nocuasgk” Overview of Indian Financial System Ei ns of Financial Overview of Indian Financial System : Characteristics, Components and Functio System. Financial Instruments : Meaning, Characteristics and Classification of Basic Financial Instruments - Equity Shares, Preference Shares, Bonds-Debentures, Certificates of Deposit, and Treasury Bills. Financial Markets : Meaning, Characteristics and Classification of Financial Markets - Capital Market, Money Market and Foreign Currency Market. ions Financial Institutions : Meaning, Characteristics and Classification of Financial Institut Commercial Banks, Investment-Merchant Banks and Stock Exchanges. Wehavereadstories aboutthe globalfinancialcrisis of 2008 that almost brought banks, stock markets, regulators, governments, internationalfinancial institutions all on their knees. Banks started to lose confidenceto provide loans andit threatened to halt the economicactivity. Crisis in one country impacted the whole world and it required a coordinated responseofall the governments and central banks to bring back economy on track, while some countries in Western Europe are still struggling to comeout. It is important to understand whata financial system is all about and whatare their constituents. Upon successful completion of this chapter, you will understand following Learning Objectives e Financial system, role and functions and components. © Financial Markets, role and importanceofthe financial markets, categoriesoffinancial markets ie. money market, capital market, foreign exchange. ¢ FinancialInstitutions, commercial banks, merchantbanks,stock exchanges. ¢ Financial instruments,types offinancial instruments and advantages. Finance Management (MU) Overview of Indian Financial 12 ee 1.1 Introduction to Financial System large se of any goodsor service to construction of Every economic activity starting from purcha require funds and involves flow of funds infrastructure projects such as airports, highways © ector, is a system responsible for Thefinancial system of a country, alsocalled as the financials transfer and supply of funds in an economy. such as banks, stock markets, regulators, © Thefinancial system comprises of many constituents d as an ecosystem consisting of ine def be can tem sys l ncia fina The merchant banke! rs etc. facilitate the savings and t rransfer of funds. to markets and instruments institutions, financial ¢ Financial system provides an ecosystem which enables the availability of funds, movement of funds and repaymentof funds. It facilitates efficient transfer of money from areas of the economyhaving surplus to theareas having deficit and provides funds for investment. © When wedeposit our surplus funds or savings with the bank, the bank pools savings of many such depositors and lends it onwardsto businesses or other household borrowers. The bank also gives interest to the depositors for depositing the money and charges interest from the borrowers for the use of money. © Acountry with well-developed financial system also invariably has strong and stable economy. The success offinancial system for the benefit of overall economy can be gauged bystudyof multiple parameters such as the depth offinancial system,accessibility of the financial system to the people, efficiency of the system and stability. © In India traditionally the penetration and reachofthe financial system has beenlimited due to various factors such as in adequateinfrastructure,illiteracy, lower incomelevels etc. In the recent past, access to financial system has improved significantly driven by increase in penetration ofinternet, rollout of Aadhar, adoption of technology by financial institutions, demonetizationetc. 1.1.1 Features/Characteristics of Financial System Financial system acts as linkage between savers and borrowers. © It consists offinancial institutions or intermediaries, financial markets, financial instruments and involves financial transactions. It is applicable atfirm level, regional level, national level and international level. «It encourages savings and investmentin the economy. Finance Management (MU! 1.1.2 1-3 Overview ofIndian Financial System Function and Role of the Financial System lizing savings for Financial system of a country provides an efficient mechanism for channe creationof assets and plays a critical role in economic developmentof the country by performing following functions. ary assets fixed Liquidity function : Financial system facilitates conversion of monet and in the process deposits, shares, debentures etc. into money minimizing bss of value shares of company, providesliquidity. For example, stock market offers platform to sell banks allow easy redemption offixed deposits. Savings function : Financial system encourages savings in the economy by providing parks regulated mechanism for deploymentof surplus funds. For example, when a depositor funds with banksthey earninterest income,thus encouraging more savings. investment Capital formation: Financial system acts as intermediary and provides fundingfor in new projects, new products, expansion etc. thereby leading to formationofcapital, whichis essentialfor sustainable economic growth. mode Paymentfunction : Thefinancial system offers convenient, reliable and cost effective of paymentfor goods andservices. Electronic fund transfer, cheque system, credit cardsetc. are some of the commonly used paymentoptions. ces Risk function: Financial system is constantly evolving and has built in checks and balan for carrying out various financial transactions and helps in improving safety of the investment. Thefinancial system also provides options to insure risk against life, property, frauds, burglary etc. Lowercost of transaction: Financial system enablestransactions at low cost thus encouraging more transactions and economic growth. 1.2 Components of the Financial System Financial system thas three major components. These are financial markets (capital market, money marketetc.), financial instruments (shares, debentures etc.) and financial institutions (banks, stock exchange etc.). In the following paragraphs these components are explained in more details. 1.2.1 System ian Financiale Overview ofindianIndom 14 Finance Management (MU) Financial Markets Financia! market is the market for + creation and exchange of financial assets like shares, cal ers, foreign currency a It 'snovaphysi l pap debentures, bonds, treasury bills, commercia an into financial assets. The mane mere “sc dealing market but refers to the arrangementfor ing on the be classified into 3 major markets depend types of financial instrument hange market. Le, Money market, Capital market and Foreign exc m debt securities (in the {a) Money market : It deals with short ter led hw 1 nature ° roams) aving a rganiz. market has organized and uno maturity of less than 1 year. Money omponent em and estment of excess funds available Or shor Money market is used by investors for inv rket is ding requirements. Organize mene by borrowers for meeting their short-term fun s nts in the money market includes cornerste mainly dominated by banks. Other participa ey market is operated bythe insurance companies, mutual fundsetc. Unorganized mon likes of moneylenders. etc. having a maturity of more (b) Capital market : It deals with securities such as shares, bonds secondary market. than 1 year. This market is further divided into primary market and shares, Primary market deals with new financial instruments such as equity shares, preference bonds etc. Secondary market orstock exchanges provide a platform for dealinginto previously issued securities such as shares, bonds etc. Participants in these markets are foreign institutions, mutual funds, insurance companies, corporates, individuals, brokers, merchant bankers etc. (c) Foreign exchange market or Forex market It deals with the transaction in currenciesof different countries. As mostinternational transactions involve exchange of one currency to another, the foreign exchange market is the largest ‘market globally by transaction value. Participants into this markets are commercial banks, corporates, brokersetc. 1.2.2 Financial Instruments Financial instruments are the financial products through which corporates andinstitutions raise funds. Financial instruments can bebroadly classified into two types; Short term and Long term. (a) Short term or money marketinstruments : These instruments have 1 year such as commercial paper, treasury bills, certificate of deposits market. Thedetails ofthese instruments are coveredin mone (b) Longterm instruments : These instruments have a of long term instruments are bonds, preference a fixed maturity such as shares etc. a maturity ofless than and form part of money y marketdiscussion. maturity of more than 1 year. Examples shares, equity shares and may or maynot have (Muy 1.2.3 Overview of Indian Financial Institutions Financial institutions act as intermediaries between the savers and users of funds. Commercial ‘banks, investment banks, financing companies etc. fall in the category of financialinstitunons Financial institutions are classified into categories of banking and non-banking institutions. (a) Banking institutions : it includes public sector banks, private banks. foreign banks, regional Tural banks, cooperative banks. payment banks, small finance banks etc. and provide banking services. State Bank of India HDFC Bank, ICICI Bank SVC Cooperative Bank is some ofthe examples of banking institutions These are regulated by India’s Central hank the Reserve Bank of India also called 2s RBI (0) Non-banking institutions : it includes non-banking financial insttutons engaged in providing services such as housing finance, consumer finance, vehicle financing, stock broking merchant banking mutual funds, developmentfinancing companies etc Depending on the activity non-banking institutions are regulated by banking regulator RBI, capital markets regulator SEBI, imsurance regulator IRDA etc. 1.3 Financial Markets In the above section, we understood the concept of financial market. Wewill discuss in more detail in below paragraphs. 