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Course Design
Advisory Council
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Chairman
Mr. Utpal Ghosh
Members
Dr. S J Chopra
Chancellor
Dr. Deependra Kumar Jha
Vice Chancellor
Dr D N Pandey
Dean-SoB
Dr Kamal Bansal
Dean-SoE
Dr Tabrez Ahmad
Dean-SoL
Mr Ashok Sahu
Head-CCE
SLM Development Team
Dr Raju Ganesh Sunder
Head-Academic Unit
Mr. Aindril De
Head-Operations
Dr. Rajesh Gupta
Dr. Meenakshi Sharma
Dr. Rakhi Dawar
Mr. Rahul Sharma
Mr. Shantanu Trivedi
Ms. Aparna
Author
Mr. Shantanu Trivedi/Mr. Rahul Sharma
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All rights reserved. No Part of this work may be reproduced in any form, by mimeograph or any other
means, without permission in writing from University of Petroleum & Energy Studies.
Course Code: MBOF 912D
Course Name: Financial Management
Version: January 2018
© University of Petroleum & Energy Studies
Block–I
Unit 2:
Financial Management–Introduction...........................................................................3
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Unit 1:
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Contents
Time Value of Money...................................................................................................13
Unit 3(a):
Compounding Techniques of TVM.17
Unit 3(b):
Discounting Techniques of TVM.23
Unit 4:
Applications of Time Value of Money.........................................................................29
Unit 5:
Case Study: An Analysis of Retirement Plans by ABC Corp....................................35
Block–II
Unit 6:
Unit 7:
Unit 8:
Unit 9:
Unit 10:
Types of Financial Statements....................................................................................39
Financial Statement Analysis.....................................................................................47
Ratio Analysis..............................................................................................................55
Dupont Analysis...........................................................................................................77
Case Study: Bata India: Step into Style.....................................................................83
Block–III
Short-Term Sources of Finance...................................................................................87
Unit 11(b):
Long-Term Sources of Finance....................................................................................95
Unit 12:
Fundamentals of Capital Budgeting.........................................................................109
Unit 13:
Capital Budgeting Evaluation Techniques...............................................................115
Unit 14:
Cost of Capital............................................................................................................127
Unit 15:
Case Study: Airnet limited: A Telecommunication Takeover.................................141
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Unit 11(a):
Block–IV
Unit 16:
Leverage Analysis......................................................................................................139
Unit 17:
EBIT–EPS Analysis...................................................................................................145
Unit 18:
Capital Structure.......................................................................................................153
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Content
Unit 19:
Dividend Decisions and Policies................................................................................163
Unit 20:
Case Study: Velvet Hands–Designing Its Own Capital...........................................169
Block–V
Working Capital Management..................................................................................171
Unit 21(b):
Estimation and Calculation of Working Capital......................................................183
Unit 22:
Receivables Management..........................................................................................187
Unit 23:
Inventory Management.............................................................................................199
Unit 24:
Cash Management.....................................................................................................205
Unit 25:
Case Study: Inventory Management by Tulips Ltd.................................................213
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Unit 21(a):
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BLOCK–I
UNIT 1: FINANCIAL MANAGEMENT–
INTRODUCTION
Introduction
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Objectives of Financial Management
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Financial Management and the scope of same
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Functions of Financial Management
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Summary
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Review Question
UNIT 3(B): DISCOUNTING TECHNIQUES
OF TVM
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Introduction
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Detailed Contents
How a Finance Functions Organisation
Operates and the Structure of it
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Present Value of Single Cash Flow
PV of a Series of Equal Future Cash
Flow or Annuity
Financial Goal–Maximization of Profit
versus Maximization of Wealth
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Present Value of Perpetuity and Annuity
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Summary
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Present Value of Growing Perpetuity
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Review Questions
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Summary
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Review Questions
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UNIT 2: TIME VALUE OF MONEY
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Introduction
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Importance of Time Value of Money
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Concept of Valuation
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Summary
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Review Questions
UNIT 3(A): COMPOUNDING TECHNIQUES
OF TVM
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Introduction
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The Effective Rate of Interest
The FV of a Series of Equal Cash Flows or
Annuity of Cash Flows
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UNIT 5: APPLICATIONS OF TIME
VALUE OF MONEY
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Introduction
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To Find the Implied Rate of Interest
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To Find the Number of Years
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Sinking Fund
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Capital Recovery
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Summary
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Review Questions
UNIT 5: CASE STUDY: AN ANALYSIS OF
RETIREMENT PLANS BY ABC CORP
Financial Management–
Introduction
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Notes
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Objectives:
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While the students complete the unit, they can:
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Understand what a Finance Manager’s role is along with what Financial Management is
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Know what are the Financial Management’s core objectives
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understand Financial Management’s key functions and the overall
scope of work
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easily narrate the finance function of any organisation
Clearly outline the overall goals of FInancial Managerment which are
wealth maximisation and profit maximisation
Introduction
The term ‘Financial management’ can be described as the management of flow of funds. This involves making financial decisions, raising funds in the most economical way and utilizing these funds to
achieve maximum benefits for the firm and its shareholders. Financial management, as a functional area, is of prime importance as all
business decisions have financial implications.
Role of a Financial Manager
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Formerly, the role of a financial manager was limited; however,
gradually, the involvement of a financial manager has increased as
every act, procedure or decision has a financial impact. A financial
manager estimates all the likely events that can occur in the course
of business and observes their monetary implications. Work of a financial manager focuses on the following:
1. Procuring the right amount of funds whenever necessary
2. Investing funds to gain maximum profits
3. Distributing funds to the shareholders to ensure wealth maximization
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Financial Management
Notes
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The above three functions cover a majority of the financial tasks of
a firm; thus, the functions of a finance manager can be summarized
as follows:
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1. Conducting overall financial planning and control
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2. Raising funds from different sources
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3. Selecting fixed assets
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4. Managing working capital
5. Managing a financial crisis
Apart from these, the financial manager also acts as an intermediary between the firm’s operations and the capital markets. There
is a two-way flow of cash between the firm and the investors. One
way is when the investors plough in funds in the organization from
the capital markets and the other way is when the firm distributes
dividends and interests amongst the shareholders.
Objectives of Financial Management
Following are the main objectives of financial management:
1. Liquid Asset Maintenance: This includes maintaining an
appropriate amount of liquid assets, thus, maintaining a balance between liquidity and profitability.
2. Profit Maximization: This involves ensuring that the firm
should gain maximum profits in a given amount of time. Moreover, all the decisions regarding investment, financing and dividend as well as strategic-level decisions of the organization
should be concerned with earning maximum profits.
3. Wealth Maximization: Wealth maximization is the maximization of wealth of the shareholders. It is also known as value
maximization or net worth maximization. It involves the comparison of the value to cost associated with the business.
Some other objectives of financial management include the ­following:
1. Confirming reasonable return to the shareholders
2. Ensuring growth and expansion in the firm’s business and value
3. Utilising funds efficiently and effectively to ensure maximum
operational productivity
4. Maintaining financial control in the firm
Unit 1: Financial Management–Introduction
The scope of this particular subject is indeed extremely fast.
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The scope of financial management is very vast. It is related to
maintaining financial control, raising funds and ensuring proper
utilization of these funds. It also involves total management. Total
management is a very wide scope of financial management. All the
functions performed by the finance manager of a company are under the scope of financial management. The functions of the finance
manager vary from company to company, depending on the nature
of business. Financial management plays four important roles: utilizing funds and controlling productivity and identifying and selecting the source of funds. Liquidity, profitability and management are
three primary functions of financial management.
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Financial Management and the Scope of Same
The firm’s liquidity is defined by raising funds and the management
of flow of funds in a company. Profitability can be ascertained by controlling costs, fixing a pricing policy and forecasting future profits.
It is the duty of the financial manager to utilise the sources of the
assets in maintaining the business. The management of assets
plays an important role in financial management. Moreover, the
manager must ensure that the sources that are required are available for the easy functioning of the business. It is often categorized
as management of long-term funds and management of short-term
funds. Long-term funds management is associated with the development of extensive plans; whereas, short-term funds management is associated with the total business cycle activities. Financial management also facilitates coordination of various activities
in a business.
Therefore, financial management is necessary to maintain the overall success and growth of any firm or company.
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Functions of Financial Management
The key to a successful business processes is financial management
as no business can utilize its potential for growth and expansion
without effective administration and efficient utilization of financial
resources.
While looking into the different requirements of a firm, the finance
manager needs to make certain decisions from time to time. These
decisions can be broadly classified into three main categories:
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Financial Management
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2. Financing or Capital Structure Decision: Managing investments and its finance
3. Dividend Decision: Managing dividends, outflow of cash and
reinvestment
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1. Investment Decision: Management of resources and its allocation
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Maximizing the shareholder’s wealth is the main objective of these
decisions. (See Figure 1.1)
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Investment Decision
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Financial Function Decision
Financing Decision
Dividend Decision
Figure 1.1: Types of Financial Function Decisions
Investment Decision: It is one of the most essential finance function decisions. Investment decisions not only include the decisions
that may reap revenues and profits (e.g., launching a new product
in the market), but also those that may reduce costs and save money
for the firm (e.g., investing in new, modern machinery, thus reducing cost). Thus, investment decisions are mostly related to the asset
composition of the firm. These assets are a sum of investments that
lead to a return on the investment made by the firm which result
in overall increase in the shareholders’ net worth. Further, these
assets can be classified into two main groups – fixed assets and current assets. Thus, the investment decision can be divided into two
different categories, that is, working capital management (related
to current assets) and capital budgeting decisions (related to fixed
assets). These are described below:
1. Current Assets or Short-term Assets (for example, raw materials, working in process, finished goods, debtors, cash, etc.):
These assets are liquefiable in nature and can be converted into
cash within a financial year without diminution in value. Management of current assets is called as ‘Working Capital Management’. These assets ensure smooth working of fixed assets
and do not directly contribute to the earnings.
Unit 1: Financial Management–Introduction
(b)
(c)
Purchasing from the available alternatives
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(a)
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2. Fixed Assets or Long-Term Assets (for example plant and machinery, land and buildings, etc.): These assets involve huge investments and yield a return over a period of time. Any decisions
in regards of the fixed assets are classified as ‘Capital-Budgeting-Decisions’ and there are multiple decisions which are under
this classification. Some of them are regarding:
Purchasing leasing assets
Producing or procuring assets.
Financing Decision: The financing decision determines how to
raise funds, for example, should the funds be raised from shareholders or should they be borrowed as debt? Both these sources have
their own features and affect the company’s left side of the balance
sheet. The borrowed funds are repayable with a commitment to bear
interest along with the principal. The borrowed funds are always
cheaper to the firm. However, these funds come with a risk element,
also referred to as ‘financial risk’, which include the risk of insolvency due to non-payment of interest or capital amount.
Dividend Decisions: Dividends are after-tax profits which are
available for distribution to the shareholders. These dividends can
also be retained by the firm for reinvestment purposes within the
firm. Dividends are also return on capital. Every firm decides the
amount of dividends that is to be distributed among the shareholders and those that should to be retained. The dividend policy is developed by the financial manager of the firm in a way that it suits
the shareholder’s interests and the company as well.
The above-mentioned decisions cannot be taken in isolation as they
are inter-related. The decisions are not taken one after the other in
an order but are executed simultaneously as one decision can affect
the course of action for the other.
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For example, assume there is a company which has taken a decision to make an investment of INR 10 Crores to be put as a
fraction of capital budgeting. And there is an investment of INR
5 crore which has been kept to be a fraction of working capital
management. In other words, on total assets, the company is investing Rs. 15 crores. Therefore, the total funds required to be
raised is Rs. 15 crores. If the financial manager raises Rs. 9 crores
from external sources and the remaining Rs. 6 crores through re-
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Financial Management
Notes
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Thus, the financial manager has to take an optimal joint decision
after evaluating the choices that will affect the wealth of the shareholders. If there is any negative effect on the wealth, it should be
rejected.
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tained earnings, the distribution of dividend to the shareholders
will be affected. However, if the dividend payout ratio is 100%, the
finance manager will have to raise the entire Rs. 15 crores from
external sources.
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How a Finance Functions Organisation Operates and
the Structure of it
Whatever decisions because of any person or any activity that are
being made - no matter how small or monumental they are - will
have an impact on the overall value of the company or firm in context of the possible financial implications.
For example, any member participating in a financial process, any
engineer planning to replace existing machinery, any promotion
manager deciding to advertise strategies to increase sales of the
company or finance manager deciding on the dividend payout ratio
have financial implications on the firm. These persons are said to be
performing finance functions.
Although every member in an organization contributes to the finance functions, there is a need of a separate finance department.
This department performs two major functions:
1. Management of the company’s finances and its future planning
and control the firm.
2. Taking decisions according to the objectives of the firm and consolidation of impactful financial proposals from all the departments.
The Chief Financial Officer (CFO) takes all the major financial decisions of a company. His main responsibilities are to plan, control
and increase the wealth of the shareholders. Some of the functions
of the CFO include the following:
1. Financial planning and analysis
2. Management of the asset structure of the firm
3. Management and balancing of the financial structure of the
firm.
Unit 1: Financial Management–Introduction
Notes
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1. Controller: As a controller, the CFO mainly focuses on budgeting, evaluations, planning and control, internal audit, taxation,
etc.
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Thus, the CFO is a part of the top management and helps in formulation of all strategic policies relating to acquisitions, mergers, capital structure, portfolio management, risk appetite, diversification,
etc. The functions of a CFO are classified into two groups:
2. Treasurer: As a treasurer, the CFO focuses on cash management, raising of funds for both short term and long term requirements.
There are a number of individuals working directly or indirectly under the CFO. Refer to Figure 1.2 to get a clear idea of the organization of financial function.
Chief Finance Officer
Controller
Treasure
Cash Manager
Credit Manager
Fund Raising
Manager
Capital Budget
Manager
Portfolio Manger
Financial Accounting
Manager
Tax
Manager
Cash Accounting
Manger
Data Processing
Manager
Internet Auditor
Figure 1.2: Organization of Finance Function
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Source: (Rustagi, 3rd Edition)
Financial Goal–Maximization of Profit versus
Maximization of Wealth
A firm’s efficiency can be assessed by its financial goals (target). Several goals are considered as a benchmark to measure the financial health
of a company. For instance, if a firm’s primary objective is to make profits, it would take steps and develop policies that would help in profit
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Financial Management
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maximization. However, these steps will not involve wealth maximization of the stakeholders. It may help a firm to achieve its objective to
make profits in the short-run, but it will not contribute toward the creation of wealth. The creation of wealth needs more time; thus, financial
management primarily focuses on wealth maximization and not profit
maximization. For a growth-oriented business, profit making must not
be the only objective. Other aspects such as sales increases, acquiring
more market share and return on capital must also be considered as
they help in earning long-term profitability.
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However, the following two goals are considered as the main objectives of financial management:
1. That the profit of the company or the firm should reach
­maximum
2. That the shareholders’ wealth also reaches the maximum
Profit Maximization
As it is clear from the terminology, it focusses on increasing the
account profit that is there for the shareholders and take it to the
maximum.
Since this has an implied effect on the firm’s objective, it has been
retained as one of the financial goals.
Advantages of Profit Maximization
1. Better decision making: It provides a yardstick to judge the
economic performance of an enterprise and is, thus, considered
as the best criterion of decision making.
2. Efficient allocation of resources: Allocation of resources
is diverted to ensure maximum profitability, hence, utilizing
scarce resources effectively.
3. Optimum utilization of resources: Profit maximization, being the primary objective of the firm, is possible only through
optimum utilization of resources. All business activities are accomplished through the use of certain resources, which lead the
business toward profitable results. Profit maximization helps
in acquiring resources in the required quantity, at a reasonable
cost and in a timely manner. It is aimed to ensure the adequacy
of resources relative to business needs and their appropriate
use. The efficiency of resources is determined by the achievement of the business objectives.
Unit 1: Financial Management–Introduction
Disadvantages of Profit Maximization
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1. Risk factor: Any investment that may be potentially profitable may carry a high risk quotient. Concept of profit maximization ignores this risk and looks into high profit generating
investments.
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4. Maximum social welfare: If all businesses follow this objective, it will ensure optimum and efficient utilization of all economic resources available in the society. This will also ensure
profitability and, in turn, lead to social welfare.
2. Ignores time factor: It does not take into consideration the
time of cost and returns, therefore ignoring the time value of
money.
3. Ambiguous: There is no clear picture since the profit is not
being drawn against the time that is being passed during the
operations of the firm or otherwise.
Wealth Maximization
The concept of wealth maximization was introduced to remove all
the drawbacks of the profit maximization method.
The method to define the value is by knowing that what is the value
of company’s share in terms of its actual market price within the
overall stock market.
The total economic value of the wealth belonging to the shareholder
- which is also called as the measure of wealth - can be calculated by
the share’s market price–which in turn is calculated as the current
value of future dividends and whatever benefits that can be then
expected from the company.
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The wealth of shareholder at any point of time can be determined
with the help of the total value of shareholdings by the respective
shareholder. Clearly, any increase in the wealth is the outcome of
the shares’ market price increment that belong to the firm. Hence, it
clearly indicates that the main objective of the firm is maximization
of shareholders’ wealth.
Summary
The main motive of financial management is to meet the objectives
of the firm by efficient management of inflow and outflow of funds.
It is a function that involves the role of the top management of a
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Financial Management
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firm. Financial management involves raising capital and allocating
that capital. It also involves allocating short-term resources, such as
current liabilities. Moreover, it deals with the dividend policies of its
stakeholders. Profit maximization and wealth maximization are its
primary objectives. The estimation of funds required, determination
of capital structure, investment of funds and total management are
the major role of financial management.
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Review Questions
1. What are the two financial goals? Explain in detail by differentiating between the two.
2. What is the scope of finance functions?
3. What are the key roles of the finance manager?
4. Explain the inter-relationship between investment, financing
and dividend functions.
Time Value of Money
Objectives:
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Unit 2
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have a clear understanding of the Time value of money concept
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have a clear understanding of the importance of same
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distinctly explain the valuation concept
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Introduction
As explained in the previous unit, the main objective of the firm is maximization of shareholders’ wealth. In addition, shareholders’ wealth is
measured by the economic value added which is the market price of the
share, which is also the present value of future dividends and benefits
expected from the firm. For this, the finance manager takes various finance decisions, such as investment, financial and dividend decisions.
However, when he takes these decisions, he has to keep in mind the
concept of economic value that is added and the time factor.
Importance of Time Value of Money
This concept is developed because there is a stark difference in the
current value of money as compared to the value of money that will
be in future.
For example, if given an option between receiving Rs. 500 today and
receiving Rs. 500 in the future, any individual would choose the former since this Rs. 500 would have a higher value today than what it
will have after a year. This difference in the worth or value of money
over time is called TVM.
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While any financial decisions are being made, Time Value of Money
acts as a critical factor that is to be considered by any finance manager. As understood from the above example, the money that we
have today is ideally preferred to the same amount in the coming
future. The reasons of the following are:
1. Future uncertainties
2. Preference for present consumption
3. Reinvestment opportunities
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Financial Management
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Example 2.1 A car manufacturing company is selling one of its cars
for a bargain price of Rs. 5,00,000. However, the buyer offers to pay
now or pay the same amount after a year. What is the preferable
choice for the company?
Solution: The company should definitely choose to receive the cash
now. They can then invest the money at 10% rate of interest for
a year. By doing so, the company will receive 5,00,000 + 50,000 =
5,50,000 after a year as compared to Rs. 5,00,000, which they would
have received had they chosen the latter offer. This difference of Rs.
50,000 is referred to as TVM. In an alternate way, Time value of
Money indicates to the rate of return that an investor can earn by
investing his present money.
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Let us understand the concept with a help of the following example.
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At the same time, ascertaining that what will be the rate of return
is not sufficient. It is equally critical to find out the value of current
assets of company or firm.
Ascertaining the rate of return is not enough. It is also important to
determine the value of current assets in the firm. Valuation helps
in ascertaining this value. It involves the process of determining the
present values of assets.
Concept of Valuation
Time value of money helps in ascertaining the future value of money. This depends on the rate of return or interest rate that can be
achieved on the investment. TVM is applicable in various areas,
such as corporate finance including capital budgeting, bond valuation and stock valuation. For example: A bond generally pays interest on periodical basis until maturity, when the bond’s face value is
also repaid. Thus, the present value of the bond depends upon what
these future cash flows are worth in today’s amount.
Let us understand the concept of valuation of TVM with the help of
an example.
Example 2.2 A firm, ABC Pvt. Ltd, manufactures garments. The
firm purchases machinery today, say at time T0 for Rs. 10,00,000,
and it is expected to give a return of Rs. 10,50,000 at the end of one
year, say at time T1. This implies that the company will be spending
Rs. 10,00,000 today and will receive Rs. 10,50,000 after one year.
However, we cannot say whether the investment is profitable for
Unit 2: Time Value of Money
Solution: There are two ways by which we can evaluate this scenario:
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By calculating the future value of investment, that is Rs. 10,00,000
at time T1
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the company as the cash inflow and outflow are occurring at two
different time periods.
By calculating the present value of return, that is Rs. 10,50,000 at
time T0.
Refer to Figure 2.1 for better understanding.
Rs 10,00,000---------(adjustment)----------
Rs 10,50,000
T0-----------------------------------------------T1
Rs 10,00,000-------(adjustment)-----------------Rs 10,50,000
Figure 2.1
In the above illustration, we easily adjust the cash flows for TVM by
using either of the following methods:
1. By compounding Rs. 10,00,000 at the required rate of return for
one year and comparing it with Rs. 10,50,000, or
2. By discounting Rs. 10,50,000 at the required rate of return for
one year and comparing it with Rs. 10,00,000
In a firm, the finance manager deals with various cash flows pertaining to different time periods; thus, TVM plays an important part in
decision making by comparing these cash flows. As discussed, TVM
converts the value of money for a particular time to anytime in the
future or present. So, these values can be called Present Values (PV)
and Future Values (FV).
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The FV of an amount is the value of that amount sometime in the
future, while PV refers to the value of money during today’s time.
A sum of Rs. 1,000 available today would yield a future value of Rs.
1,100 after one year at 10% interest per annum. Whereas, the present value of Rs. 1,100 receivable after one year is Rs. 1000 at 10%
rate of interest.
The relationship between PV and FV arises because of the interest
rate and time gap. This relationship can be deduced as follows:
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Financial Management
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FV = PV * (1 + r)n or
Notes
PV = FV/(1 + r)n
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PV and FV hold a lot of importance in financial management. They
help in ascertaining the value of money today with respect to the
value of money in the future. It also helps in determining the value
of an asset on a particular date in the future. Hence, PV and FV play
an important role in decision making in financial management.
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Where r = rate of interest and n = time period
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Summary
Compounding involves the movement of cash flows forward in time;
whereas, discounting involves the movement of cash flows back in
time. TVM helps in the assessment of equivalency of difference in
cash flow over the time, including PV and FV. They play a very important role in the decision making in financial management.
Review Questions
1. What is the mathematical relationship between future vvlue
and present value?
2. Explain how TVM can be used to compare cash flows from two
different periods.
3. What is TVM and explain its relevance in an organization?
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Unit 3(a)
Notes
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Compounding Techniques
of Tvm
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Objectives:
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At the end of this unit, students will be able to:
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Determine the future value of single cash flow
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Determine the effective rate of interest
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Determine the future value of series of cash flow
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Introduction
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As discussed earlier, the present value (PV) and the future value
(FV) help in decision making in financial management. Following
are the ways in which you can compare the cash flows from time
periods:
1. Present amount to be compounded to a future date
2. Future amoun t to be discounted to a present date
In this chapter, we will learn to compound the present amount to a
future date using two different methods.
The compounding technique is used to find the FV of a present
amount. Please note that the interest earned in the previous year
is reinvested at the existing rate of interest for the rest of the year.
Hence, the sum of principal and interest of the previous year become
the principal of the next year.
Here is how PV is compounded to determine the FV:
1. The FV of a single present cash flow
(C
2. The FV of a series of cash flows
3.1.1 FV of a single present cash flows:
The FV is defined as,
FV = PV (1 + r)n
Where, FV = Future value (which is to be calculated)
PV = Present value (which is given)
... (3.1)
18
Notes
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r = Percentage rate of interest
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Financial Management
n = time gap after which FV is to be calculated
___________________
The above equation implies that there are three variables that affect
the FV, which are PV, r% and n. When the values of these variables
change, the value of FV will also change. Since the FV is directly
proportional to these three variables, it means
___________________
Higher the rate of interest, higher the FV
___________________
Higher the time period, higher the FV
___________________
Compound value factor (CVF) is (1 + r)n. We can also write FV as
follows:
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___________________
FV = PV * CVF(r, n)
___________________
Non-Annual compounding: We have assumed that the FV is calculated on the basis of r and n. These two variables are compounded
annually but there are cases wherein the time period may be other
than one year. The equation given above can be adjusted to reflect
the different time periods. For example, if the compounding is made
every six months, the time period will be two times and the number
of time periods will be divided by two.
(C
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Table 3.1: Effect of Compounding on the Time Period
Compounding Period
Number of Periods
Annual
1
Half-Yearly
2
Quarterly
4
Monthly
12
Daily
365
From this we can deduce the following:
If the interest is compounded more frequently, the FV is bound to
increase more quickly.
If the interest is compounded more frequently, it starts earning
more interest. This improves the effective annual compound rate of
interest as well.
We will be able to better understand the above through the following example.
Example 3.1 An amount of Rs. 1,000 is invested at a rate of 10%
for a period of one year in two different projects. 1) It is compounded
annually, and 2) It is compounded semi-annually
Unit 3(a): Compounding Techniques of Tvm
1. When compounded annually as per equation 3.1, FV = PV * (1
+ r)n
FV = 1000 (1 + 0.1) = Rs. 1,100
Notes
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2. When compounded semi-annually as per equation 3.1 , FV = PV
* (1 + r)n
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Solution:
FV = 1000 (1 + 0.05)2 = Rs. 1,102.5
The Effective Rate of Interest
The effective rate of interest is the rate of interest compounded annually, which is equivalent to the interest rate compounded for more
than once per year.
(1 + re) = (1 + r/m)m, where re = effective rate of return
r = normal rate of return compounded annually
m = number of compounding periods in a year
When m = 1, then re = r, that is, the effective rate of return is equal
to nominal rate of interest.
Effective rate of interest is an important tool that helps finance managers to take decisions regarding investments with different rates of
interest that are compounded over different time intervals. Let us
understand this with the help of the example given below.
Example 3.2: A firm borrows Rs. 10,000 from a lending company.
The company provides two options to the firm 1) Receive a rate of
interest of 12% p.a., compounded monthly, or 2) Receive a rate of
return at 12.25% p.a., compounded half yearly. Which option will be
beneficial for the firm?
Solution: To understand which option will be beneficial for the firm,
effective rate of interest needs to be calculated.
(C
Option 1: Interest at 12% p.a. compounded monthly –
Effective rate of interest (1+re) = (1+r/m)m = (1+0.12/12)12 = 1.1268
Which means re = 12.68%
Option 2: Interest at 12.25% p.a. compounded half yearly –
In this case, effective rate of interest (1 + re) = (1 + r/m)m = (1 +
0.1225/2)2 = 1.1263
___________________
___________________
___________________
___________________
___________________
___________________
Financial Management
Notes
___________________
___________________
___________________
Hence, it is evident that the rate of interest in the 2nd option is lower, despite of the fact that the nominal interest rate is higher. Thus,
the borrower should select Option 2.
The FV of a Series of Equal Cash Flows or Annuity of
Cash Flows
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Which means re = 12.63%
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___________________
___________________
___________________
___________________
(C
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Many decisions on investments are based on cash flows occurring
over a number of years on the same principal amount. An annuity
refers to a certain number of equal cash flows made at regular intervals of time. Here is an example.
Example 3.3: A person deposits Rs. 1,000 in a bank for the next
three years. This is referred as an annuity of Rs. 1,000 for the next
three years.
Solution: In this case, each cash flow is compounded to give a FV.
The sum of all the FV’s is the FV of the annuity.
Table 3.2: Calculation of Future Value of Annuity from Example3.3
Year0
Year1
Year2
Year3
1000
1000
1000
|
|
|
1210
1100
1000
Total
3310
Thus,
FV = Annuity Amount * CVAF(r, n)
Example 3.3 Mr. A got an annuity that paid him Rs. 1,000 every
three months for three years. Determine the PV of the annuity when
the money is compounded annually at the rate of 16%.
Solution: In this case,
Amount received as annuity is Rs. 1,000
Rate of interest, r is 16%
Time period, t is 3.
So,
i=
16%
= 4%
4
n = 4(3) = 12
Unit 3(a): Compounding Techniques of Tvm
é1 - (1 + 0.04 ) - 12 ù
A = 1000 ê
ú
0.04
ë
û
= 9385.07
Notes
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Thus, the annuity is Rs. 9385.07.
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The annuity can be calculated as follows:
Example 3.4 Find the PV of an annuity with a FV of Rs. 11375 after
five years at a rate of 6% per annum.
___________________
Solution: In this situation,
___________________
FV is Rs. 11,375
___________________
Rate of interest, r is 0.06
___________________
___________________
Number of years, n is 5.
The PV can be calculated as follows:
PV =
11375
(1 + 0.06)5
Thus, the PV of an annuity is Rs. 8,500.
Summary
The compounding technique is used to find the FV of a present
amount. The above equations imply that there are three variables
that affect the FV, which are PV, r% and n. The effective rate of
interest is the rate of interest compounded annually, which is equivalent to the interest rate compounded for more than once per year.
An annuity is a finite series of equal cash flows made at regular
intervals.
(More solved numericals on present value and specially annuity and
annuity compounding need to be provided. The student won’t be able
to solve the review questions since very less examples of such type
has been discussed here.)
(C
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Review Question
1. A contract was offered to a company with the following terms:
An immediate cash outflow of Rs. 15,000 followed by a cash inflow of Rs. 17,900 after three years. What is the company’s rate
of return on this contract?
Financial Management
Notes
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___________________
___________________
3. How is the FV affected when the interest rate is decreased or a
holding period is increased, and why?
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2. A five-year annuity of Rs. 2,000 per year is deposited in a bank
account that pays 10% interest compound yearly. The annuity
payments begin 10 years from now. What is the FV of the annuity?
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___________________
___________________
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4. Calculate the PV of cash flows of Rs. 850 per year till infinity (a)
at an interest rate of 8% and (b) at an interest rate of 10%.
5. Find out the PVs of the following:
(a)
Rs. 2,500 receivables in five years at a discount rate of
10%;
(b)
An annuity of Rs. 950 starting after one year for five years
at an interest rate of 12%;
___________________
(C
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(c) An annuity of Rs. 7,700 starting in seven years’ time lasting for seven years at a discount rate of 8%.
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Unit 3(b)
Notes
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Discounting Techniques
of Tvm
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Objectives:
___________________
After finishing this unit, students will be able to understand and explain:
___________________
\\
The present value of a single cash flow
\\
The present value of series of equal future cash flow
\\
The present value of perpetuity and annuity
___________________
\\
Present value of growing perpetuity and annuity
___________________
___________________
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Introduction
Discounting Technique is employed for calculation of the present
value (PV) from a given future value (FV). The PV is calculated
based on the following formula:
PV = FV/ (1 + r)n
Present Value of Single Cash Flow
The PV of single cash flow can be described in relation to the following:
1. A future amount’s PV
2. A future series PV
Present Value of a Future Amount
(C
The PV of a future amount will be of lesser value in comparison to its
FV because this amount does not take into consideration the opportunity of earning interest through investing. This can be explained
by the following example:
Example 3(b).1: If a person will get Rs. 1,100 at the end of a year
with the expected return of 10%, then PV is calculated using the
formula below.
PV = FV/ (1 + r) n
PV = 1100/(1+0.1) = 1,000
(Equation 4.1)
Financial Management
Notes
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___________________
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From Equation 3(b).1, it is deduced that the PV depends on three
variables:
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This explains that Rs. 1,100 receivable after one year is worth Rs.
1,000 today. We can also say that, if invested, Rs. 1,000 will earn
an interest of Rs. 100 and will yield Rs. 1,100 at the end of one
year.
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1. FV of the amount
___________________
2. Rate of interest
___________________
3. Time period
___________________
___________________
(C
___________________
From what we have learned so far, it is clear that
1. For a given period of time, PV will be lower if the rate of interest increases
2. For a given rate of interest, PV will be lower if the time period
increases
PV of a Series of Equal Future
Cash Flow or Annuity
As discussed in the previous unit, an annuity is the finite series of
regular cash flows made at regular intervals. Series of future cash
flows can be generated from decisions taken at present. Let’s understand this with the following example:
Example 3(b).2 ABC, an investment institution, offers two different policies for three years at 10% per annum to a person, in which
the person 1) invests Rs. 2,500 only at the start of the first year or
2) pays Rs. 1,000 at the end of the 1st, 2nd and 3rd year from now.
Which of the two options should the person choose?
Solution: The best policy can be determined based on calculating
the PV:
Option 1 – Here, the investment of Rs. 2,500 is paid today; therefore, it is already the PV.
Option 2 – Rs. 1,000 is paid at the end of the 1st, 2nd and 3rd
year; thus, by discounting the value of Rs. 1,000 and changing the
time periods from 1, 2 and 3 at 10% rate of interest, we get the
PV of investment required. We get the following values by using
Equation 3(b).1.
Unit 3(b): Discounting Techniques of Tvm
Value
PV
Year0
0
0
Year1
1000
909
Year2
1000
826
Year 3
1000
751
Total
3000
2487
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Time period
Notes
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Calculating PV of the Investment in Example 4.2
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From the above table, we see that option two is profitable for the
investor.
___________________
Thus, based on the understanding of the compounding and discounting techniques, we can defer the following about the PV and FV:
___________________
The PV and FV are related to one another. We can make any of the
value as an independent variable and the other as the dependent
variable and calculate its value.
___________________
FV factor will be more than one and the PV factor less than one, for
single cash flow. The FV contains the interest portion; whereas, the
PV is devoid of interest.
Present Value of Perpetuity and Annuity
Apart from single cash flow and series of cash flow in equal installment, there are other types of cash flows as well –
1. Perpetuity: Perpetuity is the never-ending sequence of identical cash flows at identical intervals. This implies that the time
period n = infinity
PV = Cash flow/(1 + r)1 + Cash flow/(1 + r)2 + Cash flow/(1 + r)3
+…………+ Cash flow/(1 + r) ∞
This can be simplified to PVp = Annual Cash Flow/r
(C
Thus, to derive the PV of annuity, amount of perpetuity is to be
divided by rate of interest.
