Module 1
Cost of Capital
Structure:
1.1 Introduction and Meaning
1.2. Meaning & Definition
1.3 Significance of Cost of Capital
1.4 Types of Cost of Capital
1.5 Factors Affecting Cost of Capital
1.6 Measurement of Cost of Capital
1.6.1 Cost of Debt Capital
1.6.2. Cost of Preference Capital
1.6.3 Cost of Equity
1.6.4 Cost of Retained Earnings
1.7 Computation of Overall Cost of Capital or Weighted Average Cost of Capital
1.8 Mechanics of Computation (Based on Book Value & Market Value Weights)
1.9 Terminal Questions
1.1 Introduction and Meaning:
A firm may employ capital in the form of debt, preference capital, equity shares or retained
earnings. Cost will be incurred in raising any form of capital. The cost of capital of a firm is the
minimum rate of return expected by its investors.
1.2. Meaning & Definition:
Cost of capital for a firm may be defined as the cost of raising funds, i.e., the average rate of
return that the investors in firm would expect for supplying funds of the firm. Generally, higher
the risk involved in a firm, higher is the cost of capital.
“The rate of return the firm requires from investment in order to increase the value of the firm
in the market place” – Hampton, John J.
1.3 Significance of Cost of capital:
The concept of cost of capital is very important in the financial management. It plays a crucial
role in both capital budgeting as well as decisions relating to planning of capital structure. Cost of
capital concept can also be used as a basis for evaluating the performance of a firm and it further
helps management in taking so many other financial decisions.
1.4 Types of Cost of Capital:
A firm might have raised funds from various sources. Only long-term sources are taken into
consideration and they have their own specific costs. The combined cost is, in fact, known as the
overall cost of capital. The cost of capital of a firm can also be analyzed as explicit and implicit
cost of capital.
1.5 Factors affecting Cost of Capital:
Several factors like risk free interest rate, business risk, financial risk, liquidity or marketability of
the investment etc. can make cost of capital of a firm high or low.
1.6 Measurement of Cost of Capital:
Measurement of cost of capital refers to the process of determining the cost of funds to the
firm. Once the cost (specific & overall) has been determined, it is in the light of this cost that
capital budgeting proposal will be evaluated.
1.6.1 Cost of debt capital:
The cost of debt is the rate of interest payable on debt. E.g., a company issues Rs. 1,00,000, 10%
debentures at par; the before-tax cost of this debt will also be 10%.
[i] Cost of Irredeemable debt:
The before tax cost is,
Kdb = I/P
Where, Kdb= before tax cost of debt
I = Interest
P = Principal
In case debt is raised at premium or discount, P should be considered as the net proceeds
received from the issue of debentures and not the face value of securities.
Kdb = I/NP [where, NP=Net Proceeds]
When debt is used as a source of finance, the firm saves a considerable amount in payment of
tax as interest is allowed as a deductible expense in computation of tax. Therefore, the effective
cost of debt is reduced and may be calculated as follows:
Kda = Kdb (1-t)
= I/NP (1-t)
Where, Kda = after tax cost of debt
T =tax
Illustration 1:
a) X Ltd. issues Rs. 50,000 *% debentures at par. The tax rate applicable to the company is 50%.
Compute the cost of debt capital.
Solution:
We have computed the after-tax cost of debt as the firm saves on account of tax by using debt as
a source of finance.
I
1  t .
K da 
NP
4,000
a)
1  0.5

50,000
4,000

 0.5  4%
50,000
[ii] Cost of redeemable debt: Debt, which will be redeemed after a certain period during the life
time of a company, is known as redeemable debt.
The before-tax cost of redeemable debt is,
I  1/n {RV - NP}
Kbd =
1/2(RV  NP)
I = Annual Interest
n = No. of years in which debt is to be redeemed
RV= Redeemable value of debt
NP= Net proceeds of debentures
The after-tax cost of redeemable debt,
I (1 - t )  1/n { R V - N P }
Kda =
1/2( R V  N P )
I = Annual Interest
t= Tax rate
n = No. of years in which debt is to be redeemed
RV= Redeemable value of debt
NP= Net proceeds of debentures
Illustration 2:
A company issues Rs. 10,00,000 10% redeemable debentures at a discount of 5%. The costs of
flotation amount to Rs. 30,000. The debentures are redeemable after 5 years. Calculate beforetax and after-tax cost of debt assuming a tax rate of 50%.
Solution:
(i) Before – tax cost of redeemable debt
K db 
I
1
RV  NP
n
1
RV  NP
2
1
1,00,000  10,00,000  9,20,000 
5

1
10,00,000  9,20,000
2
[NP = Rs. 10,00,000-50,000 (discount) – 30,000 costs of flotation]

1,00,000  16,000 1,16,000

 12.08%
9,60,000
9,60,000
(ii) After-tax cost of redeemable debt,
K da 
I(1  t) 
1
(RV  NP)
n
1
(RV  NP)
2
1
1,00,000(1  0.5)  (10,00,000  9,20,000)
5

1
(10,00,000  9,20,000)
2
50,000  16,000
66,000


 6.875%
9,60,000
9,60,000
1.6.2. Cost of Preference Capital:
A fixed rate of dividend is payable on preference shares. In case dividends are not paid, it will
affect the fund-raising capacity of the firm. Hence, dividends are usually paid, except when there
are no profits available to pay the same.
Kp = D/P
Where, Kp = Cost of preference capital
D = Annual preference dividend
P = Preference share capital proceeds
If they are issued at premium or discount, or when costs of floatation are incurred, the nominal
or par value of preference capital has to be adjusted to find out the net proceeds from the issue
of preference shares.
Kp = D/NP
[Note: Preference dividends are not allowed to be adjusted for computation of tax and
therefore, no adjustment for taxes is required]
Illustration 3:
A company issues 10,000 10% Preference Shares of Rs. 100 each. Cost of issue is Rs. 2 Per share.
Calculate cost of preference capital if these shares are issued (a) at par.
Solution:
D
NP
1,00,000
1,00,000
a) K p 
 100 
 100  10.2%
10,00,000  20,000
9,80,000
Cost of Preference Capital, K p 
When redeemable preference shares are issued, they have to be redeemed on a maturity date.
In such a case,
MV - NP
D
n
K pr 
1
(M V  N P)
2
Where, Kpr = cost of redeemable preference shares
D = Annual preference dividend
MV=Maturity value of preference shares
NP = Net proceeds of preference shares
Illustration 4:
A company issues 10,000 10% Preference Shares of Rs. 100 each redeemable after 10 years at a
premium of 5%. The cost of issue is Rs. 2 per share. Calculate the cost of preference capital.
Solution:
K pr 
D
M V  NP
n
 100
1
(M V  NP)
2
1
1,00,000  10,50,000  9,80,000 
10

 100
1
(10,50,000  9,80,000
2
1,00,000  7,000

 100
10,15,000
1,07,000

 100  10.54%
10,15,000
1.6.3 Cost of Equity
It is the ‘maximum rate of return that the company must earn on equity share capital, in order to
leave unchanged, the market price of its stocks.
The cost of equity share capital can be calculated in the following ways:
(a)Dividend Yield Method or Dividend/Price Ratio Method: According to this, the cost of equity
capital is the ‘discount rate that equates the present value of expected future dividends per
share with the net proceed [or current market price] of a share’. Symbolically,
D
D
K 

e NP MP
Where, 𝐾𝑒 = Cost of equity capital
D = Expected dividend per share
NP = Net proceeds per share
MP = Market price per share.
This method of computing cost of equity capital is suitable only when the company has stable
earnings and stable dividend policy over a period of time.
Illustration 5:
A company issues 1000 equity shares of Rs. 100 each at a premium of 10%. The company has
been paying 20% dividend to equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs.160?
Solution:
Ke 

D
NP
20
 100  18.18%
110
If the market price of an equity share is Rs. 160
Ke 

D
MP
20
 100  12.5%
160
(b)Dividend Yield Plus Growth Method: When the dividends of a firm are expected to grow at a
constant rate and the dividend-pay-out ratio is constant, this method may be used to compute
the cost of equity capital.
D (1 g )
D
K  1 G  0
 G
e NP
NP
Where, 𝐾𝑒 = Cost of Equity capital
D1 = Expected dividend per share at the end of the year
NP = Net proceeds per share
G = Rate of growth in dividend
Do = Previous year’s dividend
In case, cost of existing equity share capital is to be calculated, the NP should be changed with
MP (market price per share) in the above equation.
Illustration 6:
a) A company plans to issue 1000 new shares of Rs. 100 each at par. The floatation costs are
expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially
and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity
shares.
b) If the current market price of an equity share is Rs. 150, calculate the cost of existing equity
share capital.
Solution:
D1
G
MP
10

 5%  15.53%
100 - 5
Ke 
a)
D1
G
MP
10

 5%  15.53%
100 - 5
Ke 
b)
Earnings – Price Ratio & Cost of Equity
When the earnings of the firm are stable or when there is an expansion situation, the cost of
equity can be determined by:
K 𝑒 = EPS/ Po
Po =Current market value of the share
EPS= Earnings per share
Illustration 7:
A firm is considering an expenditure of Rs. 60 lakhs for expanding its operations. The relevant
information is as follows:
Rs.
Number of existing equity shares
10 lakhs
Market value of existing share
60
Net earnings
90 lakhs
Compute the cost of existing equity share capital and of new equity capital assuming that newshares will be issued at a price of Rs. 52 per share and the costs of new issue will be Rs. 2 per
share.
Solution:
Cost of existing equity share capital:
Ke 
EPS
MP
EPS, or Earnings Per Share  Rs.
Ke 
9
 100  15%
60
90,00,000
 Rs.9
10,00,000
Cost of New Equity Capital:
Ke 