1.3.1 Characteristics and Role of the Financial Market © Facilitating price discovery : Financial market provides accurate and timely information on ‘the price of the financial assets to the buyers and sellers. © Provide liquidity to financial asset : Financial markets provide highly efficent and liquid platform for sale and purchase the financial assets ensuring minimum loss in value of asset ‘spon conversion into cash. © Reducing the cost of transactions : Financial markets facilitate sale and purchase of securities at low transaction cost. «Mobilization of savings : Financial markets bring together the savers and businesses together and in the process provides avenues to invest the savings. It provides a regulated platform for investment. Allocation of savings in productive sectors : As markets provide information of returns and en performance of various securities, sectors etc. investors can take informed decisions investment in various sectors/securities. This it provides mechanism for allocation savings into most productive sectors. Finance 1.3.2 Overview of Indian Financial 5) (MU) Difference between Money Market and Capital Market Sr.No, Money Market Capital Market 1, }This is a market for short term instruments. IThis is a market for long term instruments. 2. |Money market is used to meet short [Capital market is used for long term funding| lrequirements. term requirements ofcorporations, banks and Government. 3. [Bill of exchange, Treasury bills, Equity shares, Preference shares, Debentures, Commercial papers etc. are some of Government securities etc. are the instruments lcommon instruments that are dealt in that are dealt in this market. this market. 4. |Commercial banks are the largest participants in this market. IMutual funds, Foreign institutional investors, insurance companies are the major} [participants in this market. 5. {Secondary market is not as large as. Iprimary market dueto short term [Secondary market is much larger than primary| market. nature of instruments. 6. [Transactions are generally done through telephone ormails. [Transactions are generally done through stock lexchange. .4_Money Market Money market is a market for dealing (sale and purchase) in short term securities which have ‘a maturity period ofupto oneyear. This market is used by investors to park their surplus funds for short term basis. Due to large ticket size of transactions, money market is typically dominated byinstitutions such as Banks, Insurance companies etc. however individuals a> also invest funds in the money market through mutual funds. Money market in India is regulated by the country’s central bank (.c. Reserve Bank of indi? (RBI) RBI also parucipates in the market from time totime to manage liquidity in the syste® and raise funds for the Government of India Finance Mana} .1 (mt 1 Overview of Indian FinancialS) Characteristics and Role of the Money Market Characteristics and Role of the money market is as follows: » Money market deals in highly liquid short-term debt securities of maturity between 1 day to one year. e Money market caters to the working capital and short-term requirements offirms and the governments, banks and financial institutions. © The money market fulfils the borrowing and investment requirements ofproviders and users of short-term funds and balances the demandfor and supply of short-term funds. «© Money market offers higher degree ofsafety, compared to othermarkets. than otherfinancial Rate of return or interest rate on the investment is comparatively lower markets dueto shorter maturity. intervention © Itserves as a one ofthepreferred markets for the Reserve Bankof India’s (RBI's) rates. in the market to manage money flowin the system and short-term interest © «Generally, transactions take place through oral communication (for eg phone or mobile)in the icationstake place money market. The exchangeof relevant documents and written commun subsequently. There is no formal place for the trading (like a stock exchange). © Participants in the money market are RBI, Commercial Banks, Non-banking financial companies, Mutual Funds, Corporate bodies etc. Commercial banks are the most dominant participants ofthis market. 1.4.2. Money Market Instruments 1. Call market (call money) y «Call Money, Notice Money and Term Money markets are sub-markets of the Indian mone e Money 2market. Call Money refers to the borrowing orlending of funds for 1 day, Notic y market 14 days and Term Money more than 14 days upto 1 year. Call Money/notice mone Is also known as Inter-Bank market. basis. The trades are «Lending and borrowing take place on unsecured or non-collateralim,zedwhic h is an electronic - conducted both on telephone as well as on the NDS Call syste deals between screen based system set up by the RBI for negotiating money market entities permitted to operate in the money market. call/notice money «The entities permitted to participate both as lender and borrower in the Co-operative market are Scheduled commercial banks (excluding Regional Rural hanks}.comp anies and Banks and Primary Dealers (PDs). Select financial institutions, insurance mutual funds can participate only as lenders nance uy 18 Overview ofI tes Ltd. (DFHI) an a di In f eo us Ho e nc na Fi d an nt ou sc primary Dealers (PDs) are Di 1994 respectively to d an 88 19 in d he is bl ta re es we I) TC trading corporation of India (S y market instruments. ne mo for et rk ma y ar nd co se e th p develo 2. Treasury bills term borrowing for t or sh of nt me ru st in an is ill T-b © Treasury bill also. kn own as Government of India. India to of nt me rn ve Go of lf ha be on ) BI (R nk ba l tra © Treasury bills are issued by the Cen ity in the uid liq ge na ma to d an nt me rn ve Go e th meet short term funding requirements 0 ls are vernments. Treasury bil are not issued by state go financial system. Treasury bills s, 182 day and 364 day 91 ly me na s, tie uri mat 3 ly in ma of ued iss © day treasury bills. d repaid at par at the timeof tions at 2 discount an Treasury bills are issued through auc ng maturity of 364 days sury bill havi maturity (same as face value). For example, a Trea e lowerthan 100,let's say Rs.96 andatth ce pri a t ueda iss be l wil 00 .1 Rs of ue and face val rnment. Thedifference between ve Go the by or est inv e th to d pai be l maturity Rs.100 wil Rs.100 and Rs.96 will be the return by the investor. ued by Government of India, there is no risk of default The © As the Treasury bills are iss minimum amountin which they can be traded is Rs 25,000. 3. Commercial bills accepted by © Commercial bill refers to an accepted bill raised by seller on buyer and duly the buyer the buyer. When goods are sold on credit, the seller draws a bill of exchange on ller. for the amountdue. The buyer accepts It and returnsto these ed © The accepted bills signify unconditional agreementto Fepay the seller agre amount at the end ofcredit period. © Whentradebills are accepted by commercial banks, they are called commercialbills. These are negotiable instruments and are generallyissuedfor 30 days to 120 days. © The seller may either retain thebill till maturity or due date or getit discounted from some banker and get immediate cash. The amount discounted Is repayable on maturityof the bill. In case of need for funds, the bank can rediscountthe bill in the money market and get ready money. In India, the participants of the commercial bill market are banks 3% financial institutions. Thebill market in India is not well developed. 4, Certificate of deposits © Certificate of Deposits also known as CDs have a maturity period between 7 days 1 yew Most common tenor of CDs are 3, 6 and 12 months. CDs are issued in a dematerisi3™ form, ata discountto face value and redeemed at face value. Finance 1-9 Overview of indian Financial S © Itis a negotiable money market instrument, like a promissory note (Promissory denotes a promise to pay the lendercertain amount atthe endof agreed creditperiod). All scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs) and all India Financial Institutions permitted by RBI are eligible to issue Certificates of deposits. CDs are mainly subscribed to by banks, mutual funds, provident and pension funds and insurance companies. ‘© The minimum amountof a CD is Rs. 1 Lac and in multiplesof Rs 1 Lac thereafter. ‘5. Commercial paper © Commercial paper is another money market instrument in the form of promissory note and popularly referred to as CP. It is a short-term unsecured money market instrument, of ‘maturity from 7 days to 1 year. These are issued at a discountto face value and redeemed at par. Corporates, Primary Dealers (PDs), and all-India financial institutions (Fls) that have been permitted to raise short-term resources by Reserve Bank ofIndia are eligible to issue CP.It is a very popular avenue forraising short term funds for corporates. These can be issued in denominations of Rs.5 lakh or multiples thereof. All eligible issuers are required to obtain a credit rating forissuance of Commercial Paper from a credit rating agency as may be specified by the Reserve Bank ofIndia from time to time. 6. Money market mutual funds (MMMFs) ‘The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are brought under the regulationof SEBI. Itis an open-ended mutual fund which invests in short-term debt securities. This provides an additional short-term investment avenue for corporate and individuals. 