2. Annuity Due: It was assumed that the amount was paid at
maturity and then the calculation pf PV and FV were done.
However, it may happen that the amount is paid at the beginning of the time period, which is called Annuity Due.
FV = Annuity Amount * CVAF(r, n) * (1 + r)
___________________
___________________
26
Notes
Where,
r = Rate of interest
___________________
n = Time period
___________________
___________________
and
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Financial Management
CVAF = Compounded Value of Annuity factor
PV = Annuity Amount * PVAF(r, n) * (1 + r)
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___________________
Where,
___________________
r = Rate of interest
___________________
n = Time period
___________________
___________________
(C
___________________
and
PVAF= Present Value of Annuity factor
Present Value of Growing Perpetuity
1. Growing Perpetuity: is defined as the never-ending cash flow
sequences, growing at a fixed rate per period. This can be described mathematically as follows:
PV = Cash flow/(r − g)
Where cash flow = amount at the completion of the period
r = Rate of interest
g = Growth rate in the perpetuity amount
2. Growing Annuity: It is the finite series of cash flow growing
at a periodic rate. This can be mathematically defined as:
PV = CF1/(r – g)[1 − {(1 + g)/(1 + r)}2]
Where CF1 = cash flow at finish of the first period
r = Rate of interest
g = Growth rate
n = Life of annuity
Summary
Discounting technique is a method to determine PV from a given
FV. For any given period, PV will be lower if the rate of interest
falls. PV will be lower for any given rate of interest is there is an increase in the time-period. The PV and FV are related to one another.
For single cash flow, the FV factor will be greater than one, and the
PV factor is less than one.
Unit 3(b): Discounting Techniques of Tvm
1. An investment is expected to offer returns of Rs. 3,500/- p.a. for
an indefinite period with a rate of interest at 10%. Calculate its
Present Value.
Notes
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2. ABC, a finance company, offers to deposit a sum of Rs. 2,200
and then receives returns of Rs. 160 p.a. perpetually.
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Review Questions
If the rate of interest is 8%, should this offer be accepted? Should
the decision change in case the rate of interest is 5%?
3. Mr. Nagpal is offered a scheme to open a recurring deposit account for a period of 10 years earning 12% interest. Under this
scheme, Rs. 3,150 will be deposited in the first year, and for
subsequent years, the deposit amount will increase by 5% every
year. What is the PV of this scheme?
4. A company issued bonds worth Rs. 50 lacs with a repayment
tenure of seven years. If a sinking fund is earning 12%, how
much should the company invest so as to be able to repay the
bond?
(C
5. What is the PV of operating expenditures of Rs. 2,00,000 per
year, which is assumed to be incurred continuously throughout
a five-year period, if the effective annual rate is 12% ?
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Unit 4
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Notes
Applications of Time
Value of Money
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Objectives:
___________________
At the end of this unit, students will be able to under and calculate:
___________________
\\
The implied rate of interest
\\
The number of periods
\\
The concept of sinking funds
___________________
\\
The concept of capital recovery
___________________
___________________
___________________
Introduction
The concept of time value of money (TVM) is chiefly dependant on
interest rates. A borrower who borrows money today will have to
repay the money along with interest. The principle of TVM defines
that a particular amount of money lent to someone has more value
when received back early. This is due to its capacity to earn interest. Financial managers are involved in making various decisions
that have financial implications. The TVM tool can be used for such
decision making. The application of the concept of TVM is listed
below:
llCalculating
the implied rate of interest
llCalculating
the number of periods
llSinking
funds
llCapital
recovery
(C
The prerequisites of using TVM are:
1. Understanding the cash flows
2. Applying the adequate techniques (Compounding/Discounting)
3. Applying the selected technique correctly
We will further learn about the various applications of TVM.
Financial Management
Notes
___________________
___________________
___________________
When Deep Discount Bonds (DDBs) are issued by several financial
institutions, investors must pay an amount at the time of issue of
the bond. The investor, in turn, receives an amount of cash (which
might be higher) at the completion of the stated period. Thus, using
TVM, we can compute the applied rate of interest for DDBs.
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To Find the Implied Rate of Interest
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30
___________________
___________________
___________________
For example – A DDB is issued today at Rs. 1,000 and will mature
after five years amounting to Rs. 15,000. On the basis of this, we can
calculate the implied rate of interest, r, using the following formula:
FV = PV + (1+r)5
___________________
Where:
___________________
FV – Future Value
(C
___________________
PV – Present Value
r – the rate of interest
To Find the Number of Years
Finding out the time period at which an amount will grow to a certain value at a given rate of interest is something a financial manager be interested in. This can be shown by the following formula,
where number of years, n, can be calculated:
FV = PV + (1 + r)5
Sinking Fund
A financial manager will want to accrue an amount along with interest earned over a period of time where the annual amount to be
paid remains same for all years. He would also be willing to accumulate a certain amount for replacing an asset or repaying a liability
in that specific period. Now, the amount collected annually becomes
the annuity for a given period wherein the amount collected annually shall be invested for the balance duration in such a way so that
the target amount is equivalent to the amount collected at the end
of the period.
For example, Rs. 10,000 is required after five years from now in order to repay a liability. How much amount should be accrued at the
end of every year with a 10% rate of interest? This can be calculated
as follows:
Unit 4: Applications of Time Value of Money
Annuity amount = FV/CVAF(r, n)
Here, CVAF stands for Compounded Value of Annuity factor.
r is the rate of interest.
n is the time period.
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FV = Annuity amount *CVAF (r, n)
Notes
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= 10000/6.105 = 1638
Therefore, an amount of Rs. 1,638 should be accumulated and invested at 10% rate of interest to attain Rs. 10,000 by the end of five
years.
___________________
___________________
___________________
___________________
___________________
Capital Recovery
A finance manager may want to calculate the amount to be paid
annually along with interest, at a fixed rate of the interest, for reimbursing a borrowed amount over a specified period.
For example, Rs. 10,000 is to be repaid in five equal installments,
with each installment being payable at the end of each of the next five
years, so that the interest accrued at 10% per annum can also repay.
This can be calculated as follows:
PV = Annuity amount *PVAF (r, n)
Here, PVAF stands for Present Value of Annuity factor.
r is the rate of interest.
n is the time period.
Annuity amount = PV/PVAF(r, n)
= 10000/3.791 = 2637.8
(C
Thus, if at the end of each year an amount of Rs. 2,673.8 is paid then
the initial debt of Rs. 10,000 together with interest accrued 10% will
be repaid in five years.
The factor 1/PVAF(r, n) is also called Capital Recovery Factor.
Deferred Payment
If a loan along with interest has to be repaid such that every year
the payment being made remains identical and the initial installment has to be deferred for a period of few years. In such a case,
___________________
Financial Management
Notes
___________________
___________________
___________________
Example 4.1 A debt of Rs. 100,000 is to be paid, starting from the
3rd year onwards, at 10% interest in six equal installments as follows.
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the period for which the payment has been delayed, its interest are
taken into consideration while calculating the amount to be repaid
annually for paying off the entire loan with interest.
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Figure 4.1: Calculation of Annual Payments Delayed at r = 10%
___________________
___________________
___________________
___________________
___________________
(C
___________________
Years
0
1,00,000
1
Interest
for
delay in
payment
2
3
4
5
6
1,21,000
27,784
27,784
27,784
27,784
7
27,784
8
27,784
Solution: Here, the amount to be repaid is Rs. 1,00,000, but there
is a delay of two years for which interest has been calculated at @
10% p.a.
FV = PV+ (1 + r)5 = 1,00,000 (1 + 0.10)2
FV = Rs. 1,21,000
Now, PV = Annuity amount * PVAF
Annuity amount = PV/PVAF = 27784
Summary
The principle of TVM defines that a particular amount of money
lent to someone has more value when received back early. It is a
foundation for numerous applications, which include calculating implied rate of interest, number of periods, sinking funds and capital
recovery.
Review Questions
1. XYZ PVT Ltd, a firm, buys machinery worth Rs. 8,00,000 and
as down payment pays Rs. 1,50,000 and repays the balance
money in installemnts of Rs. 1,50,000 for six years each. What
is the firm’s rate of interest?
2. Ten years from now Mr. Amit Bhatnagar will start receiving
a pension of Rs. 2,000 per year. The payment will continue for
15 years. What is the worth of the annuity now, if the rate of
interest is 10%?
Unit 4: Applications of Time Value of Money
Notes
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(C
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4. Naveen Co. Pvt. Ltd. is creating a sinking fund to repay the
preference share capital of Rs. 10,00,000 which matures on 3112-2017. The annual payments start on 1-1-2010 which is the
date of issue. The company wants to invest an equal amount
every year, which will earn 10% p.a. How much is the amount
of sinking fund annuity?
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3. Mayura Industries is creating a sinking fund to repay Rs.
60,00,000 bond issue which will mature in 15 years. How much
amount do they have need put into the fund at 10% interest
rate at the end of each year to accumulate Rs. 60,00,000, with
interest being compounded annually?
___________________
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___________________
___________________
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Unit 5
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35
Notes
Case Study: An Analysis of
Retirement Plans by ABC Corp.
___________________
___________________
___________________
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India is an upcoming financial capital of Southeast Asia. Large
business houses, investors, small business enterprises and high net
worth individuals use different methods and avenues of investment
to be able to meet their short-term and long-term requirements.
These investment opportunities differ based on their returns, maturity period and the investor’s risk appetite.
___________________
ABC Corp. is a financial institution that provides financial services
with its headquarters in Mumbai, India. It provides different financial plans or policies to its customers. This corporation helps
its customers in investment plans like savings plans, stock-market
investment plans, term policies, retirement plans, etc. These plans
depend on the following characteristics:
llHigh
Risk High Return Policies
llDuration
llAmount
Short-term and Long-term Policies
under Consideration
Time Value of Money is the basic concept under which these policies
are formulated. Large business conglomerates have huge capital
requirements for multiple projects. Hence, for such firms, seeking
a loan at the appropriate time or investing in the right plan at the
right time is very important to increase the firm’s earnings.
Mr. Sudeep, who is 35 years of age, would like to retire at the age
of 65. He wants to invest in a retirement plan such that he has an
annual income of Rs. 12 lacs per annum 30 years from today.
(C
Mr. Sudeep visits ABC Corp. and understands the different policies offered by them. He informs Mr. Aman, an executive of the
company, about his requirements. Mr. Sudeep wants to open a retirement account and is able to pay Rs. 1,50,000 lump sum with
annual payments of Rs. 50,000 for the next 10 years. Mr. Sudeep
has other commitments for the first 10 years; however, after 10
years, he will have more disposable income and can increase the
annual payment.
The task for Mr. Aman is to help him meet his goals of retirement
by estimating how much he will need to save every year 10 years
from now. Assume an average annual rate of 8% return on the
­retirement account.
Contd....
___________________
___________________
___________________
___________________
___________________
___________________
Financial Management
Notes
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Mr. Sudeep is also interested in knowing how much amount is to
be paid upfront to reduce the annual payments after 10 years (10
years–30 years) to half the value calculated initially.
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___________________
___________________
___________________
(C
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BLOCK–II
UNIT 6: TYPES OF FINANCIAL STATEMENTS
S
Detailed Contents
ll
Steps in Ratio Analysis
Financial Statements
ll
Types of Comparison in Ratio Analysis
ll
Income Statement
ll
Classification of the Ratios
ll
Balance Sheet
ll
Liquidity Ratios
ll
Statement of Appropriation of Profit
ll
Activity Ratios
ll
Statement of Change in Financial Position
ll
Summary
ll
Review Questions
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ll
UNIT 7: FINANCIAL STATEMENT ANALYSIS
ll
Analysis of Financial Statements
ll
Types of Analysis of Financial Statements
ll
Methodical Presentation of Analysis of Financial Statements
ll
Techniques/Tools of the Analysis of Financial Statements
ll
Summary
ll
Review Questions
UNIT 8: RATIO ANALYSIS
Introduction
(C
ll
ll
Leverage Ratios
ll
Profitability Ratios
ll
Summary
ll
Review Questions
UNIT 9: DUPONT ANALYSIS
ll
Introduction
ll
DuPont Analysis or Profile of Profitability
ll
How is the Return on Equity Dependent on other Key
Ratios of a Company?
ll
Relationship between Debt Financing and Growth
ll
Summary
ll
Review Questions
UNIT 10: CASE STUDY: BATA INDIA: STEP INTO
STYLE
Types of Financial Statements
S
Unit 6
39
Notes
___________________
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Objectives:
At the end of this unit, the students will be able to:
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Define an Income Statement
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Create a Balance Sheet
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Describe a Profit Appropriation Statement
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Formulate a Change in Financial Position Statement
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Financial decision making and financial planning that is beneficial for a company require the right amount of information to make
these decisions. This information encompasses previous and present
values of the firm and its operations and the changes in it over time.
Such information is known as financial information. This financial
information is derived from financial statements.
Financial Statements
A precise and concise form of financial information is available
through Financial Statements. There are various reasons to prepare
financial statements:
1. To convey the real position of the firm to external parties
2. To analyse the operation and performance of the firm
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Every company holds an annual general meeting in which they present the annual report of the company to their shareholders as per
The Companies Act, 1956. This annual report contains various reports, such as the chairman’s report, balance sheet, income statements and auditors’ reports along with several scheduled annexures, key operating statistics, etc. Following financial statements
have to be prepared by every firm, irrespective of its size:
1. Income Statement (IS)
2. Balance Sheet (BS)
3. Statement of Appropriation of Profit
4. Cash Flow Statements
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Notes
Income Statement
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An income statement (IS) provides information regarding the revenue and expenditure of the firms for a given accounting period. It
gives information regarding all incomes and expenses and the firm’s
operating results for a specified period. As it matches revenues with
the costs incurred while generating that revenue, it supports the
financial managers in understanding a firm’s performance and then
help them finally calculate the net profit or net loss incurred during
that period. The format to prepare an IS for a company for a particular period is given in Table 6.1.
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Table 6.1: Performa Income Statements for the Year Ending…
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Particulars
Amount (Rs.)
Amount (Rs.)
Rs.________
Rs. _______
Revenues:
Sales Revenue
Less sales returns and
allowances
Service revenue
Interest revenue
Other revenue
Total revenues
Expenses:
Advertising
Bad debts
Commissions
Cost of goods sold
Depreciation
Furniture and equipment
Insurance
Interest expense
Maintenance and repairs
Office supplies
Payroll taxes
Rent
Research and
development
Salaries and wages
Software
Travel
Utilities
Others
Total expenses
Net income before taxes
Contd.
Unit 6: Types of Financial Statements
Amount (Rs.)
Amount (Rs.)
Income tax expenses
Income from continuing
expenses
Net income
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Particulars
Notes
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The contents of an IS are divided into three categories:
1) Revenue
2) Expenses
3) Net Profit and Loss
Revenue
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The amount of money that comes into a company during a particular time, including discounts and deductions for business activities
or sale and purchase of goods and services, is called revenue. The
revenues is generated from the sale of goods and services and other non-operating incomes. Revenue is also generated in the form of
interest and dividend received from investments made in another
firm. An increase in the value of assets or decrease in the value of
liabilities represents the increase in shareholder’s funds due to revenue generation.
Expenses
The costs incurred while generating revenues are called expenses.
Some of the major expenses that company has to incur are the cost of
goods sold, salaries, repair and maintenance, transportation expenses, etc. An expense is said to be incurred if there is an enhancement
in liabilities or reduction in assets. Depreciation is also an expense
to the firm as it decreases the value of the asset over a given time.
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Notes
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The net profit or loss is a result of the tallying of revenues and expenses. When revenues are more than expenses, there is a net profit. If expenses are more than revenues, there is a net loss. These
values of net profit and loss determine the profitability of the firm.
Thus, an IS is also called a profit and loss statement.
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Net Profit/Loss
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Balance Sheet
A Balance Sheet (BS) is considered to be the most significant financial statement of any firm as it presents a clear picture of a company’s financial position at a given point in time. A BS provides details
regarding different components such as assets, liabilities, and capital of the A BS balances the assets of the firm to its liabilities. That
is the total value of assets must be equal to total claims against the
firm. This can be represented as follows:
Total Assets = Total Claims (Debt+ Shareholder’s contribution)
= Liabilities + Shareholder’s Equity
The format for preparing the BS of a company for a particular period
is given in Table 6.2.
Assets
2017 (Rs.)
2018 (Rs.)
Rs.________
Rs.________
Current Assets:
Cash
Accounts receivables
Inventory
Prepaid expenses
Short-term investments
Total current assets
Long-term assets:
Long-term investments
Property, plant, and equipment
Total fixed assets
Other assets:
Deferred income tax
Other
Total other assets
Total Assets
Liabilities and Owner’s Equity:
Current liabilities:
Accounts payable
Short-term loans
Contd.
Unit 6: Types of Financial Statements
2017 (Rs.)
2018 (Rs.)
Income taxes payable
Accrued salaries and wages
Unearned revenue
Current portion of long-term debt
Total current liabilities
Long-term debt
Deferred income tax
Other
Notes
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Long-term liabilities:
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Assets
Total long-term liabilities
Owner’s equity
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Owner’s investment
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Retained earnings
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Other
Total owner’s equity
Total liabilities and Owner’s Equity
Table 6.2: Performa Balance Sheet for the Year Ending…The different components of a BS are:
1. Assets
2. Liabilities
3. Shareholder’s Funds
Assets
An asset can generate future inflows and reduce cash outflows. The
assets of a firm represent the investments it makes to generate earnings. Assets can be categorized as: Fixed Assets and Current Assets.
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1. Fixed Assets: These are also called capital assets. They are
permanent in nature, and it is not possible to liquidate them in
a short span of time cannot. Examples of fixed assets are plant
and machinery, furniture and fixtures, land and building, etc.
These assets are shown in the BS at their written down value,
that is, the purchase cost less depreciation to date.
Depreciation is the process of allocation of the cost of the assets
in a particular time period during which the assets were used for
the company’s activities. The amount of depreciation does not
involve any cash outflow and, thus, is taken as an expense item
and is included in the cost of goods sold or indirect expenses.
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2. Current Assets: These are liquid assets that can be monetized
quickly ideally within a period less than one year. Examples of
current assets are cash in bank balance, inventory, receivables,
loan in advances given to suppliers, etc. The total of all current
assets is also called gross working capital.
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Debts or Liabilities
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Any claims that the outsiders have against the assets of the company are called Debts or Liabilities. It is the amount payable to the
claimholders by the company. A title is called a liability if i) it leads
to a cash outflow in the future, ii) the firm has to take this obligation
into account and cannot avoid it and iii) the transaction which was
responsible for the obligation should already have occurred. Liabilities can be classified as:
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1. Long-term liabilities – These are such debts that must be
repaid over many years. Examples of long-term liabilities are
bonds, debentures, mortgage loans, loans from financial institutions, etc.
2. Current liabilities or short-term liabilities – These are the
debts incurred by a firm and must be repaid within one year.
These short-term liabilities are related to the operating cycle
of the firm. Examples of current liabilities are outstanding expenses, bills payable, bank overdraft, etc.
Shareholders’ Equity
The Shareholder’s Equity is an obligation of a firm toward its owners. It comprises of share capital and retained earnings. The share
capital is the contribution of the shareholders toward the firm;
whereas, the retained earnings reflect the accumulated effect of the
firm’s earnings less the dividends. The shareholder’s equity is also
called the net worth of the firm.
Statement of Appropriation of Profit
This statement is also called the profit and loss appropriation account. This statement shows us how the profits are utilized by the
firm as it may be bifurcated into dividends and retained earnings.
Thus, the net profit which is obtained from the IS, is transferred to
the P&L appropriations account. The format to prepare the statement of appropriation of accounts is given in Table 6.3.
Unit 6: Types of Financial Statements
Particulars
Amount
Particulars
Amount
To General
Reserve
*****
By Balance b/d
*****
To Interim
Dividend
*****
By Net Profit
*****
To Proposed
Dividend
*****
By Transfer from
General Reserve
*****
To Corporate
Dividend Tax
*****
Notes
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To Balance c/d
*****
(balancing figures)
Total
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Table 6.3: Performa of Profit and Loss Appropriation A/c
*****
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Total
*****
General Reserve
The amount that a company keeps separately out of the profits
earned or future purpose is called general reserves.
Interim Dividend
The distribution that has been declared and paid before the company has estimated its complete earnings for a particular financial
year is called interim dividend.
Corporate Dividend Tax
The profits of a company are taxable at the average marginal tax
rates of shareholders’ when distributed as dividends.
Net profit/loss
The net profit or loss is a result of the tallying of revenues and expenses. When revenues are more than expenses, there is a net profit.
If expenses are more than revenues, there is a net loss.
Statement of Change in Financial Position
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The BS and IS determine the financial condition of the company
during a period but does not give any information on the change in
financial position over that period. In order to identify the movement of funds during a period a Statement of Change in Financial
Position (SCFP) must be prepared. The SCFP illustrates how funds
are generated during a time period and how these funds are utilized.
The SCFP can be prepared in two different ways: Working Capital
Basis and Cash Basis
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Cash basis is a method to record transactions for revenues and expenses when it is received, or payments are made.
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The working capital basis is a method by which the SCFP is prepared of a company between two BSs. It represents the inflow and
outflow of funds or the sources and applications of funds for a specific period.
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When the SCFP is prepared on the basis of Working Capital, it is
termed as Funds Flow Statement, and when it Cash basis is used
to prepare the statement it is called Cash Flow Statement.
Thus, financial statements are an important tool to aid the finance
manager in better decision making. The information provided in
these statements can be further analysed to determine the financial
health of the firm.
Summary
The financial statements are used to present essential financial information is a concise and precise company. They are used to help
external parties understand the financial position of the firm and
to analyse the level of operation and performance of the company.
Various types of financial statements include the IS, BS, statement
of appropriation of profit and cash flow statements.
Review Questions
1. What is the relation between Income Statement (IS) and Balance Sheet (BS)?
2. Explain the significance of two basic financial statements with
respect to various stakeholders?
3. What are the three main categories in which the contents of IS
can be grouped? Explain each of them.
4. Explain the difference between fixed assets and current assets.
How are the assets illustrated in the BS?
5. Statement of Change in Financial Position is explained by two
statements. What are the two statements? On what basis are
these statements prepared? Explain their significance to the
firm.
Financial Statement Analysis
Objectives:
Notes
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At the end of this unit, the students will be able to understand and explain:
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Purpose of financial statements analysis
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Various types of financial statements analysis
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Financial statement presentation
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Financial statements analysis
Analysis of Financial Statements
As discussed earlier, critical financial information is made available through financial statements. In order to take key decisions
regarding the functioning of the company, Finance Manager and
other Management personnel have to analyze various financial
statements. As such, analysis of financial statements (AFS) can be
defined as the process of studying the relationship amongst different
financial information provided available through the financial statement. AFS assists a financial manager in identifying the financial
standing of the company.
Objectives of Analysis of Financial Statements
Following are the various objectives of AFS: -
1) Profitability and Efficiency analysis of the whole firm as well as
of individual departments.
2) To identify the relative significance of various components that
affect a firm’s financial standing.
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3) Analysis of the reasons for changes in the financial standing of
the firm.
4) Calculation of the firm’s short-term as well as long-term
­liquidity.
Types of Analysis of Financial Statements
The type of AFS to be used depends on the end purpose for which it
is being done. AFS is mainly required by the shareholders, creditors
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Notes
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Internal and External Analysis of Financial Statements
Internal Analysis of financial statements is done by an individual or
company has easy access to the company’s book of accounts as well
as all other relevant information to measure the company’s managerial and operational efficiency.
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and investors and management. Following are the various ways to
categorize it:
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External Analysis of financial statements is done by an external
person without having access to the company’s basic accounting records and is only based on the company’s published financial data in
annual reports and other sources.
Dynamic and Static Analysis of Financial Statements
Dynamic analysis is used for long-term analysis and planning based
on horizontal analysis of the financial statements covering a period of several years. Whereas, Static Analysis or Vertical analysis
covers a period of up to one year and provides information as on a
particular date without any periodic changes being incorporated.
Methodical Presentation of Analysis of Financial
Statements
The data available can be modified and suitably rearranged to make
it more logical and easier to analyze. In order to facilitate an inter-firm comparison, financial information can be presented methodically. The following is an example of an income statement (IS)
of a company for a particular year.
Particulars
Amount ($)
Amount ($)
$________
$ _______
Revenues:
Sales Revenue
Fewer sales returns and
allowances
Service revenue
Interest revenue
Other revenue
Total revenues
Expenses:
Advertising
Bad debts
Commissions
Cost of goods sold
Contd.
Unit 7: Financial Statement Analysis
Amount ($)
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Particulars
Amount ($)
Notes
Depreciation
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Furniture and equipment
Insurance
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Interest expense
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Maintenance and repairs
Office supplies
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Payroll taxes
Rent
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Research and
development
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Salaries and wages
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Software
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Travel
Utilities
Others
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Total expenses
Net income before taxes
Income tax expenses
Income from continuing
expenses
Net income
Income Statement (Methodical Presentation)
The following is an example of the balance sheet (BS) of a company
for a particular year.
Table 7.2: Balance Sheet (Methodical Presentation)
Assets
2017 ($)
2018 ($)
Current Assets:
Cash
Accounts receivables
Inventory
Prepaid expenses
Short-term investments
Total current assets
(C
Long-term assets:
Long-term investments
Property, plant, and equipment
Total fixed assets
Other assets:
Deferred income tax
Other
Total other assets
Contd.
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Notes
Total Assets
Current liabilities:
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Accounts payable
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$________
Liabilities and Owner’s Equity:
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Short-term loans
Income taxes payable
Accrued salaries and wages
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Unearned revenue
$________
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Current portion of long-term debt
Total current liabilities
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Long-term liabilities:
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Long-term debt
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Deferred income tax
Other
Total long-term liabilities
Owner’s equity
Owner’s investment
Retained earnings
Other
Total owner’s equity
Total liabilities and Owner’s Equity
Techniques/Tools of the Analysis of Financial
Statements
Earlier in this chapter, we have discussed the purpose of AFS. We
will now discuss the techniques of performing AFS. The following
are few techniques:
1. Comparative Financial Statements (CFS)
2. Common-Size Financial Statements (CSS)
3. Trend Percentage Analysis (TPA)
4. Ratio Analysis
Comparative Financial Statements
In Comparative Financial Statements (CFS), a BS or an IS is condensed for two or more years. This means that the person conducting
CFS can compare the BS or IS across different years. It is observed
that information of financial statements across different time periods will be more beneficial as compared to the information for a
single financial period. The CFS is prepared to depict the following:
Unit 7: Financial Statement Analysis
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1. Monetary Value of different items
Notes
2. Monetary Changes over a period
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3. Calculate proportionate changes on the basis of periodic changes
in %.
Let’s have a look at an illustration of cash flow statement.
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Particulars
Year, 20XX
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Cash flows from operating activities:
Revenues from School Districts
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Grant revenues
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Contributions and fund-raising activities
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Miscellaneous sources
Payments to vendors for goods and services rendered
(
)
Payments to charter school personnel for services rendered
(
)
Interest payments
(
)
Purchase of equipment
(
)
Net cash used in investing activities
(
)
(
)
(
)
(
)
Net cash provided by operating activities
Cash flows from investing activities:
Cash flows from financing activities:
Principal payments on long-term debt
Net cash provided by investing activities
The net increase in cash
Cash at the beginning of the year
Cash at ending of the year
Reconciliation of change in net assets to net cash provided by
operating activities:
Change in net assets
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Adjustments to reconcile change in net assets to net cash
provided by operating activities:
Depreciation
(Increase) Decrease in assets:
Accounts receivable
Increase (Decrease) in liabilities:
Accounts payable
Accrued liabilities
Net cash provided by operating activities
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Notes
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llComparative Balance Sheet: In order to analyze the ­financial
standing of the company, a comparative BS is of great assistance as it depicts the different value of assets and liabilities
across different dates.
llComparative
Income Statement: A comparative IS shows
the values of different items of the IS and its change from
one period to another. This change can be calculated in percentages and provides useful data to analyze and draw conclusions. This can also help a financial analyst to predict increasing or decreasing trends in entities like the cost of sales,
manufacture of goods, etc.
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CFS is compared for both BS and IS.
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Common-Size Financial Statements
1) A Common-Size Financial Statements (CSS) represents the relationship between the components of financial statements like
BS or IS by calculating the values in the form of percentages.
For example, the BS for two years can be compared by converting each component of a BS into a percentage. This percentage
is calculated by taking the absolute value of the component divided by the total of the BS and multiplying by 100. In the same
way, the components of the IS are converted into percentages
by taking the value of the component, dividing it by the net
sales and multiplying the factor by 100. Here is an illustration
of a CSS.
Particulars
2017 (Rs.)
2018 (Rs.)
Sales
Cost of goods sold
Gross Profit
Taxes
Total profit
Trend Percentage Analysis
This is the technique in which different financial statements are
examined over a series of years and is used for both BS and IS. The
trend percentage is calculated for every constituent and compared
with that of the base year with the value of the base being 100. TPA
can be used to study historical data and forecast the future trend.
Unit 7: Financial Statement Analysis
Ratio Analysis is one of the most used technique for AFS and gives
a precise data for analyzing the firm’s overall financial standing. It
will be discussed elaborately in the next chapter.
Notes
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Summary
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Ratio Analysis
AFS is a study of the relationship between various financial information (facts and figures) provided by the financial statement. AFS
can be employed by the Finance Manager to identify and analyze
company’s financial strengths and weaknesses. It helps analysis of
operating efficiency and profitability of the whole company as well
as different individual departments. This helps establish relative
significance of various constituents of the company’s financial position.
Review Questions
1. How is a dynamic analysis of financial statements done?
2. Explain how the methodical presentation of financial statements helps while calculating various ratios?
3. How is each item expressed in common-size financial statements (CSS)? Explain by using an example.
4. Explain how trend percentage analysis helps in the dynamic
analysis?
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5. What is the difference between the CSS and CFS for both income statement and balance sheet?
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Notes
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Ratio Analysis
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Objectives:
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At the completion of this unit, the students will be able to understand and
explain:
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Liquidity Ratios
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Activity Ratios
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Leverage Ratios
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Profitability Ratios
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Introduction
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A financial ratio helps establish a relation between multiple accounting figures which help summarize a vast amount of financial
data into key ratios which are then used by financial analysts or
company management to analyze the financial health and performance of the firm.
Example 8.1 – If a firm is making a profit of Rs. 10,00,000 and net
sales of the firm are Rs. 25,00,000, then find the ratio of net profit.
Solution: In this case,
Net profit is Rs. 10,00,000
Net sales are Rs. 25,00,000
The formula to determine the ratio of net profit is:
Net profit ratio =
Net profit after tax
× 100
Net sales
10, 00, 000
× 100
25, 00, 000
= 40%
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Net profit ratio =
Thus, the ratio of net profit to net sales is 40%.
Steps in Ratio Analysis
Basically, there are two steps of ratio analysis. These two steps involve:
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Notes
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2. Comparison of the calculated ratio with a benchmark ratio. The
benchmark ratio could be the industry’s standard or the base
year’s ratio.
Types of Comparison in Ratio Analysis
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1. Calculation of the ratios
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There are three ways in which ratios can be analyzed:
1. Time Series Analysis: When the performance or the ratios
of the firm are evaluated over a period of time, it is called time
series analysis. The information provided through time series
analysis illustrates a trend in the values, which can then be
used to examine the following:
(a)
Prediction of values for the future
(b)
Deviation from the present and long-term goals of the
firm
(c) Shift in trend and assess any significant deviation
(d) The progress of the firm
2. Cross Section Analysis: In this particular analysis, the ratios
are calculated within a given time period and then compared
with same ratios of different firms in the same industry. This
helps analyze the progress of the company in comparison to the
competitors in the market.
3. Combined Analysis: Data from both the previous analysis is
combined to extract meaningful information about the firm’s
performance.
Classification of the Ratios
Different ratios are categorized as per its nature. These ratios provide information regarding the different aspects of the firm’s performance. Mainly, the financial ratios give information on the operational and financial performance of the firm. Thus, the ratios are
classified as follows:
1. Liquidity Ratios
2. Activity Ratios
3. Leverage Ratios
4. Profitability Ratios
Unit 8: Ratio Analysis
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Liquidity Ratios
Notes
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These ratios provide information on the firm’s short-term solvency
and its ability to pay off debts. Thus, it mainly refers to the maintenance of cash, cash balances and current assets. The liquidity ratios
keep a track on the extent of the firm’s exposure to risks that will affect its short-term goals. In case a firm has low liquidity, it won’t be
able to meet its current liabilities which will result in loss of creditworthiness. All the information required to calculate liquidity ratios
appear on the balance sheet, that is why these are called balance
sheet ratios as well.
Some of the important liquidity ratios are as follows:
It is a measure of a company’s total current against its current liabilities
Total Current Assets
Total Current Liabilities
The total current assets include cash, cash convertible (which can
be converted into cash in one year), prepaid expenses and shortterm investments. Whereas, the current liabilities include all the
liabilities that need to be paid off in a period of one year, such as
outstanding expenses, bills payable, bank overdraft, provision for
tax, provision for dividends, etc. It highlights the fact if the firm’s
current assets are enough to meet its current liabilities.
Interpretation of the Ratio: The satisfactory level is 2:1; however,
this may not be applicable to all cases and may be different for different industries. This explains that the firm has twice the margin
with which the value of current assets may go down without affecting the operations of the firm.
The only flip side of using current ratio is that it considers only the
current assets of the company, not the current liabilities. Thus, the
real ability of the firm is measured using the quick ratio.
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Current Ratio
Current Ratio =
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Quick Ratio
The quick ratio is also called the acid-test ratio or the liquid ratio. It
establishes the relationship between quick/liquid assets of the company to its current liabilities. A current asset is said to be a liquid
asset if it can be converted to cash with a period of one year without
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Financial Management
Notes
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any loss of value. Quality of current assets is taken into consideration, and in comparison, doubtful assets such as obsolete stock,
defaulting debtors, and prepaid expenses are not considered.
Quick Ratio =
___________________
Quick / Liquid Assets
Total Current Liabilities
Interpretation of the Ratio: The quick ratio of 1:1 is considered satisfactory; however, this may not be applicable to all cases and may
be different for different industries. This explains that the firm has
enough liquid assets to repay the current liabilities.
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There is a serious drawback for the quick ratio, as the assets or
their components which may not be converted into cash within a
year are also added sometimes. Inventories that were removed from
the quick assets may not always be illiquid, or the receivables or
marketable securities that are considered may not be liquid enough.
Thus, the absolute liquid ratio provides a more rigorous and better
measure.