EPS
NP
9
9
 100 
 100  18%
52 - 2
50
1.6.4 Cost of Retained Earnings:
Retained earnings do not involve any cost because a firm is not required to pay dividends on
them. However, shareholders expect return on retained profit, as they are the result of some
sacrifice made by shareholders in not receiving the dividends out of the available profits.
D1
D1
 G 
 G
NP
MP
Where, Kr = Cost of retained earnings
D = Expected dividends at the end of the year.
NP = Net proceeds of the share issue
G = Growth
MP = Market Price per share.
Kr 
To make adjustment in the cost of retained earnings for tax and costs of purchasing new
securities, the following formula can be used:
Kr = [D/NP + G] × [1-t] × [1-b]
Or,
Kr = 𝐊 𝒆 [1-t] [1-b]
Where, Kr = Cost of retained earnings
D = Expected dividends at the end of the year.
NP = Net proceeds of the share issue
G = Growth
t = Tax rate
b = Cost of purchasing new securities or brokerage costs
K 𝑒 = Rate of return available to equity shareholders.
Illustration 8:
A firm’s K e (return available to shareholders) is 15%, the average tax rate of shareholders is
40% and it is expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of retained earnings?
Solution:
Cost of Retained Earnings,
K r  K e (1  t)(1  b)
where, K e  Rate of return available to shareholders
So,
t  Tax rate
b  Brokerage cost
K r  15%(1  .4)(1  .02)
 15%  0.6  0.98  8.82%
1.7 Computation of Overall Cost of capital or Weighted Average Cost of Capital:
It is the average cost of the costs of the various sources of financing. It is also known as
composite cost of capital, overall cost of capital or average cost of capital.
The formula to calculate WACC is as follows:
Where, K 𝑊 = weighted average cost of capital
X = cost of specific source of capital
W = weight, proportion of the specific source of capital
1.8 Mechanics of Computation (Based on Book Value & Market Value Weights):
In order to calculate the WACC, there must be a system of assigning weights to different specific
cost of capital. The weights may be given either by using book value of the source or market
value of the source.
Illustration 9:
A firm has the following capital structure and after-tax costs for the different sources of funds
used:
Sources of Funds
Amount
Proportion
After-tax cost
Rs.
%
Debt
15,00,000
25
5
Preference shares
12,00,000
20
10
Equity Shares
18,00,000
30
12
Retained Earnings
15,00,000
25
Total
60,00,000
100
11
You are required to compute the weighted average cost of capital.
Solution:
Computation of Weighted Average Cost of Capital
Sources of Funds
Proportion
Cost
%
%
(W)
(X)
Debt
25
5
1.25
Preference shares
20
10
2.00
Equity shares
30
12
3.60
Retained Earnings
25
11
2.75
Weighted Average Cost of Capital
Weighted Cost %
Proportion x Cost
(XW)%
9.60%
1.9 Terminal Questions:
Self-Assessment Questions
State whether the following are true or false:
1. If preference shares are issued at premium or discount, or when costs of floatation are
incurred, the nominal or par value of preference capital need not be adjusted to find out the net
proceeds from the issue of preference shares.
2. Cost of equity capital is the ‘maximum rate of return that the company must earn on equity
share capital’.
3. Market price of shares refers to the value at which a company’s share can be purchased or
sold in the market.
4. Retained earnings result due to sacrifice of dividend made by shareholders.
5. The weights used to compute WACC may be given only by using book value of the source and
not market value of the source.
6. The cost of capital of a firm is the minimum rate of return expected by its investors.
7. As there is no legal binding on the part of the firm to pay dividends to equity shareholders,
equity capital can be called as cost-free.
8. Since tax deduction is allowed on interest payable on debt capital, cost of debt is reduced to
that extent.
9. Debt can also be issued at premium or discount.
10. Floatation costs refer to additional interest paid by the debenture holders.
Section A - 2 Marks questions
1. B ltd. issues Rs. 1,00,000 9% debentures at a premium of 10%. The costs of floatation are 2%.
The tax rate applicable is 60%. Compute cost of debt capital.
2. A 5-year Rs. 100 debentures of a firm can be sold for a net price of Rs. 96.50. The coupon rate
of interest is 14% p. a., and the debenture will be redeemed at 5% premium on maturity. The
firm’s tax rate is 40%. Compute the after-tax cost of debt.
3. Assuming that a firm pays tax at 50% rate, compute the after-tax cost of debt capital in the
following cases: [2 marks for each sub question]
[i] a perpetual bond sold at par, coupon rate of interest being 7%
[ii] a 10 year, 8% Rs. 1,000 per bond sold at Rs. 950 less 4% underwriting commission.
[iii] a 6 year, 9% Rs. 500 per bond sold at Rs. 480.
4. What is cost of capital?
5. What is specific and overall cost of capital?
6. What is explicit and implicit cost of capital?
7. Calculate the price of the equity share from the following data: Po=100, EPS= 20.
Section B - 4 Marks Questions
1. Briefly discuss the importance of cost of capital.
2. What are the advantages and disadvantages of market value weights?
3. Write short notes on:
[a] Implicit cost of capital
[b] Book value weights
4. Cost of preference capital is generally lower than cost of equity capital. Explain why.
5. A co. issues 20,000 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2/share.
Calculate cost of preference capital if these shares are issued
(a) At par (b) At 5% premium (c) discount of 5%.
6. Jeo star ltd. issues 30,000 10% preference shares of Rs. 100 each redeemable after 8 years at
a premium of 10%. The cost of issue is Rs. 2 per share. Calculate cost of preference capital.
7. SMS ltd. issues 1,000 7% preference shares of Rs. 100 each at a premium of 10% redeemable
after 5 years at par. Calculate cost of preference capital.
8. A Co. issues 2,000 equity shares of Rs. 100 each at a premium of 5%. The company has been
paying 20% dividend to the equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs.180.
9. A company plans to issue 2,000 new equity shares of Rs. 100 each at par. The floatation costs
are expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share
initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of
equity shares.
a) If the current market price of an equity share is Rs. 130, calculate the cost of existing equity
share capital
10. The shares of a company are selling at Rs. 50/share and it had paid a dividend of Rs. 5 per
share last year. The investor’s market expects a growth rate of 5% per year.
(a)Compute the company’s equity cost of capital (b) If the anticipated growth rate is 8% p. a.,
calculate the indicated market price per share.
11. A firm’s K 𝑒 [return available to equity shareholders] is 18%, the average tax rate of
shareholders is 45% and it is expected that 2% is brokerage cost that the shareholders will have
to pay while investing their dividends in alternative securities. What is the cost of retained
earnings?
12. Excellent fans Ltd., needs Rs. 5,00,000 for the expansion of its activities and it is expected to
earn a rate of return of 10% on its investment. The management of the company is considering
to finance this amount by retained profits which otherwise shall be distributed to the
shareholders. The shareholders, on an average, are in 60% tax-bracket. If the shareholders
reinvest their dividends, they will earn 12% on new investment but have to incur a 2% brokerage
cost on the purchase of new securities. What is your recommendation to the management
keeping in view the shareholders?
Section C - 10 Marks Questions
1. Irony Ltd. has the following capital structure and after-tax costs for the different sources of
funds used:
Source of funds
Amount
Proportion %
After-tax cost %
Debt
17,00,000
20
6
Preference sh.
11,00,000
25
10
Equity shares
17,00,000
25
11
Retained earnings 15,00,000
30
12
Total
60,00,000
100
You are required to compute the weighted average cost of capital.
2. In considering the most desirable capital structure for a company, the following estimates of
the debt-equity (after-tax) have been made at various levels of debt-equity mix:
Debt as a percentage
Cost of debt
Cost of equity
Of total capital employed
(%)
(%)
0
5.00
12.00
10
5.00
12.00
20
5.00
12.50
30
5.50
13.00
40
6.00
14.00
50
6.50
16.00
60
7.00
20.00
You are required to determine the optimal debt equity mix for the company by calculating
composite cost of capital.
3. The following items have been extracted from the ‘Liabilites’ side of the balance sheet of XYZ
company as on 31st December 2005:
Paid up capital:
Rs.
4, 00,000 equity shares of Rs. 10 each
40 lakhs
Reserves and surplus
60 lakhs
Loans:
15% non-convertible debentures
20 lakhs
14% institutional loans
60 lakhs
Other information about the company is as follows:
Year ended 31.12
Dividend /share
Earnings/ Share
Ave. MP/share
2005
4.00
7.50
50.00
2006
3.00
6.00
40.00
2007
4.00
4.50
30.00
You are required to calculate the weighted average cost of capital, using book values as weights
and earnings/price [E/P] ratio as the basis of cost of equity. Assume 50% tax rate.
4. The following information is available for Cowboy Synergy Ltd.
Source
Amount (Rs.)
Specific
C/C
Equity Share Capital [2,00,000 shares of Rs. 10 each]
20,00,000
Preference share capital [50,000 shares of Rs. 10 each]
5,00,000
11%
8%
Retained earnings
10,00,000
7.5% Debentures of Rs. 1,000 each
15,00,000
11%
4.5%
Presently, the debentures are being traded at 94%, preference shares at par and the equity
shares at Rs. 13 per share. Find out the WACC based on book weights and market value weights.
5. Debt is the cheapest source of finance available to an organization. Critically analyze this
statement comparing debt to other sources of capital.
6. Write short notes on:
a. Redeemable and irredeemable debt
b. Retained Earnings
c. Costs of Floatation.
7. The cost of equity capital is the maximum rate of return expected by its shareholders. Justify
this statement by explaining at least two different methods of computing cost of equity capital.
8. Write short notes on:
a. implicit and explicit cost
b. market weights
c. dividend yield plus growth method
9. Explain in detail the various facets of computing cost of debt capital. Is it true that cost of debt
is affected by the tax paid by the organization? If yes, justify your answer with the right
arguments.
10. ABC ltd. has the following capital structure:
Book Value
Market Value
Equity capital (25,000 shares Rs.2,50,000
of Rs.10 each)
Rs.4,50,000
13% Preference capital (500 Rs.50,000
shares of Rs.100 each)
Rs.45,000
Reserves & Surplus
-
Rs.1,50,000
12%
Debentures
(1500 Rs.1,50,000
debentures of Rs.100 each)
Rs.1,45,000
Total
6,40,000
6,00,000
The expected dividend per share is Rs.1.40 and the dividend per share is expected to grow at a
rate of 8% forever. Preference shares are redeemable after 5 years at par whereas debentures
are redeemable after 6 years at par. The tax rate for the company is 40%. You are required to
compute the weighted average cost of capital for the existing capital structure using market
value as weights.
11. A limited has the following capital structure.
Equity share capital (2,00,000 shares)
6% Preference shares
Rs.40,00,000
Rs.10,00,000
8% Debentures
Rs.30,00,000
Total
Rs.80,00,000
The market price of the company’s equity share is Rs.20. It is expected that the company will pay
a dividend of Rs.2 per share at the end of the current year, which will grow at 7% forever. The
tax rate is 30%. You are required to compute the following:
(a) The WACC based on the existing capital structure.
(b) The new WACC if the company raises an additional Rs.20,00,000 debt by issuing 10%
debentures. This would result in increasing the expected dividend to Rs.3 and leave the
growth rate unchanged but the price of share will fall to Rs.15 per share.
(c) The cost of capital if in (b) above, growth rate increases to 10%.
12. The excerpts from the balance sheet of B Ltd. Is given below:
(Rs.’000)
Equity shares (50,000)
500
Share premium
100
Retained profits
600
8% preference capital
400
13% perpetual debt (face value of 600
Rs.100)
The ordinary shares are currently priced at Rs.39ex dividend and Rs.25 preference share priced
at Rs.18cum – dividend. The debentures are selling at 110% ex interest and tax is paid by B Ltd at
40%. B Ltd.’s cost of equity is estimated at 19%.
Calculate the WACC based on market value.
Module – 2
Cash Flows and Risk Analysis
Structure:
2.1 Introduction to Cash Flow
2.2. Cash Flows versus Accounting Profit
2.3 Components of Cash flows
2.3.1 Original or Initial Cash Outflow /Initial Investment
2.3.2 Subsequent Inflows and Outflows
2.3.3 Terminal Cash Inflows
2.4 Basic Principles of Cash Flow Estimation
2.4.1 Separation Principle
2.4.2 Incremental Principle
2.4.3 Post Tax Principle
2.4.4 Consistency Principle
2.5 Introduction to Risk analysis in Capital Budgeting
2.6 Sources/Causes of Risk & Types
2.7 Conventional Techniques of Risk Analysis
2.7.1 Risk Adjusted Discounted Rate
2.7.2 Certainty Equivalents (CE)
2.7.3 Sensitivity Analysis
2.8 Statistical Techniques
2.8.1Probability
2.8.2 Standard Deviation: An Absolute Measure of Risk and Variability
2.8.3 Coefficient of Variation: A Relative Measure of Risk
2.8.4 Decision Tree Approach
2.9 Terminal Questions
2.1 Introduction to cash flows:
Capital Budgeting decisions are related to the allocation of investible funds to different longterm assets. The basic objective of FM is to maximize the wealth of the shareholders; therefore,
the objective of Capital Budgeting is to select those long-term investment projects that are
expected to make maximum contribution to the wealth of the shareholders in the long run. The
first step is estimation or determination of cash flows. If a firm makes an investment today, it will
require an immediate cash outlay, but the benefits of this investment will be received in future.
Thus, it will have an effect on future cashflows over the life of the asset. While taking such
financial decision, the firm has to compare the total inflows with the total of cash outflows from
the investment.
Estimation of Costs & Benefits of a proposal:
First step required is the estimation of costs and benefits of different proposals being considered
for decision making.
Concepts & Components of cash flows:
In the capital budgeting procedure, the estimation of cost and benefits of different proposals
being considered for decision making is the first step.
How to Measure the Costs & Benefits of a Proposal?
Usually two alternatives are suggested:  Accounting Profit.
 Cash Flows
The term Accounting profit refers to the figure of profit as determined by the Income statement
or profit and loss account, while “Cash flow” refers to cash revenues minus cash expenses.
The Accounting profit method for valuation of cost and benefits is discarded on the following
grounds:
 Accounting profit is to large extent affected by the accounting policies being followed by the
firm.
 Accounting Profit is affected by non-cash items such as depreciation, writing off accumulated
losses etc.
 Accounting Profit measures the profit of any particular year in terms of money of that year.
 The benefits if measured in terms of accounting profit are expressed in currencies of
different time period and are not comparable.
 The Accounting Profit is based on the accrual concepts.
Cash Flows
The term cash flow is used to describe the cash-oriented measures of return generated by a
proposal.
2.2. Cash Flows versus Accounting Profit:
Accounting Profit ignores the concept of time value of money, whereas the cash flow technique
incorporates it. In Cash Flow analysis, the cost and benefits are measured in terms of actual Cash
Inflow & Cost of Finance rather than an imaginary profit figure. Accounting Profit is influenced
and affected by adopting one or the other accounting policy; however, cash flows are the actual
flows and are not affected by any policy of the firm.
2.3 Components of Cash Flows:
2.3.1 Original or Initial Cash Outflow /Initial Investment:
All capital projects required an initial cash out flow before any inflow is realized. It comprises of
cost of the new asset to purchase land, building, machinery, etc.
Several Points
Installation Cost: - Initial cash outflows include the total cost of the project in order to bring it in
workable condition. Sunk Cost: - Sunk cost is the cost which the firm has already incurred and
thus has no effect on the future or present decision. Opportunity Cost: -Using some resources for
a new proposal by divesting them from some other existing use, causes opportunity cost.
Working Capital required for the Proposal: - Additional working capital requirement i.e. the
change in working capital due to the proposal.
2.3.2 Subsequent Inflows and Outflows:
The initial cost of finance is expected to generate a series of cash inflows in the form of cash
contributed by the project. Cash inflows generated during the life of the project may also called
as operating cash flows.
2.3.3 Terminal Cash Inflows:
The cash inflows for the last year will include terminal cash inflows along with operating cash
flows. Two common cash inflows may occur in the last year. Estimated salvage or scrap value of
the project realizable at the end of the economic life of the project or at the time of its
termination is the cash inflows for last year. The working capital which was invested in the
beginning will no longer be required as the project is being terminated.
2.4 Basic Principles of Cash flow estimation
2.4.1 Separation Principle
There are two sides of a project, viz., the investment (asset) side and the financing side and the
cash flows associated with these sides should be separated.
2.4.2 Incremental principle
The cash flow of a project must be measured in incremental terms. To ascertain a project’s
incremental cash flows, you have to look at what happens to the cash flows of the firm with the
project and without the project. The difference between the two reflects the incremental cash
flows attributable to the project.
That is, Project cash flow for year t = Cash flow for the firm with the project for the year t – cash
flow for the firm without the project for year t
2.4.3 Post tax principle
Cash flows should be measured on the after-tax basis. Some firms ignore tax payments and try to
compensate this mistake by discounting the pre-tax cash flows at the rate that is higher than the
cost of capital of the firm
2.4.5
Consistency principle
Cash flows and the discount rates applied to these cash flows must be consistent with respect to
the investor group and inflation.
2.5 Introduction to Risk analysis in Capital Budgeting:
It is expected that the proposals do not involve any risk and cash flows associated with the
proposal are known with certainty. In this part different techniques and approaches which help
evaluation of cost and benefit decisions whose cash flows are not known with certainty.
Decision making process can be of three kinds: 1. Certainty Based: Decision making in situations
when the outcome of a particular decision can be ascertained. 2. Uncertainty Based: Decision
making in situations when the outcome of the decision cannot be ascertained. 3. Risky Decisions:
Decision making is called a risky situation when the occurrence of an outcome can be assigned
some probability.
Risk Analysis in Capital Budgeting
The term risk with reference to capital budgeting refers to the difference between the actual and
the expected cash flows. It may be defined as the variability of the future actual cash flows
against the expected cash flows of the proposal.
2.6 Sources/Causes of risk & Types:
1. Wrong method of investment.
2. Wrong timing of investment.
3. Wrong quantity of investment
4. Interest rate risk
5. Nature of investment instruments
6. Nature of industry in which the company is operating
7. Creditworthiness of the issuer.
8. Maturity period or length of investment
9. Terms of lending
10. National and international factors
11. Natural calamities etc.
Types of Risk:
Risk
A. Systematic
Risk
B. Unsystematic
risk
1. Marekt risk
1. Business
risk
2. Interest
rate risk and
2. Financial
risk
3. Purchasing
power risk
3. Default
credit risk
A. Systematic risk
It refers to that portion of variation in return caused by factors that affect the price of all
securities. The effect in systematic return causes the prices of all individual securities to move in
the same direction. The movement is generally due to the response to economic, social and
political changes. The systematic risk cannot be avoided.
Systematic risk arises due to the following factors:
1. Market Risk: Variations in prices sparked off due to social, political and economic events are
referred to as market risk.
2. Interest Rate risk: Generally, price of securities tends to move inversely with changes in the
rate of interest. The market activity and investor perceptions are influenced by the changes in
interest rates which in turn depend on nature of instruments, stocks, bonds, loans etc.,
3. Purchasing Power risk: Uncertainty of purchasing power is referred to as risk due to inflation.
Inflation arises at optimum level and is linked to a price which leads to rise in higher income.
B. Unsystematic risk
Unsystematic risk refers to that portion of the risk which is caused due to factors unique or
related to a firm or industry, this risk is company specific risk and can be controlled if proper
measures are taken. As it is unique to a particular firm or industry it is caused by factors like
labour unrest, management policies, shortage of power recession
It is further divided into three types;
1. Business risk: Business risk can be internal as well external. Internal risk is caused due to
improper product mix, non-availability of raw materials, incompetence to face competition,
absence of strategic management practices etc.
2. Financial risk: Financial risk is associated with the capital structure of the company. The extent
of financial risk depends on the leverage of the firm’s capital structure.
3. Credit or default risk: the credit risk deals with the probability of meeting with a default. It is
primarily the probability that a buyer will default.
Incorporation of Risk in Capital budgeting decisions
There are several techniques available to handle the risk perception of Cost and Benefit
decisions.
These are divided into conventional and statistical techniques.
Conventional techniques
Statistical techniques
Risk Adjusted discount rate
Probability distribution – Expected value of
cash flows, Standard deviation, Coefficient of
variation.
Certainty Equivalent method
Decision tree analysis
Sensitivity Analysis
2.7 Conventional Techniques of Risk analysis:
These techniques are also known as traditional techniques to evaluate risk. These approaches
are simple and based on theoretical assumptions
2.7.1 Risk Adjusted Discounted Rate
The risk adjusted discount rate is based on the premise that the riskiness of a proposal may be
taken care of, by adjusting the discount rate. The cash flows from a risky proposal should be
discounted at a relatively higher discount rate as compared to other proposals whose cash flows
are less risky. Greater the risk, higher should be the desired return from a proposal.
The risk adjusted discount rate may be expressed in terms of
Ka = K + ∞
Ka = Risk Adjusted Discount Rate
K = Risk free discount rate
∞= Risk adjustment premium
Now this risk adjusted discount rate can be used to find out the risk adjusted NPV of a proposal
CFi
Risk adjusted NPV =∑ni=0 (1+Ka)i – Co
RANPV = Risk adjusted NPV
CFi = cash inflows occurring at different point of time
Co = Initial cash out flow
Ka = Risk adjusted discount rate
Illustration 1:
The Beta Company Ltd. is considering the purchase of a new investment. Two alternative
investments are available (A and B) each costing Rs. 1,00,000. Cash inflows are expected to be as
follows:
Year
Cash Inflows
Investment A
Investment B
Rs.
Rs.
1
40,000
50,000
2
35,000
40,000
3
25,000
30,000
4
20,000
30,000
The company has a target return on capital of 10%. Risk premium rates are 2% and 8%
respectively for investments A and B. Which investment should be preferred?
Solution:
The profitability of the two investments can be compared on the basis of net present values cash
inflows adjusted for risk premium rates as follows:
Year
Investment A
Investment B
Discount
Factor @
10%+2%=
Cash Inflow
Rs.
Present
value
Rs.
12%
Discount
Factor @
10%+8% =
18%
Cash Inflows
Rs.
Present
Value
Rs.
1
.893
40,000
35,720
.847
50,000
42,350
2
.797
35,000
27,895
.718
40,000
28,720
3
.712
25,000
17,800
.609
30,000
18,270
4
.635
20,000
12,700
.516
30,000
15,480
94,115
Net Present Value
1,04,820
Investment A
Investment B
Rs. 94,115-1,00,000
Rs. 1,04,820 -1,00,000
Rs. (-) 5,885
Rs. 4,820
As even at a higher discount rate investment B gives a higher net present value, investment B
should be preferred.
2.7.2 Certainty Equivalents (CE)
The CE approach attempts at adjusting the future cash flows instead of adjusting the discount
rates. The expected future cash flows which are taken as risky and uncertain are converted into
certainty cash flows. More risky cash flows will be adjusted down lower than will be less risky
cash flows.
The CE approach may be described in the following equation
∞i CFi
RANPV = ∑ni=1 (1+Kf) - Co
RANPV = NPV of the proposal
∞i = CE factors of different years
CFi = Expected cash flows for different years
Kf= Risk free discount factor
Please note that the value of CE factors will vary between 0 and 1 and will vary inversely to risk.
The CE factors can be determined by the following ratio
∞= Certainty cash flow / Expected cash flow
The decision rule associated with the CE approach is that accept a proposal with positive CE NPV.
In case of mutually exclusive proposals, the rule is that the proposal having the highest positive
CE NPV is accepted.
Illustration 2:
There are two projects X and Y. Each involves an investment of Rs. 40,000. The expected cash
inflows and the certainty co-efficient are as under:
Year
Investment A
Investment B
1
Cash Inflow
Certainty
Cash Inflow
Rs.
Coefficient
Rs.
25,000
.8
20,000
Certainty
Coefficient
.9
2
20,000
.7
30,000
.8
3
20,000
.9
20,000
.7
Risk-free cut off rate is 10%. Suggest which of the two projects should be preferred.
Solution:
Calculations of Cash Inflows with Certainty
Year
Project X
Project Y
Cash Inflow
Rs.
Certainty
Coefficient
Certain Cash
Inflow
Rs.
Cash
Certainty
Coefficient
Inflow
Certain Cash
Inflow
Rs.
Rs.
1
25,000
.8
20,000
20,000
.9
18,000
2
20,000
.7
14,000
30,000
.8
24,000
3
20,000
.9
18,000
20,000
.7
14,000
Calculation of Present Values of Cash Inflows
Project X
Year
Project Y
Discount
Factor @ 10%
Cash Inflow
Rs.
Present value
Cash Inflow
Present value
Rs.
Rs.
Rs.
1
.909
20,000
18,180
18,000
16,362
2
.826
14,000
11,564
24,000
19,824
3
.751
18,000
13,518
14,000
10,514
43,262
Net Present Value
Project X
46,700
Project Y
Rs. 43,262-40,000
Rs. 46,700-40,000
Rs. 3,262
Rs. 6,700
As the net present value of project Y is more than that of project X, Project Y should be
preferred.
2.7.3 Sensitivity Analysis
The sensitivity analysis is a theoretical procedure whereby estimates of the variable parameters
(inputs) are changed to denote different situations/assumptions, and the effect of these changes
is measured on the expected value of the outcome (result).
The following steps are required to apply the sensitivity analysis to capital budgeting proposals:
a) Based on the expectations for the future, the cash flows are estimated in respect to the
proposal.
b) To identify the variables which have a bearing on the cash flows of a proposal. For Example,
some of these variables may be the selling price, cost of inputs, market share, market growth
rate etc.
c) To establish the relationship between these variables and the output value i.e., the effect of
these variables on the value of NPV of the proposal.
d) To find out the range of variations and the most likely value of each of these variables, and
e) To find out the effect of change in any of these variables on the value of NPV.
Limitations of Sensitivity Analysis:
1. It may be observed that the sensitivity analysis is neither a risk measuring nor a risk reducing
technique2. Moreover, the study of effect of variations in one variable by keeping other
variables constant may not be very effective as the variable may be interdependent. 3. The
analysis present results for a range of values, without providing any sense of the likelihood of
these values occurring. 4. Another limitation of the sensitivity analysis is the subjective use of the
analysis. The same sensitivity analysis which leads one decision maker to reject a proposal might
lead some other to accept it and the difference may be traceable in the risk preferences of the
decision makers.
2.8 Statistical Techniques:
The conventional techniques fail to measure and quantify the risk in precise terms. On the other
hand, there are certain statistical techniques available to measure and incorporate risk in a
capital budgeting decision process.
The most important concept used in the statistical techniques is that of probability.
2.8.1Probability:
Probability may be defined as the likelihood of happening or non-happening of an event. It may
be taken as a measure of an opinion about the likelihood of happening of an event.
Two Important Points
 The total of probability for any particular year would always be equal to one.
 The actual cash inflows may be any figure, even other than the cash inflows given in the
series.
Probability Distribution:
The series of expected cash inflows together with the associated probabilities for a particular
year is known as probability distribution.
It is defined as a set of possible cash flows that may occur at a point of time and their
probabilities of occurrence.
Expected Values of a Probability distribution:
The initial step required in evaluating a risky proposal is to find out the expected value of
probability distribution for each year.
For this, each Cash Flow of the probability distribution is multiplied by the respective probability
and then adding the resultant products.
This final figure is then considered as expected value of the CIF for that year for which the
Probability Distribution has been considered. Symbolically
EVCFi
NPV = ∑ni=0 (1+Kf) – Co
NPV = Net present value of the proposal
EVCFi =Expected value of cash inflows for different years
Kf= Risk free discount year
The expected value of a probability distribution can be interpreted as a type of a weighted
average since each possible cash flow is weighted by its probability.
Measurement of Risk:
The concepts of probability distribution and expected value of Probability Distribution help in
incorporating the variability of cash flows i.e. risk of cash flows into in the cost benefit decision
process. The dispersion of probability distribution is found out using two measures of dispersion
i.e.
 Standard deviation (SD) an absolute measure of variability.
 Coefficients of variation (CV) a relative measure of variation is considered to assess the
variability of the cash flows.
2.8.2 Standard Deviation: An Absolute Measure of Risk and Variability:
The statistical tool of standard deviation provides a measure of spread of the distribution of
expected cash flows. The standard deviation as a technique of measuring dispersion can be used
to measure the deviations of each possible cash flow above the expected value of cash flow.
The following steps are needed to ascertain the standard deviation of the probability distribution
of cash flows:
1. Find out the probability distribution of the cash flows over different years.
2. Subtract each cash flow (CF) from the expected value of the cash flow i.e. EVCF and get the
square of the differences i.e. (CF-EVCF)2.
3. Multiply the squared deviations i.e. (CF-EVCF)2 by the probabilities of the occurrence of its
corresponding cash flow i.e., find out P1 (CF1 – EVCF)2, or P2 (CF2-EVCF)2 or P3 (CF3 –
EVCF)2 etc., where P1 is the probability of a particular cash flow.
4. Add these products i.e., find out the sum of P1 (CF1 – EVCF)2 and get the square root of
this figure i.e., find out the value of
Standard deviation =
n
2
 i  1 Pi(CFi  EVCF)
This value is called the standard deviation. It may be noted that the standard deviation is
calculated by taking all deviations positive or negative. This implies that the risk aversion extends
to all the deviations from the expected value even if the deviations are positive i.e., when the
possible cash flow are more than the expected value of the cash flow. The larger dispersion will
produce a larger standard deviation and therefore, larger standard deviation indicates riskier
capital budgeting proposals.
2.8.3 Coefficient of Variation: A Relative Measure of Risk:
Coefficient of Variation (CV) is a relative measure of dispersion and can be applied in capital
budgeting decision process to measure the risk of a project particularly in case when the
alternative projects are of different sizes. The CV is defined as the standard deviation of the
probability distribution divided by its expected value i.e.
SD
CV=
EVCF
It may be noted that the CV is a pure number and is not affected by the measuring unit.
Illustration 3:
From the following, ascertain which project is riskier on the basis of standard deviation and
coefficient of variation.
Project A
Project B
Cash Inflow
Probability
Rs.
Cash Inflow
Probability
Rs.
2,000
.2
2,000
.1
4,000
.3
4,000
.4
6,000
.3
6,000
.4
8,000
.2
8,000
.1
Solution:
Project A
Cash Inflows
Deviation
Square of
Probability
Weighted Sq-
Rs.
from Mean (d)
[5,000[
Deviations ( d 2 )
2,000
-3,000
90,00,000
.2
18,00,000
4,000
-1,000
10,00,000
.3
3,00,000
6,000
+1,000
10,00,000
.3
3,00,000
8,000
+3,000
90,00,000
.2
18,00,000
n =1
 fd = 42,00,000
Probability
Weighted Sq-
fd
 ,  
deviations ( fd 2 )
2
2
n
Standard Deviation

