarly among them.

13.5.1 NET INCOME (NI) APPROACH

Increase or decrease the percentage of debt in the company's entire financing mix, according to
this notion. According to this hypothesis, a link exists between a company's worth and its capital
structure.

The NI method also assumes the following things:

1. That the oganisation's overall capital demand is known and constant.

2. Debt costs are lower than equity capitalization rates.

3. Corporate taxes are nonexistent.

145 SHOOLINI UNIVERSITY

The Net Income approach starts with the idea that a change in a company's financing mix will
change its Weighted Average Cost of Capita, which will change the company's value. Increased
returns to shareholders are possible because debt capitalization is less than equity capitalization,
therefore the cheaper debt is used more frequently (while equity is reduced). Raising shareholder
returns also increases the total value of the company's equity, boosting its overall value. The
WACC will decrease, resulting in an increase in the firm's worth. As a result of higher WACC,
lower financial leverage, and lower overall business value if debt financing is reduced. A graph
depicts the NI theory of capital cost-to-leverage relationships.

Figure 13.1

Net income approach can be ascertained as follows:

V= S+D

As,

V = Value of the company

S = Market value of equity

D = Market value of debt

Market value of equity (S) = NI / Ke

Where,

NI = Earnings available for equity shareholders

Ke = Equity capitalization rate

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NI approach, the firm's value will be highest when the weighted average cost of capital is lowest.
So, this theory suggests using all or as much debt as possible to keep the cost of capital as low as
possible.

The overall cost of capital = (E.B.I.T./ Value of the firm ) *100

13.5.2 NET OPERATING INCOME (NOI) APPROACH

The Net Operating Income strategy stands in stark contrast to the NI approach. Net operating
profits (EBIT) and the total cost of capital (WACC) are used to determine a company's market
value, based on the NOI approach. The value of a firm is unaffected by its capital structure or
funding mix. The following presumptions are made by the NOI approach:

1. To determine the value of the company overall, investors capitalise the total earnings of the
company.

2. The firm's total cost of capital is constant and is based on business risk, which is likewise
presumptively constant.

3. The expense of debt is likewise considered to be constant.

4. As the capital structure uses more debt, the risk to shareholders increases, which pushes up the
cost of equity capital, meaning that the advantages of using cheaper debt are totally outweighed
by the higher cost of equity.

5. No tax is imposed.

The market values a company based on its NOI in relation to a given risk profile. As a result,
regardless of the capital composition, the firm's worth remains constant for a specific EBIT value,
depending instead on the total cost of capital. The equity value can be calculated by subtracting
the overall worth of the company from the debt value.

Where

V = EBIT / Ko

E = Value of equity
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V = Value of firm.

D = Market value of debt

E = V–D

Ke = EBIT Interest / V–D

As a result, the funding mix has no bearing on the firm's worth. The value is constant regardless
of the debt-to-equity ratio. The Ke will fluctuate linearly with changes in the debt proportions since
changes in the debt-to-equity ratio will alter the shareholders' risk.

Figure 13.2

Leverage doesn't affect a company's overall cost of capital or its cost of debt (Kd), as seen in the
diagram. Risk for shareholders remains constant as debt or financial leverage increases since the
increase in Ke is enough to equal out the savings from more affordable debt financing.

The Net operating Income method assumes that Ko is always the same. Since Ko is always the
same, there is no optimal capital structure that is better than any other. An example can show how
the NOI method works. Because Ko is considered constant in the NOI method to capital structure
optimization, there is no optimal capital structure because any structure is an optimal one. An
example can be used to demonstrate the NOI approach.

There are two extreme viewpoints on the relationship between the leverage, the cost of capital, and
the value of the firm that are held by NI and NOI approaches. Both ideas appear to be unreasonable
148 FINANCIAL MANAGEMENT

in real-world settings. As a compromise between them, the traditional approach combines the
underlying philosophy of both. It's somewhere in the middle of the NI and NOI schools of thought
(the idea that rising leverage can raise a company's value) (that the value of the firm is constant
irrespective of the degree of financial leverage).