Absolute Liquidity Ratio
It takes into consideration the absolute liquidity available within
the firm. Thus, it includes cash, bank balances and marketable securities and divides them by the current liabilities. As such it is also
known as a super quick ratio or cash ratio.
Cash Ratio =
Cash in hand and bank + Marketable Securities
Total Current Liabilities
Interpretation of the Ratio: The cash ratio of 0.5:1 or 1:2 is considered satisfactory; however, this may not be applicable to all cases
and may be different for different industries. This also explains that
too much of highly liquid assets will be unprofitable for the company. Every firm has a borrowing capacity. Thus, the total cash reservoir ratio or the reserve borrowing capacity is also relevant.
Defensive Interval Ratio
This ratio emphasizes that not just current liabilities but also current assets should be large enough to meet the daily requirements
of liquidity to pay expenses. For this reason, defensive interval ratio
is calculated.
Defensive interval Ratio =
Total Defensive Assets
Projected Daily Cash Requirements
Unit 8: Ratio Analysis
Cash + Bank + Debtors + Marketable Securities
=
Projected Daily Cassh Requirements
Current Assets − Inventory − Prepaid Expenses
Projected Daily Cash Requirements
This also explains that the projected daily cash requirement is equal
to the Cost of Goods Sold + General Expenses− Depreciation /365.
___________________
___________________
___________________
___________________
Following are the major activity ratios:
Inventory/Turnover Ratio
It is also known as the stock turnover ratio as it measures the relation between cost of goods sold and average inventory held during
the year. It can be represented as:
Inventory Turnover Ratio =
Cost of Goods Sold
Average Inventory
Opening Stock + Closing Stock
2
Cost of Goods Sold = Opening Stock + Purchase – Closing Stock
= Net Sales – Gross Profit
Interpretation of the Ratio: The higher the Inventory/Turnover Ratio
(I/T ratio), more efficient is the inventory management. Different
standards of calculating the I/T ratios are used across different industries. Moreover, a higher ratio may be acceptable to a certain
point. In case the I/T ratio is on the higher side, it means problems in
the area of short stocking of inventory. If the I/T ratio is too high, it
may indicate problems, such as under-stocking of inventory or poor
management of purchases and sales.
(C
___________________
___________________
Activity ratios are also known as turnover ratios and performance
ratios and can be calculated as a reference to the cost of goods sold
or sale of goods as it relates to the fact how efficiently the firm has
used its assets and resources.
Average Inventory =
___________________
___________________
Activity Ratios
Where,
Notes
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=
59
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Total Liquid Assets
=
Projected Daily Cash Requirements
___________________
___________________
Financial Management
Notes
___________________
___________________
___________________
This ratio focuses on the receivables concept. If a company sells
goods on credit and the revenue is received at a later stage, the
receivables are created. The earlier the receivables are received or
recovered better would be the company’s liquidity. The company’s
credit and collection policy are reflected through the Debtor Turnover Ratio. This ratio determines the speed of the receivables collection by dividing the annual net sales by the average accounts
receivables. It is represented as follows:
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Receivables (or Debtors) Turnover Ratio
S
60
___________________
___________________
___________________
___________________
___________________
(C
___________________
Receivables Turnover Ratio =
Annual Net Credit Sales
Average Receivables
Interpretation of the Ratio: The higher the R/T ratio (or a low average collection period) denotes that the receivables are highly liquid
and indicates a very restricted credit policy. This also implies that
the firm might lose prospective customers by maintaining such a
credit policy. For this reason, the company’s credit policy should be
in line with the industry standards.
Payables (or Creditors) Turnover Ratio
This ratio underlines the payables concept. If a company buys goods
or raw materials on credit and the cost is incurred at a later stage,
payables are created. Thus, the Payables (or Creditors) Turnover
Ratio (P/T ratio) determines the speed of the debt payment made
by the firm by dividing the annual credit purchases by the average
payables. It is represented as –
Payables Turnover Ratio =
Annual Net Credit Purchases
Average Payables
Interpretation of the Ratio: A high P/T ratio (or a low average retention period) denotes that the payables are paid out in time and represents the company’s goodwill toward its suppliers. The suppliers
of the company will be interested in this ratio as this will explain the
payment pattern of the firm.
Working Capital Turnover Ratio
It signifies the company’s ability to effectively use its working capital . It signifies the speed with which the firm used the working
capital during the year. The working capital here refers to the net
working capital.
Unit 8: Ratio Analysis
The WCT ratio can be described as follows:
Annual Net Sales
WTC Ratio =
Average Working Capital
Notes
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Interpretation of the Ratio: A high WCT ratio denotes that the investment in working capital is less and the profitability is high (as
net sales are high). However, a very high WCT may also signal risk
and problems with the firm. Moreover, it may denote overutilization
of working capital or over trading by the firm with respect to its net
working capital.
61
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Net Working Capital = Total Current Assets – Total Current
Liabilities
___________________
___________________
___________________
___________________
___________________
Leverage Ratios
Leverage ratios are used to analyze the company’s long-term financial position. In other words, the long-term sources of funds comprise
shareholders’ funds and borrowings. Thus, the long-term sources of
funds comprise the following:
(a) Preference Share Capital
(b) Equity Share Capital
(c) Retained Earnings or Accumulated Profits
(d) Debenture/Loans or Long-term Debt
(C
Debt can be interpreted here as a company’s long-term commitment
to pay interest along with principal on the amount due. That is why
this particular statistic holds great significance for every person associated with the company as a stakeholder as it signifies the company’s ability to pay off its debts as well as its degree of indebtedness.
The more the debt the firm uses, the higher is the risk, which means
the higher is the probability of default. Following are the key ratios
that help analyze the degree of a company’s debt and its ability to
pay them off as follow: -
Debt-Equity Ratio
The Debt—Equity Ratio (DE Ratio) ratio examines the indebtedness
of the firm. It measures the financial leverage of a firm by dividing
the total liabilities with the stockholders’ equity. It compares the
total long-term debt to the shareholders’ funds. This ratio is represented as follows:
___________________
62
Notes
Dept
Net Worth
Total Long-term
=
Shareholder's Funds
Debt-Equity Ratio =
___________________
___________________
___________________
Interpretation of the Ratio: The DE ratio cannot be generalized as
the best measure, it has to be compared with the industry standard
in which the business is operating. Every industry has its own acceptable characteristics, such as a DE ratio in heavy industry will be
higher as compared to small manufacturing firms.
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Financial Management
___________________
___________________
___________________
___________________
___________________
(C
___________________
Total Debt Ratio
This ratio also examines the indebtedness of the firm. It measures
the financial leverage of a firm by dividing the total liabilities with
the stockholders’ equity. It compares the total debts to the total assets in a firm. This ratio is represented as follows:
Total Dept
Total Assets
Long-term Debts + Current Liabilities
=
Total Debts + Net worth
Total Debt Ratio =
Interpretation of the Ratio: The Total Debt Ratio (TD ratio) compares parts of the assets that are financed by the proportion of total
liabilities; whereas, the remaining parts of the assets are financed
by shareholders’ funds. A high TD ratio implies a higher debt for the
company, which also implies higher financial risk.
Interest Coverage Ratio
The Interest Coverage Ratio is also known as times interest earned
ratio as it measures a firm’s ability to pay off its fixed interest payment liabilities. Moreover, it examines how the operating profit covers the interest liability. This ratio is represented as follows:
IC Ratio =
EBIT
Interest
Where, EBIT = Earnings Before Interest and Taxes
Interest = Fixed Interest Liability of the Firm
Interpretation of the Ratio: A high IC ratio is beneficial for the company and its lenders; whereas, if the interest coverage ratio is towards the lower end it shows that the firm’s profitability is low in
regards to the liability of interest payment .
Unit 8: Ratio Analysis
It is also known as PC ratio and is complementary to the IC ratio as
it analyses a firm’s ability to pay a dividend to the preference shareholders. As the preference dividends are paid out from the profits
after calculation of taxes, this ratio is represented as follows:
Point After Tax(PAT)
Preference Dividend
Notes
___________________
___________________
___________________
___________________
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PC Ratio =
S
63
Preference Dividend Ratio
___________________
Interpretation of the Ratio: The PC ratio is of importance to the preference shareholders as a high PC ratio indicates a high likelihood of
payment of preference dividends.
___________________
Fixed Payment Coverage Ratio
___________________
The Fixed Payment Coverage Ratio (FC ratio) ratio examines the
firm’s ability to service debt. It examines the coverage of principal
repayment, which is ignored in both IC and PC ratios. It analyses
the relationship between the net operating profits and fixed interest liabilities, preference share dividends and principal repayments.
This ratio is represented as follows:
___________________
FC Ratio =
EBIT
I + ( PR + PD) (1 − t )
Where, I = Interest Liability
PR = Principal Repayment
PD = Fixed Preference Divided
t = Tax Rate
(C
Interpretation of the Ratio: A high FC ratio is beneficial for the company and its lenders. It helps in measuring the ability of a firm to
satisfy the fixed charges. It is useful for lenders who are interested
in analysing the cash flow amount that a firm has for repayment of
debt. A low ratio would indicate that the lenders may try to avoid
the firm. If a firm can cover its fixed charges at a faster rate than its
competitors, it is not only more effective but also profitable.
Cash Flow Coverage Ratio
This ratio examines the firm’s ability to service debt. It analyses the
coverage of debt based on cash profit only as the other ratios take
into consideration the non-cash accruals as well. Thus, the FC ratio
is modified to cash coverage of fixed liabilities. This most commonly
used formula to determine the cash-flow coverage ratio is given below.
___________________
___________________
Financial Management
Notes
___________________
___________________
___________________
Operating cashflows
Total Debt
Interpretation of the Ratio: The CC ratio ascertains the firm’s degree
of risk of default in payment. Therefore, the lower the coverage ratio, the riskier it is for the lenders of the firm.
Profitability Ratios
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Cash flow coverage Ratio =
S
64
___________________
___________________
___________________
___________________
___________________
(C
___________________
The profitability ratios ascertain the profitability and operating efficiency of the firm which are of great interest to the higher management, financial analysts, shareholders, and investors. Therefore,
the performance of the firm can be classified by relating the profits
to the sales of the firm, assets of the firm and owner’s contribution
toward the firm. We have categorized the ratios accordingly into the
following categories:
(I) Profitability Ratios based on Sales of the firm
(II) Profitability Ratios based on Assets/Investments
(III) Profitability Ratios based on Owner’s Contribution
Gross Profit Ratio
The Gross Profit (GP) ratio compares the gross profit of the firm
with net sales. It helps in ascertaining the profit margin of the firm.
It is also called the average markup ratio. This ratio is represented
as follows:
Gross Profit
× 100
Net Sales
Net Sales − Cost of Goods Sold
=
× 100
Net Sales
GP Ratio =
Interpretation of the Ratio: The GP ratio is measured in a time series
and ascertains the efficiency with which the firm produces/purchases the goods. The GP ratio cannot be studied for a single year as if
won’t produce any significant results. However, when studied in a
time series, the change in trend indicates a change in operational
efficiency.
Operating Profit Ratio
The Operating Profit (OP) ratio is based on the sales of the firm and
examines the profit margin of the firm. It compares the operating
profit of the firm to the net sales. This ratio is represented as follows:
Unit 8: Ratio Analysis
65
S
EBIT
OP Ratio =
× 100
Net Sales
Notes
___________________
___________________
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Interpretation of the Ratio: The OP ratio examines the efficiency of
the percentage of pure profit earned on every Re. 1 of the sale. This
ratio ascertains the efficiency with which a firm is able to manufacture and sell goods.
___________________
Net Profit Ratio
The Net Profit (NP) ratio is based on the sales of the firm and examines the net profit margin of the firm. This ratio compares the
net profit of the firm with the net sales. This ratio is represented as
follows:
Net PAT
NP Ratio =
× 100
Net Sales
Interpretation of the Ratio: The NP ratio analyses the net contribution made one very Re. 1 of the sale to the owner’s funds. It represents the proportion of sales that can be offered to the shareholders of the organization.
Return on Assets Ratio
The Return on Asset (ROA) ratio is based on the Assets/Investments
of the firm. It compares the net profit of the firm to the assets employed by the firm. This ratio is represented as follows:
Net PAT
× 100
Average Total Assets
Net PAT
=
× 100
Average Tangible Assets
Net PAT
=
× 100
Average Fixed Assets
(C
ROA Ratio =
Interpretation of the Ratio: The ROA ratio helps in ascertaining the
overall efficiency of a firm in generating assets through certain assets. If the ROA decreases, it implies that the firm has increased
the size of assets but has not been able to increase its profits proportionately. The ROA of the firm needs is compared with the industry
average as it cannot be generalized.
___________________
___________________
___________________
___________________
___________________
66
Notes
___________________
___________________
___________________
Return on Capital Employed Ratio
S
Financial Management
The Return on Capital Employed (RCE) ratio compares the profit of
the firm with the total funds employed/capital employed by the firm.
The capital employed (CE) by the firm can be represented as follows:
___________________
This ratio is represented as follows:
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CE = Shareholders fund + Long-term Debt = Fixed Assets + Net
Working Capital
___________________
___________________
Net PAT + {Interest*(1 − t )}
× 100
Average Capital Employed
EBIT
=
× 100
Average Capital Employed
RCE Ratio =
___________________
___________________
(C
___________________
Interpretation of the Ratio: RCE ratio, when compared with the industry average, depicts the profitability for the shareholders. Higher the ratios, more profit the shareholders earn. Moreover, it is also
considered a long-term profitability ratio as it indicates the efficiency of assets while considering long-term financing. It is useful to
shareholders as it helps evaluate the longevity and financial condition of a company.
Return on Equity Ratio
Based on the owner’s contribution towards the firm, the Return on
Equity Ratio compares profits of the firm with the contribution of
the equity shareholders of the firm. This ratio is represented as follows:
PAT − Preference Dividend
× 100
Equity Shareholders Funds
Net PAT
=
× 100
Total Shareholder's Funds
RCE Ratio =
Interpretation of the Ratio: The RCE ratio should be compared with
the industry average. It explains how well the shareholders’ funds
are utilized. Therefore, the higher the ratio, the more profitable it is
for the shareholders.
Earnings Per Share
The Earnings per Share (EPS) ratio is based on the number of equity shares available. It compares the profits of the firm to the total
number of equity shares. This ratio is represented as follows:
Unit 8: Ratio Analysis
67
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PAT − Preference Dividend
EPS =
Number of Equity Share
Notes
___________________
___________________
___________________
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Interpretation of the Ratio: EPS ratio, when examined in a time series, shows an increasing or a decreasing trend of a company. EPS
needs to be adjusted when bonus shares are issued or for retained
earnings.
___________________
Dividend per Share
___________________
The Dividend per Share (DPS) is the sum of declared dividends issued by a firm every ordinary share outstanding. It is total dividends
paid out by a business divided by the outstanding shares issued. It
compares the profits of the firm to the total dividends or the distributed profits. This ratio is represented as follows:
DPS =
Total Profit Distributed Dividends
Shares outstanding for the period
Interpretation of the Ratio: Similar to the EPS ratio, the DPS ratio is
best examined in a time series. DPS should be adjusted when bonus
shares are issued. The company declares a dividend as a percentage
of the paid-up capital. This also gives rise to the DPS Ratio = DPS/
EPS.
Price Earnings Ratio
The Price Earnings (PE) ratio is based on the market price of the
shares. It compares the EPS to its market price. This ratio is represented as follows:
PE Ratio =
Market Price Per Share
Earnings Per Share
(C
Interpretation of the Ratio: The PE ratio determines the investor’s
expectations. A high PE ratio implies that the shares will have low
risk and the investor expects high dividend growth.
Refer to the below example of ABC Corp to help understand the calculations of all ratios using the financial statements.
Example 8.2 – Below is the income statement and balance sheet for
ABC Corp. for the accounting year 2016.
___________________
___________________
___________________
___________________
Financial Management
68
INCOME STATEMENT
for the year ending Dec. 31st, 2016
___________________
___________________
___________________
Particulars
Amount (Rs)
Credit Sales
61,48,000
Less : Cost of Goods Sold
41,76,000
Gross Profit
19,72,000
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Table 8.1: Income Statement of ABC Corp
Notes
___________________
Less : Administrative Expenses
4,58,000
Less: Selling Expenses
2,00,000
Less: Depreciation
4,78,000
Operating Profit(EBIT)
8,36,000
___________________
Less: Interest Charges
1,76,000
___________________
PBT
6,60,000
___________________
Less: Provision for Tax
1,98,000
PAT
4,62,000
___________________
(C
___________________
Less : Preference Share Dividends
20,000
Earnings for Equity Shareholders
4,42,000
Less: Dividend Paid
1,96,000
Retained Earnings
2,46,000
Table 8.2: Balance Sheet of ABC Corp
BALANCE SHEET
as on Dec. 31st, 2016
Capital and
Liabilities
Amount (Rs)
Assets
Amount (Rs)
5% Preference Share
Capital
(of Rs 100 each)
4,00,000
Fixed Assets
93,38,000
Equity Share Capital
(38,200 shares of Rs
10 each)
3,82,000
Less Depreciation
45,90,000
Total Share Capital
7,82,000
Net Block(1)
47,48,000
Add: Securities
Premium A/c
8,56,000
Cash and Bank
7,26,000
Add: Profit and Loss
A/c
22,70,000
Receivables
10,06,000
Shareholders’ Funds
39,08,000
Marketable
Securities
1,36,000
Add: Long-Term
Loans
20,46,000
Liquid Assets
18,68,000
Capital Employed
59,54,000
Add: Inventories
5,78,000
Total Current Assets
(2)
24,46,000
Less: Trade
Creditors
7,64,000
Bills Payables
1,58,000
Contd.
Unit 8: Ratio Analysis
Amount (Rs)
Assets
Amount (Rs)
1,20,000
1,98,000
12,40,000
12,06,000
Notes
___________________
___________________
___________________
___________________
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Expenses
Outstanding
Provision for Tax
Total Current
Liabilities (3)
Net Working Capital
(4) = (2) – (3)
Total Assets (1) + (4)
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S
Capital and
Liabilities
59,54,000
Additional Information:
___________________
___________________
1. A loan of Rs. 1,42,000 is to be paid every year.
___________________
2. The market price of a share as on Dec. 31, 2016, is Rs. 80.
___________________
3. The firm provides a credit of 50 days to its customers but receives a credit of 90 days from its suppliers.
___________________
Calculate various financial ratios to analyze the different aspects of
operations and financial position of the firm.
Solution: The operational profitability and financial position of
ABC Corp. can be analyzed by calculating the following ratios.
Using the formulas in the chapter, we can calculate the following
ratios:
1. Liquidity Ratios
(a)
(b)
(c)
Current Ratio
=
2446000
1240000
=1.97
Quick Ratio
=
2446000 − 578000
1240000
= 1.51
Absolute Liquidity Ratio =
726000 + 136000
= 0.69
1240000
2. Activity ratios
Inventory Turnover Ratio =
(C
(a)
4176000 − 578000
= 7.22
578000
(b)
Debtors Turnover Ratio =
6148000
= 6.11
1006000
(c)
Credits Turnover Ratio =
4176000
=4.53
764000 + 158000
(d)
Working Capital Turnover Ratio =
= 5.10
6148000
2446000 − 1240000
___________________
70
Notes
___________________
___________________
3. Leverage Ratios
(a)
Debt Equity Ratio =
(b)
Total Debt Ratio =
___________________
2046000
= 0.52 or 52%
3908000
2046000 + 1240000
=0.46 or 46%
7194000
(c) Interest Coverage Ratios =
836000
=4.75
176000
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Financial Management
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___________________
___________________
___________________
___________________
(C
___________________
(d) Preference Dividend Coverage Ratio =
(e)
Fixed charge Coverage Ratio =
462000
= 23.1
20000
836000
= 1.27
660000
4. Profitability Ratios
Gross Profit Ratio =
1972000
= 0.321 or 32%
6148000
Operating Profit Ratio =
Net Profit Ratio =
836000
= 0.136 or 13.6%
6148000
462000
= 0.075 or 7.5%
6148000
Return on Asset Ratio =
462000
= 0.0642 or 6.42%
7194000
Return on Capital Employed =
0.0982 or 9.82%
462000 + 176000(1 − 0.3)
=
3908000 + 2046000
ROE =
442000
= 0.126 or 12.6%
3908000 − 400000
EPS =
442000
= 0.1157 or 11.57%
38200
DPS =
186000
= 0.0514 or 5.14%
38200
PE Ratio =
2446000
= 1.97
1240000
Example 8.3 – Payal Steel Co. has the following figures related to
its accounts:
Particulars
2015 (in Rs.)
2016 (in Rs.)
Sales(Rs. in Lacs)
12,00,000
15,00,000
Net Block
5,00,000
8,00,000
Contd.
Unit 8: Ratio Analysis
2016 (in Rs.)
Receivables
2,00,000
2,95,000
Payables
1,00,000
2,00,000
Cash at Bank
50,000
20,000
Closing Stock
2,00,000
4,00,000
Bank Over Draft
1,00,000
2,50,000
Purchases
9,00,000
12,00,000
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2015 (in Rs.)
Notes
___________________
___________________
___________________
___________________
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Particulars
Expenses
1,00,000
1,50,000
Depreciation
75,000
1,20,000
Interest on Over Draft
15,000
40,000
–
2,00,000
–
35,000
Share Capital
4,00,000
4,00,000
___________________
Reserves and Surplus
1,90,000
2,07,500
Provision for Income Tax
1,20,000
1,97,500
___________________
40,000
60,000
Loan
Interest on Loan
Proposed Dividends
Stock on 0.1-0.1-2015
___________________
___________________
___________________
___________________
1,80,000
Comment on the present state and trend with respect to profitability,
liquidity, and leverage of the company.
Solution – To understand the present state and trend of the firm
with respect to profitability, liquidity, and leverage, we calculate the
following ratios using formulas given in the chapter.
Profitability Ratios
2015
2016
1) Gross Profit Ratio
3, 20, 000
× 100
12, 00, 000
5, 00, 000
× 100
15, 00, 000
= 26.7%
= 33.3%
1, 30, 000
× 100
5, 90, 000
1, 90, 000
× 100
8, 07, 500
= 2.03%
= 23.53%
2015
2016
4, 50, 000
3, 60, 000
7,15, 000
7, 07, 500
= 1.25
= 1.01
2, 50, 000
2, 60, 000
3,15, 000
4, 57, 500
=0.96
=0.69
2) Return on Capital
Employed
Liquidity Ratios
(C
1) Current Ratio
2) Absolute Liquidity
Ratio
Contd.
72
Notes
Leverage Ratio
1) Debt Equity Ratio
___________________
___________________
___________________
2016
0
5, 90, 000
2, 00, 000
6, 07, 500
=0
= 0.33
Profitability of the firm – The gross profit of the firm increased
from 26.7% to 33.3% and the return on capital employed has also
increased from 22.03% to 23.53%. This establishes better managerial and operational efficiency and shows a marginal increase in efficiency.
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2015
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___________________
___________________
___________________
___________________
(C
___________________
Liquidity of the firm – The current and absolute liquidity ratios
have decreased from the previous year. This means that the liquidity has decreased which may be due to the increase in operational
activity or increase in current liability.
Leverage of the firm – The firm had no leverage employed in the
year 2015 but raises its debt component to 0.33 in the year 2016.
This demonstrates growth as the company wants to raise more capital at a lesser cost. The company still has scope to increase the
leverage.
Example 8.4 – ABC Corp. and XYZ Corp. are two companies in the
same industry and maintain the inventory at the same level at the
beginning of the year. From the below financial details of the two
firms, comment on the financial and operational efficiency.
ABC Corp.(Rs. in Lacs) XYZ Corp.(Rs. in Lacs)
Sales
250
200
Bank Overdraft
25
10
Stock
35
40
Expenses
30
25
Creditors
65
28
Expense Creditors
3
2
Liquid Assets
4
8
3 Months
2 Months
8 Times
2 Times
20%
30%
Debtors Velocity
Capital Velocity(to sales)
Gross Profit Ratio
Information on industry norms for comparison: Current Ratio 1:8,
Liquid Ratio 1:1, Gross Profit Ratio 25%, Return on Capital 40%,
Debtors Velocity 80 days, Creditors Velocity 75 days and Stock Velocity 4 days.
Unit 8: Ratio Analysis
Particulars
ABC Corp.
XYZ Corp.
Industry Norm
1) Current Ratio
101.50
93
81.33
40
1.8
= 1.09
= 2.03
66.5
68
41.33
30
= 0.98
= 1.38
50
250
60
200
= 20%
= 30%
20
31.25
35
100
= 64%
= 35%
200
35
140
40
= 5.71
= 3.5
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Solution: The following ratios are calculated and compared with
the industry norms. The ratios are calculated using formulas in the
chapters.
Notes
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___________________
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2) Liquid Ratio
3) Gross Profit Ratio
4) Return on Capital
5) Inventory Turn
Over
___________________
1.1
___________________
___________________
25%
___________________
___________________
40%
4
The current ratio of ABC Corp. is lower than the industry average.
On the other hand, the current ratio of XYZ Corp. is higher than
the industry average, which indicates strong liquidity position. The
same is established by the liquid ratio. The gross profit ratio of XYZ
is higher than the industry average, and that of ABC is lower than
the industry average. Furthermore, the inventory turnover for ABC
is higher than XYZ and the industry average as well. Thus, we can
say that XYZ Corp. appears to be better managed in terms of managerial and operational efficiency.
Summary
(C
___________________
The relationship between two or more accounting figures is called
financial ratio. This helps in simplifying large amounts of financial
data into ratios which are then used to identify and assess a firm’s
financial position and performance. The different types of ratios
are liquidity ratios, activity ratios, leverage ratios and profitability
­ratios.
74
Notes
___________________
___________________
___________________
1. Examine the difference between the acid test-ratio and current
ratio. Why is the stock and bank overdraft excluded from the
former?
2. Explain the effect of an increase in the capital turnover ratio on
net profit and operating leverage.
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Review Questions
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Financial Management
___________________
___________________
___________________
___________________
___________________
(C
___________________
3. Which ratios can explain the inability of the firm to pay its
dues?
4. Which ratios would you examine while evaluating the performance and future profitability of a company as an investor and
as a prospective lender?
5. The financial statements of ABC Corporation Pvt. Ltd. contain
the following information. Analyse the statements and examine the financial position of the firm by calculating the following ratios:
(a)
Liquidity Ratio
(b)
Profitability Ratio
(c) Activity Ratio
Particulars
Year1(in Rs.)
Year2(in Rs.)
Cash
2,00,000
1,60,000
Sundry Debtors
3,20,000
4,00,000
Temporary Investments
Stock
Prepaid Expenses
2,00,000
3,20,000
18,40,000
21,60,000
28,000
12,000
Total Current Assets
25,88,000
30,52,000
Total Assets
56,00,000
64,00,000
Current Liabilities
6,40,000
8,00,000
Loans
16,00,000
16,00,000
Capital
20,00,000
20,00,000
4,68,000
8,12,000
Retained Earnings
Statements of Profit for the current year
Sales
Less Cost of Goods Sold
Less Interest
Net Profit
Rs. 40,00,000
28,00,000
1,60,000
10,40,000
Less: Taxes @50%
5,20,000
PAT
5,20,000
Profit Distributed
2,20,000
Unit 8: Ratio Analysis
Current Debt to Total Debt
0.4
Total Debt to Equity
0.6
Fixed Assets to Equity
0.6
2 times
Inventory Turnover(based on sales)
8 times
Notes
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Total Assets Turnover(based on sales)
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Naveen Corp. Ltd. had a paid-up capital of Rs. 1,00,00,000 as on
31st March, 2017. The ratios as on the date were as follows. Prepare
the balance sheet for Naveen Corp. Ltd.
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Unit 9
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Notes
Dupont Analysis
___________________
___________________
___________________
Objectives:
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After completion of this unit, the students will be aware of the following
topics:
___________________
\\
DuPont Analysis or Profile of Profitability
___________________
\\
How is the Return on Equity Dependent on other Key Ratios of a Company?
___________________
\\
The relationship between Debt Financing and Growth
___________________
___________________
___________________
Introduction
Dupont Analysis or Profile of Profitability
The overall profitability of the firm consists of two key elements:
1) The profit margin on sales – This explains the earnings made
on the sale of every rupee
2) The turnover of the firm – This indicates the total activities
undertaken by the firm
Earning power of the firm is determined by combining the above two
factors. This can be described as follows:
Profitability or earnings power = Profit Margin x Assets Turnover
PAT
sales
×
sales Total Assets
PAT
=
Total
Assets
Investment
(C
=
Here, PAT is profit after taxes.
This ratio is also called return on investment (ROI). Refer to the
Figure 9.1, which represents the elements contributing to the return
on investments.
Financial Management
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Return on Investment
(ROI)
Notes
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___________________
Total Assets –
Turnover
Net Profit Margin
(NP Ratio)
___________________
Profit After Tax
(PAT)
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Sales
Sales
Total Assets
___________________
___________________
Fixed Assets
Current Assets
___________________
___________________
(C
___________________
Sales – Cost of Goods Sold – Operating Expenses – Interest – Tax
Figure 9.1: DuPont Analysis or Profile of Profitability – Return
on Investment
The left-hand side of Figure 9.1 explains the profit margin where the
cost of goods sold, interest and taxes are deducted from sales revenue to generate the PAT. The PAT is then divided by the total sales
to generate the Net Profit (NP) ratio. The right side of the above figure focuses on the total assets or investments turnover. The current
assets together with fixed assets equal to the total investments of
the firm. The sales are divided by the total investments to obtain the
asset turnover ratio.
The value of probability of a firm can be obtained by multiplying
both the LHS and RHS, that is, both the NP Ratio and Asset Turnover Ratio. This is the analysis of profitability of the firm and is
named after the famous US manufacturer DuPont Corporation, who
developed this analysis.
The above interpretation can be further used to deduce the return
on shareholders’ funds. As we understand from the previous chapter, the shareholders’ funds depend upon the use of debt in financing the total assets. Thus,
Return on Shareholders' Funds =
% Return on Investment
× 100
% Assets Financed by the Shareholders
The above-mentioned formula can be illustrated as below:
Unit 9: Dupont Analysis
Return to Shareholders
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79
Notes
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___________________
% of Assets Financed by
Shareholders
___________________
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Return on Investments(ROI)
Figure 9.2: DuPont Analysis – Return to Shareholders
___________________
How is the Return on Equity Dependent on other Key
Ratios of a Company?
___________________
In the previous chapter, we have learned that the difference between
Return on Assets (ROA) and Return on Equity (ROE) reflects the
use of debt financing. This can be deduced as follows:
___________________
PAT
shreholders Funds
PAT
Total Assets
=
×
shreholders Funds Total Assets
Return on Shareholders' funds =
=
PAT
Total Assets
×
Total Assets Shareholders Funds
= ROA x Equity Multiplier
= ROA x [1 + Debt Equity Ratio]
On the same lines, ROE can also be explained as below:
ROE =
PAT
Sales
Total Assets
×
×
Sales Total Assets Shareholders Funds
= Profit margin x Total Asset Turnover x Equity multiplier
Relationship between Debt Financing and Growth
(C
The relationship between debt financing and growth rate is such
that when the growth rate increases the need for external financing
also increases.
llInternal Growth Rate – It is the maximum growth rate that is
achieved with no external financing and is maintained using
internal financing only. This can be described as follows:
Internal growth rate =
ROA * b
1 − ROA * b
___________________
___________________
___________________
80
Notes
___________________
___________________
___________________
b = Retention Rate, that is, (1 – Dividend per Share or DPS Ratio)
llSustainable
Growth Rate – It is the growth rate that the
company can maintain without increasing its financial leverage. In this case, the company maintains the debt-equity ratio
without any external equity financing. This can be described
as follows:
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Where,
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Financial Management
___________________
___________________
Sustainable growth rate =
___________________
Where,
___________________
___________________
(C
___________________
ROE * b
1 − ROE * b
b = Retention Rate, that is (1 – DPS Ratio)
Summary
Overall profitability of a firm is indicated by two key elements,
namely Turnover and Margin of Profit. The combination of these
elements helps in ascertaining the earning power of the firm. The
difference between ROA and ROE reflects the use of debt financing.
The relationship between debt financing and growth rate is such
that when the growth rate increases the need for external financing
also increases.
Review Questions
1. What is DuPont analysis of profitability of the firm? Explain
and enumerate the elements of this analysis.
2. “A comprehensive parameter that provides information regarding everything happening in a company is Return on Investment.” Please explain.
3. Naveen Corporation has equity of Rs. 2,50,000 and a debt of Rs.
2,50,000. The net profit is Rs. 66,000.
(a)
Calculate ROE.
(b)
Calculate sustainable growth rate, assuming retention
ratio is 66.67%.
4. Total assets of ABC Ltd. are Rs. 5,00,000 and its net profit of
Rs. 66,000.
Unit 9: Dupont Analysis
Calculate ROA
(b)
Assume that the payout ratio of a company is 33.33%.
Now calculate its internal growth rate.
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(a)
Notes
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Unit 10
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Notes
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Case Study: Bata India: Step
into Style
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Bata India Limited was established in 1931 in India. It is a prime
retailer and producer of footwear in the country. It has a strong
retail presence with 1,293 stores across 500 cities in India. Other
than company owned stores, Bata brand is also available through
a large network of dealers as well. The brand is known for its quality, footwear design, comfort, and affordability. This makes Bata
a trustworthy footwear manufacturing company and the number
1 brand in India. Considering global, regional and local fashion
trends, it strives to offer fresh new collection, every season and every year for the customers.
The vision of the company is ‘To make great shoes accessible to
everyone.’
The statistics of the company looks impressive, few of which are
mentioned below:
ll4 strategically located manufacturing units
ll1293 retail stores across India
ll8034 employees across functions and locations
ll2.62 million square feet of retail space available
ll21 million pairs of footwear production capacity
llRs. 24972 million turnovers
for the year 2016–2017
Table 2: Financial Highlights of Bata India Limited for the year 2016–2017
Financial Highlights 2016–17
(in Million Rs.)
2016
2017
Profit and Appropriations
Sales and Other Income
(C
Profit before Depreciation and Taxes
Depreciation
24753.15
25438.87
3754.5
2985.81
788.01
650.05
2966.49
2335.75
790.54
748.28
Profit after tax
2175.95
1587.48
Net Profit
Profit before Tax
Taxation
2175.95
1587.48
Dividend and Dividend Distribution Tax
502.75
541.42
Retained Earnings
1673.2
1046.06
Contd....