7. Repo and the reverse repo market Repo means “Repurchase Agreement” and refers to selling specified securities under an agreementto repurchase it at a predetermined date andrate. Underrepo,the seller gets immediate funds by selling specified securities with an agreementto repurchase the same ata mutually decided future date andprice. A repo transactionfor one counterparty becomes a reverse repo transaction forthe other counter party. At present, securities acceptable under repo transactions Central Government dated securities (G-Secs), Treasury Bills (T-Bills), State Development Loans (SDLs) and Corporate Bonds. The entities permitted to undertake repo transactions include Scheduled Commercial Banks, Co-operative Banks, Primary Dealers, Mutual Funds. Insurance Companies and corporate entities Overview of Indian Financtal Systen, re 8. Inter-corporate Deposits An Inter-Corporate Deposit (ICD) is an unsecured borrowing by corporates and Financia Institutions from other corporate entities registered under the Companies Act 1956oy unsecured basis. The corporate having surplus funds can lend to anothercorporate in nee; of funds. ‘© The short term credit rating of the borrowing corporate would determine the rate at which {t would be able to borrow funds. The tenorof ICD mayrange from1 day to 1 year, but the most common tenor of borrowing is for 90 days. Primary Dealers are permitted to borrow in the ICD market. Primary Dealers cannot lendin the ICD market. 9. Discount and Finance House of India (DFHI) © Itis a primary dealer and deals in treasury bills, commercial bills, CDs, CPs, short term deposits, call money market and governmentsecurities. It was established in 1988 by RBI and is now brought under control ofSBI. © Establishment of DFHI has helped to developan active secondary market in Money Market Instruments. 1.5 Capital Market © Capital market is a market where buyers andsellers engagein creation and tradeof financial securities having a maturity of more than 1 year. Trading of the securities generally take place onscreen. © Capital market provides platform fortrading ofdebt as well as equity securities. * Capital market consists of primary market and secondary market. Primary market deals with issuance of new securities, whereas secondary market provides platform for dealing of previously-issued securities. © Primary market provides new capital while secondary market provides necessary liquidity for the sale and purchase of previously issued securities. Existing holders of securities can sel their holdings in the secondary market, thus freeing up funds for investment in primary market issues. Thus, a well-functioning secondary market is key to development of prima‘? market. * Major investors in the capital market are insurance companies, foreign portfolio mutual funds. commercial banks, non-banking financial institutions, funds. investor Provident fund, pensio® Overview of Indian Financial System 1.5.1 Functions, Role and Importance of Capital Market in India 1. Mobilization of savings for financing long term investment. 2. Provide liquidity by enabling sale of securities without anyloss of value. 3. Provide long term riskcapital to entrepreneurs. 4. . Allocation of capital to productive sectors of the economy ascapital market transfers savings to well-functioning companies. Capital Markets provide funds for projects in backward areas through competitive pricing mechanism facilitating developmenteconomic developmentof backward areas, Capital markets make it possible for companies to attract foreign capital by issuance of bonds, shares etc. 7. Provide insurance against market risk using derivative instruments. 8. Capital market serves as a reliable guide to the performance and financial position of corporate, and thereby promotes efficiency. 1.5.2 Capital Market Classification Based on the type of securities that are traded, capital market is divided into Industrial securities market and Government securities market. However,primary classification capital market Is still between primary and second markets. L— Primary Market \_ Secondary Market Fig. 15.2 1.5.3 Industrial Securities Market Industrial securities market is the market for dealing in shares and bonds ofexisting and new companies. This market is further divided into primary and secondary market which are discussed belowin detail. Puna 1.5. my 1iz Overview of Indian Financial System, Primary Market © The primary market is a market where issuance of new securities take place and is also calleq new issue market. It deals with the new securities which were not previously available for investment. Corporate enterprises and Government can raise long term funds from the primary market by issuing long term securities. These securities may be in theform of equity shares, preference shares, debentures, right issues, deposits etc. Both new and the existing companies can issue new securities in the primary market. In the primary market, new issues of equity and debt are arranged in the form of Initial Public Offering (IPO orvia private placementorin the form ofrights issue to existing shareholders. 1.5.4(A) Characteristics and Role of Primary Market © Itisa market for the fresh issue ofshares, debentures, etc. © Ithelps companies to raise capital and long-term loans. © It includes various financial institutions that support the fresh issue ofsecurities. © Itenables formationofcapital by channelizing thesavings ofthe public. © It provides risk and non-risk capital to companies that encourages setting up andexpansion of new business and creationofjobs. 1.5.4(B) Methods of Raising Funds in the Primary Market 1, Public Issues Under this method company raises funds from general public, by issuing a prospectus Securities issued by this method are generallylisted on stock exchanges andavailable for sale and purchase on exchanges. The prospectus contains information about the company such as the purpose for which funds are being raised, past financial performance of the company. background,future plans, risks, gréwth prospects of company etc. This information helps the prospectiveinvestors to take decision regarding investment. Public issues can be offollowing types (a) Initial Public Offering (IPO): This is an offering by an unlisted company for the first time in its life to the general public. It contains either a fresh issue of securities or an offer for sale ofexisting securities or both. (b)Follow-on Public Offering (FPO) : This is an offer for sale of securities by an already liste? companythrough an offer documentto the general public. It can either be a fresh issue securities oran offerfor sale of existing securities. = 113 Overview of Indian Pinancial 2. Offer tor Sele Under these method securities are not issued directly to the public but are offered for sale through intermediaries like issuing houses or stock brokers. Under this method, the sale of securities takes place in two stages. In thefirst stage, the issuing companysells the shares to the intermediaries such as issue houses and brokers at an agreed price. In the second stage, the intermediaries resell the securities to the ultimate investors at a market related price. This price is generally higher and the difference between the purchase price andtheissue price represents profit for the intermediaries. This method Is not commonin India. 3. Private Placement Private placementis the allotment of securities by a company to institutional investors and some selected individuals. It helps to raise capital more quickly than a public issue. This involves issuance of securities to less than 50 persons without issuing prospectus letter of offer and without seeking permission forlisting for the securities. The issuers could be public limit companies or private limited companies. These securities may be listed or unlisted. 4. Rights Issue ‘This is a method of raising offunds through issuance ofnew shares by the companyto existing shareholders. The shareholders are offered the ‘right’ to buy new shares in proportion to the number of shares they already possess. The existing shareholders may accept or reject the right. Shareholders who do not wish to take up the right shares can sell their rights to another person. If the shareholders neither subscribe the shares nor transfer their rights, then the companycanoffer the shares to public. 1,.5.4(C) Procedure of Raising Funds by Way of IPO Under public issue, the new shares/debentures may be offeredeitherdirectly to the public through a prospectus (offer document) or indirectly through an offer for sale. An IPO could be structured for 2 reasons. Firstly, the company may be looking for fresh fundsto finance Its expansion and diversification plan. This will increase the share capital of the company. Secondly, the company could also structure it in the form ofan Offer for Sale (OFS). Here there is no addition to shares but the existing shareholders offload part oftheir holdings in the unlisted companythrough the market and get it listed in the process. Quite often it is a combination of a fresh issue and an OFS. The main steps involved in public issue are as follows: 1 Appointment of Merchant Bankers/ Investment bankers ‘The company needs to choose merchant banker to manage the IPO. They act as intermediaries between companyand investors. Merchant banker does the due diligence to prepare the offer ‘document which contains all the details about the company. (MUD 1 Overview of Indian Financial System ities in the entire issue Th appointed to ensure full are ers rit erw und s me ti me So e. csu | e th of g in process and for market case of any in ue iss e th of on ti ip cr bs su r fo e bl si on vabscription. Underwriters are resp shortfall. 