42,00,000
 2,050
1
Project B
Cash Inflows
Deviation
from Mean (d)
[5,000[
Deviations ( d )
2,000
-3,000
90,00,000
.1
9,00,000
4,000
-1,000
10,00,000
.4
4,00,000
6,000
+1,000
10,00,000
.4
4,00,000
8,000
+3,000
90,00,000
.1
9,00,000
n =1
 fd = 26,00,000
Rs.
 , 
 fd
Standard Deviation
Square of
2
deviations ( fd 2 )
2
n
26,00,000
 1,612
1
As the Standard Deviation of Project A is more than that of Project B, A is more risky.

2.8.4 Decision Tree Approach:
2
Quite often a firm may have to take a sequential decision i.e., the present decision is affected by
the decisions taken in the past or it affects the future decisions of the same firm. In capital
budgeting, the evaluation of a project frequently requires a sequential decision-making process
where the accept-reject decision is made in several stages. Instead of taking a decision once for
all, it is broken up into several parts and stages. At each stage there may be more than one
option available and the firm may have to decide every time that which option is to be taken for.
Steps in Decision Tree Approach:
While constructing a decision tree for a given problem the following steps may be required.
1. Break the Project into clearly defined stages. In some cases, this is fairly easy to do so. For
example, a computer software company may take up the project of new package in different
stages i.e., research and development, market testing, limited production and then full
production. Similarly, other capital budgeting decisions may also be broken up in different
stages.
2. List all the possible outcomes at each stage. Specify the probability of each outcome at each
stage based on information available. This task will become progressively more difficult as more
and more stages are introduced.
3. Specify the effect of each outcome on the expected cash flows from the project.
4. Evaluate the optimal action to be taken at each stage in the decision tree, based on the
outcome at the previous stage and its effect on cash flows.
5. Estimate the optimal action to be taken at the very first stage, based on the expected each
flow over the entire projects and all the likely outcomes of the cash flows.
Evaluation of Decision Tree Approach:
The decision tree approach allows firm to deal with uncertainty in the projects by considering
the project in stages, and the decision at any stage depends upon the outcome of the previous
stage. The decision tree approach is no doubt, a useful technique in case of sequential decision
process.
Illustration 4:
Mr. wise is considering an investment proposal of Rs. 20,000. The expected returns during the
life of the investment are as under:
Year I
Year II
Event
Cash Inflow (Rs.)
Probability
(i)
8,000
.3
(ii)
12,000
.5
(iii)
10,000
.2
Cash Inflows in year 1 are:
Cash
Rs. 8,000
Inflows
Probability
Rs.
Rs. 12,000
Probability
Cash
Inflows
Rs. 10,000
Probability
Cash
Inflows Rs.
Rs.
(i)
15,000
.2
20,000
.1
25,000
.2
(ii)
20,000
.6
30,000
.8
40,000
.5
(iii)
25,000
.2
40,000
.1
60,000
.3
Using 10% as the cost of capital, advise about the acceptability of the proposal.
Solution:
Calculation of Net Present Values of Cash Inflows
Alternatives
Cash Inflows
Discount Factor
10%
values
Present Net Present
Year I
Year II
Year I
Year II
Year I
Year II
Total
Value
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
(a) (i)
8,000
15,000
.909
.826
7,272
12,390
19,662
-338
(ii)
8,000
20,000
.909
.826
7,272
16,520
23,792
3,792
(iii)
8,000
25,000
.909
.826
7,272
20,650
27,922
7,922
(b) (i)
12,000
20,000
.909
.826
10,908
16,520
24,428
7,428
(ii)
12,000
30,000
.909
.826
10,908
24,780
35,688
15,688
(iii)
12,000
40,000
.909
.826
10,908
33,040
43,948
23,948
10,000
25,000
.909
.826
9,090
20,650
29,740
9,740
(ii)
10,000
40,000
.909
.826
9,090
33,040
42,130
22,130
(iii)
10,000
60,000
.909
.826
9,090
49,560
58,650
38,650
(c) (i)
Decision Tree Analysis
(1) year 0
(2) Year I (3) Year II (4)
Net (5)
Joint (6) = (4)x(5)
Prob.
Cash Prob
Cash present Value probability
Expected Net
Inflow Rs.
Inflow Rs.
of Inflows
Present Value
Rs.
15,000
-338
.06
-20.28
20,000
3,792
.18
682.56
25,000
7,922
06
475.32
20,000
7,428
.05
371.40
30,000
15,668
.40
6.275.20
40,000
23,948
.05
1.197.40
25,000
9,740
.04
389.60
40,000
22,130
.10
221.30
60,000
38,650
.06
2,319.00
1.00
11,911.50
Total
As the proposal yields a net present value of =Rs. 11,911.50 at a discount factor of 10%, the
proposal may be accepted.
2.9 Terminal Questions:
Section A - 2 Marks Questions:
1. Define Risk?
2. What is uncertainty?
3. What is sensitivity analysis?
4. What is Probability distribution?
5. What is Decision tree?
6. What is Post tax principle?
7. What is Separation Principle?
8. What is Incremental Principal?
9. What are Terminal Cash flows?
10. What are Initial Cash flows?
Section B - 4 Marks Questions:
1. Explain briefly the Principles of cash flows?
2. Explain the various types of risks?
3. Explain the various types of decision making?
4. Explain the drawbacks of sensitivity analysis.
Section C - 10 Marks Questions:
1. Explain the various components and concepts of capital budgeting.
2. Explain the various sources and types of risk?
3. Explain the various Traditional techniques of managing risk in Capital budgeting decisions?
4. Explain the concept of Decision Tree analysis briefly with the help of an example.
Practical Problems:
1. ABC Ltd. is considering purchase of new equipment. Two alternative investments are available,
A & B, each costing Rs.2, 00,000. Cash inflows are expected to be as follows:
Cash inflows
Year
Investment A
Investment B
1
50,000
60,000
2
45000
50000
3
35000
40000
4
30000
40000
The company has a target return on capital of 10%. Risk premium rates are 2% and 8%
respectively for investments A and B. Which investment should be preferred?
2. There are two projects X&Y. Each involves investment of 50,000. The expected cash inflows
and the certainty coefficients are as under:
Project x
Project Y
Year
Cash flows
Probability
Cash flows
Probability
1
35000
0.8
30,000
0.8
2
10,000
0.7
30,000
0.7
3
20,000
0.8
10,000
0.6
Risk free cut off rate is 10%. Suggest which of the two projects should be preferred.
3. Pioneer project is considering accepting one of the two mutually exclusive projects X&Y.
Advice Pioneer Projects ltd. based on the cash flows and probabilities which are estimated as
follows:
Project x
Probability
0.1
0.20
0.40
0.20
0.10
Cash flow
12,000
14,000
16,000
18,000
20,000
Project Y
Probability
0.10
0.25
0.30
0.25
0.10
Cash flow
8000
12,000
16,000
20,000
24,000
4. A company is considering two mutually exclusive projects X & Y. Project X cost Rs. 30,000 and
Project Y Rs. 36,000. You have been given below the cash flows for each project.
Project x
Cash flows
3000
6000
12000
15000
Probability
0.1
0.4
0.4
0.1
Project Y
Cash flows
3000
6000
12000
15000
Probability
0.2
0.3
0.3
0.2
i) Compute the expected NPV for project x and project Y.
ii) Compute the risk attached to each project i.e., standard deviation of each probability
distribution
iii) Which project do you consider riskier and why?
5. ABC and Co. is evaluating two proposals A1 and A2 both having cash outflow of Rs. 30,000
each. However, these alternatives proposals may result in different cash inflows depending upon
different economic condition i.e., good, average and poor. The following information is available:
Economic life
A1
A2
Good eco condition
8000
6000
Average Eco condition
6000
5500
Poor eco condition
4500
4500
Cash inflows (annual)
Evaluate the proposals and advise the firm given that the minimum required rate of return of the
firm is 10%.
6. ABC &Co has funds of rs2,00,000 which expectedly are not required for next few years and
hence can be deposited in a bank @12% interest payable annually. Alternatively, the funds can
be used to install a new machine for the production of a new item. For this, the firm has two
options before it: Machine 1 costing Rs 1,80,000 and Rs 40,000 respectively for the next three
years. Machine 2 costing Rs 1,90,000 which is expected to give a annual cash inflows of Rs
1,00,000, rs1,00,000 and Rs 50,000 respectively for the next three years. Present the decision
situation in a decision tree and evaluate the options.
7. The RST and Co. is engaged in evaluating the following two mutually exclusive proposals, P1
and P2, for which the relevant information is as follows:
Proposal P1
Proposal P2
Cash flows (Rs.)
Probability
Cash flows (Rs.)
Probability
1,50,000
0.3
-4,00,000
0.2
2,00,000
0.3
3,00,000
0.6
2,50,000
0.4
4,00,000
0.1
8,00,000
0.1
Evaluate the proposals in terms of the standard deviation and coefficient of variation.
8. XYZ Ltd. is evaluating two equal size mutually exclusive proposals A and B for which the
respective cash flows together with associated probabilities are as follows:
Project X
Project Y
Cash flows (Rs.)
Probability
Cash flows (Rs.)
Probability
2000
0.3
1000
0.1
4000
0.4
3000
0.1
6000
0.3
5000
0.4
7000
0.3
9000
0.1
Find out the risks of the proposals in terms of the standard deviation.
9. Suppose a firm has an investment proposal, requiring an outlay of Rs.2,00,000 at present (t =
0). The investment proposal is expected to have 2 years economic life with no salvage value. In
the year 1, there is a 0.3 probability that CFAT will be 80,000; a 0.4 probability that CFAT will be
1,10,000 and a 0.3 probability that CFAT will be 1,50,000.
In year 2, the CFAT possibilities depend on the CFAT that occurs in year 1. That is, the CFAT for
the year 2 are conditional on CFAT for the year 1. Accordingly, the probabilities assigned with the
CFAT of the year 2 are conditional probabilities. The estimated conditional CFAT and their
associated conditional probabilities are as follows:
If CFAT1 = 80,000
If CFAT1 = 1,10,000
If CFAT1 = 1,50,000
CFAT2
Probability
CFAT2
Probability
CFAT2
Probability
40000
0.2
1,30,000
0.3
1,60,000
0.1
1,00,000
0.6
1,50,000
0.4
2,00,000
0.8
1,50,000
0.2
1,60,000
0.3
2,40,000
0.1
Using 10% as the cost of capital, advice about the acceptability of the proposal.
10. ABC ltd is considering an investment proposal of Rs 50,000. The expected returns during the
life of the investment are as under:
Year 1
Event
Cash inflow
Probability
1
6000
0.5
2
14,000
0.3
3
10,000
0.2
Year 2
Cash flows
of yr 1 are:
6000
Cash
inflows
12000
Probability
Cash
inflows
10,000
Probability
Cash
inflows
Probability
1
25000
0.4
30000
0.2
35000
0.3
2
20000
0.3
40000
0.6
40000
0.2
3
30000
0.3
60000
0.2
65000
0.5
Using 10% as the cost of capital, advice about the acceptability of the proposal.
11. A company has under consideration two mutually exclusive projects for increasing its plant
capacity. The management has developed pessimistic, most likely and optimistic estimates of the
annual cash flows associated with each project. The estimates are as follows:
Net Investment
Project A
30,000
Project B
30,000
Cash flow estimates
Pessimistic
1200
3700
Most likely
4000
4000
Optimistic
7000
4500
Determine the NPV associated with each estimate given for both the projects. The projects have
20 years like each and the firm’s cost of capital, 10%.
Which project do you consider should be selected by the company? Why?
References
1. Financial Management by R.P. Rustogi
2. Financial Management by Khan and Jain
3. Advanced Financial Management by Shashi K Gupta and Neeti Gupta
4. Financial Management by Prasanna Chandra
Module 3
Capital Structure & Value of the Firm
Structure:
3.1 Introduction & Concept of Value of the Firm
3.2 Capital Structure Theories
3.3 Assumptions for Various Theories
3.4 Net Income Approach (NI Approach) by Durand. (Relevance theory)
3.5. Net Operating Income Approach (NOI Approach) by Durand (Irrelevance theory)
3.6 Traditional Approach:
3.7 Modigliani-Miller Approach (Theory of Irrelevance) – Without taxes
3.8 Modigliani- Millers Approach: When the corporate taxes are assumed to exist
3.9 Terminal questions
3.1 Introduction & Concept of Value of the firm:
The two principles sources of finance for a business firm are equity and debt. What should be
the proportions of equity and debt in the capital structure of a firm? Or we can say, “how much
financial leverage should a firm employ?
Since the objective of financial management is to maximize shareholders’ wealth, the key issue
is: What is the relationship between capital structure and firm value? Alternatively, what is the
relationship between capital structure and cost of capital?
Meaning and definition of Capital Structure
“Capital structure of a company refers to the composition of its capitalization and it includes all
long-term capital sources like loans, reserves, shares and bonds.”
“The capital structure of business can be measured by the ratio of various kinds of permanent
loan and equity capital to total capital.”
3.2 Capital Structure Theories:
When the degree of debt financing is increased in the capital structure, the equity shareholders
are exposed to higher degree of risk. This results from:
 The debt investors have first claim on the profits, and
 In case of liquidation, the claim of the equity shareholders is only residual and arises only
after payment to debt investors.
Theories of capital structure, can be studied and analysed by grouping into:
 That capital structure matters for valuation of the firm, Presented by NI Approach