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___________________
___________________
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Notes
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___________________
___________________
Fixed Assets – Gross
Fixed Assets – Net
Investments
Net Current Assets
Other Non–current Assets
3987.87
4338.22
3211.5
2957.86
49.51
49.51
7424.54
8562.3
2564.01
2722.84
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Assets Employed
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Financial Management
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___________________
Financed By
Equity Shares
642.64
642.64
___________________
Reserves
11578.21
12610.17
___________________
Shareholders’ Funds
12220.85
13252.81
Debt
1028.71
1039.71
___________________
(C
___________________
(Source: Bata India Annual Report)
Questions
1. Prepare an income statement for the two years for Bata India
Ltd.
2. Prepare a balance sheet for the two years for Bata India Ltd.
3. Calculate the ratio of the stakeholders for both years 2016
and 2017 to measure the following:
4.
Measure of Investments
5.
Measure of Performance
6.
Measure of Financial Status
4. Calculate the percentage change in the ratios and comment
on the company’s overall performance.
Source: Annual Report of Bata India Limited
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BLOCK–III
UNIT 11(A): SHORT-TERM SOURCES OF FINANCE
ll
ll
Introduction
Source of Short-Term Finance
Summary
ll
Review Questions
UNIT 13: CAPITAL BUDGETING EVALUATION
TECHNIQUES
ll
Introduction
ll
Techniques of Evaluation
ll
Traditional or Non-Discounted Cash Flow
ll
Modern or Discounted Cash Flow Technique
ll
Summary
ll
Review Questions
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Detailed Contents
UNIT 11(B): LONG-TERM SOURCES OF FINANCE
ll
Introduction
ll
Types of Long-term Sources of Finance
ll
Internal Sources of Finance
ll
Retained Earnings
ll
External Sources of Finance
ll
Share Capital
ll
Preference Shares
ll
Debenture
ll
Venture Capital
ll
Summary
ll
Review Questions
UNIT 12: FUNDAMENTALS OF CAPITAL
BUDGETING
Introduction
ll
Meaning and Definition
ll
Features of Capital Budgeting Decisions
ll
Significance of Capital Budgeting
ll
Problems and Difficulties in Capital Budgeting
ll
Capital Budgeting Decisions and their types
ll
Summary
ll
Review Questions
(C
ll
UNIT 14: COST OF CAPITAL
ll
Introduction
ll
Concept of Cost of Capital
ll
Significance of Cost of Capital
ll
Factors Affecting the Cost of Capital
ll
Computation of Cost of Capital
ll
Summary
ll
Review Questions
UNIT 15 CASE STUDY: AIRNET LIMITED: A
TELECOMMUNICATION TAKEOVER
Short-Term Sources of Finance
Objectives:
Notes
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At the end of this unit, the students will be able to:
S
Unit 11(a)
87
\\
Identify the short-term sources of finance
\\
Identify the advantages and disadvantages of these sources
___________________
___________________
___________________
Introduction
An organization may source money to meet various objectives. Traditional areas of requirements may vary from capital asset acquisition
to new inventory or new product development. After establishing
a business, funds are required for daily operational requirements.
Thus, there is a constant need for liquid money to be present for
meeting these requirements. To support such requirements, shortterm funds are required. The availability of short-term funds is vital
as a lack of these may lead to shutting of business operations.
In this unit, we will understand the sources of short-term finance.
Source of Short-Term Finance
Some of the short-term sources of finance are as follows:
Trade credit
ll
Bank credit
ll
Accruals
ll
Deferred Income
ll
Commercial Papers
ll
Public Deposits
ll
Inter-corporate Deposits
(C
ll
Trade Credit
Trade credit refers to the credit that is approved or given to trading and manufacturing firms by the suppliers of raw material and
semi-finished and finished products. Generally, business organizations procure funds on a 30–90 days credit cycle.
___________________
___________________
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88
Notes
___________________
___________________
___________________
There are two key features of trade credit:
1. A company should not opt for cash discounts in lieu of quick
payment as the cost of trade credit is very significant beyond
the cash discount period.
2. In case the company is unable to avail cash discounts then it
can choose to pay by the end of the credit period. Any delay of
1-2 days is insignificant and has no impact on credit rating.
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Features of Trade Credit
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Financial Management
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___________________
___________________
___________________
___________________
(C
___________________
Advantages of trade credit
ll
Available Easily
ll
Highly Flexible
ll
No unnecessary documentation required
Disadvantages of trade credit
ll
Goodwill can be lost on a permanent basis
ll
Raw materials are priced highly
ll
Opportunity Cost of discount availed
ll
Administration cost
Bank Credit
Commercial banks’ short-term financing to business organizations
is referred to as bank credit. When bank credit is given, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit can be provided in the form
of loans, cash credit, overdraft and discounted bills.
Features of bank credit
ll
Most widely used credit facility offered by banks
ll
Based on revolving credit system
ll
Interest to be paid on the borrowed amount
Advantages of bank credit
ll
Flexible repayment terms
ll
Less expensive than cash advance loans
ll
Better rates
Unit 11(a): Short-Term Sources of Finance
ll
Make expensive purchase
ll
Long-term costs
ll
Stricter Eligibility Requirements
Notes
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Accruals
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Disadvantages of bank credit
Accruals are those expenses that the company owes to other organizations or people but have yet not been paid. It is aquick and interest-free source of financing. For example, salaries, wages, interests,and taxes are few of the key constituents of accruals. If by the
end of the financial year these expenses are not paid, they reflect as
accrued salaries/wages.
___________________
Due to the fact that no interest is payable on accruals, they are
considered as a virtually “cost-free” means of finance. But in many
countries, it might not hold true due to strict provisions for payment
of labor salaries with any delay in payment leading to significant
penalties or prosecutions. Therefore it is advisable for a company to
not use accruals as a source of finance because they may be required
to be repaid anytime.
___________________
Advantages of accruals
ll
Increased transparency on the cost of all public services
ll
Improved accountability
ll
Improved allocation of expenditure
Disadvantages of accruals
Increased accounting estimates in the budget
ll
Increased complexity in the budget
ll
Minimized parliamentary interference over budget
(C
ll
Deferred Income
Deferred income payments are incomes received by the firm in advance for the supply of goods and services for a future period. These
incomes are not reflected in the revenue category until the supply of
goods and services are not completed. In fact, until then, these are
reflected as ‘advance received income.’ Advance payment can only be
demanded by the firms having the following:
___________________
___________________
___________________
___________________
Financial Management
ll
Monopoly power
ll
Great demand for its products and services
Notes
___________________
___________________
ll
___________________
Special orders which are manufactured as customized products
Advantages of deferred income
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90
___________________
ll
Unlimited savings and tax benefits
___________________
ll
Capital gains
___________________
ll
Investment options
___________________
___________________
(C
___________________
Disadvantages of deferred income
ll
No early withdrawal provision
ll
Strict distribution schedule
ll
No ERISA (Employee Retirement Income Security Act) protection
Commercial Papers
Commercial papers (CPs) signify an unsecured short-term promissory note allotted by companies that are more secured and have a
higher credit rating. In India, the introduction of CPs was based on
the guidelines of the Vaghul Working Group.
Features of CPs
ll
ll
ll
ll
In general, the maturity period of CPs ranges from 15 days to
365 days. However, in India, it is 91 to180 days.
It is possible to sell them at a discounted price and redeem
that at face value.
The difference between the redeemable value and par value
constitute the returns on a CP.
A CP can be sold indirectly through dealers or directly
through investors.
Advantages of Commercial Papers
ll
A cost-effective method of financing working capital
ll
Cheaper than bank loans
ll
It requires a rating. Good rating reduces the cost of capital
Unit 11(a): Short-Term Sources of Finance
ll
This mode of finance is available only to a select few firms.
ll
It may reduce the availability of credit from banks
ll
Reserve Bank of India (RBI) strictly monitors its issuance
ll
ll
ll
ll
As CP is a promissory note under regulations by RBI, there
are certain requisites for companies to fulfill in order to be
eligible for fundraising through them
___________________
___________________
___________________
___________________
___________________
Maximum of 75% of the bank credit allowed to the firm can be
used to issue CP’s
Size of a single issue should be more than Rs. 1 crore
Public Deposits
Public deposits are also called term deposits. These are unsecured
deposits; however, the main purpose is to finance the company’s
working capital requirements. It is considered as an important
source of financing medium- and long-term requisites of a firm. It
refers to any cash received by a company through loans acquired
from the public or through deposits.
Advantages of public deposits
It makes the process of acquiring finance easier
(C
The interest that is paid on public deposits is deducted from
taxes
It does not dissolve the rights of the shareholders
Disadvantages of public deposits
ll
___________________
The company should be sanctioned as a fund based limit for
bank(s) finance.
ll
ll
___________________
___________________
CP’s can be issued in multiples of 5 Lakhs only
ll
___________________
The tangible net worth of the company should be more than
Rs. 4 crores according to the latest audited balance sheet
ll
ll
Notes
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Issuing Criteria for Commercial Papers
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Disadvantages of Commercial Papers
It is a risky and an uncertain way to finance the company’s
working capital requirements
___________________
Financial Management
ll
Notes
___________________
ll
___________________
___________________
The deposits maybe misused by the management as they are
not secured
Inter-Corporate Deposits
Deposits made by a firm with another firm, usually for up to a period of six months, are known as Inter-Corporate Deposits (ICDs).
Following are the various types of ICDs in practice:
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It is available for a very short period
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92
___________________
___________________
___________________
ll
___________________
___________________
(C
___________________
ll
Call deposits: In this category, deposits are repaid at the
time when they are called back. Typically, repayment can be
demanded, giving notice of just one day.
Deposits for three months: These deposits are primarily
used among companies for investing surplus funds. The borrower opts for this option to cater to short-term cash requirement.
Deposits for six months
The deposits are generally given for a short duration of up to six
months maximum at a pre-specified rate of interest.
Features of Inter-Corporate Deposits
ll
Not regulated by any authority
ll
They involve secrecy while trading.
ll
ICDs are issued based on borrower’s financial health.
Advantages of Inter-Corporate Deposits:
ll
The lender can utilize the funds in surplus with efficacy.
ll
They are secure in nature.
ll
It avails easy procurement of inter-company deposits
Disadvantages of Inter-Corporate Deposits:
ll
Its market is not structured.
ll
It involves a lot of risk due to uncertainty.
ll
It comes with restrictions on the amount that can be lent or
borrowed.
Unit 11(a): Short-Term Sources of Finance
Summary
Notes
___________________
___________________
___________________
___________________
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Short-term funds are essential to support various requirements of a
firm. The availability of short-term funds is vital as a lack of these
may lead to shutting of business operations. Some of the commonly available short-term funding sources include trade credit, bank
credit, accruals, deferred income, commercial papers, public deposits and inter-corporate deposits.
93
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These were the short-term funding sources, along with their advantages and disadvantages. In the next unit, long-term funding sources shall be discussed.
Review Questions
1. Can trade credit be categorized as a source of working capital
finance? Explain.
2. With the help of an example of any Indian corporate analyze
the significance of issuing Commercial Papers to the firm and
to their investors.
3. Can accruals be considered an interest free source of finance?
4. Elucidate the short-term sources of finance, which are cost-free
finances available to the firm.
(C
5. What is a commercial paper? What are the guidelines for issuing commercial papers in India?
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Long-Term Sources of Finance
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Unit 11(b)
95
Notes
___________________
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Objectives:
At the end of this unit, the students will be able to understand and explain
the concepts of:
___________________
\\
Types of Long-Term Sources of Financing
___________________
\\
Retained Earnings
___________________
Share Capital – Features, Advantages,and Disadvantages of Equity
Shares
___________________
\\
\\
Share Capital – Features, Advantages,and Disadvantages of Preferential Shares
\\
Debentures and Bonds
\\
Venture Capital
Introduction
In the previous unit, we learned about the short-term sources of finance. Let us now understand long-term sources of finance, which
are usually required for a period exceeding a year. The requirement
may arise due to many reasons, few of which are mentioned below:
ll
To expand the existing office space
ll
To buy a new office premise
ll
To launch a new product in the market
ll
To buy a new company
Types of Long-term Sources of Finance
(C
Long-term sources of finance are classified on the basis of from where
the funds are generated, i.e., Internal and External. New firms have
the option of raising long-term funds from external sources whereas
established companies have the luxury of generating funds from internal as well as external sources of finance.
Types of long-term financial sources are as follows:
ll
Internal Financial Sources
ll
External Financial Sources
___________________
___________________
96
Notes
___________________
___________________
___________________
Retained Earnings
Retained earnings are a crucial source of long-term funding for
well-established companies as they are that portion of income which
was not spent and was invested back into the company. It is the
process of accumulating profits and reinvesting them in the business for funding development and expansion plans. It is that portion
of equity which has been foregone by the shareholders. In normal
practice, companies save around 20-70% of profits as retained earnings and capitalize them.
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Internal Sources of Finance
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Financial Management
___________________
___________________
___________________
___________________
___________________
(C
___________________
The retained earnings could be used for various business growth
plans, such as the following:
ll
Development programs of the company
ll
Replacement of obsolete assets
ll
Renovation of equipment and plant
ll
Redemption of preferential shares or debentures, loans, etc.
Factors Influencing Retained Earnings
ll
ll
ll
Earnings Capacity of a Company: The need for plowing
back of profits arises only when the company has sufficient
earnings. Larger earnings imply a larger reinvestment ratio.
Type of Dividend Policy: Retained earnings depends on
the dividend policy, specifically the distribution of earnings,
which is decided by the top management (Board of Directors).
Companies that intend to retain extra earnings need to follow a conservative dividend policy. A conservative dividend
policy comes with instability and lots of changes in the dividend payment. It means irregular payment of dividends at
changing rates. The dividend policy also gets affected by the
category of the shareholders. If the shareholders are in the
high-income tax bracket, they expect to retain more profits
and receive lesser dividends,whereas, if the shareholders
seek regular income, they desire profits to be utilized for
paying more dividends and fewer amounts to be saved as retained earnings.
Taxation Policy of the Government: Earnings available
to stakeholders are the Profit after Taxes (PAT) minus the
Unit 11(b): Long-Term Sources of Finance
ll
Profitable Investment Opportunities: A company having
more lucrative investment prospects may decide to retain the
profits for the project.
___________________
Industry customs
___________________
Prevailing economic and social environment of the country
___________________
The life cycle of industry, etc.
Funds are raised easily without any obligation from shareholders.
As compared to other sources of finance, Retained earnings do
not involve any floatation cost thus making them a preferable
source of finance.
Retained earnings grow the capital of the company, thus, enhancing the credit standing of the company.
It maintains a stable dividend policy,and during years of less
or no profits, the company may pay uniform dividends out of
retained earnings.
It acts as a cushion to abnormal market fluctuations like depression, recession and sudden drop in the market.
(C
ll
Advantages of Retained Earnings to the Shareholders/Owners
ll
ll
___________________
Attitude and philosophy of top management
Advantages of Retained Earnings to the Company
ll
___________________
o
o
ll
___________________
___________________
o
ll
___________________
Additional Factors: The following may also affect the retained earnings:
o
ll
Notes
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ll
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preference shareholders dividend. When the tax rates are
high, fewer profits are available and less retained earnings
will be available.
In the long run, the net worth of the portfolio increases by an
increase in the share’s value.
As the share price increases, its creditworthiness increases and, hence, the security is more acceptable as collateral
­security.
___________________
___________________
Financial Management
ll
Notes
___________________
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ll
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It reduces the burden of income tax, which is paid when dividends are declared.
Advantages of Retained Earnings to the Society and Nation
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If shareholders reinvest retained earnings in profitable ventures, it results in an increase in future dividends for the
shareholders.
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It promotes the economic development of the country by raising the capital formation rate.
It encourages industrialization by internal financing.
It encourages and creates more jobs by creating more industries (profitable investment opportunities)
It increases the productivity as the retained earnings are
used for process improvements and growth of the company,
such as replacing old machinery and formulation of new companies.
Disadvantages of Retained Earnings
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Retained earnings cause a reduction in the availability of liquid funds.
Continuous profit retention may result in over capitalization.
It creates a monopoly – In bigger organizations, large retained earnings helps the business to grow bigger, which may
lead to monopoly.
The loss to shareholders – If the firm pays alesser dividend
and increases the retained earnings, shareholders will receive lesser cash in hand, which may lead them to sell their
shares for meeting their expenditures.
Excess concentration of wealth in the hands of management
may result in the misuse of retained earnings and, hence,
results in reduced shareholders’ wealth.
Excess retained earnings lead to super profit tax evasion,
which results in loss of revenue for the government.
Unit 11(b): Long-Term Sources of Finance
Share Capital
Types of Shares
As per the provisions of the Companies Act, 1956, there are only
two types of shares in India, namely Preference shares and equity
shares
Equity Shares: They are also known as ordinary shares, and they
entitle the holder to a part in company’s capital. Mentioned below
are the key features of equity shares:
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All shareholders have equal rights
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All shareholders share rewards and risks equally
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All equity shareholders are the joint owners of the company
and receive dividends as per the company’s dividend policy
formulated by the board of directors.
Major Components of Equity Shares:
Permanent Capital: Equity is the primary and permanent
source of long-term finance. It can be redeemed only at the
end of the liquidation process after all liabilities have been
settled. This also implies that the shareholders cannot sell
their share back to the company unless the company offers a
corporate action for it such a buyback. However, the shareholders are free to sell their equity shares in the stock market
freely.
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A share constitutes a small unit of the firm’s total capital. Value of a
share is obtained by dividing the total share capital of the company
by the numbers of shares. Any person who has purchased one or
more shares of a company is called a shareholder.
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External Sources of Finance
Income’s Residual Claim: The income that is available after
paying all the claims is called the Residual Claims. Thus, the
income from which dividend is announced is known as Residual Income, which is PAT minus preference dividends.
Residual Claim to Assets: As is the case with residual income,
shareholders are entitled to residual claims on assets of the
company,but they have the last priority over the assets.
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Limited Liability: the extent of liability of equity shareholders is limited to their investment in the company.
Advantages of Equity Shares from the Company’s Viewpoint
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Voting Rights or Rights to Control: equity shareholders are
the real owners of the company and have the right to vote, appoint directors and auditors at the annual general meetings.
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It is a stable and perpetual long-term source of finance.
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It involves no liability for repayment.
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No charge is created over the assets of the company.
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With an increase in the number of equity shares issued, the
Creditworthiness of the company also increases.
Advantages of Equity Shares from the Investor’s Viewpoint
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Equity shares act as a source of income (Residual).
Equity shareholders have the right to ownership, participation, and control of the company.
The possibility of investment being multiplied in future along
with steady income over the years in the form of a dividend.
Disadvantages of Equity Shares from the Company’s Viewpoint
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The cost of the source of fund is high.
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The floatation cost is high.
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Management control dilutes when the equity shares issued
increase.
The tax advantage is not available.
Disadvantages of Equity Shares from the Investor’s Viewpoint
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Equity shares provide no regularity or guarantee on the distribution of dividends.
They involve a high risk with less or no guarantee of returns.
Due to fluctuations in the share market, it is possible that the
investment might be wiped off.
Unit 11(b): Long-Term Sources of Finance
Preference shareholders have some privileges as compared to equity
shareholders.
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Preference shareholders get preference in payment of dividend where they are paid a fixed rate of dividend.
Preferential shareholders receive priority over equity shareholders in case of liquidation of the company.
But a few features of the preferential shares bear a close resemblance to equity shares in the following ways:
o
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Dividends are paid after deduction of taxes from profit
Dividend policy of the company determines the dividend
to be paid to the preference shareholders.
Tax cannot be deducted from dividend payment.
There is no maturity date on irredeemable preference
shares.
Features of Preference Shares
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Claim on Assets: Preferential shareholders enjoy priority
over equity shareholders in this regards and enjoy preferential rights over the assets after all other liabilities have been
settled.
Claim on Income: Preferential shareholders enjoy priority
over equity shareholders in this regard also and enjoy preferential rights over income after all other liabilities have been
settled.
Dividend Accumulation: All the unpaid dividends are carried
forwarded to the next financial year and paid as a cumulative
amount.
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Preference Shares
Redeemable in nature: Preference share capital when issued
as redeemable will have a limited maturity date.
Dividend Rate: Rate of dividends is fixed.
Voting Rights: Preference shareholders don’t have any say in
the working of the company as they do not have any voting
rights.
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Advantages of Preference Shares from the Company’s Viewpoint
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The control of the company is not diluted as preference shares
do not carry any voting rights.
With an increase in the preference share capital, there is a
corresponding increase in the net worth of the company as
well as its creditworthiness.
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Advantages of Preference Shares from Investor’s Viewpoint
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Fixed rate of dividends is paid to preference shareholders.
Enjoy preference over equity shares in case the company goes
into liquidation.
Low-risk factor as compared to equity shareholders.
Disadvantages of Preference Shares from the Company’s Viewpoint
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An expensive option for the firm as dividend payment is not
tax deductible.
In case there is default in the payment of dividends, creditworthiness of the firm is adversely affected.
Disadvantages of Preference Shares from Investor’s Viewpoint
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Returns are limited as decided by the management.
In general, the rate of preference dividend for preference
shareholders is less than that for equity shareholders.
More fluctuations in market price when compared to debentures.
Debenture
A debenture is an acknowledgment of a debt owed by a company to
the debenture holder. Debentures have a maturity date and carry a
fixed rate of interest but are without any collateral. Debentures are
an essential source of long-term funding for Public Limited Companies. Debentures are secured against the assets of the company.
Features of Debentures
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Fixed Rate of Interest: Usually debentures carry a fixed rate
of interest but can also have floating or zero interest rate.
Unit 11(b): Long-Term Sources of Finance
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Redemption of Debentures: The repayment of debentures is
made either in installments or lump sum. It is mandatory
for a company to make a debenture redemption reserve redemption reserve for one-time payment of debentures with a
maturity period of eighteen months or beyond.
Call and Put Option: Debentures may have ‘call’ option which
gives the issuing company a right to ‘buy’ at a certain price
before the maturity period. The call option is exercised at
a premium rate; this means that the buyback price may be
more than the debenture’s face value. Debentures may also
have a ‘put’ option that gives the debenture holder the right
to ‘sell’ and seek for redemption at pre-decided prices.
Security Interest of Debentures: Although debentures can either be secured or unsecured but in India secured debentures
are more in prevalence. Secured debentures are secured as a
charge against the assets of the company whereas unsecured
or naked debentures do not have any charge against the assets of the company.
Convertibility: Debenture holders can exercise their debentures into shares if they want.
Credit Ratings: Before public issue, debentures are rated by
credit rating agencies.
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The maturity of Debentures: Debentures have a fixed maturity date, that is, they are issued for a fixed duration such
as 5 years or 10 years. The maturity period may vary from
1 year to 20 years. In India, non-convertible debentures are
redeemed after 7–10 years.
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Fixed rate debentures are more in use in India with interest
being paid annually or half-yearly and are calculated on the
face value. The interest paid is tax deductible.
Claims on Income and Assets: Interest on debentures is paid
from EBIT and is tax deductible. Debenture interest holds
priority over preference and equity shares. As such debenture
holders have priority over assets of the company and failure
to pay debenture interest on time can push the company towards bankruptcy.
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Notes
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Types of Debentures
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On the basis of redemption, debentures can be classified into
two categories:
(a)
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Redeemable Debentures are those debentures which
must be repaid by the company at the end of the maturity period. Due notice shall be served to denture holders
regarding redeeming debentures in lump sum or installments.
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Irredeemable Debenture: is also known as perpetual debentures and are repayable only if the company defaults
on interest payments or during liquidation proceedings.
On the basis of conversion, debentures can be classified into
two categories:
(a)
Convertible Debenture: are those debentures that can
be converted into equity shares at a fixed price and after
completion of a specified period, at the option of the holders. Debenture capital can be Fully Convertible or Partially Convertible. Convertible debentures are more preferable as compared to non-convertible debentures even
though the rate of interest is lower.
(b)
Non-convertible Debenture: These debentures cannot be
converted into equity shares
On the basis of security, debentures can be classified into two
categories:
(a)
Secured or Mortgaged Debenture: Secured or Mortgaged
debentures are those debentures that are issued with a
charge on immovable assets of the company. In case of
failure in payment of interest or principal amount, debenture holders can sell the assets to satisfy their claims.
(b)
Naked, Simple or Unsecured Debenture: Naked debentures do not carry any charge on the company’s assets
with respect to the payment of interest and repayment of
principal amount.
On the basis of transfer or registration, debentures can be
classified into two categories:
(a)
Registered Debenture: Registered debentures are those
debentures that are registered with the issuing company.
Unit 11(b): Long-Term Sources of Finance
Other Types of Debentures
(a)
(b)
(c)
(d)
Zero Interest (Coupon) Debentures (ZID): are generally
issued at a discount against their maturity value and do
not earn any interest. The return on this type of debenture is the difference between purchase (issue) price and
maturity value.
Deep Discount Debenture/Bond (DDB): Deep discount
bond is the same as zero coupon bonds but is issued at a
price lower than its face value with the face value repaid
at the time of maturity. Only Public financial institutions
issue such bonds. DDBs are exposed to high risk but still
attract investors as there is minimal risk that these bonds
will be called before the maturity.
Floating Rate Bonds (FRBs): Floating rate bonds are
those bonds for which the rate of interest is not fixed. The
interest rate is floating,and it’s linked interest rate on
Treasury Bills (TBs) and Bank Rate (BR) is considered as
a benchmark.
Secured Premium Notes (SPNs): SPN is secured debentures redeemable at a premium over the face value. It is
like zero interest debenture as there will be no interest
payment in the lock-in-period. SPN holders have the option to sell back the debenture/note to the issuing firm at
face value after the given lock-in-period. SPNs are tradable instruments.
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Bearer Debenture: Bearer debentures are those debentures
that can be freely transferred and are payable to the bearer
only. Bearer debentures are negotiable instruments, and
the company keeps no records of them. The interest also
must only be paid to the bearer of the debenture.
(e)
Notes
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(b)
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Names, addresses and other particulars of the holders are
recorded in a debenture register, which is kept by the issuing company. Transfer of this type of debentures needs
a regular transfer deed. The interest is paid only to the
person on whose name the debenture is registered.
Guaranteed Debentures: For these debentures, the repayment of principal amount and interest are guaranteed by
a third party during the issue. The third parties are financial institutions, government, etc.
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(f)
Notes
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Advantages of Debentures from Company’s Viewpoint
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Callable Bonds: Callable bonds are those bonds that allow the issuer to call the bond before it reaches its maturity. Companies generally call back bonds only when
the interest rates fall in the market less than the bond’s
interest rate.
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Debenture capital is one of the cheapest sources of long-term
finance as the floatation cost is low and interest payment on
debentures is tax deductible.
Control of the company is maintained as the debenture holders do not have voting rights.
Shareholder’s wealth is maximized as debentures permit the
company to take advantage of trading on equity.
It ensures flexibility of the capital structure.
There is no need to pay any dividends on debentures only the
interest and principal amount are to be repaid.
It protects against inflation as the rate of interest is fixed and
is to be paid at face value only.
Advantages of Debentures from Investor’s Viewpoint
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Debentures are a fixed, regular and stable source of income.
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Its maturity period is definite.
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Debenture holder’s returns are protected by indenture.
Disadvantages of Debentures from Company’s Viewpoint
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Raising debenture capital involves high risk as it includes
payment of fixed interest charges and repayment of principal
amount, which are legal obligations of the issuing company.
Failure to honor such obligations may lead to bankruptcy.
According to Capital Asset Pricing Model (CAPM), raising debenture capital increases financial leverage, which raises the
cost of equity.
There are lots of restrictions on the process of raising debenture capital.
Disadvantages of Debentures from Investor’s Viewpoint
Without any voting rights, debenture holders cannot exert
any degree of control over the working of the company.
Unit 11(b): Long-Term Sources of Finance
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Receipt of debentures is fully taxable under the head income
from other sources.
Debenture holders’ lose interest charges if the inflation increases.
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Due to no provision of dividend, the possible return for debenture holders is limited.
Notes
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Thus, so far, the units describe the different sources of short-term
and long-term sources of finance and its advantages and disadvantages. Further, the chapter will explain other sources of finance like
venture capital.
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Venture Capital
Venture capital (VC) is the financial capital invested in the early
phases of anew or expanding a business that has high potential and
risk. It is the finance that is provided by the investors or venture
capitalists to start-ups or small business that is believed to have
long-term potential growth.
The objective of Venture Capital
The main objective of venture capital is to provide finance to startups that do not have access to capital markets. Thus, venture capital
becomes an essential source of finance for small businesses.
The risk is significantly high for venture capitalists or investors but
they have a say in the company’s decision-making process and as
such have a significant degree of control over the company affairs.
Features of Venture Capital Investments
Carry high degree of risk
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Liquidity is lacking
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Need a Long-term outlook
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Investments are made usually with innovative projects only
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Suppliers get to participate in the company’s management.
Different Venture Capital Funds
Following are the four types of Venture Capital Funds available to
the companies:
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Venture capital funds that are promoted by the State Government controlled development finance institutions, such as
Gujarat Venture Finance Company Limited (GVCFL) by Gujarat Industrial Investment Corporation (GIIC).
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Venture capital funds that are promoted by the Central Government, such as Technology Development and Investment
Corporation of India (TDICI) by ICICI, Risk Capital and
Technology Finance Corporation Limited (RCTFC) by IFCI
and Risk Capital Fund by IDBI.
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Venture capital funds that are promoted by Public Sector
Banks, such as Canfina by Canara Bank and SBI cap by the
State Bank of India.
Venture capital funds that are promoted by foreign banks or
private sector companies and financial institutions, such as
Credit Capital Venture Fund, Indus Venture Fund, etc.
Summary
The long-term sources of finance are those funds which are required
for a period exceeding a year. They may be required to expand the
existing office space, buy a new office premise, launch a new product
in the market and buy a new company. The major types of long-term
sources of finance are internal financial sources and external financing sources.
Review Questions
1. List out the pros and cons of equity financing.
2. How and in what sense do the preference shareholders have
‘preference’? Explain the preferences available to the preference shareholders.
3. How do the equity shares represent the residual claim in the
company? Explain.
4. Explain the advantages and disadvantages of debentures from
the company as well as the investor’s viewpoint. Comment on
its suitability as a long-term source of finance.
5. Which option out of debt and equity is a suitable source for
long-term finance? Compare their key features in a tabular
form.
Fundamentals Of Capital
Budgeting
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Unit 12
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Notes
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Objectives:
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At the end of this unit, students can expect to discuss and explain:
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Capital budgeting’s meaning and definition.
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Capital budgeting decisions features.
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Capital budgeting decisions importance.
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Capital budgeting decisions and difficulties in making them.
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Capital budgeting decisions and their types.
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Introduction
Capital budgeting decisions are those decisions which are concerned
with the allocation of huge amounts of money to various long-term
assets. It is the process by which a firm assigns funds to varied investment heads, designed to conform to the organization’s profit and
growth objectives in the long run. The capital budgeting process calls
for the estimation of cost and future benefits from the investment in
the long term. Thus, it is financial decision-making process.
In today’s competitive economy, the financial capability and prosperity of a business depend upon the effectiveness and efficiency of
capital expense evaluation and fixed assets management.
Meaning and Definition
Capital budgeting refers to the financial planning required to increase an organization’s profits in the long run.
(C
It is the organization’s decision regarding the investment of current
funds on a new project or business in order to attain proficiency and
continuous flow of future benefits in the long-run term activities.
Thus, a capital financial plan can be devised to achieve long-run cash
flow over a period of time. It includes a cash resource’s current cost
or a series of cost in lieu for an likely inflow of expected paybacks.
Capital budgeting is the method or process to plan and prioritize the
investment process of long-term assets, whose revenues (cash flows)
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Capital budgeting is a traditional planning process employed by organizations to decide if it is worth investing its present funds for
acquiring new or up gradation of fixed assets.
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are projected to exist more than a year. An organization’s asset decisions would usually embrace growth, acquirement, innovation,and
replacement of fixed assets or long-run assets.
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Features of Capital Budgeting Decisions
Following are the various features of Capital budgeting decisions:
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They require the exchange of existing resources for future
paybacks.
They have the weight of accelerating the capability, proficiency, and extent of life regarding future hedges.
Funds are invested in long-run activities.
Some of the most commonly discussed capital budgeting decisions
are:
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Introduction of a new product.
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Expansion of business by investment in plant and machinery
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Replacing and modernizing a method
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Mechanization of processes
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Choosing between various machines
Significance of Capital Budgeting
Following reasons shed some light on the significance of Capital
budgeting decisions:
Long-term Effects
One of the most significant features of capital budgeting decisions
is that they have long-term implications regarding the future of the
company. One wrong decision can greatly influence the survival of
a firm because the dearth of investment in assets might have serious implications regarding the future position of the company in
regards to the competitors.
Unit 12: Fundamentals Of Capital Budgeting
A significant portion of capital is blocked due to capital budgeting
decisions as they entail the commitment of huge amounts of money.
Irreversible Decisions
Notes
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Due caution and diligence must be exercised by the company before
taking capital budgeting decisions as there is less possibility of being
able to revert the decisions which may lead to severe consequences.
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Substantial Commitments
Capacity and Strength to Compete
If crucial decisions related to capital budgeting are delayed, it may
result in the company losing its competitive edge and lose the ground
to competitors.
Problems and Difficulties in Capital Budgeting
Capital budgeting decisions facing a finance manager are affected
by various other issues also which might not be analytical in nature.
Let us consider some example given below:
Measurement Problem
Analysis of a project involves identifying and calculating its prices
and benefits, which is difficult since it involves long and tedious calculations. Majority of replacement or expansion programs have an
impact on some alternative activities of the business(introduction
of the latest product could lead to the decrease in sales of the other
prevailing product) or have some immaterial significances.
Uncertainty
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Selection or rejection of a capital expenditure project depends on the
expected prices and benefits in the future. The future is uncertain;
hence,the prediction of future gains may be inaccurate. Due to the
inherent risk, it is impossible to predict long-term money inflows.
Temporal Spread
The expected costs and benefits are related to an expense project
opened up over an extended amount of time, which are 10–20 years
for industrial assignments and 20–50 years for infrastructure projects. The temporal spread generates some issues in approximating
discount rates for conversions of future financial inflows to present
values (PVs) and establishing equivalences.
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Every capital budgeting decision is a specific decision in a given situation and in case a firm deliberates regarding a decision at two
different junctures of time, it can result in two entirely diverse outcomes.
In general, the capital budgeting decisions can be categorized from
two different viewpoints as mentioned below:
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Capital Budgeting Decisions and their Types
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1. From the viewpoint of the Firm’s survival
It does not matter if the firm already exists or is a new entity,
it is important to take Capital Budgeting Decisions.