Financial leverage, according to conventional wisdom, raises a company's worth, but only up to a
certain extent. Beyond this point, the firm's WACC will rise, and thus its value will decrease, as a
result of an increase in financial leverage.

Debt is thought to be less expensive than equity in the usual approach. Whereas in 100% equity
firms, the cost of equity is directly proportional to total costs, when debt is added into the capital
structure and financial leverage rises, equity investors assume a minimum level of leveraging in
every firm, the cost of equity remains constant.

Even as debt is increased, the cost of equity does not rise. The interest expense may not be big
enough to threaten the dividend paid to shareholders up to a certain level of leverage, which could
be a reason for keeping Ke the same. As a result of the initial drop in Ko caused by the constant
Ke and Kd, As a result, it reveals that the corporation can take advantage of lower-cost debt. When
leverage is increased, however, this position is no longer sustainable.

An increase in leverage increases the risk of stock investors, hence the Ke also increases. If the
advantages of using debt are so high that, even after offsetting the effects of an increase in Ke, the
Ko may fall or remain constant for a specific amount of leverage, it is possible that the Ko will
decline or remain constant.

However, if the company continues to raise leverage, the risk to the debt investor may also rise,
leading to an increase in the Kd of debt. The combination of the already rising Ke and the newly
rising Ko raises the Ko. Overuse of leverage will thereby increase the company's overall cost of
capital, resulting in a fall in its value.

As a result, there comes a point at which the value of a company is negatively impacted by a
company's amount of financial leverage. The favourable leverage can be distinguished by a
specific leverage or a range of leverage. The following diagram depicts the traditional perspective.
149 SHOOLINI UNIVERSITY

Figure 13.3

The above diagram shows that the cost of debt, Kd, and the cost of capital as a whole, Ko, stay the
same no matter how much leverage a company uses. As the amount of debt or financial leverage
goes up, the shareholders' risk stays the same because the increase in Ke is just enough to cancel
out the savings from cheaper debt financing.

The NOI method assumes that Ko is always the same. Since Ko is always the same, there is no
optimal capital structure that is better than any other. An example can show how the NOI method
works.

To put it another way: The NI and NOI approaches have wildly different perspectives on how
leverage, cost of capital, and firm value are related. Both of these ideas appear to be impractical in
the actual world. As a compromise between them, the traditional approach combines the
underlying philosophy of both. It adopts a middle ground between the NI and NOI approaches,
according to which a company's value can be raised by increasing its level of financial leverage.

Financial leverage, according to conventional wisdom, raises a company's worth, but only up to a
certain extent. The firm's worth will drop if it exceeds this limit in financial leverage, which will
raise its WACC.

The standard strategy assumes that the cost of borrowing is less than the cost of investing in the
company's stock. Whereas in 100% equity firms, the cost of equity is directly proportional to total
costs, when debt is added into the capital structure and financial leverage rises, equity investors
assume a minimum level of leveraging in every firm, the cost of equity remains constant.
150 FINANCIAL MANAGEMENT

Even when debt rises, the cost of equity remains constant. The interest expense may not be big
enough to threaten the dividend paid to shareholders up to a certain level of leverage, which could
be a reason for keeping Ke the same. As a result of the initial drop in Ko caused by the constant
Ke and Kd, Thus, it demonstrates that the corporation can reap the benefits of lower interest rates.
When leverage is increased, however, this position is no longer sustainable.

In addition to increasing the risk to stock investors, leverage that exceeds a particular amount also
raises the Ke. The advantages of borrowing money could, however, make it possible for the Ko to
fall or remain stable even after the effects of a rise in Ke are taken into account. Increasing
leverage, on the other hand, raises risks for debt investors and, as a result, raises the Kd of debt.