That capital structure does not matter for the valuation of the firm, presented by NOI
approach, and
A more Pragmatic approach between the two above, presented by Traditional Approach.
3.3 Assumptions for various theories:









There are only two sources of funds used by a firm: debt & shares.
There are no corporate taxes. (This assumption was later modified)
The dividend pay-out ratio is 100%. That is, the total earnings are paid out as dividend to the
shareholders and there are no retained earnings.
The total assets are given and do not change. The investment decisions are, in other words,
assumed to be constant.
The total financing remains constant.
The operating profits are not expected to grow.
All investors are assumed to have the same subjective probability distribution of the future
expected EBIT for a given firm.
Business risk is constant over time and is assumed to be independent of its capital structure
and financial risk.
Perpetual life of the firm.
Definitions and Symbols
We will make use of some symbols in our analysis of capital structure theories:
S= Total market value of equity
D= Total market value of debt
I= Total interest payments
V= Total market value of firm (V = S+ B)
NI= Net income available to equity holders
3.4 Net income Approach (NI Approach) by Durand. (Relevance theory):
According to Net Income theory, suggested by Durand, the capital structure decision is relevant
to the valuation of the firm. In other words, a change in the financial leverage will lead to a
corresponding change in the overall cost of capital as well as the total value of the firm.
NI Approach is based on three Assumptions:
The cost of debt is cheaper than cost of equity; There are no corporate taxes; The use of debt
does not change the perception of investor in evaluating the risk.
Graphical analysis






The degree of leverage/ proportion of debt is plotted along X-axis.
Cost of capital is plotted on Y- axis.
Kd and Ke are constant for all levels of debt financing.
If a firm is a hundred percent equity firm then, Ko =Ke
But when the degree of leverage increases, Ko starts decreasing as Kd is less than Ke. This
results in increase in the value of the firm.
It may be noted that Ko will never touch Kd as there cannot be a hundred percent debt firm.
Some element of equity must be there.
The net income approach shows that the increase in debt financing in the capital mix increases
the market value of the firm and decreases in debt component in finance mix {capital structure}
reduces the market value of the firm and increases the overall capitalization rate
The total market value of the firm on the basis of NI approach can be ascertained as below:
V= S + D
V= Value of the firm
S= Market value of equity shares
D= Market value of debt
S=
Earnings available to equity shareholders
Equity capitalisation rate
Overall cost of capital or weighted average cost of capital Ko =
EBIT
V
Illustration 1:
X Ltd. is expecting an annual EBIT of Rs. 1 Lakh. The company has Rs. 4 lakhs in 10% debentures.
The cost of equity capital or capitalization rate is 12.5%. You are required to calculate the total
value of the firm according to the Net Income Approach.
Solution:
Calculation of the Value of the Firm
Rs.
Net Income (EBIT)
1,00,000
Less: Interest on 10% Debentures of Rs. 4,00,000
40,000
Earnings available to equity shareholders
60,000
Market Capitalization Rate
12.5 %
Market Value of equity (S) = 60,000 
Market Value of Debentures (D)
Value of the Firm (S+D)
100
12.5
4,80,000
4,00,000
8,80,000
3.5. Net Operating Income Approach (NOI Approach) by Durand (Irrelevance theory)
According to this approach, every capital structure is an optimal capital structure. Any
combination of debt: equity mix in the capital structure does not affect the market value of the
firm and the overall cost of capital remains constant irrespective of the method of financing. It is
an opposite theory of Net income approach.
Assumptions:
 The market capitalizes the value of the firm as a whole.
 The use of more and more debt in the capital structure increases the risk of the shareholders
and thus results in the increase in the cost of equity Ke, the increase in Ke is such as to
completely offset the benefits of employing cheaper debt.
 The debt capitalization rate is constant.
 The corporate income tax does not exist
 The business risk remains constant at every level of debt equity mix.
This approach shows that, when the market value of the firm remains same, irrespective of the
size of debt capital, weighted average cost of capital remains constant. However, the cost of
equity capital increases with the increased debt capital.
Valuation under NOI Approach
EBIT
V=
Ko
V = Value of the firm
EBIT =Net operating income or earnings before interest and tax
Ko =overall cost of capital
S= V-D
S=Market value of firm
V= Total market value of a firm
D= Market value of debt
Graphical Analysis






Degree of leverage is plotted on x axis
Cost of debt and cost of equity is plotted on y axis.
For an all equity firm, Ke =Ko
WACC or Ko and Kd are parallel to x axis, i.e., Kd and Ke are constant for all levels of leverage.
As the degree of leverage or debt proportion increases, the risk of shareholders also
increases and thus the cost of equity capital, Ke also increases.
However, the overall cost of capital remains constant because increase in Ke is just sufficient
to offset the benefits of cheaper debt financing.
The NOI approach considers Ko to be constant and therefore, there is no optimal capital
structure; rather every capital structure is as good as any other and every capital structure is an
optimal one.
Illustration 2:
(a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000, 6%
Debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate (cost of equity) according to the Net Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000. What will be the effect on the value of the
firm and the equity capitalization rate?
Solution:
(a) Net Operating Income
= Rs. 1,00,000
Overall Cost of Capital
Market Value of the firm (V) =
= 10%
Net Operating Income
Overall Cost of Capital
= 1,00,000 
Market Value of the Firm
 EBIT 


K
 0 
100
= Rs. 10,00,000
10
= Rs. 10,00,000
Less: Market Value of Debentures
= Rs. 5,00,000
Total Market Value of Equity
= Rs. 5,00,000
Equity Capitalization Rate or Cost of equity ( K e )
=
Earnings Available to Equity Shareholde rs  EBIT - I 
or 
Total Market Value of Equity Shares
 V - D 
Where, EBIT means Earnings before Interest and Tax
V is Value of the firm
D is Value of debt capital
I is interest on debt

1,00,000  30,000
70,000
 100 
 100  14%
10,00,000  5,00,000
5,00,000
(b) If the debenture debt is increased to Rs. 7,50,000, the value of the firm shall remain
unchanged at Rs. 10,00,000. The equity capitalization rate will increase as follows:
 EBIT - I 
Equity Capitalization Rate ( K e ) = 
 V - D 
1,00,000  45,000
 100
10,00,000  7,50,000
55,000

 100  22%
2,50,000

3.6 Traditional Approach:
The NI and NOI approach hold extreme views on the relationship between the leverage, cost of
capital and the value of the firm. In practical situations, both these approaches seem to be
unrealistic. The traditional approach takes a compromising view between the two and
incorporates the basic philosophy of both. It takes a mid-way between the NI approach and NOI
approach.
Graphical representation of Traditional approach
The figure shows that at the optimal capital structure the firm has lowest Ko and therefore,
the capital structure at that financial leverage is optimal.
Illustration 3:
Solution:
3.7 Modigliani-Miller Approach (Theory of Irrelevance) – Without taxes:
MM thesis relating to the relationship between the capital structure, cost of capital and
valuation is similar to the NOI approach. The MM proposition supports the NOI approach
relating to the independence of cost of capital of the degree of leverage at any level of debt equity ratio. The significance of this hypothesis is that, it provides behavioral justification for
constant overall cost of capital and therefore total value of the firm.
Assumptions:
 The capital markets are perfect and complete information is available to all the investors free
of cost.
 The securities are infinitely divisible.
 Investors are rational and well informed about the risk return of all the securities.
 All the investors have same probability distribution about the expected future earnings.
 There is no corporate income tax.
 The personal leverage and the corporate leverage are perfect substitutes.
On the basis of these assumptions, the MM model derived that:
 The total value of the firm is equal to the capitalized value of the operating earnings of the
firm. The capitalization is to be made at a rate appropriate to the risk class of the firm.
 The total value of the firm is independent of the financing mix i.e. the financial leverage.