2. Registration for IPO and Filing of Draft Prospectus of value more than Rs 50 ofsecurities issue rights a or e issu ic publ a ing mak y pan com © Any its observations. The or If SEB h wit nt me cu do offe t draf a file to lakhs is required statement! t and a draft tion stra regi a e par pre y pan com the and ker ban nt mercha prospectus. s fiscal health and business ofit ort rep iled feta di the udes incl ent tem sta tion stra The regi a the Security and plans and is submitted to the regulator of capital markets in Indi letter Exchange Board of India (SEBI). SEBI issues its observations by way of observation ‘The validity period of SEBI's observation letter is 12 months only f.e. the companyhas to openits issue within the period of twelve months starting from the date of Issuing the observation. © Post submission of registration document, draft prospectus also called as ‘Draft Red Herring Prospectus’ is submitted to the SEBI. It includes detailed financial records, future legal formal the h wit e anc pli com g sin su en r fo e bl si on sp ey are also re plans and the specification of expected share price range. This prospectus is meant for prospective investors who would be interested in buying the stock. 3. SEBI Approval SEBI verifies the facts disclosed by the company. It looks for errors, omissions, and discrepancies. Only after SEBI approves the application can the company set a date fortheIPO. ‘The company can openits issue within 3 months from the date of SEBI's approval. SEBIs approvalis also called observationletter. |4. The Roadshow © Once the prospectus is ready, underwriters and company officials go on countrywide ‘roadshows’, conduct investor meets and broker meets across India to sell the idea : retail, HNIinvestors, institutional investors. ‘* Additionally, companies looking at global investors also conduct road shows at ke? financial centers across the world like New York. Boston, London, Singapore and Hom Kong, Investors are provided with detailed information regarding company’s future p2™ and growth potential. They get a feel of investor response through these tours. ‘ Finance Manager (MU) 1 5. Finalization of Price Band & Share Number After the Roadshows, SEBI approval, the company, with assistance from the Investment bankers and underwriters decides on the price band of the shares and also decides the number of shares to be sold. There are two types of issues: Fixed Price IPO and Book Building IPO, 1, Fixed Price IPO : In a Fixed priceissue - the companydecides the price of the share Issue and the number of shares beingsold. Ex,: XYZ Ltd public issue of 10 lakh sharesof face value Rs.10/- each at a price of Rs.65/- eachto the public 2. Book Building IPO ; In this method, Company uses hook building process to discover the price of the issue. The company decides a price bandandit gives the investor an option to choosetheprice at which he/she wishesto bidfor the company shares. Bx.: XYZ Ltd issue of 10 lakh sharesof face value Rs.10/- each at a price band of Rs.60 to Rs.70/- is available to the public thereby generating upto Rs.7 Crores, Here the amount generated through the issue would depend on the highest amount bid by most investors. “6. Available to Public for Purchase Onthe dates mentioned in the prospectus, the shares are available to public, Investorscanfill out the IPO form and specify the price at which they wish to make the purchase and submit the application. 7. allotment of Shares ¢ Once the subscription period is over, members of the underwriting banks, share issuing companyetc. will meet and determine the price at which shares are to be allotted to the prospective investors. © The price would be directly determined by the demand and the bid price quoted by investors. Once the price is finalized, shares are allotted to investors based on the bid amountsand the shares available. In case of oversubscribed issues, shares are not allotted to alt applicants. © Investors who have applied through ASBA & to whom shares were allotted would get the shares credited to their DEMAT accounts & their funds getting debited from their bank accouat or else for thase investors to whomthe shares were notallotted, funds wauld ger unblocked in their bank account » 8. Listing E Thelast step Is the listing in the Stock Exchanges. Finally, thereis the actual listing uf the stock which converts the {PO Into a secondary market play. From that day. purchased and sold on the secondary inarket. ee stock can be W Finance Management (MU) 1-16 Overview ofIndian Financial System 1.5.4(D) Financial Intermediaries involved in the IPO Process Financial Intermediaries involved in the IPO process are as follows: 1. Merchant Banks : Merchant banksact as issue managers, lead managers or co-managers. Merchant banksare responsible for compliance and marketingofthe issue. 2, Registrars to the issue : Registrars are intermediaries who undertakeall activities connected with new issue management suchas allotment of shares. They are appointed by the company in consultation with the merchantbankers to the issue. 3. Bankers : Some commercial banks act as collecting agents and some act as co-ordinating bankers. Theyplay an importantrole in transfer, transmissionand safe custodyof funds. 4. Brokers : They act as intermediaries in purchase and sale of securities in the primary and secondary markets. They have a network of sub brokers spread throughout the length ang breadth of the country. 5. Underwriters : Generally, investment bankers also act as underwriters. They agree to take a specified number of shares or debentures offered to the public, if the issue is not Fully subscribed by the public. Company needs to pay a separate fees called underwriting fees. Underwriters maybe financial institutions, banks, mutual funds, brokersetc. 1.5.5 ¢ Secondary Market/Stock Exchange Secondary market is a market for sale and purchaseof existing securities. Secondary market generally means organized stock exchanges as they provide a continuous and regular market for buying andselling of securities. In some cases, unlisted securities are traded over the phone. howeverit represents small portion of equity market. * Stock exchanges in India are regulated under the Securities Contracts (Regulation) Act 1956, Under the Securities Contracts (Regulation) Act, 1956 a stock exchange is defined as ‘an association, organization ar body of individuals, whether incorporated or not, established for the purpose ofassisting, regulating and controlling business of buying, selling and dealing securities. Securities can be listed and traded on multiple stock exchanges. © In India, currently there are 6 stock exchange as listed by SEB). There are BSELtd Stock Exchange, National Stock Exchangeof India Ltd known NSE, Calcutta Stock in or Bombay Exchange Ltd India International Exchange (India INX), NSE IFSC Ltd, Metropolitan Stock Exchan ge of Indis Ltd, BSE and NSE are the two ofthe largest stock exchanges in India. BSE is also the oldest stock exchange in Asia and has the distinction of the largest numbersof listed companies in the world. However, NationalStock Exchangeor NSE ts the largest stock exchange in Of the daily turnover and counts as al! major financial institutions are based in Gandbinagar and only provide derivative services. India in terms as investors, INX and IFSC W Finance Management (MU 1.5.5(A) Characteristics of Stock Exchange 1, Stock exchangeprovides a continuous and regular marketfor buying and selling of securities. 2. Stock market allowstradingof onlylisted securities. Each listed security has unique ticker or code provided by the exchange. 3. Stock markets provides periodic information related to trading of securities such as price, volumeetc. 4. Tradingin the stock market takes place through the authorisedstock brokers, 5. Interest of the participants are protected through a surveillance mechanism on the trading activity capable of detecting any abnormal trading activity. 6, Stock exchange are considered as an indicator of the current and future of the economic activities of the country. 1.5.5(B) Role and Functions of Stock Exchanges 1. Stock exchanges provide liquidity through a continuous and ready market. 2. Stock exchanges ensure mechanism for safe and uninterrupted trading and transfer of securities. 3. Stock exchange encourage Jong term savings in the economy by providing a liquid, accessible and Jong term securities market 4. Stock exchanges provide mechanism for new capital formation as for existing holders can easily sell their securities and can participate in new public issues. 5. Stock exchanges enable allocation of funds from unproductive sectors of the economy to productive sectors. 6, Entrepreneurs or existing businesses can use stock exchange information as an important parameterfor deciding investments tn new businesses. 7. Publicly listed companies on stock exchanges have an added advantage of creating larger brand awareness as multiple investors trade on stock exchanges 8, Listed companies on stock exchanges need to provide periodic updates on their financial and business performance. This also puts pressure on the management todisclose information and operate efficientty. 1.5.6 Government Securities Market . © Government securities also called as ‘Gilt edged’ securiues market. The term ‘gilt edged’ means the gold edged and refers to the best quality in the context of securities. Since Government Securities have nil degree of the nsk of default, so these are called gilt-edged securives its a market where Governmentsecurities are traded. Government issues both long term and short term securities. Finance Ma (ML ¢ Lis ew of Ind) c aretraded in this e also‘called G are nt me rn ve Go l tra Cen by ued © The long term 1 securities iss ills are traded in the money ernmentsecurities called as treasury market. Short term Gov market -term The G-sec market is a source of long and State funds to the Government of India securities having a fixed d ate of matunty and are Gove rnments. The Government bonds are the open market. G-sec are issued by in loans long-term and medium raise to issued o Central Government 9 State Governments © © cipalities Semi Government authorities like City Corporations, muni Autonomous bodes such Airports, Port Trusts etc State Government entities such as Transport corporations, State Electricity Boards © Public Sector Enterprises © All India andStatelevel financialinstitutions etc. © G-sec market in India for all practical purposes represents securities issues by Central Government. G-Secs are securities issued for a tenor ranging from5 years to 40 years. These are aimed at financing the shortfails in fiscal balances. ¢ G-Secs carry a coupon rate or interest rate which is paid half-yearly and are redeemed ar maturity at par value on maturity date. The G-Secs issuances are managed by the RBI. which issues them onbehalf of the Centre by auction method. The total auctionsize generally ranges between Rs. 15,006 - Rs 18,000 Cr * Considering such Jarge issuance size, they are underwritten by Primary Dealers. Commercial banks, Primary Dealers, Insurance Compamtes, Provident Funds, Mutual Fundsare the primary investors in the G-sec market. G-Secs have a very liquid and vibrant secondary market. 