(a)
For a new firm – a company which has only been recently
in corporated needs to take key decisions regarding plant
and machinery to be installed, standby arrangements, capacity utilization, etc.
(b)
For an existing firm – a company which is well established needs to take various critical decisions regularly
to maintain a competitive edge over others. Some such
decisions can be: -
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(i)
Replacement and Modernization Decisions – This
is the most common capital budgeting decision. All
types of plant and machinery have a fixed life, and
after it has completed its economic life, there is an urgent need to replace it. This decision is called replacement decision. However, if the existing plant needs to
be technologically updated (though the economic life
may not be over), the decision is known as modernization decision. In general, these decisions are also
known as Cost Reduction Decisions.
(ii)Expansion – Sometimes, the firms are interested in
increasing the production and market share. In such
instances, it is required on the part of the finance
manager to evaluate the marginal costs and marginal
benefits in order to take a decision regarding the expansion.
(iii)Diversification – Sometimes, the firm is interested in
diversifying into new product lines and new markets.
Unit 12: Fundamentals Of Capital Budgeting
The capital budgeting decisions under this category are classified as follows:
(a)
(b)
Mutually Exclusive Decisions: in a case where a selection of one alternative results in automatic rejection of
remaining alternatives, it is called a mutually exclusive
decision.
Accept—Reject Decisions: in a case where each alternative is evaluated independently without having any implications on other alternatives, it is called an accept-reject
decision which must be made when: -
(i)A particular proposal’s cost and benefits does not impact or get impacted by other proposals cost and benefits.
(ii)Desirability of other proposals is not impacted by selection or rejection of other proposals.
(iii)The various proposals that are being considered are
not competitive.
Contingent Decisions: Sometimes, a capital budgeting
­decision may be contingent on other decisions. For example, installing a project at a remote location may require
expenditure for transportation development or development of infrastructure. Any capital budgeting decision
should be analysed in their entirety. Thus, consideration
and evaluation of contingent decisions must be done concurrently.
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(c)
Notes
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2. From the viewpoint of the decision situation
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When the company is facing a situation like this, it
is necessary for the finance manager to evaluate the
marginal benefits and cost along with the impact of
broadening product portfolio on profitability levels
and current market share. In general, these decisions
are also known as Revenue Increasing Decisions.
So, we have learned the importance of capital budgeting, its types,and
features. In the next chapter, we will learn about the techniques of
capital budgeting.
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Notes
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The first and perhaps the foremost decision of a firm is to define
the business or new projects that it wants to be involved in. After
the business has been chosen the company needs to make decisions
regarding investment in machinery, plant, building, equipment, infrastructure, and various other fixed assets under the Capital Budgeting process. As the funds available to a company will vary from
time to time, it is essential to take investment decisions which will
yield maximum returns. Determination of Debt-Equity ratio, price
of market securities, timing of raising funds are some of the essential capital budgeting decisions.
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Summary
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Review Questions
1. Explain the concept of capital budgeting and its various types?
2. What are mutually exclusive projects and how do they differ
from accept-reject projects?
3. What are the different categories of investment decisions?
What are the factors affecting capital budgeting decisions?
4. Explain the concept that ‘Capital budgeting decisions are longterm decisions.’
5. What are challenges that a firm may face while taking a decision regarding capital budgeting?
6. How does capital budgeting differ for a new firm and an existing firm?
7. How are capital budgeting decisions classified based on decisions?
Capital Budgeting Evaluation
Techniques
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Unit 13
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Notes
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Objectives:
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After completion of this unit, students can be expected to understand and
discuss:
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Techniques of evaluation
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Payback period.
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The accounting rate of return.
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The net present value technique.
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The profitability index method.
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The internal rate of return.
Introduction
Capital budgeting decisions start with Cost and Benefit analysis
of various alternatives. There are different techniques available to
evaluate the different alternative proposals. Each technique has its
own methodology and acceptance criterion. However, these techniques follow two assumptions:
ll
ll
Certainty about cash flows
There are no constraints regarding the funds available to the
firm.
Techniques of Evaluation
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The following elements affect the acceptance or attractiveness of
any investment proposal:
ll
The Net Investment (amount to be invested)
ll
The Operating Cash Inflows (potential benefits)
ll
The economic life of the project (Duration)
The techniques that can be used are grouped into two categories, as
shown in the figure 13.1 below:
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Financial Management
Pay Back Period
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Accounting Rate of Return
Internal Rate of Return
Project Evaluation Technique
Notes
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Traditional or Non-discounted Cash Flow
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Net Present Value Method
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Modern or Discounted Cash Flow
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Profitability Index
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Figure 13.1: Techniques of Capital Budgeting
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Traditional or Non-Discounted Cash Flow
This technique does not discount cash flows to find their present
worth. Under this technique two strategies are available: - Payback
period method and accounting rate of return method.
Payback Period
Payback period (PBP) is defined as the duration during which the
initial investment in a project may be recovered and is one of the
most widely used techniques for estimating investment plans. It is
calculated based on cash flow after taxes.
There are two techniques to calculate PBP -
1. Equal Annual Cash Flows: Here, the cash inflows are in the
form of an annuity. PBP can be calculated using the following
formula: PBP =
Initial investment cash outlay
Annual cash inflow
2. When annual cash inflows are unequal: Here the cash
flows are different for each year as such the following cumulative cash flow method is used for calculation of PBP: Thus,
“PBP = Period after which the cumulative cash inflows are equal to
the net cash outflow at the commencement of the project.”
Unit 13: Capital Budgeting Evaluation Techniques
Standard or maximum PBP is compared with calculated PBP for the
basis for acceptance or rejection of a project.
Advantages of Payback Period
Easy to understand.
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The cost involved in calculating the PBP is less as compared
to other methods.
Cash Flows after PBP is ignored.
Due to the fact that it does not consider all cash inflows resulting from an investment, it is not considered a suitable
technique to calculate profitability.
Money’s time value is not considered.
ll
There is no balanced foundation for setting a minimum PBP.
As share value is not dependent on PBPs of investments, it
does not necessarily result in maximization of shareholders
wealth.
Example 13.1 – A proposal requires a cash outflow of Rs. 30,000 and
it is desired to generate a cash inflow of Rs. 10,000, Rs. 8,000, Rs.
8,000,Rs. 6,000 and Rs. 4,000 each year over the next five years. PBP
is calculated using cumulative cash flow value. Determine the PBP.
Table13.1: Cash Flows for Time Periods
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Solution
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ll
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Disadvantages of Payback Period
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Considered: Calculated PBP = Standard PBP
ll
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Reject: Calculated PBP > Standard PBP
ll
Notes
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Accept: Calculated PBP < Standard PBP
ll
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Rules of Acceptance and Rejection of the Payback Period
Year
Annual Cash
Flow
Cumulative
Cash Flow
0
−30,000
1
10,000
10,000
2
8,000
18,000
3
8,000
26,000
4
6,000
32,000
5
4,000
36,000
Financial Management
Notes
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Accounting Rate of Return
Accounting Rate of Return (ARR) is defined as the annualized net
income received on the average funds devoted to a project and is
based on the concept of Return on investment.
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From the above table, in the 4th year, the cash inflows surpass the
initial investment. Hence, the PBP is four years. Hence, the project
may be accepted.
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AAR =
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Average annual accounting profit
Initial investment in
n the project
Thus, ARR is like the financial ration rate of return on the capital
and, thus,indicates the profitability of the firm.
Rules of Acceptance and Rejection of the Accounting Rate
of Return
Standard ARR is the expected profits that a company expects on an
investment. Selection or rejection of a project is based on a comparison of standard ARR with calculated ARR.
Accept: Calculated ARR > Standard ARR
Reject: Calculated ARR < Standard ARR
Considered: Calculated PBP = Standard PBP
Advantages of ARR
ll
ll
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Simple and easy to understand.
The relevant data and information required to calculate the
ARR can be conveniently obtained from the accounting records.
ARR illustrates an investment’s economic desirability in
terms of percentage return.
Disadvantages of ARR
ll
Post PBP cash flows are ignored.
ll
Time value of money is not considered.
ll
Expected Life of the proposal is ignored.
ll
Size of the investment required for the project is not recognized by the ARR.
Unit 13: Capital Budgeting Evaluation Techniques
1
2
3
4
5
Project 1
4,000
4,000
4,000
4,000
4,000
Project 2
6,000
3,000
2,000
5,000
5,000
ll
ll
Calculate the average rate of return for the projects.
Solution: The Accounting Rate of Return or ARR is calculated
as follows:
Average Annual PAT
× 100
AAR =
Average Investment in the Project
ll
Total Earnings from Project 1 = Rs. 20,000
ll
Total Earnings from Project 2 = Rs. 21,000
ll
Refer to the below table for calculations.
Years
Project
1
Project
2
1
4,000
6,000
2
4,000
3,000
3
4,000
2,000
4
4,000
5,000
5
4,000
5,000
Total Earnings
20,000
21,000
Earnings After Tax
10,000
10,500
Average Earnings After
Tax
2,000
2,100
Initial Investment
10,000
10,000
Accounting Rate of
Return
20
21
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Notes
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Years
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Example 13.12 – Pooja Brass Co. is contemplating two different projects, each with a requirement of an initial cash out flow of Rs. 10,000
and with a life of five years. Company’s required rate of return is
15%,and the tax rate is 50%. Straight-line basis depreciation will be
used. The cash flows follow:
Thus, the ARR for Project 2 is higher than that of Project 1.
Hence, Project 2 should be considered by Pooja Brass Co.
So far, we have discussed the traditional or non-discounted techniques of capital budgeting. Now, let us discuss the modern or discounted cash flow technique.
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Financial Management
Notes
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The discounted cash flow technique is also known as the time adjusted cash flow technique. This technique explains that cash flows that
occur at different times will have different economic worth because
it considers the time value of money. All procedures used under this
technique work around the premise under which future cash flows
are discounted for calculation of present values.
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Modern or Discounted Cash Flow Technique
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Net Present Value Method
Net Present Value (NPV) of an investment proposal is calculated
through summing up PV’s of all cash outflows related to a proposal
and reducing them from the sum of PV’s of all cash inflows, the result is the Net Present Value (NPV) of an investment proposal.
For the purpose of calculation of NPV, both cash inflows and outflows
are applied to both cash inflows and outflows. Being the overall cost
of capital, this discount rate, presents the minimum requirements
regarding the returns required for financial stability of shareholders.
Calculation of Net Present Value
NPV = PV of inflows – PV of outflows
NPV =
CF1
1
(1 + k)
+
CF2
2
(1 + k)
+
CFn
(1 + k)n
− CF0
CFi
∑ (1 + k)
i
Where, I = 1,2,……,n
CFi= Cash flow at the i-th time
k = Discount rate
n = life of the project in years
Decision Rule:
If the NPV > 0, proposal must be accepted and if the NPV < 0 proposal must be rejected
Advantages of the Net Present Value Method
ll
Time value of money is identified.
ll
All cash inflows and outflows are considered.
Unit 13: Capital Budgeting Evaluation Techniques
ll
The discounting rate k, which is the minimum rate of return,
integrates both the return and premium to set off the risk.
Net contribution of a proposal towards the wealth of the firm
can be computed with its help.
Drawbacks of the NPV Method
ll
ll
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ll
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ll
It is based on real cash flows and not on accounting profits.
Notes
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121
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Many complex calculations are involved.
As the cash flows are occurring after a huge time gap there
might be some uncertainties.
Determine the rate of return beforehand is hard.
Projects are evaluated against an expected rate of return only
not against the actual rate of return.
The difference in the initial outflows, size of the proposals,
etc. are ignored, as the decisions under NPV are based on
value only.
Example 13.3 – A firm is considering an investment proposal having an initial investment of Rs. 1,50,000. The project is expected to
generate an annual cash inflow of Rs. 20,000, Rs. 50,000, Rs. 60,000,
Rs. 40,000 and Rs. 30,000, respectively, during the next five years.
Determine the NPV.
Solution-
Table13.2: Calculation of PV of Cash Flows
Present Value
factor @ 10%
rate
Annual Cash
Flow
0
−1,50,000
1
20,000
1.100
18,182
2
50,000
1.210
41,322
3
60,000
1.331
45,079
4
40,000
1.464
27,321
5
30,000
1.611
18,628
(C
Year
Total NPV
Present Value of the
cash flow
−1,50,000
531
As the NPV is positive in the above-mentioned example, the
project will be accepted by the firm.
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Financial Management
Notes
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Internal Rate of Return Method
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Internal Rate of Return (IRR) is the rate of discount at which the
NPV of a proposal is zero. In simple words, IRR is that discounting
rate which PV of cash outflow is same as PV of cash outflow.
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In the IRR technique, the time schedule of occurrence of future cash
flows is known; however, the discounting rate is unidentified and
has to be calculated through a trial and error method.
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Calculation of Internal Rate of Return
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CO0 =
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CF0
0
(1 + k)
+
CF1
1
(1 + k)
+.+
CFn
(1 + k)
n
+
SV + WC
(1 + k)n
Where,
CO0 = Cash outflow at time 0
CFi = Cash flow at the i-th time
k = Discount rate (yet to be calculated)
n = life of the project in years
SV = Salvage Value
WC = Working Capital
Decision Rule
To take a decision on the basis of IRR method, it is required by the
firm to have its own cut-off rate/rate of return.
The proposal can be accepted only if IRR >cut-off rate and will be
rejected otherwise.
Advantages of Internal Rate of Return Method
ll
Money’s time value is considered.
ll
All cash inflows and outflows are considered.
ll
ll
It is not based on accounting profits but based on actual cash
flows.
It is profit oriented and selects proposals that are expected to
earn more than the cut-off rate.
Unit 13: Capital Budgeting Evaluation Techniques
ll
ll
It involves difficult calculations.
Pre-determination of cut-off rate/hurdle rate is required,
which is a difficult task
Being a scaled measure it tends to be prejudiced toward small
projects that may yield higher returns.
Notes
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Disadvantages of Internal Rate of Return Method
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It is assumed that future cash flows of a project are invested
again at the rate of IRR.
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“Modified IRR is an enhanced version of IRR, and it recognizes that original outlays are funded at financing cost of
the company, and positive cash flows are plowed back at
the company’s cost of capital.”
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Profitability Index Method
Profitability Index (PI) or cost-benefit ratio or PV index is the profit
per rupee that has been invested in the proposal based on the discounting of future cash flows. It can be calculated as the ratio of PV
of future cash inflows to the PV of future cash outflows.
Computation of Profitability Index
PI =
Total present value of cash in flows
Total present valu
ue of cash out flows
n
CFi
∑ (1 + k)
i =1
i
/ C0
Decision Rule
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Accept a proposal if PI > 1; reject the proposal otherwise. However,
if PI = 1, the firm may be indifferent to the proposal.
Example 13.4 – A firm is evaluating a proposal with a cash outflow
requirement of Rs. 40,000 at present and Rs. 20,000 at the end of
the 3rd year. It is anticipated to produce the cash inflows of Rs.
20,000, Rs. 40,000 and Rs. 20,000 at the end of the 1st, 2nd and 4th
year, respectively. The rate of discount is given as 10%, calculate
the PI of the project and arrive at a decision of whether to accept
the proposal.
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Financial Management
Notes
Solution
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Present values
1
−40,000.00
0.909
18,181.82
Year
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0
−40,000
1
20,000
2
40,000
0.826
33,057.85
3
−20,000
0.751
−15,026.30
4
20,000
0.683
13,660.27
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Cash Flows (in Rs.)
Present Value Factor
(@10%)
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PV of cash outflows: Rs. 40,000 + Rs. 15,026.3 = Rs. 55,026.3
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PVs of cash inflows: Rs. 18,181082 + Rs. 33,057.85 + Rs. 13,660.27
= Rs. 64,900
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PI =
(C
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64, 900
= 1.18
55, 026.3
As PI > 1, the project can be accepted as per the profitability method
calculations.
Example 13.5 – ABC Ltd. is considering an expansion of the installed capacity of one of the plants at the cost of Rs. 35,00,000. The
firm has a minimum required rate of return of12%. Below are the
expected cash inflows over the next six years, after which the plant
will be scrapped away for nil value. Using the IRR technique, find
out whether the proposal should be considered.
Year
Cash Inflows
1
Rs. 10,00,000
2
Rs. 10,00,000
3
Rs. 10,00,000
4
Rs. 10,00,000
5
Rs. 5,00,000
6
Rs. 5,00,000
In order to find out the IRR, the approximate IRR needs to be ascertained first. Calculating the PV @ rates 11%, 12% and 13%.
Year
Cash Inflows
PVF
PVF
PVF
(@11%)
(@12%)
(@13%)
PV (11%)
PV (12%)
PV (13%)
1
10,00,000
0.901
0.893
0.885
9,00,900.90
8,92,857.14
8,84,955.75
2
10,00,000
0.812
0.797
0.783
8,11,622.43
7,97,193.88
7,83,146.68
3
10,00,000
0.731
0.712
0.693
7,31,191.38
7,11,780.25
6,93,050.16
4
10,00,000
0.659
0.636
0.613
6,58,730.97
6,35,518.08
6,13,318.73
5
5,00,000
0.593
0.567
0.543
2,96,725.66
2,83,713.43
2,71,379.97
6
5,00,000
0.535
0.507
0.480
2,67,320.42
2,53,315.56
2,40,159.26
36,66,491.77
5,74,378.34
34,86,010.56
Unit 13: Capital Budgeting Evaluation Techniques
NPV @ 12%: Rs. 74,378.34
NPV @ 13%: Rs. -13,989.44
Interpolating between 12% and 13%,
Notes
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IRR = 12% + 74,378/(74,378+13,989.44)
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As we can see that the NPV is going negative between the rates 12%
and 13%, the IRR should be between 12% and 13%.
= 12.84%
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As we can see that IRR > 12%, the project is acceptable based on the
IRR technique.
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Summary
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Capital Budget involves the decision regarding allocation of currently available funds into new projects and as such becomes one of the
key decisions for a company. Several Capital Budgeting techniques
have been referred to which are employed by a company for analysis
of the potential of new projects. It encompasses two non-discounted
cash flow techniques, PBP and ARR and three discounted cash flow
techniques, NPV, IRR,and PI.
The proposal for new project or business is accepted only under the
following conditions:
1. If calculated PBP is less than standard PBP.
2. If calculated ARR is more than standard ARR.
3. If IRR is more than the cut off rate.
4. If NPV is higher than 0.
5. If PI is more than 1.
Review Questions
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1. Capital budgeting makes use of the concept of time value of
Money (TVM). How are they used? Which are the different capital budgeting techniques that use TVM?
2. Do a comparison of NPV and IRR methods? Which of the two is
a more rational method?
3. What is the significance of profitability index (PI) method? How
is it used to compare projects having different sizes? In what
circumstances is PI better than NPV?
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Financial Management
Notes
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4. An investment proposal to install a new production plant is being considered by ABC Ltd. at a cost Rs. 50,000 and life expectancy of five years without any salvage value. The cash inflows
for the next five years are mentioned in the table below: -
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Table13.3: Cash Flows for Time Periods
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Year
Annual Cash Flow
0
-50,000
1
10,000
2
12,000
3
13,000
4
15,000
5
20,000
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(C
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Compute the following:
(a)
PBP
(b)
ARR
(c) IRR
(d) NPV @ 10% discount rate
(e)
PI value @ 10% discount rate
5. Naveen Co. is considering purchasing one of the following two
machines, whose relevant data is provided below.
Table13.4: Values of Machine X and machine Y
Details
Machine X
Machine Y
Estimated Life
3 years
3 years
Capital Cost
Rs. 90,000
Rs. 90,000
Year 1
Rs. 40,000
Rs. 20,000
Year 2
Rs. 50,000
Rs. 70,000
Year 3
Rs. 40,000
Rs. 50,000
Earnings
Deduce the most profitable option for the company based on the
calculation of the following:
(a)
PBP
(b)
ARR
(c) NPV using 10% discount rate
Cost of Capital
Objectives:
Notes
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At the end of this unit, students will be able to explain and discuss:
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Unit 14
127
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Cost of capital
\\
Its Concepts
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\\
Its Significance
___________________
\\
Factors affecting it
\\
Compute the cost of capital:
\\
Long-term debt and bonds cost
\\
Preference share capital cost
\\
Equity share capital cost
\\
Retained earnings cost
\\
Explain the weighted average cost of capital.
Introduction
While formulating a company’s capital structure, one of the most important concepts is the cost of capital. It has two major applications:
1. Capital budgeting where it is employed as the rate of discount,
and
2. Determination of the firm’s best capital structure .
Two major approaches have emerged with a basic difference in the
relevance of cost of capital:
1. According to Modigliani Miller, cost of capital for a company is
fixed and is an independent financing level.
(C
2. According to Traditionalists, capital cost is varying and is
linked to the capital structure.
Under both the approaches, the most optimum policy is the one
which maximizes the value of a company. Thus, the cost of capital is
the lowest possible rate of return of the firm’s stakeholders or providers of funds.
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Notes
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The notion of cost of capital assumes varying meanings in diverse
context. Following are the three different viewpoints regarding the
cost of capital:
1. From Investors’ Viewpoint: An investor can describe it as
‘the measurement of the sacrifice made by him in capital formation.’
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Concept of Cost of Capital
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Financial Management
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___________________
2. From Firm’s View Point: It is the lowest aspired rate of return required to validate the capital’s usage.
3. From Capital Expenditure’s View Point: The cost of capital is the least desirable rate of return which is used to value
cash flows.
In lieu of capital contribution from the side of investors, company
must pay cost of capital as the rate of return. It can also be said
that weighted average cost of all finance sources utilized by the firm
including equity, preference, long-term debt and short-term debt is
the cost of capital.
Significance of Cost of Capital
The cost of capital is a key concept in the monetary decision-making
process and serves as a standard to assess decisions related to investment, debt policy, and financial performance.
Following are the decisions in which it is useful: -
1. Designing Optimal Corporate Capital Structure: It assists with framing a robust and cost-effective capital structure
for a firm keeping in mind the cost constraints. In order to develop a well-balanced capital structure, particular costs of various funding sources and weighted average cost of capital are
measured.
2. Investment Evaluation/Capital Budgeting: The cost of
capital is used as a cut-off rate for capital budgeting. Capital
expenditure means investing in long-term projects such as investment in new machinery. It is also known as capital budgeting expenditure.
3. Financial Performance Appraisal: performance can be effectively appraised through analysis of the cost of the capital
Unit 14: Cost of Capital
Factors Affecting the Cost of Capital
1. Risk-Free Interest Rate(If): It is the interest rate that is received on risk-free securities, for instance securities issued by
Indian Government. It is determined by the market sources of
demand and supply and consists of two mechanisms:
(a)
(b)
Notes
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It is the minimum expected rate of return for the firm’s investor
against their investment and is directly associated with firm’s risk
characteristic. Following are the factors relevant for deciding the
cost of capital:
129
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framework as it compares the actual profitability of the investment project with the overall cost of raising funds. If the actual
profitability is lower than the cost of raising funds, then the
financial performance is not satisfactory and vice versa.
Real Interest Rate: It is the rate of interest that is paid
to the investor.
Purchasing Power Risk Premium: Purchasing power is maintained by investors and, for the period during
which their money is lent to the firm, they want to be
compensated. Therefore, in order to calculate the riskfree interest rate, the premium for purchasing power risk
is added to the real interest rate. Higher is the inflation,
bigger is the purchasing power risk premium, and higher
is the risk-free interest rate.
(C
2. Business Risk: It is the intrinsic risk related to the firm’s compulsion to pay dividend and interest to investors. Every project has an effect on the business risk. If a proposal with high
risk is accepted by the firm, then in order to compensate for
the increase in the risk, the investors may increase the cost of
funds. This increase in cost to compensate for the business risk
is known as a business risk premium.
3. Financial Risk: It is defined as the likelihood of the business
not being able to honor its financial obligations. Higher the
amount of fixed cost securities in the capital structure, the financial risk would be bigger because a combination of sources
of finance may have an impact on investors income.
While measuring the cost of capital, company’s assets and capital
structure are assumed to be unchanged; there is another factor in
___________________
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Financial Management
Notes
___________________
___________________
___________________
For calculation of cost of capital following method is used:
k = If + b + f
Where,
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the form of demand and supply force, that affects the cost of finance
in the long run.
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130
___________________
k = Cost of capital from multiple sources
___________________
If = Risk-free interest rate
___________________
b =Business risk premium
___________________
f = Financial risk premium
___________________
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___________________
Only changes in the demand and supply of a source of the fundwill
affect the cost of capital over time if the company’s business and
financial risks are assumed to be fixed. It has to be noted that cost
of capital raised by a firm can vary from another firm because the
extent of business and financial risk related with each business is
different because the risk- cost of a source of the fund remains fixed.
Computation of Cost of Capital
1. Composite Cost and Component Cost: A company can use
multiple sources of finance including shares and debentures to
raise the requisite amount of money. The individual cost with
respect to the different sources of finances used is called the
component cost. It can also be termed as the composite cost of
capital which comprises of the sum of the average cost of each
source of fund utilized by the company.
Component costs are summed up to determine the overall cost
of capital.
2. Marginal Cost and Average Cost: Marginal Cost calculates
the additional cost incurred for raising new funds whereas Average cost is the mean of marginal costs of components.
3. Explicit Cost and Implicit Cost: The cost of capital can be
either implicit or explicit. According to Porter field, “Explicit
cost of any source of capital is the discount rate that compares
the present value of cash inflows that are incremental to the
taking of the financing opportunity by the present value of its
incremental cash outflow.”
Unit 14: Cost of Capital
Notes
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The implicit cost is the opportunity cost for a firm that the firm
gave up to use the factor of production owned by it. The implicit
cost incurs from the utilization of owned rather than rented
assets.
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An interest-bearing debt’s explicit cost of will be the rate of discount that equates net cash received today to the future interest and principal payment.
4. Historical Cost/Book Cost: The book cost has its origin in the
accounting system in which book values, as maintained by the
books of accounts, are readily available. They are related to the
past. It is commonly used for the computation of cost of capital.
5. Future Cost: It is the cost of capital that is highly probable for
raising funds for financing an investment proposal.
6. Specific Cost: It is the cost associated with a particular component/source of capital. It is also known as the component cost of
capital. These costs include the costs of equity (Ke),preference
share (Kp)debt (Kd), etc.
7. Spot Cost: It is the costs that are prevailing in the market at
a certain time. For example, a few years back, the cost of bank
loans (house loans) was around 12%; now, it is 6%, which is the
spot cost.
8. Opportunity Cost: The opportunity cost is the benefit that the
shareholder fore goes by not investing the funds elsewhere as
they have been retained by the management.
Computation of Specific Cost of Capital
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It is the responsibility of a financial manager to calculate the specific
cost of each type of funding that may be required for the company’s
capitalization as a company can raise funding from multiple sources.
Investors required a rate of returns is equal to the component cost
of a particular source of capital. Investors’ required rate of returns
includes interest, discount on debt, dividend, capital appreciation,
earnings per share on equity shareholders’ funds and dividend and
share of profit on preference shareholders’ funds.
Compensation of specific sources of finance, such as equity, preference shares, debentures and retained earnings is discussed below:
___________________
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Financial Management
Notes
___________________
___________________
___________________
The cost of debentures and bonds measure the price of borrowing
funds to finance the projects. Following variables help in deciding
the cost:
1. The present levels of interest rate – In case there is an increase
in the interest rate, debt cost for the company also increases.
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Cost of Bonds and Debentures
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___________________
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2. The risk of default from the firm – The Cost of debt increases
with an increase in the risk of default by a company.
3. The tax advantage –The tax benefit makes the after-tax cost
of debt lower than the pre-tax cost as it is a function of the tax
rate.
The cost of debt can be described as the returns desired by the likely
lenders of the company.
ll
Cost of Capital of Perpetual Debt – Perpetual debt is
availed by the firm on a regular basis. It is computed as follows:
Ki =
I
B0
Where, Ki = Cost of Capital of Debt (before tax)
I = Annual Interest Payable B0 = Net Proceeds
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Cost of Capital of Redeemable Debt – The cost of capital
of redeemable debt is calculated as follows:
kd =
l (1 − t ) + (RV − B0) / N
RV + B0
2
Where, Kd = After-tax Cost of Debt
t = Tax Rate
N = Life of Debenture
RV = Redemption Value of Debentures
B0 = Net Proceeds
Example 14.3 – XYZ Ltd. issues 20% debentures of face value Rs.
1,000 each, redeemable at the end of eight years. The debentures
Unit 14: Cost of Capital
Solution: The cost of debentures can be calculated by the simple use
of the formula:
l (1 − t ) + (RV − B0) / N
RV + B0
2
Notes
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kd =
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are issued at a discount of 5% and the floatation cost is estimated to
be 1%. Find the cost of capital of debentures, assuming tax rate to
be 50%.
Where, Kd = After Tax Cost of Debt
N = Life of Debenture = 8
RV = Redemption Value of Debentures = 1000
B0 = Net Proceeds = (1000 − 50 − 10 = 940)
200 (1 − 0.05) + (1000 − 940) / 7
1000 + 940
2
Kd = 11.20%
Cost of Preference Shares
Preference share capital is also used by companies to raise capital
but is diverse from Equity Share capital in the following ways:
1. Preference share receive the dividends at a pre-determined rate
and have priority over equity shares
2. If the company goes into liquidation, preference shares have
priority over equity shares during repayment
Preference share-holders should be paid pre-determined dividends
regularly because it may otherwise affect the credibility of the company significantly and may pose hindrances while raising funds in
future. If the dividend is not paid to preference shareholders, they
are entitled to voting rights under Sec. 87 of Companies Act 1956.
(C
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___________________
t = Tax Rate = 50%
kd =
___________________
Cost of Capital of Redeemable Preference Share – If the preference
shares are redeemable by the firm at the end of the specified period,
it is computed as follows:
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Financial Management
P0 =
Notes
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___________________
n
PDi
Pn
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∑ (1 + kp) + (1 + kp)
i
i =1
n
Where P0 = Net Proceeds on Issue of Preference Shares
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PD = A
nnual Preference Dividend at a Fixed Rate of
­Dividend
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Pn = Amount Payable at the Time of Redemption
___________________
kp = Cost of Preference Share Capital
___________________
___________________
___________________
n = Redemption Period of Preference Shares
An approximation of the above formula can also be written as
(C
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kp =
ll
Pn − P0
N
Pn + P0
2
PD +
Cost of Capital of Irredeemable Preference Share – In
case of irredeemable preference shares, dividends are paid
perpetually at a fixed rate. It is computed as follows:
Kp =
PD
P0
Where P0 = Net Proceeds on Issue of Preference Shares
PD = Annual Preference Dividend at fixed Rate of Dividend
kp = Cost of Preference Share Capital
Example 14.4 – XYZ Ltd. issues 15% preference shares of face value Rs. 100 each, with a floatation cost of 4%. Find the cost of capital
of preference shares if,
(a) preference shares are irredeemable
(b) preference shares are redeemable after 10 years with net
proceeds of Rs. 96 each.
Solution: When the preference shares are irredeemable, the cost of
preference shares can be calculated as follows:
Kp =
PD
P0
Unit 14: Cost of Capital
When the preference shares are redeemable, the cost of preference
shares can be calculated as follows:
100 − 96
15+
10
Kp =
= 15.71%
100 + 96
2
Cost of Equity Share Capital
Equity share capital also incurs a cost that is calculated as the rate
of discount at which projected dividends are discounted to reach the
current value of shares. The investors invest their money in equity
shares only because they expect a stable return on their investment.
ll
Cost of capital of equity shares when dividends are
distributed perpetually – It is computed as follows:
P0 =
D0 (1 + g )
ke − g
D1
=
ke − g
Where, D1 = D0(1+g)
g = Constant Dividend Growth Rate
Ke = Cost of Equity Share Capital
P0 = Current Market Price of Equity Shares
Cost of capital of equity shares when zero dividends
are distributed – It is computed as follows:
(C
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Notes
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Pn − P0
PD +
N
kp =
Pn + P0
2
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15
Kp =
= 15.63%
96
P0 =
Pn
(1 + ke )n
Where,P0 = Current Market Price of Equity Shares
Pn = Expected Market Price at the End of the Year n
Ke = Cost of Equity Share Capital
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Financial Management
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Solution:
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___________________
D1
+g
P0
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Ke =
S
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Example 14.5 – Determine the cost of equity capital from the following information of ABC Company. The current market price of
an equity share is Rs. 80. The current dividend per share is Rs. 6.40.
The company is expecting that dividends would grow at 8%.
Notes
___________________
=
___________________
___________________
= 0.08 + 0.08
___________________
= 0.16 or 16%
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Rs.6.40
+ 0.08
Rs.80
Cost of Retained Earnings
Earnings generated by the firm is distributed among the shareholders. However, some of it may be retained by the firm for reinvestment purposes, which is known as retained earnings. Thus, in terms
of cost, the retained earnings are the opportunity cost of the foregone dividends. Therefore, there is an opportunity cost involved in
the firm’s retained earnings, and an estimation of this cost can be
considered as a measure of the cost of retained earnings, Kr.
Retained earnings are assumed as fresh subscription of the share
capital and therefore its cost, Kr, is assumed equivalent to the equity
share capital’s cost, Ke,
Moreover, there is no need to adjust the retained earnings for taxation or flotation cost as the earnings have already been taxed. The
formula given below can be used for this:
Kr = Ke(1 – t)(1 – C)
Here,
Kr is the cost of retained earnings
Ke is the cost of equity share capital
T is the marginal tax rate applicable to shareholders
C is the commission and brokerage costs in terms of percentage
14.5 Weighted Average Cost of Capital
The rate of return that should be earned by a company to meet in-
Unit 14: Cost of Capital
WACC = w1ke + w2kd + w3kp//
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vestor requirements is described as the Overall cost of capital which
comprises varying costs in proportion to the capital structure. Therefore, WACC is defined as the weighted average of the cost of capital
from multiple sources and can be described as follows:
Notes
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___________________
___________________
Where, WACC = Weighted Average Cost of Capital
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ke = Cost of Equity Capital
___________________
kd = After Tax Cost of Debt
___________________
kp = Cost of Preference Share Capital
___________________
w1 = Proportion of Equity Capital in Capital Structure
___________________
w2 = Proportion of Debt in Capital Structure
___________________
w3 = Proportion of Preference Capital in Capital Structure
Example 14.6 – Consider the following capital structure of Sudeep
Corp.