The cut off rate for the investment decision of the firm depends upon the risk class to which
the firm belongs, and thus is not affected by the financing pattern of these investments.
The Arbitrage Process:
The arbitrage process refers to undertaking by a person of two related actions or steps
simultaneously in order to derive some benefits e.g., buying by a speculator in one market and
selling the same at the same time in some other market; or selling one type of investment and
investing the proceeds in some other investment. The profit or benefit from the arbitrage
process may be in any form: increased income from the same level of investment or some
income from lesser investment. This arbitrage process has been used by MM to testify their
hypothesis of financial leverage, cost of capital and value of the firm.
3.8 Modigliani- Millers approached -When the corporate taxes are assumed to exist:
The MM model is based on the assumption that there is no corporate tax. This assumption is
unrealistic and the tax aspects of the leverage firm are very significant in practice.
According to MM approach, the value of the unlevered firm can be calculated as:
VU
=
𝐄𝐁𝐈𝐓
𝐊𝐨
(1-t)
And the value of a levered firm is:
VL = Vu + t D
Where Vu is the value of unlevered firm
And t D is the discounted present value of the tax savings resulting from the tax deductibility of
the interest charges, t is the rate of tax and D is the quantum of debt used in the mix.
Illustration 4:
There are two firms X and Y which are exactly identical except that X does not use any debt in its
financing, while Y has Rs. 1,00,000 5% Debentures in its financing. Both the firms have earnings
before interest and tax of Rs. 25,000 and the equity capitalization rate is 10%. Assuming the
corporation tax of 50%. Calculate the value of the firm using M and M approach.
Solution:
The market value of the firm X which does not use any debt
Vu 
EBIT
1  t 
Ko
25,000
 0.5
0.10
Rs.1,25,000

The market value of the firm Y which uses debt financing of Rs. 1,00,000
VL  Vu  td
 Rs.1,25,000  0.5  1,00,000
 Rs.1,25,000  50,000
 Rs.1,75,000
3.9 Terminal questions:
Self-Assessment Questions:
State whether True or False
1. Capital structure is the mix of preference and equity share capital.
2. Increased use of debt increases the financial risk of equity shareholders.
3. According to M&M theory the total value of the firm is static.
4. According to the NI approach, a firm cannot increase its value by increasing the proportion of
debt in its financing.
Section A – 2 Marks Questions
1. Define Capital structure.
2. Name various theories of capital structure.
3. What is Arbitrage?
4. Give any two assumptions of NI approach.
5. Give any two assumptions under MM approach.
6. Give any two assumptions of Traditional Approach.
Section B – 4 Marks Questions:
1. Explain the concept of Value of the firm?
2. Explain NI approach briefly.
3. Explain NOI approach briefly.
4. Explain Arbitrage process.
5. Explain Traditional Approach briefly.
Section C – 10 Marks Questions:
1. Critically evaluate NI approach.
2. Critically evaluate NOI approach.
3. Explain the traditional approach of capital structure theories.
4. Explain MM approach of capital structure theories.
Practical Problems:
1. The expected EBIT of a firm is Rs.2, 00,000. It has issued Equity share capital with Ke at 10%
and 6% debt of Rs. 5,00,000.
(a) Find out the value of the firm and overall cost of capital, WACC.
(b) Also, if the firm issued 6% debt of Rs.7,00,000 instead of Rs.5,00,000, What would be the
position.
(c) If the firm issues 6% debt of Rs.2,00,000 only instead of Rs.5,00,000, what would b the
position.
2. A firm has an EBIT of Rs 2,00,000 and belongs to a risk class of 10%. What would be the value
of cost of equity capital if it employees 65 debt to the extent of 30%, 40% or 50% if the total
capital fund of Rs.10,00,000.
3. ABC Ltd having an EBIT of Rs.1,50,000 is contemplating to redeem a part of the capital by
introducing debt financing.
Presently it is a 100% equity firm with equity capitalization rate, Ke, of 16%. The firm is to
redeem the capital by introducing debt financing up to Rs.3,00,000 i.e., 30% of total funds or up
to Rs.5,00,000 i.e., 50% of total funds. It is expected that for the debt financing up to 30%, the
rate of interest will be 10% and the Ke will increase to 17%. However, if the firm opts for 50%
debt financing, then interest will be payable at the rate of 12% and the Ke, will be 20%. Find out
the value of the firm and its WACC under different levels of debt financing.
4. ABC Ltd. has EBIT of Rs 4,00,000. The firm currently has outstanding debts of Rs. 15,00,000 at
an average cost Kd, of 10%. Its cost of equity capital Ke, is estimated to be 16%.
 Determine the current value of the firm using Traditional valuation approach.
 Determine the firm’s overall capitalization rate, Ko.
5. The following is the data regarding two companies X and Y belonging to the same risk class:
Company X
Company Y
Number of ordinary shares
90,000
1,50,000
Market price per share(Rs)
1.20
1.00
6% Debentures (Rs)
60,000
-
Profit before interest (Rs)
18,000
18000
All profits after debenture interest are distributed as dividends. Explain how under MM
approach, an investor holding 10% of shares in company will be better off in switching his
holding to company Y.
6. Companies U and L are identical in every respect except that the former does not use debt in
its capital structure, while the latter employs Rs.6,00,000 of 15% debt, assuming that (a) all the
MM assumptions are met, (b) The corporate tax rate is 50% (c) The EBIT is Rs 2,00,000, and (d)
the equity capitalization of the unlevered company is 20%, what will be the value of the firms, U
and L? Also determine the WACC of both the firms.
7. A company’s expected EBIT is Rs. 50,000. The company has Rs.2,00,000, 10% debentures, the
equity capitalization rate, Ke of the company is 12.5%. Using NI approach, determine the value of
the firm and also the WACC.
8. A company expects a Net operating income of Rs.2,00,000. It has Rs.6,00,000, 6% debentures.
The overall capitalization rate is 12%. Calculate the value of the firm and the equity capitalization
rate, Ke according to NOI approach.
If the debenture debt is increased to Rs.8,50,000, What would be the effect on the value of the
firm and the equity capitalization rate?
9. Compute the market value of the firm, value of the shares and the average cost of capital from
the following information;
Net operating Income
2,00,000
Total Investment
10,00,000
Equity capitalization rate
(a) If the firm uses no debt
10%
(b) If the firm uses Rs. 4,00,000 debentures
11%
(c) If the firm uses Rs.6,00,000 debentures
13%
Assume that Rs.4,00,000 debentures can be raised at 5% rate of interest whereas Rs.6,00,000
debentures can be raised at 6% rate of interest.
10. There are two identical firms A and B which are exactly identical except that A does not use
any debt in its financing, while Y has Rs.2,00,000 5%debentures in its financing. Both the firms
have EBIT of Rs. 30,000 and the equity capitalisation rate is 15%. Assuming the tax of 50%,
calculate the value of the firm using M&M approach.
11. The following is the data regarding two companies “A” and “B” belonging to the same
equivalent risk class.
Company A
Company B
Number of ordinary shares
1,00,000
1,50,000
8% Debentures
50,000
-
Market price per share
Rs.1.30
Rs.1.00
Profit before Interest
Rs. 20,000
Rs. 20,000
All profits after paying debenture interest are distributed as dividends. You are required to
explain how under MM approach, using Arbitrage, an investor holding 10% of shares in company
“A” will be better off in switching his holding to company “B”
Module 4
Dividend Decisions and Valuation of Firm
Structure:
4.1 Introduction
4.2 Concept & Significance
4.3 Relevance theories of Dividend policy
4.3.1 Theory 1 – Walter’s Theory
4.3.2 Theory 2 – Gordon’s model
4.3.3 Dividends and Uncertainty- The bird in the hand argument
4.4 Irrelevance theories of Dividend Policy
4.4.1 Modigliani-Miller Model
4.5 Terminal Questions
4.1 Introduction:
The term dividend refers to that profits of a company which is distributed by company among its
shareholders. The dividend decision is one of the three basic decisions which a financial manager
may be required to take. The investors are interested in earning maximum return on their
investments and to maximize their wealth, on the other hand a company needs to provide funds
to finance its long-term growth.
The question is: Should the company pay dividend to its shareholders or should it reinvest profits
to create additional value for them in future?
4.2 Concept & Significance:
If a firm pays dividends, it affects the cash flow position of the firm but earns a good will among
the investors who, therefore, maybe willing to provide additional funds for the financing of
investment plans of the firm. On the other hand, the profits which are not distributed as
dividends become an easily available source of funds at no explicit costs. Therefore, in taking the
dividend decision, the financial manager has to consider and critically analyse various factors.
The firm must consider the effect of dividend policy on the objectives of the maximization of
shareholder’s wealth. If the payment of dividends is expected to increase the market value of the
share (i.e., increase in the wealth of the shareholders) the dividend must be paid, otherwise, the
profits may be retained and used as an internal source of finance. So the firm must find out and
establish a relationship between the dividend policy and the market value of the share.
There are two schools of thought about the relationship between the dividend policy and value
of the firm. One school of thought associated with Gordon, Walter, etc. holds that the future
capital gains are riskier and the investors prefer current dividends. The other school of thought
associated with Modigliani and Miller holds that the investors are basically indifferent between
current cash dividends and future capital gains.
4.3 Relevance Theories of Dividend Policy:
Relevance theories of dividend policy means that dividend policy of a company are relevant and
affect the market price of the share.
4.3.1 Theory 1 – Walter’s Theory
The theory based on certain assumptions says that the dividend policy has a bearing on the
market price of the share.
In Walter’s model, the dividend policy of the firm depends on the availability of investment
opportunities and the relationship between the firm’s internal rate of return and its cost of
capital. Thus:



Retain all earnings when r > Ke
Distribute all earnings when r<Ke
Dividend policy has no affect when r= Ke
Walter gives a mathematical model to testify the above.
P=
 r 

 E  D 
D  K e 

Ke
KE
Where,
P = Market price of equity share,
D= Dividend per share paid by firm
R= Rate of return on investment of the firm,
Ke= Cost of equity share capital, and
E= Earnings per share of the firm.
Illustration 1:
The following information is available in respect of a firm:
Capitalization rate = 10%
Earnings per share = Rs. 50
Assumed rate of return on investments:
(i) 12%
(ii) 8%
(iii) 10%
Show the effect of dividend policy on market price of shares applying Walter’s formula when
dividend payout ratio is (a) 0% (b) 20% (c) 40% (d) 80% and (e) 100%
Solution:
D r E  D/k e
P

Ke
Ke
Effect of dividend policy on market price of shares
(i) r=12% (ii) r=8% (iii) r=10%
(a) When dividend pay-out ratio is 0%
0 .1250  0 / .10
0 .0850  0  / .10
P

P

.10
.10
.10
.10
.12
.08
50
50
.
10
.
10
 0
 0
.10
.10
 Rs.600
 Rs.400
(b) When dividend pay-out is 20%
.12
.08
10 .10
50  10 P  10  .10 50  10
P

.10 .10
.10
.10
48
 100 
 100  320
.10
 Rs.420
 Rs.580
(c) When dividend payout is 40%
.12
.08
20 .10
50  20 P  20  .10 50  20
P

.10 .10
.10
.10
36
 200 
 200  240
.10
 Rs.440
 Rs.560
(d) When dividend pay-out is 80%
.12
.08
50  40
40 .10
40 .10
50  40 P  
P

.10 .10
.10
.10
 400  120
 400  80
 Rs.520
 Rs.480
0 .1050  0 / .10

.10
.10
.10
50
.
10
 0
.10
 Rs.500
P
.10
50  10
10 .10
P

.10
.10
 100  400
 Rs.500
.10
50  20
20 .10
P

.10
.10
 200  300
 Rs.500
.10
50  40
40 .10
P

.10
.10
 400  100
 Rs.500
(e) When dividend Pay-out is 100%
.12
.08
.10
50  50
50  50
50 .10
50 .10
50 .10
50  50 P  
P

P

.10 .10
.10
.10
.10
.10
 500  0
 500  0
 500  0
 Rs.500
 Rs.500
 Rs.500
Conclusion: From the above analysis we can draw the conclusion that when,
(i) r>k, the company should retain the profits, i.e., when r=12%. Ke = 10%;
(ii) r is 8%, i.e, r<k, the payout should be high; and
(iii) r is 10%; r=k; the dividend pay-out does not affect the price of the share.
4.3.2 Theory 2 – Gordon’s model:
Myron Gordon has also proposed a model suggesting that the dividend policy is relevant and can
affect the value of the share and that of the firm.
According to Gordon, the market value of a share is equal to the present value of future stream
of dividends.
Gordon’s basic valuation formula is as follows;
P=
E (1  b )
K e br
Where,
P= Market price of equity share,
E= Earnings per share of the firm,
b= Retention ratio ( 1-payout ratio)
r = rate of return on investment of the firm.
Ke= cost of equity share capital
br = g i.e., growth rate of the firm
Illustration 2:
The following information is available in respect of the rate of the return on investment ®, the
cost of capital (k) and earning per share (E) of ABC Ltd.
Rate of Return on investment (r) = (i) 15%; (ii) 12%; and (iii) 10%
Cost of capital = (k) 12%
Earnings per share (E) = Rs. 10
Determine the value of its shares using Gordon’s Model assuming the following:
D/p ratio (1-b)
Retention ratio (b)
a
100
0
b
80
20
c
40
60
Solution:
E1  b 
P
Ke  br
Dividend Policy and the Value of Shares
(i) r=15% (r>k)
(ii) r=12% (r=k)
(iii) r=10% (r<k)
a) When D/p ratio is 100% or b=0
101  0 
0.12  (0)(0.15)
10

0.12
 Rs.83.33
P
101  0 
0.12  (0)(0.12)
10

0.12
 Rs.83.33
P
101  0 
0.12  (0)(0.10)
10

0.12
 Rs.83.33
P
(b) When D/p ratio is 80% or b=.20
101  0.20
0.12  (0.20)(0.15)
8

0.09
 Rs.88.89
P
101  0.20
0.12  (0.20)(0.12)
8

0.096
 Rs.83.33
P
101  0.20
0.12  (0.20)(0.10)
8

0.10
 Rs.80
P
(c) When D/p ratio is 40% or b= .60
101  0.60 
0.12  (0.60)(0.15)
4

0.03
 Rs.133.33
P
101  0.60
0.12  (0.60)(0.12)
4

0.048
 Rs.83.33
P
101  0.60
0.12  (0.60)(0.10)
4

0.06
 Rs.66.67
P
4.3.3 Dividends and Uncertainty- The bird in the hand argument:
The basic assumption in Gordon’s basic valuation model that cost of capital (Ke) remains
constant for a firm is not true in actual practice. Thus, Gordon revised his basic model to
consider risk and uncertainty. In the revised model, he suggested that even when r=Ke dividend
policy affects the value of the shares on account of uncertainty of future, shareholders discount
future dividends at higher rate than they discount near dividends. Because investors are rational
and they want to avoid risk, they prefer near dividends than future dividends.
The logic underlying the dividend effect on the share value can be described as the bird in the
hand argument.
4.4 Irrelevance theories of Dividend Policy:
Relevance theories of dividend policy means that dividend policy of a company is relevant and
affect the market price of the share.
4.4.1 Modigliani-Miller Model:
MM have argued that the market price of the share is affected by the earnings of the firm and is
not influenced by the pattern of income distribution. They have used the arbitrage process to
show that the division of profits between dividends and retained earnings is irrelevant from the
point of view of the shareholders.
The formula for valuation is
Po =
D1  P1
1  Ke
Where,
Po= Present market price of the share
Ke= cost of equity share capital
D1= expected dividend at the end of year 1
P1= expected market price at the end of year 1
The value of P1 can derived from the above equation as follows
P1= Po (1+ Ke)- D1
If the firm’s required investment is financed out of the issue of new equity shares then, the
number of shares to be issued can be computed with the following formula
I  ( E  n D1)
P1
Further, the value of the firm can be ascertained with the help of the following formula
m=
nPo =
(n  m) P1  ( I  E )
1 K e
Where,
m= number of shares to be issued.
I= Investment required.
E= Total earnings of the firm during the period.
P1=Market price per share at the end of the period.
Ke= cost of equity capital.
n= number of shares outstanding at the beginning of the period.
D1= dividends to be paid at the end of the period.
nPo= value of the firm.
Illustration 3:
ABC Ltd. belongs to a risk class for which the appropriate capitalization rate is 10%. It currently
has outstanding 5,000 shares selling at Rs.100 each. The firm is contemplating the declaration of
dividend of Rs. 6 per share at the end of the current financial year. The company expects to have
a net income of Rs. 50,000 and has a proposal for making new investments of Rs. 1,00,000. Show
that under the MM hypothesis, the payment of dividend does not affect the value of the firm.
Solution:
A) Value of the firm when dividends are paid:
(i) Price of the share at the end of the current financial year
P1  P0 1  ke   D1
 1001  .10   6
 100 1.10  6
 110  6  Rs.104
(ii) Number of shares to be issued
I - E - nD1 
P1
1,00,000  50,000  5,000  6

104
m

(iii) Value of the firm
nP0 
80,000
104
n  mP1  1  E 
1  ke
80,000 

 5,000 
  104  1,00,000  50,000
104 


1  .10
5,20,000  80,000
 104  1,00,000  50,000
104

1.10
6,00,000  50,000
1.10
5,50,000
 Rs.5,00,000
1.10
B) Value of the firm when dividends are not paid:
(i) Price per share at the end of the current financial year
P1  P0 1  ke   D1
 1001  .10   0
(ii) Number of shares to be issued
I - E - nD1 
m
P1
1,00,000  50,000  0