There is already a rise in Ke, and there is an additional increase in Ko as a result of this. A decrease
in the company's value might arise from increasing the company's overall cost of capital through
excessive use of leverage. As a result, the value of a corporation can only be reduced so much
through the use of financial leverage. The favourable leverage can be distinguished from the
unfavourable leverage by a specific leverage or a range of leverage. The following graphic
illustrates the traditional point of view.

Figure 13. 4
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Table 13.1

13.5.3 MODIGLIANI–MILLER’S APPROACH

Modigliani–approach Miller's is quite similar to the NOI approach. In other words, the value of a
company is not dependent on its capital structure, according to this theory.

The two, on the other hand, are vastly different. In theory, the NOI approach doesn't exist at all.
Despite this, it fails to show how a company's capital structure is immaterial to its worth. Even if
the MM strategy, which focuses on behaviour, supports the NOI approach, the firm's overall value
and cost of capital should be independent of the firm's capital structure. MM Because the average
cost of capital is based on the weighted average of capital costs, the MM method asserts that the
company's debt-equity mix or capital structure is not a factor in the calculation.

Basic Proportions

The following are the three basic proportions of the MM approach.

1. The total cost of capital, denoted by K, as well as the value of the company, denoted by V, are
unaffected by the capital structure. In other words, K and V remain the same across all different
152 FINANCIAL MANAGEMENT

proportions of debt to equity. The overall market value of the company can be calculated by
multiplying the anticipated Net Operating Income (NOI) by the rate that is suitable for the
company's risk profile.

2. To compute the cost of equity, known as Ke, the capitalization rate of a pure equity stream is
multiplied by a risk premium. Financial risk is closely tied to the amount of debt in a company's
capital structure. Since the use of debt represents a more expensive source of finances, Ke rises in
a way that precisely compensates for this.

3. The interest rate at which an investment is considered to be profitable is unrelated in any manner
to the method by which the investment is financed.

Assumptions

The following presumptions must be made in order to use the MM approach:

1. Capital markets are perfect: This ensures that investors are not restricted in their ability to
purchase or sell stocks.

2. The form is capable of being categorised into standardised risk groups. There will be no
difference in the level of business danger posed by any of the forms contained within the same
class.

3. When it comes to determining the value of any company, all investors have the same
expectations regarding a company's net operating income (also known as EBIT).

4. The dividend payment ratio is currently set at one hundred percent. That is to say, there are no
earnings that have been retained.

5. There are no taxes levied on corporations. On the other hand, this presumption turned out to be
incorrect subsequently.

13.6 ARBITRAGE PROCESS

The "arbitration process" is how the MM hypothesis is tested in the real world. Arbitrage is the
practise of purchasing a security at a cheaper price in one market and then selling it at a higher
153 SHOOLINI UNIVERSITY

price in another market. Because of this, the prices of the securities on the market can no longer
be different. So, the arbitrage process brings the prices of securities back into balance.

This is because investors in the overvalued firm would sell their shares, borrow more money on
their own accounts, and invest in the undervalued firm to get the same return on a smaller
investment. When an investor uses debt to do arbitrage, this is called "homemade leverage" or
"personal leverage." The following example can be used to explain how arbitrage works.

13.6.1 HOW TO FIGURE OUT THE ARBITRAGE PROCESS?

When working out the arbitrage process, students need to remember the following three steps:

Step 1: Investors' Current Position: In this step, you need to know what investments and income
the investor has now (return).

Step 2: Figure out how much money you saved by switching from a firm with debt to one without.

The amount of money saved on an investment is equal to the total amount of money made from
selling shares and taking out loans, less a certain percentage of the investment. Here, the income
will be the same as it was at the last company.

Calculation of Increased Income: by investing the complete amount of money that is at your
disposal.