Sources
Amount
Specific Cost of Capital
Equity Share Capital
Rs. 20,00,000
11%
Preference Share Capital
Rs. 5,00,000
8%
Retained Earnings
Rs. 10,00,000
11%
Debentures
Rs. 15,00,000
4.5%
Solution –
Now, WACC will be calculated as follows:
BV(Rs.)
Weights
Cost of
Capital
Weighted
Cost of
Capital
Preference
Share Capital
5,00,000
0.1
0.080
0.0080
Equity Share
Capital
+20,00,000
0.4
0.110
0.0440
Retained
Earnings
10,00,000
0.2
0.110
0.0220
Debentures
15,00,000
0.3
0.045
0.0135
50,00,000
1.0
(C
Source
0.0875
Therefore, the WACC for the company’s capital structure is 8.75%.
Financial Management
Notes
Example 14.7 – The following information is taken from the financial statement of ABC Ltd.
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138
___________________
Capital
Rs. 8,00,000
___________________
Share Premium
Rs. 2,00,000
___________________
Reserves
Rs. 6,00,000
Shareholders’ Funds
Rs. 16,00,000
12% Irredeemable
Debentures
Rs. 4,00,000
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An ordinary dividend of Rs. 2 has been paid. The dividends are expected to grow at a constant rate of 10%. The share price of ordinary
shares is quoted at Rs. 27.5 and debentures at 80%. Total number of
shares is 80,000. Calculate WACC.
___________________
Solution –
___________________
___________________
(C
___________________
Cost of Equity Ke =
=
D1
+g
P0
Rs 2 x 1.1
+ 0.1 = 18%
Rs 27.5
Market value of Equity = 80,000 * 27.5 = Rs. 22,00,000
I
Cost of Debt =
B0
= Rs. 12/Rs. 80 = 15%
Market Value of Debt = 4,00,000 * 0.80 = Rs. 3,20,000
WACC = (22,00,000/25,20,000) * 0.18 + (3,20,000/25,20,000) * 0.15
= 0.176
WACC = Or 17.6%
Thus, in this chapter, we see how a business plans its capital budgeting by estimating its cost of capital from different sources. They
may raise funds from either equity or debt or both. Now, in the next
chapter, we will learn how to determine the optimal capital structure by using debt financing and its effect on earnings of the shareholders.
Summary
The least expected rate of return that a company desires is defined
as the cost of capital, so that it can attract requisite funds for its capital needs. To put in other words, it is the weighted average cost of
different sources of finance employed by the firm such as preference
Unit 14: Cost of Capital
Capital budgeting is an essential component of the financial decision-making process and helps with: - Investment decision evaluation
139
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shares, short term debt, long-term debt and equity shares.
Notes
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___________________
___________________
- Debt policy designing for a firm
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- Financial performance appraisal.
The cost of capital helps in understanding the corporate capital
structure, capital budgeting,and financial performance appraisal.
Cost of capital is aggregate of financial risk premium, risk-free interest rate, and business rate premium.
1. Explain the significance of the cost of capital in capital budgeting.
2. Why are the expenses of raising preference share capital is lower than the cost of raising equity capital? Explain.
3. Explain why “a new issue of capital is costlier than the retained
earnings.”
4. Discuss if WACC can be used as a cut-off rate for capital budgeting.
5. Calculate the cost of capital for a seven-year bond of Rs. 100 of
a firm that can be sold for Rs. 07.75 and is redeemable at a premium of 5%. The interest rate is 15%,and the tax rate is 55%.
6. Calculate the cost of capital when the company issues 10% irredeemable preference shares at Rs. 105 each when book value is
Rs. 100.
7. Calculate the cost of capital when the expected dividend at the
end of the year is Rs. 4.5, share price is Rs. 90 with a growth
rate of 10%.
8. Calculate the WACC based on the following financial information of the company.
(C
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Review Questions
Sources of Finance
___________________
Amount (Rs)
Cost of Capital
11% Preference Share
capital
1,00,000
11%
Equity Share Capital
4,50,000
18%
Retained Earnings
1,50,000
18%
16% Debt
3,00,000
8%
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Unit 15
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Notes
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Case Study: Airnet limited: A
Telecommunication Takeover
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The telecommunications industry is a subset of the information
and communication technology sector. This industry comprises of
telephone companies, internet service providers, and DTH service
providers. The telephone calls are still the industry’s biggest revenue generator. Telecom, today, has revolutionized our lives; it’s
not just about voice calls anymore but about the text (messaging,
email), images (video streaming) and high-speed internet access for
computer-based data applications, such as broadband information
services.
India is one of the major telecommunications markets in the world
and has millions of internet subscribers. It is world’s second largest
smartphone market and is expected to have a billion unique mobile
subscribers by 2020.
Higher penetration in the rural markets and non-voice revenues
will give India’s telecommunications market another push. The
rise of an affluent middle class is generating demand for the mobile
and internet segments.
Airnet Limited is a leading Indian telecommunications company
with its operations spread across all major cities in India. The headquarters of the company is in New Delhi. The company’s product offerings include 2G, 3G and 4G wireless services, mobile commerce,
fixed-line services, high-speed DSL broadband and DTH services.
As of 2017, it has a customer base of around 10 million users, and
by the end of 2020, it is looking at a growth rate of 35%. Moreover,
it is looking for global expansion.
(C
As the company is in its expansion mode, it has two lucrative corporations to acquire. Below are the details of the two projects. Note
that the company has Rs. 25 Cr at its disposal to invest in one of
the two corporations.
A. Corporation A
a.
Revenues generated – Rs. 10 Cr and growing at the rate
of 8%
b.
Expenses incurred – Rs. 2 Cr and increasing at the rate
of 12%
c.
Depreciation Expenses – Rs. 50 Lacs
Contd....
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Notes
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___________________
___________________
a.
Revenues generated – Rs. 15 Cr and growing at the
rate of 7%
b.
Expenses incurred – Rs. 6 Cr and increasing at the rate
of 10%
c.
Depreciation Expenses – Rs. 1 Cr
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B. Corporation B
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Financial Management
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___________________
___________________
___________________
___________________
(C
___________________
Considering tax rate of 25% and a discount rate of 10%, find out
in which project should the company invest? Also, use the payback
period method, net present value methods, internal rate of return
method and probability index method to support your decision.
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(C
BLOCK–IV
UNIT 16: LEVERAGE ANALYSIS
S
Detailed Contents
ll
Pecking Order Theory
Concept of Leverages
ll
Factors Determining Capital Structure
ll
Types of Leverages
ll
Capital Structure Theories
ll
Combined Leverage
ll
Summary
ll
Summary
ll
Review Questions
ll
Review Questions
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ll
UNIT 17: EBIT–EPS ANALYSIS
UNIT 19: DIVIDEND DECISIONS
AND POLICIES
ll
Constant EBIT with Different Financing Patterns
ll
Introduction: Dividend Decisions
ll
Financial Break-Even Level
ll
Dividend Policy
ll
Indifference Point/Level
ll
Dividend Relevance Theory
ll
Summary
ll
Dividend Irrelevance Theory
ll
Review Questions
ll
Summary
ll
Review Questions
UNIT 18: CAPITAL STRUCTURE
Introduction
ll
Significance of Capital Structure
ll
Patterns of Capital Structure
(C
ll
UNIT 20: CASE STUDY: VELVET HANDS–
DESIGNING ITS OWN CAPITAL
Unit 16
S
139
Notes
Leverage Analysis
___________________
___________________
___________________
Objectives:
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At the end of this unit, students will be able to:
___________________
�
Explain the concept of leverage
\\
Discuss the operating leverage and its Importance
___________________
\\
Discuss the financial leverage and its importance
___________________
\\
Describe combined leverage
___________________
Introduction
A firm raises its required finance by either equity or debt or both.
While determining an optimum capital structure, a firm can use
fixed cost carrying securities for maximization of shareholders’
wealth. Leverage implies using debt funding to complement investment. As leverage can help maximize gains or losses, companies employ it to enhance returns to stock. The relationship between debt
financing and its impact on shareholder earnings would be covered
in this chapter.
Concept of Leverages
Leverage defines the link between two interrelated variables where
a modification in one variable is divided by alteration in another
variable. In simple words, Leverage is used to define a company’s capability to use fixed cost assets or fund sources to amplify the earnings to owners.
Mathematically, leverage can be defined as:
% Change in dependent variable
% Change in dependent variable
(C
Leverage =
___________________
Types of Leverages
There are three types of leverages discussed below.
1. Operating Leverage: the relationship between levels of EBIT
and Sales revenue
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Financial Management
Notes
___________________
___________________
___________________
3. Combined Leverage: relation between sales revenue and
EPS using both operating and financial leverage.
Operating Leverage
Operating leverage (OL) is used for measuring the effects of changes
in revenue from sales on the EBIT level. Mathematically, Operating
leverage can be defined as:
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___________________
2. Financial Leverage: relation between levels of PAT/EPS and
EBIT
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140
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___________________
___________________
___________________
___________________
(C
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Operating Leverage =
% Change in EBIT
% Change in Sales Revenue
Operating leverage of 1 denotes that the percent change in EBIT
level is directly proportional to the percent change in sales level.
This means that EBIT will increase or decrease proportionally with
an increase or decrease in the sales revenue. This happens when the
total Cost is variable, without any fixed costs. In case, if some fixed
cost involved, the degree of operating leverage (DOL) will be more
than 1 every time.
Refer to the below example to understand the variation of DOL
when the sales level changes from 1,000 units to 1,400 units.
Example 16.1
Table 16.1: Change in DOL when the Sales Level Changes
Sales Level
1000 Units
1400 Units
Sales @ Rs. 10 per Unit
Rs. 10,000
Rs. 14,000
− Variable Cost @ Rs. 7 per unit
7000
9800
− Fixed Cost
1,000
1,000
EBIT
2,000
3,200
DOL=
3000/2000
4200/3200
1.5
1.31
When the sales level changes from 1,000 units to 1,400 units,the
DOL changes from 1.5 to 1.31.Thus, the firm will have a different
DOL at different levels of operations. If the firm is operating above
the break-even level, the DOL will decrease with increasing sales
level. This is because the contribution of the fixed cost will become
relatively smaller when compared to the total sales revenue. Moreover, it should be noted that in case a company is operating at a
break-even level, the DOL is undefined.
Unit 16: Leverage Analysis
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A firm should always avoid operating under high DOL. A high DOL
condition is a high-risk situation for the firm and an even marginal
decrease in the sales will significantly affect the profits of the firm.
Moreover, the firm should operate at a DOL that is slightly higher
than the break-even point so that the effect of fluctuations of sales
can be minimized.
Notes
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Financial Leverage
The financial leverage (FL) describes the effects of variation in EBIT
levels on the level of EPS. Mathematically financial leverage can be
defined as:
Financial Leverage =
% Change in EPS
% Change in EBIT
We may note here that EBIT is the dependent variable when calculating OL and becomes an independent variable when considering
FL. Thus, EBIT is also called the linking point in the leverage study.
To understand the implication of debt in FL, consider the following
example continued from the OL.
Example 16.2 Consider the same example of OL (Example 15.1) in
the absence and presence of debt financing.
1. In the absence of debt financing:
Table 16.2: Change in FL when the Absence of Debt Financing
1000 Units
1400
Units
EBIT
2000
3200
− Interest
–
–
− Tax @ 50%
1000
1600
PAT
1000
1600
No. Of Shares
500
500
EPS
Rs. 2
Rs. 3.2
% Change in EBIT
= (3200 − 2000)/2000 = 60
% Change in EPS
= (3.2 − 2)/2 = 60
FL
= 60/60 = 1
(C
Sales Level
Thus, when the fixed interest charge in the form of interest on
debt financing is not there, both EBIT and EPS change by the
same percentages and FL = 1.
2. In the presence of debt financing: The firm raises Rs. 2,000 by
issuing 10% debentures to partly finance the capital requirements
___________________
___________________
___________________
___________________
___________________
___________________
Financial Management
Table 16.3: Change in FL When the Presence of Debt Financing
Sales Level
1000 Units
1400
Units
EBIT
2000
3200
− Interest
200
200
PBT
1800
3000
− Tax @ 50%
900
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142
1500
PAT
900
1500
Notes
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___________________
No. of Shares
300
300
___________________
EPS
Rs. 3
Rs. 5
___________________
% Change in EBIT
=(3200− 2000)/2000 = 60
% Change in EPS
=(5 −3)/3 = 66.67
FL
= 66.67/60 = 1.11
___________________
___________________
(C
___________________
Thus, when a change in the fixed interest rate is included in the
shape of interest on debt-financing, Degree of financial leverage
is greater than one and both EPS and EBIT change by varying
percentages.
As results total earning to the shareholder’s increase because
the additional funds generated through debt financing are
available to them. This fixed income charge is tax deductible
and provides a tax shield. This tax shield also increases the
earnings and, hence, proportionately increases the EPS.
Combined Leverage
Operating Leverage bears implications for operating risks and is
measured as the proportionate alteration in EBIT due to the proportionate change in sales. Financial Leverage bears implications
for financial risk and is calculated as changes in EPS due to changes
in EBIT.
Combined leverage can be defined as the proportionate change in
EPS due to the proportionate change in sales. Combined leverage
(CL) is a product of OL and FL.
The CL may also be described as percentage change in EPS for an
agreed percentage modification in sales levels and shall be calculated as follows:
CL = OL × FL
CL =
% Change in EPS
% Change in EBIT
× % Change in EBIT
% Change in Sales Revenue
Unit 16: Leverage Analysis
The Degree of Combined Leverage (DCL) = DOL x DFL
Summary
Leverage can be described as the capability of a company to utilize
its immovable assets such that they yield the highest rate of return
in terms of revenue to the firm. It represents fixed cost portion of
a firm. Operating leverage refers to the measurement of operating
risk from the fixed operating costs. Financial leverage (FL) refers to
the measurement of risk associated with financing a part of assets
of a firm, including fixed financing charges. The higher the FL, the
higher the financial risk and the cost of capital. Operating leverage
for a defined level of sales is calculated by dividing proportionate
change in earnings before income and taxes (EBIT) to proportionate
change in sales. FL at a given level of sales is computed by dividing
percent change in EPS to percent change in EBIT.
Review Questions
1. The following information for XYZ Company Ltd. is provided.
Calculate
(a)
(b)
Notes
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___________________
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Thus, the CL explains how OL and FL interact, and a change in
sales level produces a change in EPS level.
143
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% Change in EPS
CL =
% Change in Sales
Operating leverage with 4,000 and 6,000 quantity of sales
Operating breakeven point
Given, selling price Rs. 300 per unit, variable cost Rs. 200
per unit, fixed cost Rs. 2, 40,000
2. Analyse the importance of the financial leverage (FL) for a firm.
(C
3. What is leverage? How does increase in leverage indicates an
increased risk?
4. ABC Ltd. has an average selling price of Rs. 10 per unit. Its
variable cost is Rs. 7 per unit, and fixed cost is Rs. 1,70,000.
It finances all its funds through equity. XYZ Ltd. is identical
to ABC Ltd., except it finances 50% of its funds through debt
financing and pays an interest charge of Rs. 20,000. Determine
the degree of operating leverage (DOL), FL and combined leverage (CL) at Rs. 7,00,000 sales and tax of 50% for both the firms.
___________________
___________________
___________________
___________________
___________________
___________________
Financial Management
Notes
5. Examine the balance sheet and income statement of Sudeep
Corp.
___________________
___________________
___________________
Balance Sheet
Liabilities
Amount
Assets
Amount
Equity Capital (Rs 10
per share)
Rs. 8,00,000
Fixed Assets
Rs. 10,00,000
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Retained Earnings
3,50,000
10% Debt
6,00,000
Current Liabilities
1,50,000
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Current Assets
Income Statement
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Rs. 3,40,000
−Operating Expenses
1,20,000
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EBIT
2,20,000
PBT
1,60,000
−Tax@50%
80,000
PAT
80,000
(C
Sales
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Calculate–
(a) OL, FL and CL
(b) If total assets remaining constant and
(i)
Sales increasing by 20%
(ii)
Sales decreasing by 30%
9,00,000
EBIT–EPS Analysis
Objectives:
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Notes
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After completion of this unit, the students will demonstrate knowledge of:
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Constant and varying earnings before income and taxes (EBIT) with
the different financial pattern
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The connection of EPS and EBIT
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Financial break-even level
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Indifference point/level of EBIT
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Introduction
As has been previously discussed, varying combinations of equity,
preference, and debt financing have distinct tax and cost consequences. The financing pattern affects the apportionment of earnings before income and taxes (EBIT) over different elements, especially, the returns to the shareholders.
Unique EPS (earnings per share) will result from unique combinations of various sources of finance which implies, thus, diverse levels
of EPS would be there for different patterns of financing. Therefore,
there is an interaction between varying levels of EBIT and financing
patterns, which affect the EPS in multiple ways. These implications
of financing patterns can be studied as ‘EBIT–EPS’analysis under
the following two categories:
Constant EBIT with diverse financing patterns
Varying EBIT with diverse financing patterns
Constant EBIT with Different Financing Patterns
(C
The issue of bonds helps a firm enhance its leverage as the revenue so generated is used to issue new assets. This is accomplished
by differentiating the financial leverage and keeping EBIT at same
levels. The effects of a change in leverage on the EPS, keeping EBIT
constant, is discussed by using the below example:
Example 17.1 ABC Corporation expects the EBIT as Rs. 1,50,000
on an investment of Rs. 5,00,000 (which is the total funds available).
Funds are generated by the firm through the issue of equity share cap-
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Financial Management
Notes
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1. Equity Share Capital to be issued at Par.
2. Half of the funding is through equity shares, and the remaining
half is through preference shares.
3. Half of the funding through equity shares, one-quarter of
funding through preference shares and the remaining quarter
through 10% debentures.
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ital, preference shares at 12% or a combination of both. Below are four
options available for the company to determine the capital structure:
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(C
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4. Half of the funding through 10% debentures, a quarter of funding through preference shares and the balance through equity
share capital.
Solution: Assuming the tax rate to be at 50% the EPS the above
options is calculated in the following way:
Table 17.1: Change in EPS at Different Financing Levels
Option1
Option2
Option3
Option4
Equity Share Capital
Rs. 5,00,000
Rs. 2,50,000
Rs. 2,50,000 Rs. 1,25,000
Preference Share
Capital
Not
applicable
Rs. 2,50,000
Rs. 1,25,000 Rs. 1,25,000
10% Debentures
Not
applicable
Not
applicable
Rs. 1,25,000 Rs. 2,50,000
Total Funds
Rs. 5,00,000 Rs. 5,00,000
Rs.
5,00,000
Rs. 5,00,000
EBIT
1,50,000
1,50,000
1,50,000
1,50,000
− Interest
Not
applicable
Not
applicable
12,500
25,000
PBT
1,50,000
1,50,000
1,37,500
1,25,000
− Tax 50%
75,000
75,000
68,750
62,500
PAT
75,000
75,000
68,750
62,500
Not
− Preference Dividend applicable
30,000
15,000
15,000
Profit for Equity
Shares
75,000
45,000
53,750
47,500
No. of Equity Shares
(of Rs. 100 each)
5,000
2,500
2,500
1,250
EPS
15
18
21.5
38
We can see from above example that as the company increases the
financial leverage, there is a gradual increase in the EPS. Here, in
all the four options, the company is expecting a return of 30%. Using
equity financing in Option 1, the EPS is Rs. 15, which is same as the
post-tax investment returns. In Option 2, the EPS has increased from
Unit 17: EBIT–EPS Analysis
Example 16.2 Using the details from Example 16.1, the return on
investment is reduced from 30% to 18%. Find the effect on EPS,
when EBIT is reduced to 18%.
Solution
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Option1
Option2
Option3
Option4
Rs. 90,000
Rs. 90,000
Rs. 90,000
Rs. 90,000
12,500
25,000
− Interest
PBT
Notes
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Table 17.2: Change in EPS When EBIT is Reduced
EBIT
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Rs. 15 to Rs. 18 because the shareholders have an extra benefit of 3%.
In Option 3, the additional benefit to shareholders enhances further
when 10% debt is also introduced; thus, EPS increases to Rs. 21.5. In
Option 4, the EPS finally increases to Rs. 38. When preference shares
and debts are used more by the company to raise funds, the after-tax
return on investment of preference shares and debt is more than after-tax cost. This, in turn, causes the EPS to gradually increase.
90,000
90,000
77,500
65,000
− Tax 50%
45,000
45,000
38,750
32,500
PAT
45,000
45,000
38,750
32,500
30,000
15,000
15,000
− Preference Dividend
Profit for Equity Shares
45,000
15,000
23,750
17,500
No. of Equity Shares(of Rs.
100 each)
5,000
2,500
2,500
1,250
EPS
9
6
9.5
14
(C
In this case, the EPS under Option 1 is Rs. 9, which is equivalent to
the post-tax return on investment. Since in Option 1, the company
is using all the equity to finance the funds, in Option 2, the EPS
reduces to Rs. 6. This is because the firm uses 50% equity and 50%
preference shares for financing. Moreover, the company is expecting
a return of 9% but is paying 12% to preference shareholders. The
burden then lays on the equity shareholders, which results in the reduction of EPS. Further, in Options 3 and 4, the EPS will eventually
increase as after-tax cost using debt financing is less.
It is evident from the above two instances that return on investment
of the firm lends changes to financial patterns which in turn is depicted on the behavior of EPS. The financial leverage is believed to
be favorable where the return on investment of the company is higher than debt cost and this lends the earnings of the shareholders to
be greater as the degree of financial leverage is higher. Same is true
the other way.
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Notes
Varying EBIT with Different Financing Patterns
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Practically, considering EBIT as constant is unrealistic. The EBIT
level varies with a change in financing patterns; therefore, the consequence of financial leverage on EPS should be analyzed under the
hypothesis of variable EBIT. Refer to the below example for the same:
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Table 17.3: Change in EPS at Different Financing Levels of EBIT
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(C
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Poor Economic
Condition
Total Assets
ROI
EBIT
Rs. 2,00,000
5%
Normal Economic
Condition
Rs. 2,00,000
8%
Rs. 10,000
Good Economic
Condition
Rs. 2,00,000
11%
Rs. 16,000
Rs. 22,000
10,000
16,000
22,000
–
–
–
A & Co.( No financial leverage)
EBIT
− Interest
PBT
10,000
16,000
22,000
− Tax @ 50%
5,000
8,000
11,000
PAT
5,000
8,000
11,000
No. of Shares
2,000
2,000
2,000
3
4
6
10,000
16,000
22,000
− Interest
6,000
6,000
6,000
PBT
4,000
10,000
16,000
− Tax @ 50%
2,000
5,000
8,000
PAT
2,000
5,000
8,000
No. of Shares
1,000
1,000
1,000
2
5
8
10,000
16,000
22,000
− Interest
9,000
9,000
9,000
PBT
EPS
B & Co.( 50% financial leverage)
EBIT
EPS
C & Co.( 75% financial leverage)
EBIT
1,000
7,000
13,000
− Tax @ 50%
500
3,500
6,500
PAT
500
3,500
6,500
No. of Shares
500
500
500
1
7
13
EPS
From the above table it can be concluded that when EBIT levels
change according to financial patterns, it leads to changes in EPS
levels. This can be further explained by taking the EBIT levels of
‘Normal Economic Condition’ in the above example as 100 and then
calculating the percentage increase or decrease in the levels of EPS
when the levels of EBIT changes.
Unit 17: EBIT–EPS Analysis
Poor Economic
Condition
EBIT
62.50
Normal
Economic
Condition
Good
Economic
Condition
100
137.50
62.50
100
137.50
−37.5%
-
+37.5%
EPS
% Change from Normal
% Change from Normal
40.00
100
160.00
−60%
-
+60%
14.30
100
185.70
−85.7%
-
+85.7%
C & Co.( 50% financial leverage)
EPS
% Change from Normal
The table above helps us conclude that as the EBIT levels change, financial leverage is enhanced with a magnifying effect on EPS. Moreover, note that if ROI is equal to the financial leverage, there is no
magnifying effect on EPS. This also means that firms leveraged or
unleveraged have the same EPS when EBIT or ROI is the same as
the cost of debt.
Financial Break-Even Level
Break-even level is that stage of EBIT, where fixed financial charges
are barely covered by the EBIT, and the EPS is nil. In case the financial break-even level is higher as compared to the present EBIT, the
EPS shall be negative.
Below mentioned is the method to calculate break-even level:
llIn
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case the firm has employed only Debt:
Financial Break-even EBIT = Interest Charge
(C
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B & Co.( 50% financial leverage)
EPS
Notes
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A &Co.( No financial leverage)
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Table 17.4: Percentage Change in EPS at Different Financing Levels of
EBIT
llIn
the case where the firm employs preferential share capital
along with the debt:
Financial Break-even EBIT = Interest Charge + Preference Dividend (1 − t)
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Notes
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The point where EPS is fixed despite debt-equity combination, it
is called the indifference level of EBIT. In other words, it is the instance where two or more financial plans of the firm provide the
same EPS at a given level of EBIT.
Indifference Point Analysis: When EPS from different financial
plans is an independent variable and EBIT is a dependent variable,
the indifference point would be the level where ROI Is same as the
after-tax cost of debt because, at this juncture, the company would
be indifferent regarding the capital structure. The following example will shed more light on the concept:
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Indifference Point/Level
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(C
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Example 17.3 Suppose after implementing an expansion plan for
Rs. 50,00,000 a company is expecting an EBIT of Rs. 55,00,000. The
fund’s requirement can be achieved either by issuing equity share
capital at the cost of Rs. 5,000 each or by issuing 10% debentures.
If the total number of shares is 10,000, calculate the EPS under the
two plans.
Solution
Table 17.5: Calculation of Indifference Point
Financial Plan 1
Number of existing Shares
Financial Plan 2
10,000
10,000
Number of New Shares
1,000
-
Total Number of Shares
11,000
10,000
-
Rs.50,00,000
Rs.55,00,000
Rs.55,00,000
-
Rs. 5,00,000
PBT
Rs. 55,00,000
Rs. 50,00,000
Tax@50%
Rs. 27,50,000
Rs. 25,00,000
PAT
Rs. 27,50,000
Rs. 25,00,000
EPS
Rs. 250
Rs. 250
10% Debentures
EBIT
−Interest
Therefore, in the above example, it clearly illustrates that the EPS
is Rs. 250 irrespective of the composition of capital structure or how
the new funds are raised.
Thus, the indifference level for an all-equity plan and equity–debt
plan may be arrived using the following formula:
EBIT (1 – t)
(EBIT – Interest(1 – t)
=
N1
N2
Unit 17: EBIT–EPS Analysis
Notes
t is the tax rate.
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N1 is the number of equity shares outstanding under the first alternative.
After learning about the EBIT and EPS analysis in detail, we will
learn about capital structure in the next unit.
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Review Questions
1. Explain EBIT–EPS analysis and how it is dissimilar from leverage analysis?
2. What is financial break-even point? How is it calculated? Show
financial break-even point graphically.
3. Rs. 20 Lacs are required by a firm with two options:
100% equity
50% equity and 50% of 15% Debt
The expected EBIT of the company is Rs. 2,50,000 with a tax
rate of 40% and the equity shares are currently being issued at
Rs. 100 per share. Find out the EPS for each of the options.
(C
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For a given level of EBIT, a blend of diverse sources of finance will
have an outcome of specific earnings per share. The EBIT level varies with a change in financing patterns; therefore, the consequence of
financial leverage on EPS is analyzed under the postulation of changing EBIT. Financial break-even point is achieved when fixed financial
charges of the company are barely met by the EBIT level. At the point
where EPS is fixed despite the type of debt-equity mix competition.
4. The operating income of a firm is Rs. 1,86,000 and tax is 50%.
Capital structure details are given below.
15% Preference Shares
Equity Shares (Rs. 100 each)
14% Debentures
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Summary
(b)
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N2 is a number of equity shares outstanding under the second alternative.The value of EBIT in this equation is the indifference level of
EBIT.
(a)
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Here,
Rs. 1,00,000
4,00,000
5,00,000
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Notes
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Determine the EPS of the firm.
(b)
Determine the percentage change in EPS when there is a
30% change in EBIT.
(c) Determine the degree of financial leverage at the current
level of EBIT.
5. The following information about a firm’s capital structure is
available:
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(a)
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(C
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Number of Shares Issued
10,000
Market Price of Shares
Rs. 20
Interest Rate
12%
Tax Rate
46%
Expected EBIT
Rs .15,000
The firm needs to raise additional capital of Rs. 1,00,000. What
should be the composition of financing by the firm to produce high
EPS? Also, find the indifference level of EBIT for the two alternatives. What is the EPD for the EBIT?
Capital Structure
Objectives:
Notes
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At the end of this unit, the students will be able to explain and identify:
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The significance of capital structure in business
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Patterns of capital structure
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Pecking Order Theory
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Factors influencing capital structure
Capital Structuring Theories
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Net Income Approach
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Net Operating Income Approach
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Traditional Approach
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Modigliani–Miller Approach
Introduction
In order to sustain a business, in the long run, it is crucial to plan
regarding the capital structure. At first glance, you will notice that a
balance sheet has two sides Liability and Assets. The liability side is
inclusive of the finance that has been collected from multiple internal and external sources and shall be used for developing the business or meeting unexpected exigencies.
While preparing a balance sheet for a company, the liabilities side is
under perfect capital structure planning making the balance sheet
correct and balanced. This shows that in order to make a strong
balance sheet capital structure planning is required which enhances
the ability of the business to face the losses and markets fluctuations.
(C
Significance of Capital Structure
Capital structure’s significance can be described is as follows:
1. To decrease the business’ overall risk
2. To adjust according to the business environment
3. To find new sources of funds – idea generation
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Notes
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Patterns of Capital Structure
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For a new company, any of the following four capital structure patterns may apply:
llOnly
with equity shares
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llWith
both equity and preference shares
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llWith
both equity shares and debentures
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llWith
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(C
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all three out of equity shares, preference shares, and debentures
Pecking Order Theory
The pecking theory plays a great role in the capital structure. According to it, finance costs increase due to irregular information.
Following are three key sources of finance:
llInternal
llDebt
financing
financing
llEquity
financing
According to the Pecking Order Theory, sources of finance are duly
prioritized by companies where internal sources of finance are most
preferred. In case there is a need to resort to external sources of
finance, debt financing is preferred over equity financing. The theory starts with asymmetrical information, as managers know more
about the risks, prospects, and values of the firm as compared to
outside investors. Asymmetric information is a situation that can
be termed at information failure. In this situation, one business
has more knowledge about the market as compared to others. This
asymmetric information influences the decisions to choose between
internal and external sources of financing and favors debt financing
over equity financing.
Factors Determining Capital Structure:
The factors determining capital structure are explained as follows:
on equity: It refers to taking benefit of equity share
capital to borrow funds on favourable terms.
llTrading
degree of control: If a company wants maximum voting
rights only in their hands and do not want to raise capital
llThe
Unit 18: Capital Structure
of investors: In general, the company’s policy is to
diversify the category of investors for securities. It means
that the investor’s mix should include the ones that are bold
and risk-taking, which will prefer equity shares, while the
conscious investors will include those who prefer loans and
debentures.
Notes
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llChoice
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by sharing the voting rights, they may influence the capital
structure. In this scenario, the company’s capital structure
will consist of debenture holders and other loans.
market conditions: During the whole lifecycle of
the company, the capital structure also gets influenced by
the prevailing market conditions. During the depression, the
company will prefer debentures/loans as a source of capital;
whereas, during inflation or a boon, the company will opt for
equity shares.
llCapital
of financing: If a company wants the capital for a
smaller period, they will prefer bank loans or internal financing. On the other hand, if the investment is required for a
longer period, the companies will prefer issuing debentures
or equity shares.
llPeriod
of financing: prior to deciding on a capital option, cost
of a factor should be analyzed by a company regarding the
capital structure.
llCost
of the company: Bigger is the size of an organization,
more are its financing options. Big companies enjoy significant goodwill and can conveniently opt for issuing equity
shares or debentures, whereas small firms must use internal
finance or bank loans.
llSize
Capital Structure Theories
(C
Relation amongst capital structure, company’s value and cost of capital is determined by four different theories:
1. Net Income Approach (NI)
2. Net Operating Income Approach (NOI)
3. Traditional Approach
4. Modigliani–Miller Approach (MM)
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Notes
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According to this approach, by keeping a higher proportion of debt
in the capital structure, the firm can reduce the overall cost of capital (WACC/Weighted average cost of capital) which in turn would
lead to an increase in the firm’s value. Cost of capital is reduced
using debt because it is an economical finance source. WACC is that
average cost of equity and debts which has been weighted, where
capital raised from each source is assigned a weight.
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Net Income Approach
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“WACC = (Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt)/Total Amount of Capital (Debt + Equity)”
According to the NI approach, the value of a firm is affected by the
WACC which in turn is impacted by the firm’s financial leverage.
Assumptions of Net Income Approach
llFollowing
llInvestor
are the main assumptions:
confidence is not affected by an increase in debt
llDebt’s
cost is lower than equity’s cost
llThere
is no tax burden
Cost
Ke, ko
kd
Ke
ko
kd
Debt
In the figure, as the percentage share of debt (kd) increases in the
capital structure, the WACC (Ko) reduces.
Net Operating Income Approach
Let us first know the assumptions of the Net Operating (NOI) Approach
Unit 18: Capital Structure
The key assumptions of NOI approach are as follows:
llRegardless
of the degree of leverage, the overall rate of capitalization remains fixed. For a given level of EBIT, value of a
firm would be: EBIT/Overall capitalization rate
of Equity = Total Value of the Firm − Value of Debt.”
Cost of equity surges and WACC remains fixed with an rise in debt.
If the amount of debt in the capital structure surges, there is an rise
in the risk for shareholders.
According to this approach, change in the debt-equity ratio of the
firm has no impact on its value based on the assumption that there
is an increase in the cost of capital for equity shareholders with a
corresponding increase in benefits derived from the increase in debt
results.
This can be clearly seen from Figure 18.1. If the debt to equity ratio
increases, there is a simultaneous increase in the cost of equity (Ke),
which keeps the WACC constant.
cost of Equity, Ke
Cost of Capital
Notes
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ll“Value
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Assumptions of Net Operating Income approach
Weighted Average
Cost of
Capital (WACC)
(C
Cost of Debt, Kd
Degree of Leverage
Figure 18.1: NOI Approach to Capital Structure
Traditional Approach
Let us first discuss the assumptions of the traditional approach.
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Notes
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1. For a fixed period, the rate of interest on debt remains fixed,
and then it increased with an increase in leverage.
2. The anticipated rate of return for equity shareholders remains
fixed or increases gradually.
3. WACC initially reduced and thereafter increases due to the
activity rate of interest and expected rate of return. Optimal
capital structure is the lowest point on the curve.