110
50,000

110
 100  1.10
 Rs.110
(iii) Value of the firm
nP0 
n  mP1  1  E 
1  ke
50,000 

 5,000 
  1.10  1,00,000  50,000
110 


1  .10
5,50,000  50,000 110

 50,000
110
1

1.10
6,00,000  50,000
1.10
5,50,000
 Rs.5,00,000
1.10
Hence, whether dividends are paid are not, the value of the firm remains the same Rs. 5,00,000.
4.5 Terminal Questions:
Section A – 2 Marks Questions
1. What is Dividend?
2. What is Retention ratio?
3. What is dividend payout ratio?
4. Give any two assumptions under Walter’s model.
5. Give any two assumptions under MM model.
Section B – 4 Marks Questions
1. Explain the concept of Dividend policy of a firm.
2. Explain the significance of Dividend policy of a firm.
3. Enumerate all the assumptions underlying MM theory of Dividend policy.
4. Explain the Bird in the hand approach.
Section C – 10 Marks Questions
1. Explain the concept and significance of Dividend policy in a firm?
2. Critically evaluate Walter’s model of Dividend policy.
3. Critically evaluate Gordon’s model of dividend policy.
4. Critically evaluate Modigliani Miller model of dividend policy?
Practical Problems:
1. Following are the details regarding three companies X Ltd, Y Ltd, and Z Ltd.
X Ltd
Y Ltd
Z Ltd
r=12%
r= 6%
r= 8%
ke= 8%
ke= 8%
ke= 8%
E= Rs 10
E= Rs 10
E= Rs 10
Compute the value of an equity share of each of these companies applying Walter’s equation
when dividend payout ratio is (a) 0% (b) 20% (c) 60% and (d) 100%
Ans:
X Ltd
Y Ltd
Z Ltd
Rs 187.5
Rs.93.75
Rs.125
Rs. 175
Rs.100
Rs.125
Rs. 150
Rs. 112.5
Rs.125
Rs. 125
Rs.125
Rs.125
2. The following information is available in respect of ABC Ltd.:
EPS = Rs.10 (constant)
Cost of capital Ke= 10% (constant)
Find out the market price of the share under different rate of return, “r” of 8% , 10% and 15% for
different payout ratio of 0% , 40%, 80% and 100%.
Ans:
0%
150
100
80
40%
130
100
88
80%
110
100
96
100%
100
100
100
3. The following information is available in respect of the rate of return on investment(r), cost of
capital (ke) and EPS of ABC Ltd.
Rate of return on investment (r) = (i) 14% (ii) 10% (iii) 8%
Cost of capital Ke = 12%
EPS = Rs12
Determine the value of its shares using Gordon’s model assuming the following.
D/P Ratio(1-b)
Retention ratio (b)
(a)
100
0
(b)
80
20
(c)
40
60
4. The EPS of ABC Ltd is Rs 10 and the cost of equity, Ke is 10%. Both are expected to remain
constant for several years. The rates of return on fresh investment by the firm may be 8% , 10%
or 15%. Apply Gordon’s model and find out the market price of the share for payout ratios of 0%,
40%, 80% and 100%.
Ans:
0%
0
0
0
40%
400
100
77
80%
114
100
95
100%
100
100
100
5. The following information is available in respect of return on investment (r), the cost of capital
(ke) and EPS of ABC Ltd.
R= 12%
EPS= Rs.45
Determine the value of its shares using Gordon’s model, assuming the following:
D/P Ratio (1-b)
Retention Ratio (b)
Cost of equity (ke) %
(a)
30
90
30
(b)
40
70
20
(c)
50
40
16
(d)
70
20
12
6. XYZ ltd belongs to a risk class of which the appropriate capitalisation rate is 15%. It has
currently 6000 outstanding shares selling at Rs. 100 each. The firm is contemplating the
declaration of Rs.6/share at the end of the year. The company expects to have a net income of
Rs.60,000 and has a proposal for making new investments of Rs. 1,00,000. Show that under the
MM hypothesis, the payment of dividend does not affect the value of the firm.
7. ABC Ltd currently has 1,00,000 outstanding shares selling at Rs.100 each. The firm has net
profits of Rs.10,00,000 and wants to make new investments of Rs. 20,00,000 during the period.
The firm is also thinking of declaring a dividend of Rs 5 per share at the end of the current fiscal
year. The firm’s opportunity cost of capital is 10%. What will be the price of the share at the end
of the year: if (i) a dividend is not declared (ii) a dividend is declared (iii) How many new shares
must be issued.
Ans:
When dividend is not paid
P1= 110
When dividend is paid
P1= 105
No. of shares to be issued= 14,285 shares
8. X Ltd has 80,000 shares outstanding. The current market price of these shares is Rs.15 each.
The company expects a net profit of Rs.2,40,000 during the year and it belongs to a risk class for
which the appropriate capitalization rate has been estimated to be 20%. The company is
considering dividend of Rs. 2 per share for the current year.
(a) What will be the price of the share at the end of the year – (i) if the dividend is paid (ii) if
dividend is not paid.
(b) How many new shares must the company issue if the dividend is paid and the company
needs Rs.5,60,000 for approved investment expenditure during the year.
Ans:
When the firm pays dividend P1 =16 Rs
No. of new shares = 30,000
When the dividend is not paid P1=18
9. A company is expected to pay a dividend of Rs 6 per share next year. The dividends are
expected to grow perpetually at a rate of 9%. What is the value of its share if the required rate of
return is 15%?
Ans:
Rs 100
10. The current price of a company’s share is Rs. 75 and dividend per share is Rs.5. Calculate the
dividend growth rate, if its capitalisation rate is 12%.
Ans
g= 5%
Module – 5
Working Capital - Planning and Management
Structure:
5.1 Introduction
5.2 Operating Cycle or Circular Flow Concept
5.3 Types of Working Capital Needs
5.4 Current assets financing policy
5.4.1 Hedging Approach (Also known as Matching Approach)
5.4.2 Conservative Approach
5.4.3 Aggressive Approach
5.5 Working Capital: Monitoring and Control
5.6 Estimation of Working capital
5.6.1 Cash and Bank Balance
5.6.2 Stock of raw material / Work in progress / Finished Goods
5.6.3 Investment in Debtors / Receivables
5.6.4 Creditors for Purchases / Expenses / Wages
5.7 Components of Working capital
5.7.1 Cash Management
5.7.2 Inventory Management
5.7.3 Receivables Management
5.9 Terminal Questions
5.1 Introduction:
Long term funds are required to create production facilities through purchase of fixed assets
such as plant and machinery, land, building, furniture etc. Investments in these assets represent
that part of firm’s capital which is blocked on a permanent or fixed basis is called fixed capital.
Funds are also needed for short term purposes for the purchase of raw materials, payment of
wages and other day to day expenses etc. These funds are known as Working capital.
Working capital management is significant in financial management. Working capital is
concerned with short-term financial decisions.
Meaning of Working Capital
Working capital is descriptive of that capital which is not fixed. But the more common use of the
working capital is to consider
There are two concepts of working capital namely,
1. Balance sheet concept
2. Operating cycle/ circular flow concept.
1. Balance sheet concept
1
(a) Gross working capital
In broader sense working capital means the total current assets or funds invested in current
assets.
(b) Net Working Capital
In a narrow sense working capital means Net Working capital, i.e., the difference between
current assets and current liabilities is called net working capital.
5.2 Operating cycle or Circular Flow Concept:
Funds which are invested in current assets keep revolving fast and are being constantly into cash
and these cash flows are out again in exchange for other current assets. Hence, it is also known
as revolving or circulating capital. The circular flow concept of working capital is based upon this
operating or working capital cycle of a firm.
The operating cycle refers to the average time that elapses between the acquisition of raw
materials and the final cash realisation.
Operating cycle
Cash
Debtors
Raw materials
Sales
Work in progress
Finished goods
Gross operating cycle = RMCP+ WIPCP+ FGCP+ RCP.
Inventory conversion period: It is the time taken for the conversion of raw materials into
finished goods sales. It consists of




RMCP = Raw Material Conversion period.
WIPCP = Work in Progress Conversion Period
FGCP = Finished Goods Conversion Period
RCP = Receivable conversion period: It is the time taken to convert the credit sales
into cash realization.
2
It starts with the following,
Acquisition of Raw Materials and other resources
Conversion of raw materials into finished goods.
Realization of cash from sale of goods [either cash or from debtors
Net Operating Cycle = Gross Operating Cycle Period- Payable Deferral Period
The following list of formulae can also be applied to determine conversion period:
1. Raw Materials conversion period
2. Work In Progress conversion period
3. Finished Goods conversion period
4. Receivables conversion period
5. Payables deferral period
Average stock of raw material
Raw material cconsumption per day
Average stock of work in progress
Total cost of production per day
Average stock of finished goods
Total cost of goods sold per day
Average accounts receivable
Net credit sales per day
Average payable
Net credit purchases per day
Illustration 1:
From the following information extracted from the books of a manufacturing concern, compute
the operating cycle in days:
Period covered
365 days
Average period of credit allowed by suppliers
16 days
3
(Rs.’000)
Average total of debtors outstanding
480
Raw material consumption
4,400
Total production cost
10,000
Total Cost of Sales
10,500
Sales for the year
16,000
Value of average stock maintained:
Raw materials
320
Work-in-progress
350
Finished goods
260
Solution:
Computation of Operating Cycle
(a) Length of Raw Material Inventory Period =
Average Stock of Raw M aterial
Raw M aterial Consumption Per Day

(b) Length of W-I-P Conversion Period =
320
 365  27days
4400
Average Stock of Work - in - Progress
Total Cost of Production Per Day
350

 365  13days
10,000
(c) Length of Finished goods conversion Period =
(d) Receivables conversion period =
Average Stock of Finished Goods
Total Cost of goods sold Per Day
260

 365  9days
10,500
Average accounts receivable
Net credit sales per day
480

 365  11days
16,000
4
(e) Gross Total Period of Operating Cycle (a+b+c+d)
60 days
Less: Average Period of Credit Allowed by Suppliers
16 days
Net Total Period of Operating Cycle
44 days
Working Capital Management
Management of Working capital refers to management of Current Assets and Current Liabilities
and the inter-relationship that exists between them. O R
Managing all aspects of current assets and current liabilities is called working capital
management.
The main objective of Working Capital Management is management of current assets and
current liabilities of the firm in such a way that a satisfactory level of working capital is
maintained.
5.3 Types of Working Capital Needs:
The working capital need therefore, can be bifurcated into permanent working capital and
temporary working capital as follows:
1. Permanent or Fixed Working Capital
The minimum level of current assets which must be maintained by any firm all the times is
known as Permanent working capital.
2. Temporary or Variable Working Capital or Fluctuating Working Capital
Over and above the Permanent working capital, the additional amount of working capital
required to meet the requirements arising out of the fluctuations in the sales volume. This extra
working capital needed to support the increased volume of sales is known as Temporary or
fluctuating working capital.
Working capital management is three dimensional in nature:
Dimension 1: Formulation of policies with regard to profitability, risk and liquidity
Dimension II: Decision about the composition and level of current assets
Dimension III: Decision about the composition and level of current liabilities
General principles of working capital management Policy
The following are the general principles of a sound working capital management policy
5
1. Principle of risk variation: Risk here refers to the inabilities of a firm to meet its obligations as
and when they become due for payment.
2. Principle of cost of capital: The various sources of raising working capital finance have different
cost of capital and degree of risk involved. Generally, higher the risk lower is the cost and lower
is the risk higher is the cost. Therefore, a proper balance should be maintained between these
two.
3. Principle of equity position: This principle is concerned with planning the total investment in
current assets. i.e., the amount of working capital invested in each component should be
adequately justified i.e. every rupee invested in current assets should be contributed to the net
worth of the firm.
The level of current assets may be measured with the help of two ratios.
a) Current assets as a percentage of total assets
b) Current assets as a percentage of sales
4. Principle of maturity payment: It is concerned with the planning of the sources of finance of
working capital. According to this, a firm should make every effort to relate maturities of
payments to its flow of internally generated funds.
To achieve the above-mentioned objectives, the financial management has to perform the
following basic functions,
Estimating the working capital requirements
Financing of working capital needs.
Analysis and control of working capital.
There are various working capital policies indicating the relationship between current assets and
the sales.
1. Flexible Policy: Here the investment in current assets is very high i.e., the firm maintains a
huge balance of cash and redeemable marketable securities, carries a large amount of inventory
and grants generous terms of credit to customers i.e., high level of debtors.
2. Restrictive Policy: Here, investment in current assets is very low i.e., retains very small cash
resources, manages with small amounts of inventories, offers stiff terms of credit to customers’
6
i.e., low investment in debtors; but it leads to frequent production stoppage, delayed deliveries
to customers and loss of sales.
3. Moderate Policy: This lies between the above two policy, where a balance is struck between
the two extremes.
Conservative
Policy
Moderate
Policy
Aggressive
Policy
Costs of Assets
5.4 Current assets financing policy:
Sales
(Working
Capital)
After establishing the level of current assets, now the
firm must determine how these should be
financed i.e., what mix of long-term capital andPolicies)
short-term borrowings should the firm employ to
support its current assets.
So, the two components of working capital need to be financed accordingly for which the
different sources of funds can be grouped as follows:
(1) Long term sources which provide funds for a relatively longer period.
(2) Short term sources which usually provide funds for a short period, say, up to one year or so.
(3) Transitionary sources which provide funds to a business through the normal business
operations e.g., credit allowed by suppliers and outstanding labor and other expenses.
5.4.1 Hedging Approach (Also known as Matching Approach):
The Hedging approach to working capital financing is based upon the concept of bifurcation of
total working capital needs into permanent working capital and temporary working capital, the
life duration of the current assets and the maturity period of the sources of funds are matched.
The general rule is that the length of the finance should match with the life duration of the
assets.
5.4.2 Conservative Approach:
7
Under this approach, the finance manager does not undertake risk. As a result, all the working
capital needs are primarily financed by long term sources and the use of short-term sources may
be restricted to unexpected and emergency situation only.
5.4.3 Aggressive Approach:
A working capital policy is called an aggressive policy if the firm decides to finance a part of its
permanent working capital by short term sources. The aggressive policy seeks to minimize excess
liquidity while meeting the short-term requirements.
5.5 Working Capital: Monitoring and Control:
1. Monitoring the Operating cycle: It is already noted that the total working capital need depends
upon the length of the operating cycle. The lengthier the operating cycle, the greater would be
the working capital need.
 The actual operating cycle period should be ascertained foe each element i.e., the raw
materials, WIP, the finished goods etc. over a period of time an should be compared with the
standard operating cycle period set for the same firm or the industry as a whole.
 There should always be an attempt to reduce the length of the operating cycle, total as well
as for each element. This makes the firm have comfortable liquidity.
 Efforts are needed to control the Receivables conversion period. If the firm relaxes the
collection, the customer will always like to take the liberty.
2. Working capital Ratios: Another analytical tool for monitoring the working capital is the
accounting ratios, particularly the working capital ratios which are as follows:
 Current Ratio i.e., Current assets to Current liabilities ratio
 Liquidity Ration i.e., Quick assets to current liabilities ration
 Current Assets to Total assets ratio
 Current assets to Total sales ratio
3. Monitoring the Liquidity: Proper liquidity ensures the short-term survival of the firm. Sufficient
liquidity can be obtained by efficient management of different elements of working capital. The
liquidity problems can be reduced by taking the following steps in the firm:
 Reduce the safety stock, resulting in reduction of the order size. This reduction of order size
however, will have many repercussions such as frequent and costly orders, loss of quantity
discounts, probability of stock out etc., and therefore, must be decided very carefully.
 Payments can be delayed to the creditors to improve liquidity but this is not possible without
impairing the goodwill of the firm.
 Liquidity can also be improved by concentrating more on collections of receivables. More
effective control systems should be introduced and the customers may be offered incentives
for prompt payments.
5.6 Estimation of Working capital:
8
“Working capital is the life blood and controlling nerve center of a business” No business can be
successfully run without an adequate amount of working capital. To avoid the shortage of
working capital at once, an estimate of working capital requirements should be made in advance
so that arrangements can be made to procure adequate working capital.
There are various methods of estimating working capital requirements of a firm, like percentage
of sales method, regression analysis, cash forecasting method, operating cycle method,
projected balance sheet method.
Note: We would be using operating cycle method of practical problems.
Operating cycle method
Working capital required = Cost of goods sold × Operating cycle (cycle) / 365 or 360 days + Desired
cash balance
5.6.1 Cash and Bank Balance:
A minimum desired cash and bank balance is to be maintained by a firm which should be
considered as an important component of current assets while estimating the working capital
requirements.
5.6.2 Stock of raw material / Work in progress / Finished goods:
a. Stock of Raw material
The amount of working capital funds to be invested in holding stock of raw material can be
estimated on the basis of budgeted units of production, estimated cost of raw material per unit
and the average duration for which the raw material is held in stock by using the following
formula
Budgeted annual unit of production × estimated cost of raw material per unit × Average raw
material holding period in days or months or weeks / No. of days or months or weeks in a year.
b. Stock of Work in progress
In manufacturing/ processing industries the production is carried on continuous basis. At the
end of the period, some work remains incomplete even though all or some expenses have been
incurred, this work is known as work –in – progress or partly completed or semi-finished goods.
The work – in – progress consists of direct material, direct labour and production overheads
locked up in these semi-finished goods.
The amount of funds estimated to be invested in work – in – progress may be computed as:
Budgeted annual units of production x estimated WIP cost per unit x Average WIP holding period
in days or months or weeks / No. of days or months or weeks in a year.
Note. (i) 360 days a year may be assumed to simplify calculations.
(ii) In the absence of information about stage of completion of WIP with regard to material
labour and overheads, 100% of material cost, and 50% of labour and production overheads cost
may be assumed as the estimated cost of work – in – progress.
(iii) In case cash cost approach is followed for estimation of working capital, then depreciation
should be excluded from production overheads while calculating cost of work-in – progress.
However, under the total approach, depreciation is also included.
9
c. Stock of Finished Goods
The amount of funds to be invested in holding stock of finished goods can be estimated on the
basis of annual budgeted units of production, estimated cost production per unit and the
average holding period of finished goods stock by using the following formula:
Budgeted annual units of production x Estimated cost of production per unit x Average holding
period of finished goods in days or months or weeks / No. of days or months or weeks in a year.
Note. (i) Cost of production consists of 100% of material , labour and production overheads
costs.
(ii) Under the total cost approach, depreciation is included in the cost of goods produced.
However, depreciation is to be excluded under the cash cost approach.
5.6.3 Investment in Debtors / Receivables:
When the sales are made by a firm on cash basis, the amount is realised immediately and no
funds are blocked for after sale period.
Budgeted units of credit sales x cost of sales per unit x Average collection period of receivables in
days or months or weeks / No. of days or months or weeks in a year.
Note. (i) Cost of sales = Cost of goods produced/ sold + Office and administrative overheads +
Selling and distribution overheads
(ii) Selling price per unit should be considered in place of cost of sales per unit in case total
approach is to be followed for estimation of working capital. Under the total approach, all costs
including depreciation and profit margin are included.
Prepaid Expenses
Some of the expenses like wages, manufacturing overheads, office and administrative expenses
and selling and distribution expenses etc.
5.6.4 Creditors for purchases / expenses / wages:
a. Trade Creditors
The term trade creditors refer to the creditors for the purchase of raw material, consumables,
stores etc.
Budgeting annual units of production x Estimated raw material cost per unit x Average payment
period of creditors in days or months or weeks / No. of days or months or weeks in a year.
b. Creditors for Wages and Other Expenses
Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services
already rendered by employees.
Budgeted annual production in units x estimated labour or overheads cost per unit x Average time
lag in payment of wages or overheads in days or months or weeks / No. of days or months or
weeks in a year.
Note. (i) The creditors for wages and each of the overheads may be calculated separately.
10
(ii) In case of selling overheads, budgeted annual sales in units should be considered in place of
budgeted production units.
c. Advanced Received
Sometimes a payment may be received in advance along with purchase order, such advances
reduce the amount of net working capital required by a firm.
PROFORMA STATEMENT OF WORKING CAPITAL REQUIREMENTS
Particulars
Current Assets:
(i) Stock of Raw material (for .... month’s consumption)
(ii) Work in process (for .... months):
(a) Raw material
(b) Labour
(c) Overheads
(iii) Stock of finished goods (for ... month’s sales)
(a) Raw materials
(b) Labour
(c) Overheads
(iv) Sundry debtors or receivables (for .... month’s sales)
(a) raw materials
(b) labour
(c) overheads
(v) Payments in advance (if any)
(vi) Balance of cash (required to meet day to day expenses)
(vii) Any others (if any)
Amount
........
........
..........
..........
...........
.........
...........
Less: Current Liabilities:
(i) Creditors (for..... month’s purchases of raw material)
(ii) Lag in payment of expenses (outstanding expenses.... months)
(iii) others (if any)
Working capital (CA – CL)
Add: Provision / Margin for contingencies
Net working capital required
Illustration 2:
Raju Brothers Private Limited sells goods on a gross profit of 25%. Depreciation is taken into
account as a part of cost of production. The following are the annual figures given to you:
11
Rs.
Sales (two months’ credit
18,00,000
Material consumed (one-month credit)
4,50,000
Wages (one-month lag in payment)
3,60,000
Cash manufacturing expenses (one-month lag in payment)
4,80,000
Administration expenses (one-month lag in payment)
1,20,000
Sales promotion expenses (paid currently in advance)
60,000
Income-tax payable in 4 instalments of which one lies in next year
1,50,000
The company keeps one month’s stock each raw material and finished goods. It also keeps Rs.
1,00,000 in cash. You are required to estimate the working capital requirements of the company
assuming 15% safety margin.
Solution:
Statement of Working Capital Requirements
Current Assets:
Rs.
1