SUMMARY
When planning the capital structure, it's important to remember that there isn't a single Notes model
that can be used as the best way to do business. Marketability of corporate securities is essential
for a well-balanced capital structure. Because investors regard huge corporations as less hazardous,
they are more likely to issue different forms of securities for them. The Net Income (NI) approach
examines the relationship between leverage, the cost of capital, and the value of the firm. Based
on EBIT and WACC, the market value of a company can be determined, according to the NOI
technique. Capital structure does not affect a company's value according to the Modigilani-Miller
approach.
154 FINANCIAL MANAGEMENT

REVIEW QUESTION
1. Give a short explanation of the main things to think about when planning the capital structure.

2. Give a brief explanation of the Modigliani-Miller method for figuring the cost of capital.

3. Describe the conditional theory of the structure of capital.

4. Besides quantitative factors, what other important things should a company think about when
deciding about its capital structure?

FURTHER READING
Books:

Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.

Prasanna Chandra: Financial Management, Tata McGraw Hill

I.M. Pandey: Financial Management, Vikas Publishing House

https://drive.google.com/file/d/1MWRnLmEZ1ES04wfiETlVWlBBM8BFtjwC/view.pdf
155 SHOOLINI UNIVERSITY

UNIT-14: WORKING CAPITAL

MANAGEMENT

CONTENT:
▪ Objectives
14.1 Introduction
14.2 Meaning and Concept of Working Capital
14.3 Significance of Adequate Working Capital and Optimum Working
Capital
14.4 Managing Working Capital
14.5 Working Capital Cycle (Operating Cycle)
Review Questions
Further Reading

OBJECTIVES
After completing this unit, you should be able to

● Recognize the meaning and significance of working capital

● Identify the factors affecting working capital

● Explain how to determine working capital requirements

156 FINANCIAL MANAGEMENT

14.1 INTRODUCTION
In the first unit, we talked about the most important parts of managing money, like how to get
money and how to use it wisely. First, the company agrees to get money to pay for its working
capital needs. Then, it agrees to get money to pay for its fixed assets. The area of finance
responsible for handling the company's current liabilities and assets is known as working capital
management. Management of each current asset and total working capital are the same thing.

14.2 MEANING AND CONCEPT OF WORKING CAPITAL

Working Capital is the money that can be readily used. Money is needed to purchase raw material
stocks, ongoing works, finished goods, stores of consumables, different debtors, and routine cash
needs. But the company's suppliers also give it credit. In the same way, neither the organization
nor the workers have to pay for expenses right away. So, some money is automatically made
available to pay for what the current assets need. It's not uncommon for current assets to be needed
for more money than current obligations can provide. Management of working capital is all about
making sure the company has adequate money to pay its expenses at all times.

Types of Working Capital

1. Gross working capital: means total of all current assets of a company.

2. Net working capital: means excess of current assets over current liabilities.

The term working capital can also be categorized as:

1. Permanent: It is sometimes called "hard core working capital." It is the minimum amount of
money that a business must always have in its current assets. It should be paid for in the long run.

2. Temporary working capital: Working capital needs that are temporary are known as
"temporary" or "additional" working capital. It's best to get it from places you can turn to right
away.
157 SHOOLINI UNIVERSITY

Figure 14.1

14.2.1 FACTORS AFFECTING THE WORKING CAPITAL

1. Nature of Business: As a rule of thumb, cash is the preferred method of payment in some
organisations, and the operational cycle is also very quick. Service firms, for example, have a low
working capital requirement. The operational cycle for manufacturing enterprises is typically long,
and in order to enhance sales, a company must provide credit to clients, increasing the need for
working capital. Working capital requirements for a trade business are also lower than those for a
manufacturing business.

2. Production Policy: the required working capital is also influenced by the company’s production
policy.

3. Credit Policy: If a business gives customers a lot of credit, it may make more money, but it will
also have more money tied up in debts from different customers.

In the same way, a company with a very effective debt collection system and strict credit terms
may need less working capital than a company with a less effective debt collection system and
more flexible credit terms.