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Assumptions of Traditional Approach
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(C
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According to the traditional approach, the total cost of capital is the
lowest at a certain point of debt to equity ratio. Any change in both
these components will result in rise in the capital cost. Whereas NI
and NOI are two conflicting approaches, the traditional approach is
the ‘intermediate approach.’
Figure 17.2 clearly explains the traditional approach. There exists
a degree of leverage where WACC is the least. Beyond that range,
the WACC increases, which results in an upsurge in the capital cost.
Cost of Equity, Ke
Weighted Average Cost of
Capital (WACC)
Coast of Capital
___________________
Optimal Level of
D/E and WACC
Cost of Debt, Kd
Degree of Leverage
Figure 18.2: Traditional Approach to Capital Structure
Modigliani-Miller Approach
According to the Modigliani–Miller approach (MM approach), the
capital structure of a firm has no relation to its valuation and firm’s
value in the market is free from the leverage. According to this approach, it is the operating profits that have a direct bearing on a
firm’s market value.
Unit 18: Capital Structure
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taxes are levied
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llCost
of transactions for sale and purchase of securities as well
as bankruptcy is nil.
llThe
Notes
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Assumptions of the MM Approach
llNo
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According to the MM approach market value of a firm is affected by
its growth prospects and investment risks rather than the capital
structure. It would be said that a company with high growth prospects would have a higher market value and higher stock prices. In
case the investors feel that growth prospects of a firm are not good,
its market value would not be substantial.
symmetry of information – The investor will have access to
the same information as what shareholders will have.
llBorrowing
llEBIT
cost is similar for both investors and companies.
is independent of debt financing.
Example 18.1 Consider a firm ABC with the following figures in
INR:
Earnings before Interest Tax (EBIT)
1,00,000
Bonds (Debt part)
3,00,000
Cost of Bonds Issued (Debt)
10%
Cost of Equity
14%
(a) Use the NI approach to calculate the value of a firm
(b) What will be the change in the company’s value in case the debt
increases to Rs. 4,00,000 from Rs. 3,00,000.
Solution
1,00,000
Less: Interest cost (10% of 300,000)
30,000
Earnings after Interest and Tax (since the tax is
assumed to be absent)
70,000
Shareholders’ Earnings
70,000
Market value of Equity (70,000/14%)
5,00,000
Market value of Debt
3,00,000
(C
EBIT
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Notes
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Total Market value
8,00,000
EBIT/(Total value
of firm)
Overall Cost of Capital
100,000/800,000
12.50%
If the debt portion increases to Rs. 4,00,000,
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EBIT
1,00,000
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Less: Interest cost (10% of 300,000)
40,000
Earnings after Interest Tax (since the tax is
assumed to be absent)
60,000
Shareholders’ Earnings
60,000
Market Value of Equity (60,000/14%)
428,570 (approx.)
Market Value of Debt
4,00,000
Total Market Value
8,28,570
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(C
___________________
EBIT/(Total value of
firm)
Overall Cost of Capital
100,000/828,570
12% (approx.)
Thus, we can see that by increasing the leverage, the cost of capital
reduces.
Example 18.2 Consider a firm XYZ with the following figures. Determine in which case the WACC is the least.
Solution There are five scenarios of different possible mixes of debt
to equity proportions. We can see that the WACC is least for Case
3, where the debt and equity portion is 50% each. This supports the
traditional approach of capital structuring.
Particulars
Case 1
Case 2
Case 3
Case 4
Weight of debt
10%
30%
50%
70%
90%
Weight of
equity
90%
70%
50%
30%
10%
Cost of debt
10%
11%
11%
14%
16%
Cost of equity
WACC
Case 5
17%
18%
19%
21%
23%
16.30%
15.90%
15.50%
16.10%
16.70%
As per the above exercise only up to a particular level the WACC
is reduced due to increasing debt. When that level is breached any
subsequent rise in debt level would lead to an increase in the WACC
and a fall in the company’s market value.
Unit 18: Capital Structure
Review Questions
1. Explain the traditional theory of cost of capital and capital
structure.
2. Explain the assumptions and implications of the net income
(NI) and net operating income (NOI) approaches?
3. Is there an optimal capital structure as per the NI and NOI
approaches?
4. Critically examine how the Modigliani–Miller (MM) approach
to capital structure is an extension of the NOI approach.
5. ABC limited and XYZ limited are identical companies, except
that ABC Ltd. uses debt while XYZ does not. The levered firm
has issued 10% debentures worth Rs. 9,000,00. The total assets
of both the firms are Rs. 15,000,00 each, and EBIT is 20% of
total capital.
Assuming capitalization rate to be 15% for the all-equity firm,
(a)
Use the NOI approach to calculating the value of two
firms.
Use the NOI approach to calculate WACC of both firms.
(C
(b)
Notes
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Capital structure is defined as the proportion of equity and debt in a
company’s finances. It boosts a business’s power to withstand losses
and changes in the financial markets. It decreases the overall risk
of a business and adjusts according to the business environment.
There are four capital structure patterns. The pecking theory plays
a great role in the capital structure. It states that the cost of financing increases with asymmetrical information. There are various factors that determine the capital structure, such as trading on equity,
the degree of control, choice of investors and period of financing.
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Summary
6. A company’s current operating income is Rs. 5,000,00. The firm
has Rs.1 0,000,00 of 8% debt outstanding. The cost of equity is
15%.
(a)
Calculate the current value of the firm using the traditional valuation approach.
(b)
Compute the overall capitalization rate of the firm.
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(d) For the second plan, in (c), calculate the value of the firm
using the MM approach. Assume that all the assumptions
of the MM theory are met.
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(c) If the firm raises the leverage by raising an additional Rs.
5,00,000/- debts and uses the debts to retire an equivalent
amount of equity. Thereafter the cost of equity becomes
18%, and the cost of debt becomes 12%. Should this approach be selected by the company?
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Dividend Decisions
and Policies
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Unit 19
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Notes
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Objectives:
After completion of this unit, the students shall:
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Understand the notion and significance of dividend decisions
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Understand Dividend Policy and know its Relevance
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Explain dividend relevance theory– Walter Model and Gordon Model
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Explain dividend irrelevance theory– Modigliani–Miller Approach
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Introduction: Dividend Decisions
It is one of the most crucial decisions that must be taken by the finance manager as it relates to total amount that must be paid to the
equity holders as a pay-out. The pay-out made to the shareholders
is categorized in terms of earnings per share (EPS) and is given as
dividend. The optimal dividend decision results in an increase of
wealth of shareholders with a simultaneous increase in the price
of company’s shares. Maximization of shareholder’s wealth is the
essence of financial management; it is all the more essential for the
finance manager to arrive at a mutually beneficial solution for both
the company as well as shareholders.
Dividend Policy
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It is a purely financial decision that decides the percentage of company’s income to be paid to shareholders so that their confidence in
the firm receives a boost. It is very critical to decide what portion
of the profits should be paid back as dividends and what should be
retained as a portion of retained earnings. According to different
dividend models, some models believe that shareholders do not have
any concerns with the dividend policy, whereas others believe that
dividends have a great impact on share prices. These views gave rise
to following theories:
1. Dividend Relevance Theory
2. Dividend Irrelevance Theory
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As the name suggests, this theory believes that dividends are important and have a substantial impact on the share price of the company. There are two models, which are based on this theory:
Walter’s Model
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This model was proposed by Prof. James E Walter, which states that
dividends do hold significant relevance and impact the firm’s share
prices.
The model explicitly defines the relations between the ROI or internal rate of return (r) and the cost of capital (k) through the following
probable scenarios:
(a) If r > k, that implies that there are better internal opportunities and more can be gained compared to what shareholders
gain by reinvestment. In such a scenario, the firm should retain
100% of the earnings. These types of firms are called ‘Growth
firms’ and have ‘Zero Pay-out.’
(b) If r < k, it means shareholders have better investment opportunities outside the firm. In such a scenario the payout ratio
is 100% meaning that the firm should pay all its income as a
dividend.
(c) If r = k, the firm’s dividend policy will not have any impact on
the firm’s value. Here, the firm can retain anything between 0%
and 100%.
Mathematically, Walter’s model can be represented as follows:
æ r ö
* (E - D)
D çè Ke ÷ø
P=
+
Ke
Ke
Where, P = Price of the share
D = Dividend per share paid by the firm
r = Rate of return on investment of the firm
Ke = Cost of equity share capital
E = Earnings per share of the firm
Unit 19: Dividend Decisions and Policies
llInternal
sources of finance only are used and no requirement
for external sources.
llIndependent
of any changes in investments, the rate of return
(r) and the cost of capital (K) remain constant.
income of the firm is either retained or evenly distributed to shareholders
llThe
llThe
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llEntire
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Assumptions of Walter’s Model
EPS and dividend per share (DPS) remain constant.
firm has an ongoing tenure.
Gordon’s Model
As per Gordon’s model, firm’s market value is equal to the future
dividends current value.
P = {E * (1 − b)/Ke − br}
Where, P = Price of a share
E = Earnings per share.
b = Retention ratio
1 – b = Proportion of earning which is distributed as dividends
Ke = Capitalization rate
br = Growth rate
Assumptions of Gordon’s Model
llThe firm is an all-equity firm; no external finance is needed, but
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only internal income is used for financing the investment .
llThe
cost of capital (K) and rate of return (r) remain fixed.
llThe
life of the firm is indefinite.
llGrowth
llCost
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Proposed by Myron Gordon, this model also substantiates the fact
that dividends are vital and have an impact on the share prices. In
order to understand the effects of dividend policy, this model proposes usage of dividend capitalization.
llRetention
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ratio remains fixed after it has been decided.
rate is constant (g = br).
of capital is greater than br.
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EPS or E = Rs. 10
Cost of capital Ke = 0.1
Find out the diverse market prices of the share under the different
rate of return, r, of 8%, 10% and 15% for the different pay-out ratio
of 0%, 40%, 80% and 100% using Walter’s Model and Gordon Model.
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Example 19.1 The key details for ABC limited are as follows:
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Solution
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For Walter Model,
æ r ö
* (E - D)
D çè Ke ÷ø
P=
+
Ke
Ke
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DPS is calculated as Pay-out ratio * EPS
r = rate of return on investment
D/P Ratio
Values of D
8%
10%
15%
0%
0
80
100
150
40%
4
88
100
130
80%
8
96
100
110
100%
10
100
100
100
For Gordon Model,
P = {E * (1 − b)/Ke − br}
r = rate of return on investment
D/P Ratio Values of b
8%
10%
15%
0%
1
0
0
0
40%
0.6
76.93
100
400
80%
0.2
95.24
100
114.28
100%
0
100
100
100
From the calculation of price per share from both the methods, we
can state that
llFor
r >ke, the share price is maximum if the payout ratio is
minimum, that is if the company retains entire earnings.
llFor
r < ke, the share price is maximum if the payout is 100%,
implying that all retained income has been paid back to the
shareholders.
Unit 19: Dividend Decisions and Policies
As the name suggests, this theory believes that dividends are not
important and do not affect the share price. There is one theory,
Modigliani–Miller who is based on this.
As per the Modigliani–Miller approach, the dividend has no effect on
the company share price and suggests that the investment policy increases the share capital. Moreover, according to it the satisfaction
level of investors is always high if ROI is more than equity capitalization rate ‘Ke.’
Equity capitalization rate can be defined as the rate at which equity of the firm is created by capitalization of income, revenue or
dividends. If ROI is lower than this rate, shareholders will prefer to
receive more dividends from firm’s earnings.
Assumptions of Modigliani–Miller Approach
llThe
market is a perfect capital market
llEntire
relevant market information readily available
llNo
floatation or transaction costs
llNo
investor is large enough to influence the market price
llSecurities
are infinitely divisible.
llThere
are no taxes. Dividends and the capital gains are taxed
at the similar rate.
llThe
llNo
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Modigliani–Miller Approach on Dividend Policy
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Dividend Irrelevance Theory
company follows a constant investment policy.
uncertainty about the future profits
to no risk factor, Investors are certain regarding the dividends, future investments, and profits of the firm
(C
llDue
Summary
Dividend Policy is a purely financial decision that decides what
percentage of the firm’s income is to be paid back to investors to
enhance their confidence in the future of the firm. It involves two
forms of theories, the ‘Dividend Relevance Theory’ and the ‘Dividend
Irrelevance Theory.’
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Notes
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1. List out the assumption under Gordon’s Model of dividend effect? Is the value of the firm affected by dividend policy under
this model.
2. “Models proposed by Walter and Gordon Models are based on
the similar assumptions. and therefore there is no elementary
variance between them. Do you agree? Why?
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3. ‘Irrelevance hypothesis proposed by Miller and Modigliani is
based on unrealistic assumptions.’ Explain.
4. A company has total investments of Rs. 5,00,000 assets and
50,000 outstanding shares of Rs. 10 each. It earns a rate of
15% on its investments and has a policy of retaining 50% of the
earnings. If the appropriate discount rate for the firm is 10%,
determine the price of its share using the Gordon Model. What
will happen to the price of the share if the company has a payout of 80% or 20%?
5. The Earning per Share of a company is Rs. 10. It has an internal rate of return of 15%, and the capitalization rate of the risk
class is 12.5%. If Walter’s model is used,
(a)
Calculate the best pay-out for the company?
(b)
At this pay-out what would be the price per share? and
(c) In case a different pay-out is used, how it will affect the
price of shares?
Unit 20
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Notes
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Case Study: Velvet Hands–
Designing Its Own Capital
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Velvet Hands Ltd. is an interior designing and home décor firm. It
is newly incorporated and is a listed company. It started its business in 2015 and is experiencing tremendous growth. Its headquarters are based in Mumbai, India.
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Overview of the Industry
Interior designing and home décor is largely an unorganized sector.
Interior designing firms specialize in designing and decorating interior spaces. A recent study indicates that the interior designing
market in India is growing at a whopping 60%.
Earlier, Interior designing used to be a part of the architecture,
but in 1980’s it started to be considered as a separate discipline.
With more corporates and luxury lifestyles coming up, this field has
grown tremendously.
What is helping this industry grow?
llModern construction in all major cities and small towns in
India.
llThe increment in the disposable income of people in India.
llNeed to make smaller spaces more practical, comfortable and
multi-functional.
Velvet Hand’s has an all-equity capital with Earning before income
and taxes of Rs. 2 Cr. The company appoints a new finance manager, Mr. Sudeep, to look into its financials and provide an optimal
capital structure such that the cost of overall capital is minimized
and the company can increase its earning by leveraging on taxation. The firm has 10 lakh shares outstanding.
As per Mr. Sudeep’s discussion with the company’s business heads,
he explains that ‘an ideal capital structure would be the best
debt-equity ratio for a firm that maximizes its value. Being tax deductible, debt financing generally offers the lowest cost of capital’.
He also recommends for the purpose of analysing the cost of debt,
short-listing a few of the best-performing companies in the industry. Mr. Sudeep was then asked to pursue the idea and develop an
optimal capital structure for the company. At first, he obtains the
following estimated cost of debt for the firm at the different capital
structure:
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Contd....
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Notes
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0%
20%
30%
40%
50%
Cost of Debt Rd
-
8%
8.5%
10%
12%
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Percentage of Capital
Financed with Debt
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The company gives out dividends at a constant growth rate of 10%
and pays a dividend of Rs. 2 per share to its shareholders. The company wants to maintain total capital (Equity + Debt) of the firm at
Rs. 25 Cr.
Mr. Sudeep has to use the above data and his knowledge of capital
structure theories and cost of capital to formulate an optimal capital structure for Velvet Hands Ltd.
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BLOCK–V
UNIT 21(A): WORKING CAPITAL MANAGEMENT
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Detailed Contents
UNIT 23: INVENTORY MANAGEMENT
Introduction
ll
Introduction
ll
The Concept of Working Capital
ll
Inventory
ll
Summary
ll
Components of Inventory
ll
Review Questions
ll
Inventory Management Motives
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UNIT 21(B): RECEIVABLES
MANAGEMENT
ll
Techniques of Inventory Management
ll
Objectives of Inventory Control
ll
Introduction
ll
Functions of Inventory Control
ll
Estimation Process
ll
Types of Manufacturing Inventories
ll
Summary
ll
Inventory Costs
ll
Review Questions
ll
Factors Affecting Inventory
ll
Summary
ll
Review Questions
UNIT 22: ESTIMATION AND CALCULATION
OF WORKING CAPITAL
Introduction
ll
Characteristics of Accounts Receivables
ll
Classifications/Types of Accounts Receivable
ll
Accounts Receivables Management
ll
Objectives of Accounts Receivable Management
ll
Costs Involved in Accounts Receivable Management
ll
Benefits of Accounts Receivable Management
ll
Controlling Cash Flows
ll
Credit Policies
ll
Accelerating Cash Collections
ll
Credit Standards
ll
Summary
ll
Credit Analysis
ll
Review Questions
ll
Credit Terms
ll
Summary
ll
Review Questions
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ll
UNIT 24: CASH MANAGEMENT
ll
Introduction
ll
Objectives of Cash Management
ll
Factors Determining Cash Requirements
ll
Role of planning, control and cash budget in cash management
UNIT 25: CASE STUDY: INVENTORY
MANAGEMENT BY TULIPS LTD
Working Capital Management
Objectives:
Notes
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After completion of this unit, the students shall demonstrate following skills:
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Unit 21(a)
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Define Working Capital and its management
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Describe the Working Capital Cycle
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Explain Operating Cycle
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Analyse the Working Capital determinants
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Define the Advantages of Adequate Working Capital
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Describe the Excessive and Inadequate Working Capital
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Evaluate the Disadvantages of Inadequate Working Capital
Introduction
The funds which are invested in business are of two types- longterm and short-term. The long-term investments are meant for more
than a year. They generally include fixed assets, such as debentures,
capital equipment, etc., and are recorded in the books of account for
earning profits during their life period of two or more years.
Funds required to meet the daily expenses of the business operations are called working capital, which includes current assets and
current liabilities. The working capital management decisions involve cash flow within a year.
The Concept of Working Capital
Working capital is categorized into quantitative and qualitative concepts.
(C
According to the quantitative concept, the amount of total current
assets is considered as the working capital. Thus, working capital
includes the liabilities that need to be paid off. Such a working capital asset is called gross working capital.
According to the qualitative concept, the amount by which the current asset is more than the current liability is considered as working
capital. Thus, it is the amount left after all the liabilities are paid.
This type of working capital asset is called networking capital.
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Notes
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Current Liabilities
Current Assets
Bank Overdraft
Cash and Bank Balances
Creditors
Raw, Material, Work-in-progress
Outstanding Expenses
Spare Parts
Bills Payable
Accounts Receivable
Proposed Dividends
Accurued Income
Provisional Taxation e.t.c.,
Prepaid Expense, Short-term
Investments
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Figure 21(a).1: Structure of Working Capital
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The net working capital and gross working capital are extremely
important in a firm when it comes to financial planning. The gross
working capital is considered if you need to ascertain the extent to
which the current assets are to be utilized. Whereas, if you analyse
the liquidity of a company, you will have to consider the net working
capital.
Classification of Working Capital
Classification of working capital can be done on the basis financial
reports and variability. The classifications are explained as follows:
1. Based on Financial Reports: Working capital can be categorized based on the financial reports of a firm. A firm may gather
information related to working capital through financial statements like the Balance Sheet or P&L Account. Working capital
can be categorised on the following basis:
(i) Cash Working Capital: The cash working capital can
be determined from analysing the profit and loss account.
Working capital defines the competence and capabilities
of a firm’s cash flow based on the ‘Operating Cycle Concept.’
(ii)
Balance Sheet Working Capital: The necessary data for
this can be obtained from a firm’s balance sheet. Working
capital is of three types- net working capital, gross working capital and working capital deficit.
2. Based on Variability: On the basis of variability working
capital can be divided into two key categories: fixed and variable working capital. Working capital when classified based on
variability is very useful in taking hedging decisions. The two
categories of working capital made based on variability are discussed below:
Unit 21(a): Working Capital Management
Notes
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It can also be defined as the extra assets required by a
firm to cope up with the sales variations above the permanent level. The formula used to calculate temporary
working capital is given as follows:
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(i) Temporary working capital: is also known as seasonal
or fluctuating working capital, refers to the supplementary investment required by firms during busy season of the
year. Temporary working capital is expected to increase
with the business’s growth.
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“Temporary Working Capital = Total Current Assets
− Permanent Current Assets”
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(ii) Permanent Working Capital: it refers to a portion of
the entire current assets that does not change with the
variation in sales in the market. In general, a business
maintains a minimum level of cash, accounts receivables
and inventories even when the sales decrease to the minimum level. Such an investment with the business is
termed as permanent working capital.
___________________
It can also be defined as the working capital that is unaffected by market fluctuations. Hence, it is also called as
regular working capital.
WORKING CAPITAL
Based of Financial Reports
Cash Working
Capital
Balance Sheet
Working Capital
Based on variability
Temporary
Working Capital
Permanent Working
Capital
Figure 21(a).2: Classification of Working Capital
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Working Capital Cycle
It enables you to understand the basic requirements and functioning of working capital. The cycle begins with the cash outflow, followed by several activities, such as buying raw materials,
manufacturing of goods and distribution of finished products, and
ultimately ends with cash inflow. Refer to the working capital cycle
illustrated below.
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Purchase
Notes
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Raw
Materials
Cash
Realizaion of
Income
Production
Process
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Debt Collection/Credit
Payment
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Sales
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Work-in-progress
Finished
Goods
Proudction
Process
Figure 21(a).3: Displaying Working Capital Cycle
The current assets and current liabilities remain available at every
point of a business. These assets and liabilities remain circulated
throughout the business process. If the circulation ceases in the process, it becomes a threat to the existence of the business. That is
why working capital has also been termed as circulating capital.
The cycle of working capital depicts that cash is used for the procurement of raw materials and fixed assets or making payment to
creditors. Processing of raw material is done to produce finished
goods for sale. The workers involved in the operation are paid wages
as well as all the overhead expenses. The sale of finished goods results in cash or credit payments. If the cash is not received, it will go
into cash receivable account and collected from debtors later.
Upon realization of cash, the cash is further used for acquisition
of fixed assets, raw materials and for payment of debts, dividends,
taxes, and interests. Thus, this cycle continuously remains active
through the life of the business.
Operating Cycle
The profits earned from the business depend upon the magnitude of
sales, thereby, restricting the maximization of shareholders’ wealth.
In simple words, an excellent sales effort is the only key that generates huge profits. However, the sales do not generate cash immediately. There is always a virtual time lag between the realization of
cash and sale of goods. This creates the requirement of additional
working capital to sustain the operation of the business until the
cash is received.
Unit 21(a): Working Capital Management
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Notes
Overhead
Expenses
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Finished
Goods
Wages
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Sales
Materials
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Creditors
Debtors
___________________
Cash
Funds from Operation
Tax
Issuance of shares
Interest
Borrowing
Dividend
Figure 21(a).4: Operating Cycle
An operating cycle refers to the period between the procurement of
raw materials and final compensation. It involves the following stages before the raw material is converted into cash:
llPurchase
of raw material from available cash
llProcessing
raw materials for work-in-progress
llProcessing
of work-in-progress into completed goods
finished goods on credit to create debtors and accumulate bills receivables
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llSelling
llGenerating
ables
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cash through conversion of debtors and bills receiv-
The length of the cycle varies from business to business. It may be
long for a manufacturing firm and short for others, as they may not
have raw materials and work-in-progress.
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Duration of the Operating Cycle
The time required for the individual stages of the operating cycle
minus credit period allowed by the firm’s suppliers is equal to the
operating cycle’s total duration. It can be represented as,
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O=R+W+F+D–C
In the above expression,
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O = the total length of the operating cycle
R = the raw material storage time
W = the time consumed during work-in-progress
___________________
F = the duration for which the finished goods were stored
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D = Collection period for debtors
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C = Collection period for creditors
The different elements of the operating cycle can be calculated as
follows:
R=
Average Stock of Raw Materials and Stores
Average Raw Material and Stores Consumption Per Day
W=
Average Work-in-Progress Inventory
Average Cost of Production Per Day
F=
Average Finished Goods Inventory
Average Cost of Goods Sold Per Day
D=
C=
Average Book Sales
Average Credit Sales Per Day
Average Trade Creditors
Average Credit Purchase Per Day
Determinants of Working Capital
While there are no definite parameters that point out the determinants of a firm’s capital, here is a list of factors that have an influence on the quantum of a firm’s capital. These factors are elaborated
below:
1. Nature of industry: The configuration of an asset is directly
associated with the size of a business and the industry to which
Unit 21(a): Working Capital Management
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it belongs. Smaller enterprises have a comparatively smaller
amount of inventory, cash, and other requirements. Hence, the
nature and size of business directly influence the working capital of a firm. For example, automobile manufacturer will need
a lot of working capital to keep his manufacturing unit going,
whereas, a small tea vendor would not need much capital to
conduct daily business activities.
2. The demand of creditors: The creditors of a business are usually concerned about the security of loans. They anticipate from
the business that the advances paid by them to the business are
adequately and fully covered. They prefer that liabilities should
be lower than assets.
3. Cash requirements: Cash is a significant current asset that
contributes to the successful and effective operations of the production of a firm. For the smooth functioning of a firm, it must
have adequate cash and must be utilized appropriately.
4. Time: Time is a major determinant of working capital. The
amount of time required by a business to manufacture goods
also affects the level of working capital. The working capital
amount required would be greater when the time required is
longer, and it would be lesser when the time required is comparatively shorter. Moreover, the level of working capital is also
dependent on the unit cost of merchandise sold and inventory
turnover. The greater the cost, the larger would be the amount
of working capital.
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5. The volume of sales: The level of sales is an essential determinant that affects the working capital’s composition and size.
Current assets are usually maintained by business for the operational activities, thereby, resulting in profitable sales. The
sales volume and size of the working capital share a direct relationship with each other. An increase in the inventories, receivables, cost of operations and the investment of working capital
is evident with an increase in the volume of sales of a business.
6. Purchases and sales terms: In case a business’s purchase
terms on an advantageous credit basis, and those of sales are
less, inventory would attract more cash investment. The working capital requirements are possible to be reduced when the
credit terms are favorable as, in such cases, a business gets
enough time to make payment to creditors and suppliers.
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8. Receivables turnover: A firm must necessarily have good
control over its receivables. Low working capital requirements
are highly influenced by better facilities for payables and timely collection of receivables.
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7. Inventory turnover: The working capital requirements are
expected to be low when the inventory turnover is high. A business can minimize its working capital requirements with the
help of an effective inventory control system.
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9. Business cycle: It is common for any business to expand
during economic growth and prosperity and decline during the
depression. As a result, a business would require more working
capital when the business is in the phase of prosperity. Similarly, it would require less working capital during the depression.
10. Variation in sales: A seasonal type of business would require
a greater amount of working capital for a moderately lesser
period.
11. Production cycle: We have already discussed that the operating cycle is the time required to transform raw materials into
finished products. The more the time taken to complete the production cycle, the greater the working capital requirement. A
firm must ensure to reduce the period of the operating cycle to
reduce their working capital requirements.
12. Liquidity and profitability: If a business anticipates taking
a higher amount of risk to earn more profits or face losses, it
automatically minimizes the size of the working capital with
respect to its sales. If the business anticipates increasing its
liquidity, it raises the amount of its working capital. However,
this strategy would expectedly reduce the volume of sales and
profitability of the business. Hence, a business must select between profitability and liquidity and then settle upon its working requirements.
13. Profit planning and control: The management of a company decides the amount of working capital required by taking
into consideration its policies and strategies for planning and
control. The presence of sufficient cash contributes to cash generation. This makes it possible for the company’s management
to retain a part of its profits and significantly increase the internal financial resources of the business.
Unit 21(a): Working Capital Management
Notes
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Advantages of Adequate Working Capital
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14. Activities of the firm: A business that is involved in the supply of heavy inventory or is involved in selling goods and services to customers on easy credit conditions, requires a higher
amount of working capital than a business that sells services or
makes cash sales.
1. Business with sufficient working capital can make timely payments to the suppliers for the raw materials they purchase.
This, on the other hand, helps in getting regular supplies of
raw materials from the suppliers without any delay and interrupting in the production process.
2. Adequacy of working capital helps a business to make the maximum utilization of its fixed assets regularly. For instance, if
a factory has insufficient stock of raw materials, the machines
in the factory will not be used justifiably, thereby, affecting the
productivity.
3. If the working capital of a business is adequate, it can enjoy
the benefit of cash discount by buying raw materials for cash
or through the method of making payment prior to the due
date.
4. A firm can consider purchasing an adequate quantity of raw
materials if it has adequate working capital. This is beneficial
when the prices of raw materials are expected to rise in the future. Similarly, if a company gets a bulk order for goods, it can
make the most of this opportunity if it has adequate working
capital.
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5. In spite of making enough profits, a business might face problems in making payments to its shareholders at an appropriate rate due to the paucity of cash. This problem of payment of
dividend can be easily resolved through the adequate working
capital.
6. Financial institutions, especially banks, are always ready to
provide even an unsecured loan to firms having sufficient working capital. This is mainly because having an more current assets in comparison to current liabilities is considered a sign of
good security.
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A business should always consider maintaining sufficient working
capital as per the needs of its activities. However, the amount of
working capital must neither be too much nor be too less. Excess
of working capital would imply idle funds that add to the cost of
capital without earning any profits for the business. On the other
hand, when working capital is inadequate, it reduces sales, thereby,
affecting the profitability of the business. The disadvantages of excessive working capital are discussed below:
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Excessive and Inadequate Working Capital
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1. Excessive working capital leads to the needless and redundant
collection of large inventory. Moreover, it also increases the
risks of theft, waste, and misuse.
2. Excessive working capital leads to the implementation of liberal credit policy, thereby, resulting in higher debts and higher
chances of bad debts.
3. These are idle funds to the business, adding to the firm’s cost
without earning any profits. This has a negative effect on the
firm’s profitability.
4. Due to the presence of excessive working capital, the management of the firm becomes carefree and careless, thereby, resulting in negligence in the control of cash and expenses.
Disadvantages of Inadequate Working Capital
1. If a firm has inadequate working capital, it has to face the problem of being unable to pay its creditors on time. This affects the
credit purchase of goods from the suppliers. Moreover, such a
firm is not availed any cash discount.
2. Due to the regular disruption in the process of acquiring raw
materials and scarcity of stock, the machines in the firm cannot
be used optimally, which in turn affect productivity.
3. Due to a lack of sufficient working capital, the machinery and
equipment are not maintained properly, thereby, resulting in a
halt in the production in several cases.
4. Due to inadequate working capital, a firm is usually not able to
pay the short-term dues within the stipulated time. This negatively affects the relationship of the firm with banks, creditors,
etc. It also creates a problem for the firm to arrange for funds
when in need.
Unit 21(a): Working Capital Management
Summary
Notes
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Working capital is the short-term investment that a business must
make to handle the daily operational expenses. Working capital can
be segregated as net working capital and gross working capital. They
can be classified based on financial reports and variability. Operating cycle is the duration between the acquisition of raw materials
and realization of cash is called the. Working capital is affected by
various other determinants.
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5. Due to inadequate working capital, the firm often fails to keep
adequate stock of final goods. This leads to a significant decrease in the sales of the firm. Moreover, the firm would also be
compelled to limit its credit sales.
Review Questions
1. Define working capital management.
2. Why is working capital management crucial to a business?
3. What do you mean by working capital deficit?
4. What are the stages involved in the working capital cycle?
5. Discuss the operating cycle.
6. What do you mean by the duration of operating cycle?
7. How can working capital be classified based on financial reports?
8. Distinguish between permanent and temporary working capital?
9. Explain any five determinants of the working capital of a firm.
(C
10. What are the various factors that would affect the working capital decisions of a fast food retailer?
11. Is it beneficial for a company to have adequate working capital?
Give reasons in support of your answer.
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Estimation and Calculation
of Working Capital
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Unit 21(b)
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Notes
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Objectives:
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After completion of this unit, the learners will be able to :
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Apply Procedures to Estimate Working Capital
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Define Working Capital as a ratio of Net Sales
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Describe Working Capital as a ratio of Total Assets
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Explain Working Capital Based on Operating Cycle
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Analyse the Requirement of Cash and Bank Balance, Inventories, and
Receivables
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Introduction
The efficiency of a firm’s planning and management is always subject
to the correct estimate of the working capital requirement. Hence,
the estimation procedures play a very important role.
Estimation Process
It is important that a firm estimates the net working capital in advance, to ensure smooth operations of the business. After this is
done, the net working capital can be categorised as temporary and
permanent working capital. This process helps in identifying the financing pattern and helps in ascertaining the amount of working
capital that needs to be financed from short-term sources and the
amount that needs to be financed from long-term sources.
Here are the different ways through which working capital requirements of a firm can be estimated:
(C
1. Working Capital as a Percentage of Net Sales: This approach is based on the assumption that a company’s working
capital requirements are proportional to the firm’s net sales
volumes. The estimation process consists of three steps:
llApproximating
total current assets as a percentage of projected
llApproximation
of the total liabilities as a percentage of project-
net sales
ed net sales
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2. Working Capital as a Percentage of Total Assets or Fixed
Assets: This approach works around the principle that working capital requirements are related to a firm’s total assets (including both current assets and fixed assets).
Another approach mentions the relationship of working capital
requirement with the total fixed assets. Both these approaches
are relatively simple but difficult to calculate. The main shortcoming of these approaches is that they require establishing
the relationship of current assets or total assets with the net
sales or fixed assets, which is quite difficult to calculate.
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llNet working capital will be the difference between both of them
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3. Working Capital based on Operating Cycle: The operating
cycle helps in determining the time scale over which the current assets are maintained. The operating cycle for different
components of working capital gives the time for which an asset is maintained.
According to this method, an analysis of different elements of
working capital is done, and subsequently a separate approximation is done for every single one of these components. These0
different components include:
Current Assets
llCash
llRaw
in Hand and at Bank
Material Inventory
llInventory
of Work-in-progress
llInventory
of Finished Goods
llReceivables
Current Liabilities
llCreditors
for Purchases
llCreditors
for Expenses
The different components of current assets require funds depending
upon the respective operating cycle and the cost involved. The current liabilities, on the other hand, provide finance depending upon
the respective operating cycle or the period of payment. The estimation of working capital can be made as follows:
Unit 21(b): Estimation and Calculation of Working Capital
Notes
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(b) Need for Raw Materials: Every manufacturing maintains an
inventory of raw materials to meet the needs of the production.
The numbers of units required of different materials depending
on various factors, such as raw materials consumption rate, the
time lag in procuring fresh stock, contingencies and other factors.