Stock of raw material  4,50,000  
12 

37,500
75 1 

Stock of finished goods at cost 18,00,000 
 
100 12 

1,12,500
Advance Payment of sales promotion expenses
60,000
12
75 2 

Debtors at cost 18,00,000 
 
100 12 

2,25,000
Cash
1,00,000
Rs.
Less: Current Liabilities:
1

Creditors for materials  4,50,000  
12 

37,500
5,35,000
1

Wages outstanding  3,60,000  
12 

1

Cash manufacturing expenses outstanding  4,80,000  
12 

30,000
1

Administration expenses outstanding 1,20,000  
12 

40,000
10,000
1,17,500
Net Working Capital
4,18,000
Add: 15% Safety Margin
62,700
Working Capital Required
4,80,700
Working Notes:
(i) Profit has been ignored and debtors have been taken at cost. The profit has been ignored
because this may or may not be used as a source of working capital.
(ii) Income tax has also been ignored as it is charged on profits.
Illustration 3:
A proforma cost sheet of a company provides the following particulars:
13
Elements of cost
Material
40%
Direct Labour
20%
Overheads
20%
The following further particulars are available:
a) It is proposed to maintain a level of activity of 2,00,000 units.
b) Selling price is Rs. 12/- per unit.
c) Raw materials are expected to remain in stores for an average period of one month.
d) Materials will be in process, on average half a month.
e) Finished goods are required to be in stock for an average period of one month.
f) Credit allowed to debtors is two months.
g) Credit allowed by suppliers is one month.
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements, a forecast Profit and
Loss Account and Balance Sheet of the company assuming that:
Rs.
Share Capital
15,00,000
8% Debentures
2,00,000
Fixed Assets
13,00,000
Solution:
Statement of Working Capital
Current Assets:
Stock of Raw Materials (1 month)
Rs.
24,00,000  40
100  12
80,000
Work-in-process (1/2 month):
Materials
Labour
24,00,000  40 1

100  12
2
40,000
24,00,000  20 1

100  12
2
14
Rs.
Overheads
24,00,000  20 1

100  12
2
20,000
Stock of Finished Goods (1 month)
Materials
Labour
20,000
24,00,000  40
100  12
24,00,000  20
100  12
Overheads
80,000
24,00,000  20
100  12
40,000
Debtors (2 months) at cost
40,000
Material
1,60,000
Labour
Overheads
1,60,000
Less: Current Liabilities:
24,00,000  40
Creditors (1 month) for raw materials
100  12
Net Working Capital Required:
80,000
80,000
3,20,000
6,40,000
80,000
5,60,000
(Note: Sales = 2,00,000 x 12 = Rs. 24,00,000)
15
Forecast Profit and Loss Account
For the year ended……..
To Materials
9,60,000 By Cost of goods sold
To wages
4,80,000
To overheads
4,80,000
To cost of goods sold
To Gross profit c/d
To Interest on Debentures
19,20,000
19,20,000
19,20,000
19,20,000 By sales
24,00,000
4,80,000
24,00,000
24,00,000
16,000
4,80,000
4,64,000 By Gross profit b/d
To Net Profit
4,80,000
Liabilities
4,80,000
Forecast Balance Sheet
as at……..
Rs.
Assets
Rs.
Share capital
15,00,000
Fixed Assets
8% Debentures
2,00,000
Stocks:
Net profit
4,64,000
Raw materials
80,000
creditors
80,000
Work-in-process
80,000
Finished Goods
1,60,000
Debtors
4,00,000
Cash & Bank balance
16
13,00,000
(balancing figure)
22,44,000
2,44,000
22,44,000
Working Notes:
a) Profits have been ignored while preparing working capital requirements for the following
reasons:
i)
Profits may or may not be used for working capital.
ii)
Even if profits have to be used for working capital, they have to be reduced by the
amount of income tax, dividends, etc.
b) Interest on debentures has been assumed to have been paid.
Illustration 4:
X & Co. is desirous to purchase a business and has consulted you and one point on which you are
asked to advise them is the average amount of working capital which will be required in the first
year’s working.
You are given the following estimates and are instructed to add 10% to your computed figure to
allow for contingencies:
Figures for
the year
Rs.
(i) Amount blocked up for stocks:
Stocks of finished product
5,000
Stocks of stores, materials, etc.
8,000
(ii) Average credit given:
Inland Sales – 6 weeks credit
3,12,000
Export Sales 1 ½ weeks credit
78,000
(iii) Lag in payment of wages and other outgoings:
Wages – 1 ½ weeks
2,60,000
Stocks of materials, etc – 1 ½ months
48,000
Rent, Royalties, etc - 6 months
10,000
Clerical staff – ½ month
62,400
17
Manager ½ month
4,800
Miscellaneous Expenses – 1 ½ months
48,000
(iv) Payment in Advance:
Sundry Expenses (Paid Quarterly in advance)
8,000
(v) Undrawn profit on the average throughout the year
11,000
Set up you calculations for the average amount of working capital required.
Solution:
Statement Showing the Calculation of Average Working Capital Required
Current Assets:
Rs.
Rs.
(i) Stock of finished products
5,000
(ii) Stocks of stores materials, etc.
8,000
(iii) Sundry Debtors
(a) Inland (6 weeks) 3,12,000 x 6/52
36,000
(b) Export Sales (1 ½ weeks) 78,000 x 3/52 x ½
2,250
(iv) Payments in Advanced 8,000 x ¼
38,250
2,000
53,250
Less: Current Liabilities:
Lag in payment of:
Wages (1 ½ weeks) 2,60,000 x 3/52 x ½
Stocks, materials, etc. (1 ½ months)
7,500
48,000 3

12
2
Rent, Royalties, etc. (6 months) 10,000 
6,000
6
12
18
Clerical Staff (½ month)
Manager (½ month)
5,000
62,400 1