4. Inventory: A more efficient business can keep raw materials on hand for a shorter period of
time, requiring less working capital.
158 FINANCIAL MANAGEMENT

5. Abnormal Factors: Unexpected things like strikes and lockouts mean that you need more
working capital. When there is a recession, there needs to be a larger amount of finished goods in
stock. In the same way, when there is inflation, more money is needed to keep the same amount
of current assets.

6. Conditions of Supply: In case of ready supply of raw materials, spare parts, supplies, etc., less
working capital is required

7. Business Cycle: The quantity of working capital required by a corporation might fluctuate based
on changes in production and sales over time.

8. Growth and Expansion Activities: As the firm's sales or fixed assets expand, so does its
working capital.

9. Level of Taxes: The tax laws in force determine the amount of taxes that must be paid. Taxes
must be paid in advance depending on last year's earnings.

10. Dividend Policy: Cash is used to pay dividends, but profit is retained as a source of working
capital.

11. Operating Efficiency: Efficient operations require less working capital

12. Price Level Charges: High market inflation necessitates more working capital requirement to
maintain same production levels.

13. Depreciation Policy: Depreciation costs do not require any money to be paid out. Depreciation
affects how much tax you have to pay, how much of your profits you keep, and whether or not you
get any dividend.

14. Availability of Raw Materials: A company's working capital needs might be affected by
whether or not certain raw materials are continuously available without interruptions.

14.3 ADEQUATE/OPTIMUM WORKING CAPITAL-ITS IMPORTANCE

To run day-to-day, a business needs money. Whether these funds are enough or not will determine
how well the day-to-day business can be done. If a company has a lot of "working capital," that
159 SHOOLINI UNIVERSITY

means it has money that isn't being used. Such businesses cost money. On these funds, the
company has to pay a lot of money in interest. This leads to too much capital.

Over-capitalization means that the company has more money than it needs. This leads to a low
rate of return, which means that the company isn't making the best use of its resources.

If the company doesn't have enough money to run, it is said to be under-capitalized. A company
like this could go out of business. This is because if the company doesn't have enough working
capital, it is unable to pay its debts. Many firms that are otherwise successful (their products are in
high demand and they have good marketing conditions) fail because they don't have enough cash
on hand.

An organization's overall health, as well as the types and quantities of its present assets, all
influence the optimal working capital to asset ratio.

1. The Trade-off between Profitability and Risk

The payment of current liabilities requires the usage of cash. In order to accomplish this goal,
existing assets such as inventory and receivables are converted into cash. The present liability cash
payments are preferable to the majority of the other available options.

When a corporation agrees to fulfil a contractual commitment, it is typically aware of the date on
which the corresponding payment is due. Because of their dependence on the rate at which current
assets are converted into cash, cash inflows are notoriously difficult to forecast. When a company
has lower requirements for its net working capital, the consistency of its cash flows improves.

As a result of the fact that most businesses are unable to predict whether or not their cash inflows
will be equal to their cash outflows, they require current assets with a higher value than their
current liabilities. When compared to its current liabilities, a corporation is considered to have a
greater ability to pay its debts when they become due if it has a larger gap between its current
assets and current liabilities.

There is a trade-off that takes place between the risk likelihood and profitability of a company. Is
the link between resources and costs, when viewed in this light, the result of the firm's engaging
in productive activities with its assets, whether they be current or fixed?
160 FINANCIAL MANAGEMENT

A organization’s profits can be enhanced by

(1) Growing revenues

(2) Decreasing costs.

When a business is unable to pay its payments because of a financial crisis, it is considered
technically insolvent.

Table 14.1: The Effects of Changing Ratios in Profits and Risks

14.4 MANAGEMENT OF WORKING CAPITAL

To effectively manage working capital, a number of steps are required, including the following:

1. Monitoring levels of cash receivables and inventory: The manager should know how much
money is in each of the current asset accounts every day or every week.