1.5.7 Long-term Loans Market In addition to primary and secondary markets, sometimes long term marke tis also referred as a part of the capital market. Commercial banks and non-banking finan cial companies provide long term loans to corporate and individual customers. Long into {a} Term Loan Market {b) Mortgages Market (c} Financial Guarantees Market term Loans market {5 further classified | | | | : : W Esnance Management (Mi 1-19 1.5.7(A) Term Loan Market Term loans are long term loans offered by financial institutions for businesses to meet their long term requirements and generally having maturity of more than 3 years. Governmentof India had created industrial financing institutions such as ICICI, IDBI, IFCI to provide long term loans to corporate customers. The primary objective was to provide loans for setting up and expansion of newprojects. However, over the years, the role of these institutions have diminished as ICICI and IDBI has converted into a bank and commercial banks noware the main providers of long term loans. 1.5.7(B) Mortgage Market This market consists of the institutions which supply mortgage loan. A mortgage loan is a loan against the security of immovable property like real estate. The term ‘mortgage refers to the transfer of interest in a specific immovable property to secure a loan. Many non-banking financing institutions such as HDFC, LIC Housing Finance, Tata Capital Housing and all major commercial banks such as SBI, Bankof Baroda, ICICI Bank provide mortgages to individual and non-individual customers. 1.6 Foreign Exchange Market/Forex Market Foreign exchange marketdeals with the transaction in currencies ofdifferent countries. The rate at which one currency is converted into another is called as Exchangerate. Foreign exchange market provides mechanism for exchanging onecurrency into another. 1.6.1 Organization of Foreign Exchange Market © The foreign exchange market is also known as forex, FX, or the currency market. It is an overthe-counter (OTC) global market that determines the exchange rate for currencies around the world. ¢ Participants are ableto buy,sell, exchange, and speculate on currencies. © Participants in the Foreign exchange markets are banks, forex dealers, corporates, central banks, investment management firmsetc. © Itis the largest and most liquidfinancial market in the world. © Foreign exchange markets are screen based and comprises of a global network of financial centres.It has no physical location and operates 24 hours a day. 1.6.2 Terminologies used in Foreign Exchange Market Currencies are always traded in pairs, so the “value” of one of the currencies in that pair is relative to the value of the other. For example, USDINR means value of 1 USD in terms of Rupee which is currently prevailing in the range 73-75. Finance Overview of Indian Financial System agement (MU exchange market. USDbeing ti of the foreign exc nship is the main function a quoted relative° to Usp s are i rates of othe. r ¢ urrencie ge an ch ex d, rl d wo orl e th e of yy e e Ee e currenc reserv called cross currency rate. is o another not involving USD int cy en rr cu e on of e rat n Ce ‘on’ versio Forward of exchange tra des; a) Spot b) There are two main types ; t cies with, a standard settlemen ren cur of nge 10 ex cha t ers ref on : A spot transacti . S| a currency at the eframe of two days or T+2. The p' rice of tim ae currency in the FX market is referred point of exchange for a different to as a spot rate. Forward : In a Forward transaction, a buyer andseller agree on an exchangerate for any . This in the future, and the transaction occurs onthatdate date provides certainty to both the buyer d regardless of what the marker andsellerof the foreign currency as the exchangerates are fixe rates are then. The duration of the trade can be one day, a few days, months oryears. and Card Rates depending on the The types of FX rates offers are called Interbank, Merchant market. banks within the Indian The inter-bank rate entails the foreign exchange trading price between usually centralized by a forex market. The foreign exchangeof currencies between banks is commercial bank which conducts the trade and determinesthe inter-bankrates to other banks such as central banks and nationalized banks among others. Merchantrates,onthe other hand,consist of the foreign currency prices offered to merchants of the import and export businesses within the Indian market. These merchants gettheir merchantrates from any of the numerous commercial banks that deal in the Indian forex market. * Card rates are currency prices that are designed for basic and minor forex transactions such as tourism and hospitality transactions. For example, when a Foreign Tourists walk into any bank andasks for conversion of USD into Rupees,they will be offered exchange at card rates. 1.7_ Financial Instruments Financial Instruments or products comprise of short term and long term instruments. Short term instruments are also called money market instruments. We have been discussed in detail about money marketinstruments in the money market section 1.4.2 of the financial markets, hence we haveonlylisted only these instruments in the below paragraphs. Long term or capital market instruments are discussed in more details in following paragraphs 1.7.1 Money Market Instruments 1. Call money/notice money 2. Treasury bills 3._ Commercial Paper 4 Commercial Bill 5. REPO 6 Certificate of Deposit 7. Money Market Mutual Fund These instruments have been discussed in detail in the money market section. 1.7.2. Capital Market Instruments Equity/Hybrid Instrument 9. Equity, Preterence Shares DebtInstrument ©.g. Bonds, Debentures Derivatives e.g. Futures, Options, Swaps Fig. 1.7.1 1.7.2(A) Equity Shares © Equity shares also called ordinary shares of a company and represent proportionate ownership in the company. Share capital also called as ownership capital of the company,is divided into a number of equity shares and each share represents ownership in the company. « Accompanyissues new shares when it requires long term funds. Equity share capital is the sourceofrisk capital for the company. « Equity share issuance is the most preferred route for raising long term risk capital for the companies as this provides access to capital without any fixed commitmentlike interest paymentetc. Company makes paymentof dividend to the shareholders only after servicing the interest and tax payments. Equity share are lowestin tarms of claimsover the assets and earnings of the company.In case the company suffers heavy losses and ends up bankrupt, the holders of the equity shares are the last ones to get their money backafter creditors, bondholders, and holders of preference shareholders. Shares of listed public companies can be bought and sold the on stock exchanges thus providingliquidity to the shareholders. ° 1,7.2(B) Preference Shares © Preference shares are also part of the share capital of the company. They carry preferential right overthe dividend in comparisonto equity shares of the company. © reference shareholders generally get fixed dividend which is much higher than equity shareholders. ¢ Mani Overview of Indian Financial Systep, 122 pent (MU) any. t voting rights in the comp t’ ge Preference sharehold ors don' . company, pre’ ference In case of liquidation of the shareholders are paid before equithety d operation creditors of +d to financial an e ar mp co ty ori pri In r we lo are but shar eholders, company. es 7.2(C) Bonds and Debentur ed interchangeably on many ms, bond and debentureare us The ter Jong term debt instruments {in © the nature loan) of more than occasions and represen; 1 year. Financia) t, Autonomous bodies, Municipalities, These are issued by Corporates, Governmen funding requirements. Institutions etc. to meet their long t erm Government Securities or G-sec, while ed call e ar nt rnme Gove by ed issu es Debentur Corporate bonds. debentures issued by Corporates are called at regular intervals (monthly, Bond/debentures issuers pay interest al so called as coupon semi-annually or annually) and principal amounts on maturity to the holders of these instruments. highly ° Bonds generally have a fixed maturity period (repayment period). However sometimes In caseof rated companies issue bonds without any fixed maturity called as perpetual bonds. at the fixed perpetual bonds, company needs to only service interest to the bondholders interval. They are either secured bya collateral or claims over assets of the company or unsecured in nature. Bonds/debentures are freely transferable and may or may not be listed on stock exchanges. Bonds/Debentures also classified as convertible and non-convertible debentures/bonds. A convertible instrument can be converted into equity aftera fixed maturity. .7.2(D) Derivatives A Derivatives instrument derives its value from one or moreits underlying assets such 2s -quity shares, bonds, foreign currency etc. It represents contract overthe future estimated market value of an underlying securities. Futures/Forwards, Options and Swaps are the most commos lerivative contracts Futures : These are financial contracts in which both parties agree to buy andsell the underlying asset/security at a pre-agreed price on a specified future date. Future contrac® trade on stock exchanges. For example, future contract of Reliance Industries shares dated ¢ months from current date indicates the rate price at which a buyer andseller are ready to UY or sell at a future date. Similarly contracts when entered in case of currencies or commoditi® they are called as forwards. Both the buying andselling party are bound by the contract « Option : Options contracts are instruments that give the holder of the instrumentthe right to buyor sell the underlying asset at a pre-agreed price at a future date. Buyer of the option has to pay a premium forright to buyorsell the security.Seller of this option also called option writer receives the premium for agreeing to sell or buy the asset at a pre-agreed price at a future date. An option to buyis called as Call option, while an option to sell is called Put option. When the price of underlying security on future date is higher than the pre-agreed price, the holder of the option can buy the asset at a pre-agreed price andsell at higher price. In case the price at a future dateis lower, then holder option does notbuythe asset. 