12
2
4,800 1

12
2
Miscellaneous Expenses (1 ½ months)
2,600
4,800 3

12
2
200
Net Working Capital
Add: 10% Margin for Contingencies
6,000
27,300
25,950
2,595
28,545
Note:
Undrawn Profits have been ignored for the following reasons:
(i) Profits may or may not be used as working capital.
(ii) Even if it is to be used for working capital, it should be reduced by the amount of income-tax,
drawings, dividend paid etc.
5.7 Components of Working capital:
It primarily is made up of current assets and current liabilities.
Current assets can be listed as follows:
Cash and bank balances, Fixed deposits with bank, Government and other trustee securities
(other than long term purpose), Receivables or debtors, Stock of raw materials, Stock of work in
progress, Stock of finished goods, Other consumable spares, Advance payment of tax, Prepaid
expenses, Deposits kept with pubic bodies etc., for the normal business operations (e.g., earnest
deposit kept by construction companies, etc., maturing within the normal operating
cycle.),Money receivable from contracted sale of fixed assets during the next 12 months.
Current liabilities can be listed as follows:
Short term borrowings (including bills purchased and discounted from banks and others),
Unsecured loans, Pubic deposits maturing within one-year, Sundry creditors (trade) or raw
materials and consumable stores and spares, Interest and other charges due for payments,
Advance/progress payments from customers, Deposits from dealers, selling agents etc,
Installments on term loans, deferred payment credits, debentures, redeemable preference
shares and long term deposits not payable within one year, Statutory liabilities, Provident fund
19
dues, Provision for taxation, Sales tax, excise, Miscellaneous current liabilities, Dividends,
Gratuity payable within one year, Other provisions or payments due within a period of 12
months.
5.7.1 Cash Management:
Cash management refers to management of various aspects of cash i.e., management of inflow
and outflow of cash
John Maynard Keynes put forth 3 motives for holding cash.
1. Transaction Motive
Firm requires cash to meet their transaction needs. The collection of cash from various sources
like, sales of goods, sale of assets and additional financing is not perfectly synchronized with the
disbursement of cash into various uses like purchase of raw materials, acquisition of current
assets and meeting other obligations.
2. Precautionary motive:
There may be some uncertainty about the magnitude and timing of cash inflows from sale of
goods / services, sale of assets and issuance of securities and there may be uncertainty about
cash outflows on account of purchases and other obligations.
3. Speculative Motive:
Firm would like to tap profit-making opportunities arising from fluctuations in commodity prices,
security prices, interest rates and foreign exchange rates. A cash rich firm is better prepared to
exploit such bargains. Hence, firm, which has speculative leanings, may carry additional liquidity.
Objectives of Cash Management:
1. Meeting Payment Schedules.
2. Sufficient cash balance should be maintained.
a. To prevent insolvency.
b. To relationship with the bank is not strained.
c. For good relationship with suppliers.
d. To avail cash discount.
e. For strong credit rating.
f. To exploit favourable business opportunities.
g. To meet contingencies.
3. To minimizing funds committed to cash balances i.e. to minimize cash balance.
Optimum Cash Balance: A Few Models
The cash budget for a firm may indicate the period when it is expected to have a shortage or
surplus of funds. If a shortage is expected was and means of overcoming it must be thought of
and in case of expected surplus, its profitable usage in marketable securities should be exported.
Baumol’s Model:
20
Suggested by W.J.Baumol (1952), this model is the same as the economic order quantity model
of the inventory management. This model attempts to balance the income foregone on cash
held by the firm against the transaction cot converting cash into marketable securities or vice
versa. This model can be presented as follows:
Assumption:
The Baumol’s model assumes that the firm uses cash at an already known rate per period and
that this rate of use is constant.
Holding Cost:
There is always cost of holding cash by a firm. This cost may be the opportunity cost in terms of
the interest foregone on the investment of this cash.
Transaction Cost:
Whenever cash is to be converted into marketable securities, or vice versa, there is always a cost
involved in the form of brokerage, commission, etc.
Determination of Optimum Cash Balance
Limitations of the Model:
The Baumol’s model suffers from the following shortcomings:
i. The model assumes a constant rate of use of cash. This is a hypothetical assumption.
Generally the cash outflows in any firm are not regular and hence this model may not
give correct results.
ii. The transaction cost will also be difficult to be measured since these depend upon the
type of investment as well as the maturity period.
Miller – Orr Model:
Also known as Stochastic Model, Miller and Orr (1966) have expanded the Baumol’s model
which is not applicable if the demand for cash is not steady. In case, uncertainty over cash flows
is large, the inventory type model cannot be used.
The model assumes
i. Out of the two assets i.e. cash and marketable securities, the latter has a marginal yield and
21
ii. Transfer of cash to marketable securities and vice versa is possible without any delay but
of course of at some cost.
The model has specified two control limits for cash balance. An upper limit, H, beyond which
cash balance need not be allowed to go and a lower limit, L, below which the cash level is not
allowed to reduce. The cash balance should be allowed to move within these limits. If the cash
level reaches the upper control limit, H then at this point a part of the cash should be invested in
marketable securities in such a way that the cash balance comes down to a pre – determined
level called the return level, R. If the cash balance reaches the lower level L, then sufficient
marketable securities should be sold to realize cash so that the cash balance is restored to the
return level R. No transaction between cash and marketable securities is undertaken so long as
the cash balance is between the two limits of H and L. The Miller – Orr model has been
presented in following figure
Miller – Orr Model
The spread between the lower and the upper limit computed by the model is that which
minimizes the sum of transaction cost and the interest cost. The firm buys securities when it
gets to the upper level and reduces its cash balance to the return level; and sells securities when
it gets to the lower limit and raises its cash balance to the same point. The model requires three
steps. The first step involves specifying a minimum cash balance, which comprises the lower
limit for the cash balance (for some firms, it may be zero). The second step, involves estimating
the variability in future cash flows. This could be assessed on the basis of past experience of the
firm. The third step involves computing the spread as a function of the variability, the
transaction cost and the market interest rate. This spread is added to the lower cash limit in
order to find out the upper cash limit for the firm.
Miller Orr model attempts to answer two basic questions about the cash management:
1. When should transfer be affected between cash and marketable securities? and
2. How much cash is converted into marketable securities and vice versa?
Implications of Baumol’s and Miller – Orr Model:
22
Though the two models differ in complexity, yet they have some common applications. Both
models imply that:
(i)
The greater the interest rate or carrying cost, the lower is the target or optimum cash
balance, and
(ii)
The greater the transaction cost, the higher is the target cash balance.
5.7.2 Inventory Management:
Management of various aspects of materials pertaining to material purchase control, issues
control and stores control is referred to as inventory management
Types of Inventories
a. Raw Materials
b. Work-in Progress
c. Finished Goods
d. Consumable Stores
e. Spare parts and Components
Objectives of Inventory Management
1) To ensure continuous supply of materials, spares and finished goods so that production
should not suffer at any time and the customers demand should also be met.
2) To avoid both over-stocking and under-stocking of inventory.
3) To maintain investments in inventories at the optimum levels as required by the operational
and sales activities.
4) To keep material costs under control so that they contribute in reducing cost of production
and overall costs.
5) To eliminate duplication in ordering or replenishing stocks. This is possible with the help of
centralised purchases.
6) To minimize losses through deterioration, pilferage, wastages and damages.
7) To design proper organisational for inventory management.
8) To ensure right quality goods at reasonable prices. Suitable quality standards will ensure
proper quality of stocks.
9) To facilitate furnishing of data for short-term and long-term planning and control of
inventory.
5.7.3 Receivables Management
Introduction
Receivables constitute a significant portion of the current assets of a firm. But, for investment in
receivables a firm has to incur certain costs. Further, there is a risk of bad debts also.
Meaning of Receivables
Receivables represent the amounts owed to the firm as a result of sale of goods or services in
the ordinary course of business.
Meaning of Receivables Management
23
Receivables management is the process of making decisions relating to investment in trade
debtors.
Receivables management involves the consideration of the following aspects:
1. Forming of credit policy
2. Executing the credit policy
3. Formulating and executing collection policy
1. Forming of credit policy: For efficient management of receivables, a concern must adopt a
credit policy. A credit policy is related to decisions such as credit standards, length of credit
period, cash discount and discount period, etc.
a) Quality of trade accounts or credit standards: The increased volume of sales is associated with
certain risks.
b) Length of credit period: The length of credit period and the quantum of discount allowed
determine the magnitude of the investments in receivables.
c) Cash discount: Cash discount is allowed to expedite the collection of receivables.
d) Discount period: The collection of receivables is influenced by the period allowed for availing
the discount.
24
2. Executing credit policy: After formulating the credit policy, its proper execution is very
important. The evaluation of credit applications and finding out the credit worthiness of the
customers should be undertaken.
a) Collecting credit information: This information should be adequate enough so that proper
analysis about the financial position of the customers is possible.
b) Credit analysis: After gathering the required information, the finance manager should analyse
it, find out the credit worthiness of potential customers and also see whether they satisfy the
standards of the concern or not.
c) Credit decision: After analyzing the credit worthiness of the customer, the finance manager
has to take a decision whether the credit is to be extended and up to what level.
d) Financing investments in receivables and Factoring: Banks allow the raising of loans against the
security of receivables.
3. Formulating and executing collection policy: The collection of the amounts due to the
customers is very important. The concern should devise procedures to be followed when
accounts become due after the expiry of credit period. The objective is to collect the dues and
not annoy the customer.
Steps to be followed,
(a) Sending a reminder for payments
(b) Personal requests through telephone
(c) Personal visits to customers
(d) Taking the help of collecting agencies
(e) Taking legal action
The collection of book debts can be monitored with the use of
 Average Collection Period
 Ageing Schedule
Factoring and Receivables Management
A factor is a financial institution which offers services relating to management and financing of
debts arising out of credit sales. It may be broadly defined as the relationship created b an
agreement, between the seller of goods/services and a financial institution called a factor
whereby the latter purchases the receivables of the former and also controls and administers the
receivables of the former.
Mechanism of Factoring
1. An agreement is entered into between the selling firm and the factor firm. The agreement
provides the basis and the scope of the understanding reached between the two for
rendering services.
2. The sale documents should contain the instructions to make payments directly to the factor
who is assigned the job of collection of receivables.
3. When the payment is received by the factor, the account of the selling firm is credited by the
factor after deducting its fees, charges, interest, etc., as agreed.
25
4. The factor may provide advance finance to the selling firm if the conditions of the agreement
so require.
Functions of a Factor
1. Bill discounting facilities
2. Administration of credit sales
3. Maintenance of sales ledger
4. Collection of accounts receivables
5. Credit control
6. Protection from bad debts
7. Provision of finance
8. Rendering advisory services
Benefits of Factoring
1. It ensures a definite pattern of cash inflows from credit sales
2. Serves as a source of short- term finance
3. Ensures better management of receivables.
4. Enables the selling firms to transfer the risk of non-payments, defaults or bad debts to the
factoring firms in case of non-recourse factoring.
5. Relieves the selling firms from the burden of credit management and enables them to
concentrate on other important business activities.
6. Saves in cost as well as space as it is a substitute for the in-house collection department.
7. Provides better opportunities for working capital management.
8. The selling firm is also benefited by the advisory services rendered by a factor.
Types of Factoring
1. Recourse and non-recourse factoring: In a recourse factoring agreement, the factor has
recourse to the client if the receivables purchased turn out to be bad.
2. Advance and maturity factoring: under this agreement, a certain percentage of receivables
are paid in advance to the client, the balance being paid on the guaranteed payment date.
3. Conventional or full factoring: In conventional or full factoring, the factor performs almost all
the services of factoring including non-recourse and advance factoring. It is also known as
Old Line Factoring.
4. Domestic and export factoring: In domestic factoring, 3 parties are involved, viz., the selling
firm, the factor and the buying firm. In contrast, 4 parties are involved in case of export
factoring or cross-border factoring, viz., exporter, the importer, the export factor and the
import factor.
5.9 Terminal Questions:
Section A – 2 Marks Questions
1. What is Working capital?
2. What is Permanent working capital?
3. What is Hedging approach?
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4. What is Operating cycle concept?
5. What is Cash management?
6. What is Inventory management?
7. What is conservative policy?
8. What is moderate policy?
9. What is Receivables management?
10. What is Factoring?
11. What is recourse and non-recourse factoring?
12. What is full factoring?
Section B – 4 Marks Questions
1. Explain operating cycle concept.
2. Explain the concepts of financing the working capital.
3. Explain the three policies indicating the relationship between current assets and sales.
4. What are the three motives of holding cash?
5. Explain the factoring mechanism.
6. Explain the objectives of Inventory management.
7. Explain Baumol’s Cash management model.
8. Explain Miller –Orr cash management model.
Section C – 10 Marks Questions
1. Explain the various principles and policies of working capital management?
2. Explain the types of working capital needs.
3. Write a note on Monitoring and control of working capital.
4. Explain the various dimensions of credit policy in receivables management.
Problems on operating cycle’s concept:
1. From the following information extracted from the books of a manufacturing concern,
compute the operating cycle in days:
Period covered
365 days
Average collection period of credit allowed by suppliers
16 days
Rs ‘000
Average total of debtors outstanding
480
Raw material consumption
4,400
Total production cost
10,000
Total cost of goods sold for the year
10,500
Sales for the year
16,000
Value of average stock maintained:
Raw materials
320
Work in progress
350
Finished goods
260
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2. From the following data, compute the duration of the operating cycle for each of the two
companies:
X Ltd
Y Ltd
Stocks:
Raw material
50,000
70,000
Work in progress
40,000
55,000
Finished goods
35,000
48,000
Purchase/ consumption of 2,60,000
3,70,000
raw material
Cost of goods purchased/
4,00,000
4,80,000
sold
Sales (all credit)
4,60,000
5,32,000
Debtors
82,000
2,08,000
Creditors
30,000
37,000
Assume 360 days per year for computational purposes.
Problems on Working Capital Management
1. Prepare an estimate of working capital requirement from the following information of a trading
concern:
a. Projected annual sales
b. Selling price
c. % of net profits on sales
d. Average credit period allowed to customers
e. Average credit period allowed by suppliers
f. Average stock holding in terms of sales requirement
g. Allow 10% for contingencies.
1,00,000 units
Rs. 8 per unit
25%
8 weeks
4 weeks
12 weeks
2. From the following details, you are required to make an assessment of the average amount of
working capital of ABC Ltd.
Items
Avg period of Estimate for the
credit
first year (Rs)
28
Purchase of material
Wages
7 weeks
2 weeks
36,00,000
20,50,000
Overheads:
Rent, Rates etc.
Salaries
Other overheads
Sales (cash)
Sales (credit)
Average amount of stock and WIP
Average amount of undrawn profits
7 months
2 months
3 months
3 months
-
2,00,000
9,00,000
8,50,000
3,00,000
70,00,000
5,00,000
4,00,000
It is assumed that all the expenses and incomes were made at even rate for the year.
3. XYZ Ltd. sells its products on a gross profit of 20% on sales. The following information is extracted
from its annual accounts for the year ended 31st March 2005:
(Rs.)
Sales (3 months credit)
40,00,000
Raw materials
12,00,000
Wages (15 days in arrears)
9,60,000
Manufacturing expenses (1 month in arrears)
12,00,000
Administration expenses (1 month in arrears)
4,80,000
Sales promotion expenses (payable half yearly in advance)
2,00,000
The company enjoys one-month credit from suppliers of raw materials and maintains 2 months
stock of raw materials and one and a half month’s finished goods. Cash balance is maintained at
Rs. 1,00,000 as a precautionary measure. Assuming 10% margin, find out the working capital
requirements of XYZ Ltd.
4. Shyam Ltd. sells goods on a gross profit of 25%. Depreciation is taken into account as a part of
cost of production. The following are the annual figures given to you,
Rs.
Sales (2 months credit)
18,00,000
Material consumed (1-month credit)
4,50,000
Wages (1-month lag in payment)
3,60,000
Cash manufacturing expenses (1-month lag in 4,80,000
payment)
Administration expenses (1-month lag in
1,20,000
payment)
Sales promotion expenses (paid currently in
60,000
advance)
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Income tax payable in 4 instalments of which
1,50,000
one lies in next year
The company keeps one month’s stock of each raw material and finished goods. It also keeps Rs.
1,00,000 in cash. You are required to estimate the working capital requirements of the company
assuming 15% safety margin.
5. A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Material
40%
Direct Labour
20%
Overheads
20%
The following further particulars are available:
a. It is proposed to maintain a level of activity of 2,00,000 units
b. Selling price is Rs. 12/- per unit
c. Raw materials are expected to remain in stores for an average period of 1 month
d. Materials will be in process, on average half a month
e. Finished goods are required to be in stock for an average period of one month
f. Credit allowed to debtors is 2 months
g. Credit allowed by suppliers is 1 month
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements, a forecasted Profit &
Loss A/c and also Balance Sheet of the Company, assuming that:
Share Capital
15,00,000
8% Debentures
2,00,000
Fixed Assets
13,00,000
6. M/s ABC Ltd is desirous to purchase a business and has consulted your opinion and advise them
about the amount of working capital which will be required in the first year of working.
You are given the following details and are instructed to add 10% to your computed figure to
allow for contingencies:
Amount for
the year (Rs)
Particulars
1. Amount blocked up for stocks
 Stocks of finished goods
 Stocks of stores, materials, etc.
5,000
8,000
2. Average credit given:
 Inland Sales – 6 weeks credit
 Export Sales – 1.5 weeks credit
3,12,000
78,000
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3. Lag in payments of wages and other outgoings:
 Wages - 1.5 weeks
 Stocks of materials, etc – 1.5 weeks
 Rent, royalties, etc – 6 months
 Clerical Staff – 0.5 month
 Manager – 0.5 month
 Miscellaneous Expenses – 1.5 months
4. Payment in advance:
 Sundry Expenses
advance)
(paid
quarterly
2,60,000
48,000
10,000
62,400
4,800
48,000
in 8,000
5. Undrawn profit on the average throughout the 11,000
year
7. A proforma cost sheet of a company provides you the following details:
Elements of cost
Amount per unit (Rs)
Raw Materials
85
Direct Labour
35
Overheads
70
Total Cost
180
Profit
40
Selling Price
300
The following further particulars are available:
a. Raw materials are in stock on an average for one month. Materials are in process on an
average for half a month. Finished goods are in stock on an average for one month.
b. Credit allowed by suppliers is one month. Credit allowed to customers is two months. c. Lag in
payment of overheads expenses is one month.
d. One-fourth of the output is sold against cash. Cash in hand and at bank is expected to be Rs.
35,000.
You are required to prepare a statement showing the working capital needed to finance a level
of activity of 1,04,000 units of production.
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You may assume that the production is carried on evenly throughout the year, wages and
overheads accrue similarly and a time period of 4 weeks is equivalent to a month.
8. From the following information, you are required to estimate the working capital:
Particulars
Raw materials:
Direct labour
Overheads (excluding depreciation)
Cost per unit (Rs)
400
150
300
Total cost
800
Additional information:
Selling price
Rs. 1000 per unit
Output
52,000 units p.a
Raw material in stock
average 4 weeks
WIP
average 2 weeks
(assume 50% completion stage with full material
consumption)
Finished goods in stock
average 4 weeks
Credit allowed by suppliers
average 4 weeks
Credit allowed to debtors
average 8 weeks
Cash at bank expectation
Rs. 50,000
Assume that the production is sustained at an even pace during the 52 weeks of the year. All
sales are on credit basis. State any other assumption that you might have made while
computing.
Factoring Problems
9. The following information is available for a company
Monthly credit sales
Average maturity period
Factor’s fee/ commission
Interest rate charged by factor
Collection department’s cost (if there is no factoring)
Factor’s average remittance period
The company’s cost of raising funds (other than factor)
Rs.10,00,000
40days
1%
15%
4500 per month
10 days
24%
Calculate the effective interest rate charged by the factor and advise the company ignoring all
other factors including risk of default.
10. A company is considering using a factor; following information is relevant:
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(a) The current average collection period for the company’s debt is 80 days and ½% of debtors
default. The factor has agreed to pay over money due after 60 days, and it will suffer the loss of
any debts.
(b) The annual charge for the factoring is 2% of turnover payable annually in arrears.
Administration cost saving will total Rs.1,00,000 per annum.
(c) Annual sales, all on credit, are Rs.10,00,000. Variable costs total 80% of sales price. The
company’s cost of borrowings is 15% per annum. Assume year consisting of 365 days.
Should the company enter into a factoring agreement?
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