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(a) Need for Cash and Bank Balance: This is least productive
of all current assets; hence, a minimum balance must be maintained. It is also important as it provides liquidity to the firm,
which is of utmost importance to any firm.
(c) Need for Work-in-progress: In any manufacturing firm, the
production process is continuous and generally consists of several stages. At any particular time, there will be a different
number of units in different stages on completion. The value
of raw materials, wages and other expenses locked up in these
work-in-progress goods is the working capital requirement for
work-in-progress.
(d) Need for Finished Goods: In almost all the firms, the finished goods are not immediately sold after purchase/procurement/completion of the production process. The goods remain in
the storage house for some time before they are sold. The cost
that is incurred in procuring, producing or purchasing these
units is locked up and, hence, working capital is required for
them.
(e) Need for Receivables: The term receivables include the debtors and bills. When the goods are sold on a cash basis, the sales
revenue is realized immediately. When the sales are done on
credit basis there would be a time gap between completion of
sales and collection of the revenue.
Summary
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For the efficient functioning of a firm, it is important to have the
correct estimate of the working capital requirement. It is a must
for a firm to estimate in advance the net working capital that will
be required for smooth operations of the business. Once estimated,
it can be bifurcated into short term and fixed working capital. The
different ways of estimating working capital requirements are considering working capital as a percentage of net sales or a percentage
of total assets. These are based on the operating cycle.
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Notes
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1. Discuss the method of estimation of working capital requirements based on sales.
2. Explain the factors considered while determining the need for
working capital.
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Review Questions
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3. How can the value of work-in-progress be estimated? What are
the relevant factors?
4. The administration at Royal Industries has asked for a statement that shows working capital requirements necessary for
manufacturing 1,80,000 units every year. Following is the cost
structure for the company’s manufacturing for the above mentioned product:
Category
Cost per unit
Raw Materials
Rs. 20
Direct Labour
Rs. 5
Overheads (including depreciation of
Rs. 5 per unit)
Rs. 15
Profit
Rs. 10
Selling Price
Rs. 50
Additional information
(a) Expected cash balance is minimum Rs. 20,000
(b) Raw materials holding period is 2 months
(c) Work-in-progress (assume 50% completion stage) would be
equivalent to production during half a month
(d) Inventory holding period in the warehouse is a month
(e) Good are purchased on a month’s credit, sales are done on a
credit basis of two moths; Ou of total sales 25% are cash sales
(f) Payment of wages for a month observe a time lag, and in case
of overheads the lag is for a month and a half
From the above mentioned facts, prepare a statement showing
working capital requirements.
Receivables Management
Objectives:
Notes
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After completion of this unit, the students will be able to:
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Unit 22
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Explain the concept of accounts receivable.
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Describe the characteristics and types of accounts receivable.
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Discuss the concept of accounts receivable management.
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Discuss the objectives of accounts receivable management.
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Explain the cost and benefits of accounts receivable management.
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Describe the credit policies, credit terms, credit standards and credit
analysis.
Introduction
The term receivables refer to the debt owed to the company by customers that arise from the sale of goods and services in the normal
course of business.
Receivables management is also termed as trade credit management. This is because a company creates accounts receivable by
granting trade credit to be collected from its customers on a future
date. It can also be called as an extension of credit provided to its
customers, thereby, allowing them a rational time within which
they can pay their debts to the company for the goods they have
already received.
Characteristics of Accounts Receivables
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Knowing the significant features of accounts receivables will help
you in understanding and identifying a company’s accounts receivables. The major features of accounts receivable are as follows:
llThe
payments that arise from accounts receivable are fixed in
nature and are measurable.
llThe
period of maturity of accounts receivables may or may not
be fixed.
llSuch
trade usually does not occur in an active security market.
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Financial Management
Notes
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ables.
is a certain level of risk involved with accounts receiv-
llThe
holder of accounts receivables can considerably recuperate
all their investments made, excluding some credit ­deterioration.
llThe
concept of accounts receivables is based on fiscal value.
llThe
concept of accounts receivables implies futurity.
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llThere
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Classifications/Types of Accounts Receivable
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Accounts receivables are classified into two types:
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(i) Trade Receivables
(ii) Non-trade Receivables
Trade receivables refer to the claims arising from the sale of goods
and services in the regular course of business. It can also be said that
trade receivables are open accounts of the customers, in which the
customers buy goods but the business does not receive cash from the
customer for those goods. In such cases, cash is either not collected
or the services provided to customers are not yet billed. Examples of
trade receivables include accounts receivable and notes receivable.
Non-trade receivables refer to the claims arising from events that
do not include the sale of goods or services in the regular course of
business.
Examples of non-trade receivables include advances paid to employees or officers, claims against dealers or suppliers, rent deposit, dividends receivable and subscriptions receivable.
Accounts Receivables Management
Accounts receivables management is a result of taking effective
decisions that are related to the investment of the current assets
of a company, with the objective of maximizing the returns on investment in receivables. The primary objective of any commercial
business is to make profits. Credit is a significant tool to enhance
the sales of a company; however, it must be considered that sales
are profitable to the company. The process of granting credits to the
customers must not only focus on maximizing sales, but must also
lead to an increase in the overall return on investment. Therefore,
management of accounts receivables should consider the functioning of sound credit policies, procedures and practices.
Unit 22: Receivables Management
Notes
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As discussed earlier, accounts receivables are a marketing tool
that helps in the promotion of the sales of a business, thereby,
leading to profits. Thus, it can be said that the major purpose of
receivables is to maximize the amount of sales in a business. Many
successful businesses use accounts receivables to reduce the cost
of credit and lead to higher investments in receivables. Increasing
the credit sales is also an important part of accounts receivables
management. It covers various areas of an organization, including
credit analysis, credit terms, credit collection, and credit receivables as well as financing and monitoring of receivables. Moreover,
accounts receivables management concentrates on making optimum investment in sundry debtors and helps maintain effective
control of the cost of trade credit. It is also useful in the creation of
a balance between profitability of a business and the costs incurred
by the business.
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Objectives of Accounts Receivable Management
It can be summarized that the objective of accounts receivables management is to promote and contribute to the sales of an organization.
However, this is applicable only until it reaches a point where the
return on investment (ROI) in funding receivables in the future is
lesser than the cost of funds that are increased to finance the additional credit, which is the cost of capital. The costs and benefits
that play an important role in achieving the objectives of receivables
management are discussed below.
Costs Involved in Accounts Receivable Management
The main categories of costs that are related to the extension of credit and accounts receivables are as follows:
(i) Collection cost
(ii) Capital cost
(C
(iii) Delinquency cost
(iv) Default cost
Collection Cost
Collection costs are referred to all types of administrative costs that
are incurred in the collection of receivables from the customers who
owe debts to the business. Collection costs include the following:
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Financial Management
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(b) Expenses incurred in obtaining credit related information from
customers, either through external specialist groups or by the
company’s internal staff. However, such expenses are usually
not incurred when a company does not indulge in selling on
credit.
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(a) Additional expenses incurred in creating and maintaining a
credit division in a company, which includes employees, accounting records, stationery, etc.
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Capital Cost
An increase in the accounts level reflects an investment in acompany’s assets. These assets have to be financed, thereby, incurring
costs. Usually, a time lag exists between the time of sale of goods to
customers and time of payment made by the customers. However,
during this lag, the company has to remunerate its employees for
services rendered to the company. Similarly, the suppliers have to
be remunerated for the provision and regular flow of raw materials.
This implies that the company has to maintain additional funds to
meet their daily obligations, while waiting for their customers to
clear their dues.
Delinquency Cost
Delinquency costs refer to those costs that crop up when certain
customers fail to repay their debts or meet their obligations. These
costs arise when payment on credit sales granted by the company
is due, subsequent to the expiration of the credit period. Some of
the important components of delinquency costs include the following:
(i) Blocking-up of funds up to a future date
(ii) Cost associated with collection of dues, including reminders,
legal charges, etc.
Default Cost
Default costs refer to those costs that businesses are unable to recover from their customers. Sometimes, businesses are unable to
recuperate the dues due to the inability of their customers to do so.
These debts are recorded as bad debts and are written off, as they
cannot be realized on a future date. Default costs are usually related
to accounts receivables and credit sales.
Unit 22: Receivables Management
Notes
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Apart from the costs, the benefits are yet another feature having a
bearing on accounts receivables management. Benefits come from
credit sales. They refer to the rise in sales and expected profits due
to a more liberal policy. When a business allows trade credit, which
means when it invests in receivables, it aims to increase its sales. A
liberal trade credit policy influences a company in two ways. First,
benefits are sales-expansion oriented. This means a company may
allow a trade credit either to induce more sales to existing customers
or to attract new and prospective customers. The objective of investing in receivables is generally termed as growth oriented. Second,
the company may extend the credit facility to its customers to secure
their present sales against competitors. In this case, the primary
objective is sales retention. With the increase in sales, the profits of
a firm also increase.
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Benefits of Accounts Receivable Management
Thus, it can be said that investments made by a company in receivables
consider both cost and benefit. It is equally important to know that the
extension of trade credit highly influences the sales, profitability and
costs of a business. Moreover, a moderately liberal policy and higher
investments in receivables yields more sales. However, costs will increase with liberal policies as compared to more rigorous policies. Here,
you can conclude that accounts receivable management must seek for
a trade-off between cost and benefit. This summarizes that the decision
made toward the commitment to funds to receivables will depend on
the comparison of costs and benefits. Thus, this will help to determine
the maximum level of receivables. The costs and benefits that are taken into consideration for comparison are marginal costs and benefits.
The company must consider the additional costs and benefits that lead
to a change in the trade credit policy or receivables.
Credit Policies
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The objectives of a company are not merely related to the receivables
management, but are also involved in the immediate collection of
receivables. However, the company must simultaneously focus on
the benefit–cost trade-off involved in the different areas of accounts
receivable management. Credit policies are the firm’s decision area.
The credit policy of a firm acts as a framework to find out and assess
whether to extend credit to a customer and how much. There are two
broad dimensions of the credit policy decision taken by a firm:
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(ii) Credit standards
A company is required to set up and utilize credit standards while
making credit decisions or while developing suitable sources of credit information and techniques of credit analysis.
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(i) Credit analysis
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Credit Standards
Credit standards refer to the primary requisites to extend customer
credit. The various quantitative factors that help to establish credit
standards include a list of factors, such as financial ratios, credit
references, credit ratings and average payments period. For better
understanding, the overall standards are categorized as restrictive
and non-restrictive.
The trade-off in relation to credit standards includes the following:
(i) Collection cost
(ii) Average collection period
(iii) Level of bad debts
(iv) Level of sales
The critical changes and effects on the profits earned by a business
occur due to the reduction of credit standards. This is showed in
Table 22.1. It indicates that when the credit standards are tight,
the opposite effects would apply. The opposite are given in brackets.
Table 22.1: Effect of Standard’s Relaxation
Item
Increase (I) or
decrease (D) in
directions
Positive (+) or
negative (-) effect on
profits earned
Average collection period
I (D)
+ (−)
Sales volume
I (D)
− (+)
Bad debt
I (D)
− (+)
Example 22.1: A producer is selling an item at Rs 10 per unit. He
sold 30,000 units on credit during recent yearly sale. The average
cost per unit is Rs. 8, variable cost per unit is Rs 6 and the total fixed
cost is Rs 60,000. He has assumed the average time for collection as
30 days.
Unit 22: Receivables Management
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Notes
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The producer is considering a reduction in the credit standards,
which is anticipated to lead to an 15 % increase in unit sales. Without affecting the bad debt expenses, the average time for collection
is expected to increase to 45 days. The increase in sales would also
lead to an increased net working capital up to the limit of Rs 10,000.
The increase in expenses incurred in collection maybe considered
negligible. The required ROI is15 %.
Decide whether the credit standard must be relaxed.
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Solution: Calculation of Marginal Profits
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Table 22.2: Calculation of Marginal Profits
Particulars
Debit
Credit
A. Proposed Plan
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3,45,000
1. Sales Revenue (34,500 × Units Rs. 10)
2. Less: Costs
a. Variable cost (34,500 × Units Rs. 6)
2,07,000
b. Fixed
60,000
2,67,000
78,000
3. Profits from sales
B. Current Plan
3,00,000
1. Sales Revenue (30,000 × Units Rs. 10)
2. Less: Costs
a. Variable (30,000 × Rs. 6)
1,80,000
b. Fixed
60,000
2,40,000
3. Profits
60,000
C. Marginal Profits with New Plan
18,000
Credit Analysis
Apart from setting credit standards, a firm must find ways to evaluate credit applicants. Credit analysis is another aspect of credit
policies of a firm. The main steps of the credit analysis process are
categorized below:
(i) Obtaining credit information
(ii) Analysis of credit information
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The decision of granting credit to a consumer and the amount of
credit is decided using credit analysis.
Credit Terms
Credit term is another significant decisional area in receivables management. After the establishment of the credit and assessment of the
creditworthiness of the consumers, the business is required to find
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Financial Management
Notes
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(i) Credit period: Credit periods are the time for which trade
credit is provided and the period within which the customer
must repay the overdue amounts.
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out the various conditions based on which trade credit will be provided to the customers. The various terms and conditions introduced by
the business under which goods and services are sold to customers on
credit are called credit terms. It includes three major parts:
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(ii) Cash discount: Cash discount is an offer provided by the business to the customer under which the amount due by customer
to the business is reduced.
(iii) Cash discount period: It is time during which a discount is
availed.
Table 22.3 shows how an increase in cash discounts affects various
items:
Table 22.3: Increase in Cash Discounts
Item
Increase (I) or
decrease (D) in
directions
Positive (+) or negative
(-) effect on profits
earned
Average Collection Period
I
+
Sales Volume
D
+
Bad Debt Expenses
D
+
Profit Per Unit
D
−
Example 22.2 Consider a company, which is planning to announce
2% discount to customers, on terms that the overdue amount is paid
within 10 days of the credit purchase. If discounts were given, the
sales of the company would go up by 15 %. The average time of collection would reduce by 15 days. The ROI expected by the company
is 15 % and total sales that would be on discount are 60 %. Moreover, it will not affect the bad debt expenses of the company. Do you
think the company must execute the plan?
Solution: First, let us find the profit earned on sales by the ­company.
Profit earned = 45,000 (Rs. 10 – Rs. 6)
= 45,000 × Rs. 4
= Rs. 18,000
Now, after knowing the profit on sales made by the company, you find
the amount saved on average time for collection. Moreover, the additional investment in accounts receivables also needs to be deduced.
Unit 22: Receivables Management
(Rs. 8 × 30,000) + (Rs. 6 × 4,500)
=
360 ÷ 75
= Rs. 55,625
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Proposed plan =
Cost of Sales
Turnover of receivables
Notes
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Present plan =
(Rs. 8 × 30,000)
340 ÷ 75
Thus, the additional amount invested in accounts receivable will be,
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= Rs. 55,625 – 30,000
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= Rs. 25,625
Now, you must find the cost of additional investment made at 15%.
The additional bad debt expenses can be obtained by finding the difference between bad debts with respect to the proposed and present
plan.
æ Additional investment ö
ç
÷ = Rs. 55,625 - Rs.30, 000
è in accounts receivable ø
= Rs. 25, 625
The bad debt expense in relation to the present plan can be calculated as follows:
(Bad debt with present credit period) = 0.01 × 45,000
= Rs. 10,350
Additional bad debt expenses = Rs. 10,350 – Rs. 3,000
= Rs. 7,350
(C
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= 30,000
Therefore,
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Therefore, the additional cost connected to the credit period extension is Rs. 11,193.75(3,843.75 + 7,350). As per this, the benefit will
be Rs. 18,000.
The net profit will be Rs 6,806.25 (18,000 – 11,193.75). In this case,
the company must extend the period of credit from 30 to 60 days.
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Accounts receivables have a great role to play in the formation of
a company’s assets. The continuous growth in the credit sales, allowed by the companies to their customers, leads to the creation of
accounts receivables. Any credit sale is recorded in the account of
sundry debtors, also known as ‘Bills receivables’ or ‘Trade debtors’.
One of the most important forces that induces the growth and development of a modern-day business is trade credit. For most successful businesses, trade credit is the most effective marketing tool that
acts as a bridge between the producers and consumers. Credits are
granted by companies to protect and secure their sales from their
rivals and attract prospective customers. It is not possible for any
business to enhance their sales without using credit facility. The increase in sales further leads to an increase in the company’s profits.
However, any investment made on the accounts receivable by a company involves a huge amount of risks and incurs additional costs.
Hence, accounts receivables form an important aspect of a business,
due to which companies need to pay a lot of attention toward effective and efficient management of accounts receivables.
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Summary
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Review Questions
1. What is trade credit?
2. State the characteristics of accounts receivables.
3. What do you mean by accounts receivables management?
4. What are the different types of cost?
5. What do you mean by benefits and credit policies?
6. Distinguish between credit analysis and credit standards.
7. A change in credit policy has led to an increase in the sales of
a product. It also led to an increase in the discount given, a decrease in investment in accounts receivable and a decrease in
the doubtful accounts. What does this signify?
8. N.M.P. Corporation disclosed its latest annual report in millions as follows:
Unit 22: Receivables Management
2016
2017
Net sales
61,050
71,532
Net beginning accounts receivables
4,764
5,100
Net ending accounts receivables
3,100
4,600
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(a) Find the corporation’s accounts receivables turnover ratio for
the two years.
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Particulars
(b) Find the average collection period for the two years.
(C
(c) Is the corporation’s account receivables getting better or weakening?
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Inventory Management
Objectives:
Notes
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Post completion of this unit, learners shall be capable of:
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After completion of this unit, the students will be able to:
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Elaborate the concept of inventory management.
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Explain the components of inventory.
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Discuss the motives and objectives of inventory management.
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Discuss the techniques of inventory management.
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Discuss the objectives and functions of inventory control.
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Discuss the types of manufacturing inventories.
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Explain the costs incurred in maintaining inventory.
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Describe the factors affecting inventory management.
Introduction
Inventory management is defined as the sum total of the actions essential for the procurement, storing, clearance or usage of materials.
It is one of the key components of current assets and working capital
management, which plays an important role in the organization’s
smooth operation.
Efficient inventory management requires a substantial number of
assets. Inventory management is one of the challenging tasks of a finance manager. Efficient management of inventory reduces the cost
of production and, hence, increases the company’s profitability by
minimizing the overall cost of the firm.
Inventory
(C
The American Institute of Accountants defined the term ‘inventory’
as the collection of those items of tangible assets that
(a) Are held for sale in the ordinary course of business,
(b) Are in the production process or
(c) Are to be consumed currently for the production of goods or
­services.
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Financial Management
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Components of Inventory
The various forms of inventories that exist in a manufacturing business are raw materials, work-in-progress, finished goods, and stores
and spares. Figure 23.1 gives the list of components:
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For a business, inventories are the product stocks, which are manufactured for sale, and the raw materials used to manufacture those
products.
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Inventory
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Raw materials
Work-inprogress
Finished products
Stores and Spares
Figure 23.1: Components of Inventory
1. Raw Materials: Raw materials are those inputs from which
the finished product is manufactured through conversion process.
2. Work-in-progress: It is the stage between raw materials and
finished products.
3. Finished Products: When the product is completely manufactured and ready for sale, it is called a finished product.
4. Stores and Spares: It includes office and plant cleaning materials such as soap, brooms, oil, fuel, light bulbs, etc., which are
purchased by the firm and stored for the purpose of machinery
maintenance.
Inventory Management Motives
There are three main motives for holding inventories:
1. Transaction Motive: It includes goods production and goods
sale. It deals with the continuous production of goods as well as
delivery of goods at a given time.
2. Precautionary Motive: It deals with the holding of some
amount of inventory for the unexpected demand and supply
gap.
Unit 23: Inventory Management
Techniques of Inventory Management
Notes
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All types of organizations maintain inventory in one or the other
form:
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3. Speculative Motive: It deals with the holding of some amount
of inventory to take the advantage of price changes and getting
the discounts on quantity.
to Order (MTO): It allows customers to purchase products that are customized as per their specifications. The ‘MTO’
strategy increases the wait time for the customers, as the product will be manufactured only once the customer places the order.
llMake
llAssemble to Order (ATO): In this production strategy, the man-
ufactures keep the basic parts of the product ready beforehand.
The final product is quickly assembled or manufactured once
the customer places the order.
to Stock (MTS): It is a traditional business strategy
where the manufacture produces the products beforehand as
per the product’s demand forecasts.
llMake
Objectives of Inventory Control
The basic objective of inventory control is to keep overall investments at a minimum level. Moreover, inventory control should try to
ensure that items are available at right place and right time. Some
of the other objectives are mentioned below:
llTo
minimize waste and surplus
llTo
minimize holding and shortage cost
llTo
increase efficiency of production
(C
Functions of Inventory Control
There are many functions of inventory in a business. The primary
function is to use it in production to increase the profitability, that
is, to achieve maximum benefit out of investment cost. The key functions of inventory are as follows:
llIt
helps to achieve return on investment.
llIt
acts as safety stock for the business.
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Financial Management
Notes
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of operations: The inventory accumulated between two inter-dependent operations is to reduce the output
synchronization.
llDecoupling
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llIt
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llInventory
aid in smoothening the operations process.
dling cost.
helps the business to minimize the material han-
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Types of Manufacturing Inventories
Various stages of inventory constitute the manufacturing inventory
as a whole. The different types of manufacturing inventories are as
follows:
material: The raw materials constitute the materials
that are used in the manufacturing of the final product. Thus,
every company maintains some level of raw materials.
llRaw
inventory: The Work-in-progress inventory includes partially produced or partially completed products.
llWork-in-progress
material: These are products that are purchased or
manufactured by a firm. These are ready for sale and available
tithe customers for purchase.
llFinished
and consumables: These products are used during
the manufacturing process. An adequate amount of inventory
needs to be maintained for this so as the production process is
not delayed.
llSpares
Inventory Costs
Inventory costs include the following costs:
of procuring items: It is the basic expenditure that is
incurred in procuring the raw materials.
llCost
of carrying items in inventory: It is the maintenance
cost that is incurred while carrying items in inventory.
llCost
out cost: It is the cost associated with the opportunity
cost lost by exhaustion of inventory.
llStock
cost: The cost associated with the usage of procurement and usage of systems that are used to manage inventory.
llSystem
Unit 23: Inventory Management
As inventory management plays an important role in deciding the
firm’s business results, it is very important to learn about the factors
that affect inventory. The key factors that influence the inventory in
any business are mentioned below.
parameters: Various economic parameters affect
inventory. For example, the price of inventory, procurement
costs, carrying costs, shortage costs, etc.
Notes
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llEconomic
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Factors Affecting Inventory
If the demand for a product is more, the inventory
required will be more. This, in turn, will affect the inventory
management mechanisms.
llDemand:
cycle: It is the time gap between placing one set of
order and the next order.
llOrdering
time: It is the time that a supplier takes to deliver the
goods once an order is placed.
llLead
of supply echelons: Echelon inventory is the inventory between a stage in the supply chain and the final customer.
llNumber
of stages of inventory: It is the total number of
stages between the first stages of procurement of raw materials
to the final stage of delivering goods.
llNumber
Summary
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The nature of inventory is always dynamic. Inventory management calls for steady and rigorous assessment of external and internal factors. In any enterprise or company, all capabilities are
interlinked and related to each other and are often overlapping.
The major domains like inventory, supply chain management and
logistics act as the backbone of any business delivery chain. Therefore, these functions are extraordinarily vital to marketing and finance managers.
Inventory control is a vital feature that determines the efficiency of
the supply chain and its impacts on the financial position of the businesses. Every enterprise continuously looks to hold optimum level of
inventory so that they can meet the demand and tries to encounter
with situations like over or under inventory level, thereby improving
the financial figures.
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Notes
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1. What are the objectives of inventory management? Explain the
costs and benefits associated inventory management.
2. Explain the Economic Order Quantity model of inventory control. What are its shortcomings?
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Review Questions
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3. Discuss the techniques of inventory management.
4. What are the benefits from Inventory control?
5. XYZ and company buy a component for production at Rs. 10
per unit. The annual requirement is 2000 units, carrying cost
of inventory is 10% per annum and the ordering cost is Rs. 40
per order. Find the EOQ.
Cash Management
Objectives:
Notes
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At the completion of this unit, the students shall be able to understand and
explain:
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Unit 24
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The cash management concepts
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The aims of cash management
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The factors affecting cash requirements
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Role of planning, control and cash budget in cash management
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Planning
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Control
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Cash Budget
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Explain how to manage cash outflows and inflows
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Accelerate cash collections
Introduction
Cash is used as a medium to exchange goods and services and discharging the debts, and is one of the most important components
for a firm. It is used to run the business, manage the operations and
under working capital management cycle, management of cash is an
important area.
Efficient management of the inflow and the outflow of cash improves
the overall performance of the organization. Cash management
involves the proper balance between liquidity and profitability because the insufficient cash funds affect the production process while
an excess of cash does not mean higher profits.
Nature of Cash
(C
Cash is required to meet the regular operations of the business. In
cash management, the term cash is used in two diverse senses:
1. Narrow Sense: Narrow Sense considers cash as a currency,
and the other accepted equivalents are demand drafts, cheques
and demand deposits.
2. Broad Sense: Broad sense does not only include the components of narrow sense, but they also include cash assets, mar-
Financial Management
Notes
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Significance of Holding Cash
As every transaction results in either an inflow or outflow of cash in
an organization, cash becomes one of the key components. Some of
the motives of holding cash are discussed as follows:
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ketable securities and bank’s time deposits. These securities
can be conveniently converted into cash through sale.
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1. Transaction Motive: It is due to the need of keeping cash
for various expenses such as procurement of raw materials and
payment of business expenses, taxes, dividend, etc.
2. Precautionary Motive: Cash may be required by the Organizations for payment of unexpected expenses. Such short-notice unforeseen cash requirements may warrant firms to hold
cash.
3. Speculative Motive: Certain companies desire to hold cash
for speculative transactions such as purchase of raw materials at low prices or if the firm deals in bulk sale and purchase
of products according to the rates. Hence, organizations
having such speculative dealings may warrant additional
liquidity.
Objectives of Cash Management
An essential function of the financial manager requires maintenance of ideal cash balances. Ideal level of cash means that it is neither surplus nor insufficient. In other words, upkeep of cash reserve
holding additional cash should meet the requirements while not
having excess cash that will remain idle. From this, we can analyse
the objectives of cash management as follows:
1. Meeting needs of cash payment
2. Maintaining a minimum cash balance
Aspects of Cash Management
The aspects of cash management can be examined under three
heads:
1. Cash inflows and outflows,
2. Cash flow within the organization
3. Cash in Hand
Unit 24: Cash Management
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Notes
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Surplus cash arises when the cash inflows exceed cash outflows. On
the other hand, the deficiency will arise when the cash inflows are
less than the cash outflows. The balance of cash is known as synchronization. The organization should look into various factors to resolve the uncertainties involved in cash flow predictions and create
a balance between cash receipts and payments.
Factors Determining Cash Requirements
As discussed, an organization has to decide the cash balance based
on their needs, which is determined after taking into consideration
the following factors:
of the business: This involves the type of activities
performed by the business. A firm having short operating cycle
will have a requirement for less cash, while a giant manufacturer would need substantial cash.
llNature
of operations: Businesses that have significant
seasonality in their activities have fluctuating requirements for
cash. A ceiling manufacturer would need a lot of cash during
peak summer season and less during the winter.
llSeasonality
policy: A firm having seasonal fluctuations in its
sales will have significant variations in their requirement for
cash.
llProduction
conditions: The requirement for cash is also affected
by the degree of competition in the market. A firm would need a
lot of cash to meet demand when competition is high. The case
would be the opposite when competition is low.
llMarket
Role of Planning, Control and Cash Budget in Cash
Management
Cash Planning or Cash Budget
(C
One of the main finance functions is cash planning and control of
cash. One of the key responsibilities of a finance manager is maintenance of adequate cash which can be realised only through methodical cash planning.
Cash planning involves planning and controlling the cash usage. A
projected cash flow statement which has been readied on the basis of expected receipts of cash and payments provides an insight
into financial condition of an organization’s. Cash planning can be
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Cash Forecasting and Budgeting
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Because Cash forecast deals with approximation of cash flows, it is
employed as a technique to predict future cash flows at dissimilar
stages. It also provides the management with information to enable
timely and necessary actions.
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done as per the policy of the company on the daily, weekly, monthly
or quarterly basis, for example big organizations opt for daily and
weekly forecasts whereas medium size organizations create weekly
and monthly forecasts.
Notes
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For maintenance of the cash flow in any organization, a cash budget
is a crucial tool. In simpler words, it presents approximated inflows
and outflows of cash during a planning period in a statement form.
The cash budget is also known as short-term cash forecasting since
it highlights the surplus or deficit cash in an organization.
Purpose of Cash Budget
1. Cash requirement approximation
2. Finance planning for short-term
3. For acquisition of capital goods, scheduling payments.
4. Procurement of raw materials in a planned manner
5. Credit policy evolution and implementation
6. Long-term cash forecasting’s accuracy verification
Preparation of Cash Budget or Elements of Cash Budget
The main purpose of cash budget preparation is estimation of cash
surplus or deficit on basis of estimated cash flows during a given
period and consists of following steps:
Step 1: Period Selection
The planning horizon is the period for which the cash budget is prepared and may differ for different organizations. The cash budget
period is defined based on the organization’s size. It is determined
by the requirement of a specific case. Monthly cash budgets are prepared by organizations facing seasonal variations in its business. If
there are fluctuations in cash flow, preparation of daily or weekly
cash budgets shall be pursued. If the cash flows are stable in nature,
longer period cash budgets may be used.
Unit 24: Cash Management
Factors affecting cash flows are separated into two major categories:
(a) operating cash flows and (b) financial cash flows.
Notes
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Operating Cash Flows: Operating cash inflows are cash sales, a collection of accounts receivables and disposal of fixed assets. Whereas,
the operating cash outflows are billed payables, procurement of raw
materials, wages, factory expenses, administrative expenses, maintenance expenses and procurement of fixed assets.
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Step 2: Selection of factors that affect cash flows
Financial Cash Flows: Financial cash inflows are loans and borrowings, the sale of securities, dividends received, refund of taxes, rent
received, interests received and issue of new shares and debentures.
On the other hand, cash outflows include redemption of loans, procurement of shares, income tax payments, interests paid and dividends paid.
Selection of time
period
Selection of
factors that
affect cash flows
Figure 24.1: Preparation of Cash Budget
Controlling Cash Flows
After estimation of cash flows, the financial manager must ensure
that there is not any significant deviation between the actual cash
flows and the projected cash flows.
(C
That financial manager will have control over the collection of cash
receipts and cash disbursements. Both collection and disbursement
have a combined impact on cash management’s overall proficiency.
The idea is to speed up a collection of accounts receivables so that
the organization can use the money. In contrast, organizations want
to delay accounts payables without affecting their credit standing
with suppliers.
Hence, to maintain effective cash management, a firm needs to
(A) collect accounts receivables as early as possible and
(B) Delay the accounts payables without affecting their credit
standing.
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Notes
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Accelerating cash collection will increase the cash availability and
reduce the company’s dependency on borrowings. Systematic planning can be involved to accelerate cash inflow process. Here are the
methods which can be used to accelerate cash collections:
1. Prompt Payment of Customers: Prompt payment by customers will be possible by prompt billing. The seller needs to inform the customers in advance about the amount and period of
payment. Automation of billing and enclosure of self-addressed
envelope will be helpful for quick payment of cash.
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Accelerating Cash Collections
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2. Early Conversion of Payments into Cash: The process of
conversion of cheques into cash should be faster. The time lag
between when the cheque is prepared by a customer and is
credited to the organization’s account should be minimized. It
is also known as cash cycle. The time taken to convert raw materials into cash is called cash cycle.
There are three steps involved in the cash cycle:
(i) Mailing Time: in known as “Postal Float” and signifies the
time taken to transfer the cheques from the customer to the
organization.
(ii) Lethargy: The time taken between sending the cheques to
bank and processing inside the business.
(iii) Bank Float: Collection within the bank or the time taken
by the bank in collecting the payment from the customer’s
bank.
The postal float, lethargy and bank float are collectively known as
‘deposit float.’ Faster collection of cash is possible when an organization reduces the transit, lethargy and bank float.
Summary
One of the critical areas of the working capital management cycle
is cash management. It is the most liquid asset as well as the basic
input required for continuous operation of a business. The aspects of
cash management can be examined under three heads: cash inflows
and outflows, cash flow within the organization and cash balances held at the point of time. Cash planning provides a system for
Unit 24: Cash Management
Review Questions
Notes
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1. What are the objectives of cash management? Explain the factors affecting the cash needs of a firm.
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planning the usage of cash. A cash budget is an important tool for
the maintenance of the cash flow in any organization over a period.
Cash budget is prepared to estimate cash flows during a period and
establish the likelihood of surplus or deficit.
2. It has been observed in your organization that a substantial
cash surplus is available for a short period that is not utilized
properly to generate maximum yield. How would you plan for
short-term investment of funds?
3. ‘Cash Budget is an important technique for cash management.’
Explain the statement. What are the different methods of preparing the cash budget?
4. What are the reasons for uncertainty in cash budget and how
can these be handled?
(C
5. Explain the statement ‘Cash Management always attempts at
minimizing cash balances.’
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Case Study: Inventory
Management by Tulips Ltd
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Tulips Ltd. manufactures and sells air purifiers in India. It is one
of the foremost manufacturers of air purifiers in the country. Air
purifiers remove impurities from the air and make it clean. It electronically removes impurities such as smoke, dust particles, pollen,
and other airborne irritants.
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An air purifier comprises an outer plastic body, three filters made
of different materials that trap air impurities and a motor that intakes air and releases purified air.
As the company manufactures air purifiers, it is considering the
option of purchasing motor parts from a supplier. The supplier will
deliver the components in the required quantities at Rs. 9 per unit.
Assume that the transportation and storage cost is negligible. The
company has been manufacturing the component from a single raw
material in cost saving lots of 2,000 units at the cost of Rs. 2 per
unit.
– The demand is 20,000 units per year
– Holding cost is Re 0.25 per unit per annum
– Lowest stock level is 400 units.
– Direct labor cost is Rs. 6 per unit
– Fixed manufacturing overheads are Rs. 3 per unit based production of 20,000 units.
– Cost of Hiring machine is Rs. 200 per month.
– The company also avails services of an analyst to provide the
best alternative so that the total inventory cost is reduced.
(C
– Analyse the above inventory problem and state whether the
company should purchase or produce the motor part.
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