1.8 Financial Institutions Financial institutions provide financial services such as deposit, fund transfer, lending, investing etc. The term “financial institutions” refers to all kinds of organizations which intermediate and facilitate financial transactions of both individual and corporate customers. Financial Institutions are integral to the financial sector of the economy. Strong financial institutions support economic growth of the country while weakerfinancial institutions lead to inadequate funding for the economicactivities. 1.8.1 Role and Function of Financial Institutions 1, Mobilize savings : Financial institution provide multiple avenues for investment of surplus funds for individual and corporate function. 2. Supply of Credit : Financial institutions extend loans to the individual and corporate borrowers. 3. Transfer of Funds : They provide fund transfer services in very costeffective manner thus enabling flow of goods and servicesin the economy. 4, Risk Mitigation : Financialinstitutions extendscredit to diversified customer base, helping to mitigate the largescale risk of default. 5. Flow of Funds: Financial institution dueto their diversified presence ensuresflowofcredit to all the geographies ofthe country. 6. Financial Inclusion : Financial institutions through their widespread network facilitate financial inclusion. 1.8.2 Classification of Financial Institutions (a) Bankinginstitutions (b) Non-bankingfinancialinstitutions Overview of Indian Financial Non-Banking Financial Institutions }— Regulated by ABI-NBFCs Reguiated by SEBI-Stock |__ Exchange. Merchant Bank. Venture Capital, Stock Broking Companies [ L_ Reguiated by IRDA Sector Banks insurance Companies Private Sector Banks t— Foreign Banks L_ Regional Rural Banks 1.8.3 Fig. 1.8.1 Banking Institutions ution that doesthe Accordingto the Banking Regulations Act, a bankinginstitution is an instit of deposits of money business of banking, The term banking businessis defined as the accepting from the public for the purpose of lending or investment and repayable on demand. A banking institution mobilizes the savings ofthe public through accepting of deposits of moneyandlends the same to theindividual and corporate customers to meet their short term, medium term and long term financial requirements and invests the surplus amountin various securities. Central Banks : Central banks are the financial institutions responsible for monitoring and regulation of banking institutions in the country. Reserve BankofIndia is India’s central bank was set up in 1935 by RBI act and is head- quartered in Mumbai. Reserve Bank of India performs important functions of inflation management by setting up benchmark interest rates and controlling flow of money in the economy. Lowerinterest rates lead to higher inflow of money drives up demand of goods andservices andleadsto higherinflation. Higher interest rates lead to highercostof funds and hence tempers the demand andputs brakeson inflation. Reserve Bank ofIndia also maintainsstability in the foreign exchange markets. It also acts @& banker to the Government by issuing the Government securities and buying and selling of Government securities. (mit 1.6.3(A) Commercial inking s from Commercial banks are the backbone of the Indian finanetal system They accept deposit tail and carparate customers and lead the funds to retail and corporate customers for thelr working capital and long tern funding requirenients, There four major types commercial banks i india Le (4) Public Sector banks, (b) Private Sector banks, (c) Foreign banks and (d) Kegional rural banks 1.8.3(B) Functions and Role of Commercial Banks Primary Functions 1, Accept deposits : Commercial s accept deposits from public. These deposits are in the form of savings deposits, time de ostts and cu Mt deposi {a)Saving deposits ; These are the deposits made to the savings accounts that a person uses to deposit: and withdraw monies without any restrictions, Any person competent to contract can open a savings account and deposit funds tn the count. Banks pay interest to depositors for the amounts lying in the savings account. Generally, Individuals use sayings bank accounts for depositing short termsavings for meeting regul expenses, A savings account can also be openedin the nameof duly formed club, soctety, provident fund and trust. Savings accounts generally have a limit on number of transactions and charges are payable for additional transactions. (b)Time deposits : These are deposits for a fixed period of time and generally carry higher rate of interest than saving deposits, Typically banks offer time deposits for 7 days and moreperiod, Banks generally put restrictions on early withdrawal of deposits by charging penalty etc. (c) Current account : Current account ts a type of bank account for those who want to make large number of transactions on a regular basis. Unlike savings account there is generally notransaction limit. Deposits made in these accounts i.e. current deposits do not earn any interest. These are used by professtonal, businesses entities for managing day to day cash flow. 2, Making loans and advances : Commercial banks provide loans and advances for short term and long term fund requirements toindividuals and non-individuals for various needs. 3. Transfer of funds : Banks form part of payment and settlement system in the country and enable transfer of funds from In¢ person to another, Secondary Functions 1 Overdraft facility : It is an advance given to a customer by keeping the current account to overdraw up to the given limit. Overview of Indian Financt e js a commercial bill acknowledging ds purchased. Bani. goo the nst agai re tu fu in te da later chang! of exchange : Bill of ex t to the sel Her e facility of earlypa) ymen provid 3, 4. 5. by discounting the bil | of exchange. sultancy ete. r eturns, bill payment, tax con tax of ing fil es, tax of n tio Utility services ; Collec exchangeservices to the e foreign currency id ov pr s nk Ba : es ic rv Foreign exchange se n currencies. customers by buying andselling foreig urities ; Purchasing and selling of the sec securities. It offers services of selling and buying the s facility to the c ‘ustomersfor safe keeping ofvaluable ker 6. Lockerfacilities : Bank provides loc items, documents etc. 1.8.4 Types of Commercial Banks Commercial banks are classified into public sector banks, private sector banks, foreign banks, and regional fural banks. 1.8.4(A) Public Sector Banks Public sector banks are the banks that are majority (more than 50%) owned by Governmentof © India. As of April 2020, India had 12 public sector banks, largest of them is State bankofIndia also called as SBI. Other large public sector banks are Punjab National Bank, Bank of Baroda, Canara Bank, BankofIndia, Union BankofIndia, Central Bankof India etc. Public sector banks dominate shareof public deposits and loans, however it has down rapidly in recent years. * The public sector banks cameinto existence, when Reserve Bankof India acquired 60% stake in erstwhile Imperial Bank of India and renamed it as State Bank of India. Further nationalization took place when in a major decision, Government ofIndia nationalized 14 majorprivate banks in 1969and 6 morein 1980to increase penetration of bankingin India. 1.8.4(B) Private Sector Banks ‘These include banks in which major shareholdingis held by private shareholders. In India at presentthereare22 private sector banks. HDFC Bank,ICICI Bank, Kotak Bank, Indusind bank,Yes Bank, Federal Bank are amongthelargest private sector banks in India. IDBI Bank alsoclassified as private sector bank; however, Life Insurance Corporation of India (LIC of India) holds majority stake in IDB! Bank. LICis at present 100% owned by the Govern ment of India. 1.8.4(C) Foreign Banks These are the banks that needto follow regulations in their home country of operations. In India, currently there are 46 foreign branches are wholly owned subsidiaries as on May 31, 2020. country as well as in the banks operating in India through Overview of indian Financial System es However. they have limited presence and each bank only operate through few branch Standard Chartered, Citibank, HSBC are amongthe largest foreign banks operating in India. 