Ratio analysis is a quick and fairly accurate way to figure this out. Managers can find out what's
different by comparing ratios to those from previous periods and to industry standards. You can
use the following ratios:

(a) Current assets as a percentage of total assets

(b) Current assets as a percentage of current liabilities

(c) Current assets minus inventory

(d) Cash and marketable securities as a percentage of current assets

2. To have understanding of the percentage of funds in current accounts: Most businesses

have to put a lot of money into working capital. Most of the time, between 30 and 60% of a
company's total assets are tied to current accounts.
161 SHOOLINI UNIVERSITY

3. Keeping track of the time it takes to manage current accounts: There is a lot of time spent
by financial managers on the daily chores related to the firm's existing assets and obligations.
Estimates vary, but between one third and two thirds of a manager's time was spent on managing
the working capital.

14.4.1 HOW MUCH WORKING CAPITAL IS NEEDED?

Several factors need to be included in the analysis, such as the following:

1. Size of the firm: If a business is large in terms of assets or revenues, then the amount of working
capital it needs will be influenced by this. In the event of cash flow issues, a small business may
keep a cash reserve of extra current assets. As a result, when a few customers fail to pay on time,
it damages small firms more than it does large ones. With more resources available, a larger
company may not need as much working capital as the total assets on sale.

2. Activities of firm: If the business needs to keep a lot of inventory on hand or sell on easy credit
terms, it will need more working capital than a business that only sells services or goods for cash.

3. Availability of credit: Working capital requirements are less onerous for a company that has
easy access to bank credit than they are for one that does not.

4. Attitude towards profits: All funds have a cost, and when a company has a lot of current assets,
it tends to make less money. Some businesses want more cash on hand and are willing to pay small
costs to get it. Other businesses keep the smallest amount of working capital possible so they can
make the most money from their operations.

5. Attitude towards risk: The risk of running out of money is lower when there is more working
capital, especially cash and securities that can be sold. Firms that don't want to take even a small
chance of running out of cash may want to keep extra cash on hand. Other businesses take risks to
make money, and they may not even keep enough cash on hand to always pay their bills on time.

14.4.2 FORECASTING WORKING CAPITAL REQUIREMENT

Let’s see some of the methods used in practice:

1. Current assets holding period: How much working capital is required based on how long
current assets are retained and how much they cost based on the company's performance last year.
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2. Ratio of sales: How much working capital you require as a proportion of sales, based on the
assumption that current assets increase with sales. Statistical tools like linear regression can be
used to do this. A formula is made to find the best straight line. Notes that the data and this formula
can be used to show how two variables are related, like sales from the previous month and working
capital. The method of least squares is the most common way to do regression.

Let's use the following numbers that we found in the books:

Table 14.2

3. Ratio of fixed investment: To figure out how much working capital is needed as a share of
fixed investments

14.5 WORKING CAPITAL CYCLE (OPERATING CYCLE)

Process by which raw materials are purchased and added to a manufacturing process, resulting in
finished products, and then sold on credit and turned into accounts receivable and debtors,
followed by the creation of a cash flow statement. The working capital cycle goes like this.
Currency is constantly being converted into raw materials, work in progress, finished commodities,
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creditors, and back to cash in a never-ending cycle. The cash cycle or the operating cycle are other
names for this cycle.

The working capital cycle is depicted below:

Figure 14.2
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REVIEW QUESTIONS
1. Why do we divide working capital into permanent and variable categories.?

2. If the volume of sales is the most important element that affects working capital, what accounts
for this relationship? What other factors besides sales affect a company's available working
capital? Why?

3. When managing working capital, what are two processes that are carried out?

4. For what purpose is it necessary for the management to be aware of the percentage of funds that
are held in current accounts?

FURTHER READING
● Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.
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● Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New
Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2.

● Chandra, P., Financial Management—Theory and Practice, New Delhi, Tata McGraw

● Hill Publishing Company Ltd., 2002, p. 3