1.8.4(D) Regional Rural Banks (RRB) nt Regicnal rural banks are scheduled commercial banks operating at regionallevel in differe ctates Theyare established to provide credit (loans) to weaker sections of the society. They central provide banking to rural and semi-urban areas. The RRBs have 3 shareholders ie. ively. eovernment of India, sponsor bank and state government in the ratio of 50:35: 15 respect ponsor bank can be any commercial banks; however currently only public sector banks are the sponsor banks. Currently there are about 43 functioning RRBs in India. Examples of RRBs operating in Maharashtra are Vidharbha Konkan Gramin Bank and Maharashtra Gramin Bank and are sponsored by Bank of India and Bank of Maharashtra respectively. 1.8.5 Cooperative Banks * These banks are established on the cooperative basis and owned by its members. They are registered under Cooperative Societies Act, 1912 and are run by a managing committee, elected by the members. They were established with the objective of promoting savings and proving creditin the rural areas. © Cooperative banks are further divided into urban cooperative banks and state co-operative banks. Urban co-operative bank refer to the cooperative banks located in urban and semi- urban areas. The primary customer base of these banks are small businessmen, a group of communities etc. State co-operative banks act as custodian of the cooperating banking the state. Currently there are about 1482 urban cooperative banks and 58state cooperative banks in the country. well © Cooperative banks were traditionally under the dual control of cooperativesocieties as as Cooperative society overlooked incorporation, registration, management, audit, supersession of board of directors and liquidation, RBI was responsible for regulatory RBI. functions. Cooperative banking sector has beentraditionally plagued with number of frauds. Recently Government of India brought cooperative banks under the RBI supervision to improve the functioning of cooperative banks and safeguard the deposits in the cooperative banks. 1.8.6 Other Banks * inaddition to the commercial and cooperating banking, RBI has tn recent past granted licenses to small finance banks and payment banks. Small finance banks play role in serving under banked sections ofsociety to improvethe financial inclusion in the country. 12 Overview of Indian Financial Syston f the example of small finance Ujjiwan Small Finance Bank are someo d deposits, currently upto Rs. 1 Lakh Der cte tri res ept acc to ed How e ea Fe ete net banking, mobile banking, debit cards via er nsf tra d fun like e ec er ee a ao ntry. Paytm Payment bank, Ing, ment banks in the cou ‘hereate currently only handful pay ment banks. Post Payment Bank are examples of pay s ied on the basis of Scheduled and Non-Scheduled . Banks can also beclassif banks are covered under the 2"4 Schedule of the Reserve Bank ofIndia Banks. Scheduleg Act, 1934. Mostof the banks India are scheduled commercialbanks. © Scheduled Banks are covered underthe depositor insurance program of Deposit Insurance and Credit Guarantee Corporation (DICGC), whichis beneficial for all the account holders holding savings andfixed / recurring deposit account. Under DICGC, bank deposits of up to Rs lakh are insured. 1.9 Non-Banking Finance Institutions © Non-banking institutions do not hold banking license, however, facilitate finance related services, RBIdefines non-banking finance company as a companyregistered under the CompaniesAct 1956 engaged in the businéss of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securitiesof a like nature,leasing, hire-purchase, insurance. NBFCs are regulated by different regulators depending on the type activit ies carried. These include a) Non-banking finance companies or NBFCs (e.g. Sunda ram Finance, Tata Capital) regulated by RBI b) Insurance Companies (eg. LIC, New India, HDFC Life) regulated by insurance regulator IRDA c)entities regulated by SEBI such as Mutual Funds. (SBI Mutual ICICI Prudential Mutual Fund), Merchant Bank Capital Funds, Stock Exchanges s(e. -g. Axis Capital, Kotak Mahindra), Venture etc, 4) housing finance companies (e.g. Finance, Magma Home Finance) regul and also understand briefly about 1.9.1 Merchant Banks Fund, NBFCs regulated by the RBI. broaderrange of services and more popularly know n Indiabulls Housing Finance Management (MU) 1 29 Overview of Indian Finan ; ged inthe business of issue «Merchant Banker in India is defined as, any person whois enga ng, or subscribing to the management either by making arrangements regarding selling, buyi securities as manager, consultant,adviser in relation to such an issue management. Merchant Banks are the financial institutions which provide a wide range offinancial services nt, consulting services to such as issue management, financial advisory, portfolio manageme large corporate houses or individuals. -known global Goldman Sachs, Morgan Stanley, Credit Suisse, CLSA are some of the well tal Markets, merchant banks, In India, Axis Capital, Kotak Mahindra Capital Company,SBI Capi are examples of some ofthe large merchant bankers. 1.9.1(A) Role and Function of Merchant Bank ffersall the Merchant Banks provide a rangeof services, although not every merchant bankero services. Followingis list of importantfunctions/services provided by merchant banks. ies 1. Issue management : Merchant Bankers advise on the issuanceofdifferent types of securit such as equity shares, preference shares and debentures. Issue management services involve functions such as public issue, underwriting, marketing,pricing of issues. 2. Underwriting of public issue : Merchant bankers coordinate and participate in underwriting of public issues, coordination with other underwriters etc. 3. Loan syndication : The Merchant Banks arrangeloans for the clients for their projects by forming a consortium of financiers 4. Portfolio management : Merchant Banks help their clients in investing and managing investment portfolio by investing funds into various asset classes such as equity, debt etc. depending on the risk appetite of the clients. 5. Broking : Many Merchant Banksact as brokers of stock exchanges. They buy and sell shares andotherlisted securities on behalfof their clients. 6. Advisory on mergers/acquisitions : Some Merchant Banks provide consultation and advisory servicesto theclients on strategic decisions such as expansion, mergers, acquisitions, takeovers, sale of business etc. 7. Valuation : Merchant bankers provide valuation services for various purpose such as investment in unlisted securities, merger and acquisitions of business or a division of business, brandetc. 8. Project appraisal : Merchant bankers provide services related to project appraisals from different angles of investment, technology, location, marketing etc. 9, Leasing services : Some Merchant Banks are engaged in leasing services in which lessor allows the use of specific assets to the lessee for a certain period for payment of rentals. 30 Finance Management(MU) 1.9.1(B) Overview of Indian Financial 5 JStem bllicic I ker ii 's Pu n a B t n a h c r e M Role of ic. e offer document wh th e ar ep pr e to nc lige nker does a he due di ring complian,, ba su en nt r ha fo rc le Me ib : e ns nc po res| 1, Due dilige y. They are also an mp co e th t ou ab ils contains all the deta ess. e entire issue proc th in es i it al rm fo l 5 ue. Deipending on with the lega for the iss s er it wr er nd l tu in po may ap ation With meti mes company So ng: ti ri s own or In syndic rw it de on Un r ke 2. an i b nt a merc! ha hant banker acts the size of issue merc other underwriters sue proce’ ss with and coordinate the is underwriters. g ofthe iss' ue. Merchant banker, in et rk ma r fo e bl si ers are resp on stors and gauge the ve in e 3. Marketing : Merchant bank iv ct pe os pr e et th ere company official me arrange roadshows, wh response ofthe investors. e the issue dependingon th of ng ci t ri n e ) m n P e o g a n a s vise the m 4. Pricing : Merchant banker ad setc. market conditions, response from investor nkers 1.9.1(C) Categories of Merchant Ba ities and Exchange Board of India (SEBI), Merchant banksin India are regulated by the Si ecur Iii es Category I, Category II, Category gori cate four into s ker ban hant merc fied whichhasclassi and Category IV merchantbankers. folio gers, Consultants, Advisors, Port Mana e Issu as act can er bank hant merc I gory Cate banker ca! nnot act as an issue manager but Managers and Underwriters. Category II merchant er cannotact as issuer or provideportfolio bank nt cha mer III ry ego Cat er. anag co-m a as can act s can only act as advisor or consultant for managementservices. Category IV merchant banker hant bankers registered with SEBI. issue of capital. At present there are more than 200 merc © 1.9.2 Stock Exchanges t sub-section of the capita Stock exchange has been explained in details in the secondary marke market section. Review Question: Q.1 Explain the meaningof Financial System and characteristics of financial system. Q.2 Explain the role of financial system. Q.3 Whatare the components of financial system? Q.4 What are the financial markets and whatare the types of financial markets? Q.5 What the characteristics offinancial market and role of the financial market? Q.6 Distinguish between capital market and money market Module» 2.17 CMe Return and Risk a a Concepts of Return and Risk : Measurement of Historical Returns and| Expected Returns of » Single Security and a Two-security Portfolio; Measurement of Historical Risk and Expected Risk of 3 Single Security and a Two-security Portfolio. We comeacrossthe sentencessuchas ‘highertherisk, higher the reward’or‘norisk, nopai, ‘in our everyday conversations. While intuitively we know the conceptofrisk and return, we w, learn how to measurethe risk and return in this chapter. We will also learn how to minimizeris, for a required return or maximize returnsfor an acceptable level of risk. Learning Objectives ¢ Components of return, measurement ofhistorical and expected return. © Understanding risk, measurement of risk on historical and expected returns, norma distribution curve. « Measurementof historical and expected return of twosecurity portfolio. e Measurementofhistorical and expected risk of two security portfolio. 2.1 Concepts of Return and Risk 2.1.1 Historical Returns - Return on Asset of a Single Security Portfolio When we invest funds in financial assets such as fixed deposits, mutual funds, shares debentures etc., we earn returns in two forms 1. Income from the asset in the form ofinterest or dividend 2. Change in theprice of asset known as capital gain orloss So the total return is sum total of interest/dividend inco me and capital gain or loss. inance Manager Return 22 (MUj} and Risk Returnis generally expressedin percentage terms and calculated as total return dividedby the beginning investment return earned in the form of dividend income is called dividend yield, returnin the form of interest income is called interest yield and return from change in price is called capital gain yield. Thus, total return expressed in percentage terms {s sum of capital gain yield and interest yield or dividend yield. Mlustration : Let us consider an example. Let's assume we invested money in the shares of Reliance Industries Limitedatthe cost of Rs.2000per share one year ago. Todayafter 1 year, price Return ’ eturn " of Reliance shares appreciates to Rs.3000. During the year, Reliance also paid a dividend of Rs.100. Calculate the rate of return. £2000 2000) + 100 2000 1100 = 2000 * 55% Here R 100, 3000 - 2000 2000* 2000 R = 0.05+0.50 R = 0.55 or 55% Here, 5% is knownas dividend yield and 50% is knownascapitalgain yield. In general, the return for a year is can be calculated as below: DIV, + (P; - Po) ea(21.1) where DIV,- Dividend received during the year P,- Price at the endof the period Py - Price at the beginning of period R- Return for the period. Illustration 2 negative returns Let's take one more example. Assume thatyou invest fundsin shares of Suzlon Energy Limited at a price of Rs.7 per share. Companyis making a loss and hencedoes notdeclare any dividend. Furtherat the endofthe yearprice of share dropsto Rs.5. Calculate therate of return The investmentin shares of Suzlon yielded returns of - 28.6% consisting of - 28.6% capital gain yield and 0% dividendyield. Return and Rigy 2.1.2 e Av erag w ement (MU) Finance M. Rate of Return arket for ors hol investments. Many invest rm te g Jon) te of return over a histor, May cons idered as ma ra @ e g a t r e e k r a av m s l or ta st ve Capi rn Petey, ear For suc h in y e n o n a h t e n. The average rate of retu or ur mm r fo e v es 1: ti an a securi ows ur eof returns th ct pi ct re pr ge rate of return is as foll ra 3 e} av r fo a ul period convey , The form tury ns tor each pe to the average of re R, Rate of return for { riod A213) 1s R= ne x period. INustration erstand the average returns. Table 2); al share price data to und Let’s have a look the historic of each year from 2010 to 2020. For the ease ary Janu *t d on 1 showsthe sh are prices of MRF limite by the company each year. eredthe divi dend declared of understanding we have n ot consid Table 2.1.1: Share prices of MRF Closingprice Capitalgain [ % Return [Date 01-01-2009 | 1.631 01-01-2010 5,668 4,037 248% 01-01-2011 5,943 275 5% 01-01-2016 |__7.782 12,975 19,228 39,672 35,345 01-01-2018 67,826 0101-2012 01-01-2013 01-01-2017 01-01-2019 01-01-2020 _Average 51,397 _61,119 66,597 1,839 5,193 6253 20,444 -4327_ 16,052 16,429 - 6,707 5.478 31% 67% 48% 106% - 11% 45% 32% - 10% 0% 52% Based on the Table 2.1.1 Average rate of return for MRF Limited in last 10 years will = 28845431 + 67 + 4B + 106 + (- 11) + 45+ 32+ (- 10) +9 R 10 52% Note : Pee Please note we have not considered dividends, including which the average rate ofof return wel ven higher. It's a common practice to calculate average annualreturn while evaluating fustoncal returns. Frnance Management (MU) Return and Risk 2.1.3 Holding Period Return «In above examples we calculated the annual rate of return. What if we wantto calculate the cate of return for the period for which we were holding the security. This return is referred to as the holding period return or HPR Holding period return isexpressed as a percentage andis the (otal return receivedfromholding an asset or portfolioof assets over a periodoftime The holding period return ts calculated by multiplying a notional investment amount of 1 with returns on for each period and then subtracting 1 from thetotal value. Iitustration Let's calculate the holding period return for MRF Ltd between 2015 to 2019, based on the price history ay provided in Table 2.1.1, The annual returns considered for calculation are 2015 - (11%), 2016 ~ (4596), 2017 - (329%), 2018 - (-109), 2019 - (9%) R © 1x ((1~ 10%) (1 + 45%) (1 + 32%) (1 - 1096)(1+ 996)) - 1 = (1) (0.90) (1.45) (1.32) (0.90) (1.09) - 1 = 169-1 = 0.69 or 69% Molding period for 5-year period for MRF Ltd between 2015 to 2029 Is 69%. If we were to calculate annual compound rate of return for the above period, we need to calculate the geometric which will be calculated as follows : Compound annualrate of return = = 2.1.4 5 (0.90) (1.45) (1.32) (0.90) (1.09) - 1 1.10 - 1.00=0.10 or 10% Measures of Risk for One Security Insectton 2.1.2, we calculated the average return of MRF Limited for 10-year period which was 52% p.a. However,therate of return in each period wasnotconstant and varied from between ~ 9% to 248%. This variation in rate of return gives rise to the risk. Measurementofthis variation or uncertainty is the measure ofrisk associated with the investment. There are two measures of this variation orrisk 1, Variance and 2. Standard deviation. * Variance is calculated as the average of sum of square of difference between actual rate of return and average rate of return. Varianceis expressed as o. * Standard deviation ts the square rootof the variance andis expressed as o Variance (0?) = aye Ry? (2.1.3) W Finance M. Return and Risk 25 nt (MU) (214) Standard Deviation o = where R,- Rate of return of security in i™ interval ofperiod R - Average rate ofreturn. Illustration Let's calculate variance for MRFLimited. Wewill follow the below steps. 1. Calculate the average rate of return. This is denoted as R. As seen previously for MRF Limiteg R= 52. 2. Then calculated the difference betweenthe actualrate of return and averagerate of return for each period. 3. Calculate square of each of this difference and take sum of the squares of eachof this difference, which is denoted as ))(R - R)?. 4. Lastly divide this sum by n - 1, where nis numberof observation in sample data. Weare dividing the sum by n - 1 to accountfor loss degree of freedom when we considera sample data. This is because we are only considering sample from entire population of returns of the security. Let’s calculate the variance for MRF Limited Date 01-01-2009 01-01-2010 01-01-2011 01-01-2012 01-01-2013 01-01-2014 01-01-2015 Annual Returns (%) (R- R) (R-R)? 248 5 31 67 48 106 01-01-2016 196 -47 -21 15 -4 54 38416 2209 441 225 16 2916 -11 -63 3969 01-01-2017 45 -7 49 01-01-2018 01-01-2019 32 10 -20 ~62 400 3044 01-01-2020 9 -43 1849 TOTAL AVERAGE RETURN 52 54334 2 . Return and Risk 2-6 nance Management (MU) gzapeszy’s (5-s2y'+ on-s2y’s (67-52)? + (48-5277 (106-S2y%s (19 say's (45-52)! s (52-52) (10-52)(9-52 9 Variance o* = 6037 Standard Deviation = {eos =78 Whatdoes this indicate? MRF shares offered an average annual return of 52, but had a standard deviation of 78 which is an indicator of fluctuation of actual returns from average returns. This variation orfluctuations in returns is quite high and indication of high degree of volatility in returns. However, kindly note that the standard deviation for 10 years may not adequateto calculate the implied risk and the risk may be lowerif we lookat larger population of data. Whenever weinvest in shares for short term, we should be prepared for the volatility in the prices 2.1.5 Expected Returns of Single Security In the previous examples wecalculated risk and returns based onhistorical information. We canalso calculate risk and returns based on the expected returns. For this welist rate of returns expected under possible scenarios and assign probability to each of the possible scenarios. Expected return is equal to the weighted average of rate of returns under all the possible outcomes. Expected Rate of Return expressed as E(R)can becalculated as below E(R) = Ear ww (2.1.5) Where P- Probability of the outcome R- Rate of Retum i-i* outcome n- Total numberof possible outcomes Illustration Let's take an example of security XYZ Ltd whose possible returns under various scenarios are tabulated as below : Return andRis, 2-7 Finance Management (MU Table 2.1.2 Scenario Probability (P,)| Rate of Return Expected Rate of| Return (%) (R,)| Return (Pu (Ri) 0.20 -10 (0.20)(- 10) Stable growth 0.30 10 (0.30)(10) High growth 0.50 20 (0.50)(20) Total 1.00 Negative growth 11.00 be calculated as below: Based ontheTable 2.1.2, expected return will = 11% E(R) = (0.20) (- 10) + (0.30) (10) + (0.50) (20) as below: Variance ofreturns in the above examplewill be calculated 2.1.6 Expected Risk of Single Security k In section 2.1.4 we calculated the risk of investment based on historical returns. Theris measures i.e. variance and standard deviation canalso be calculated by assigning probabilities to expected returns. In the above example, returns from investmentin XYZ Ltd are expected to vary between -10% to 20% underdifferent scenarios. Risk associated with investmentin XYZ Ltd will be calculated as below: Variance (02) (0.20) (- 10-11)? + (0.30) (10 - 11)*+ (0.50)(20 - 11)? (0.20) (441)+ (0.30) (1) + (0.50) (81) = 88.1+ 0.30 + 40.5 =128.9 Standard Deviation (6) = 128.9 = 11.35 For large number of probable outcomes, variance canalso be expressed as below: Variance (07) = P;(Rj- E(R))"* Pz (Rz - E(R))* + P3 (Ra- E(R))*+ ... + Pa (Rn- E(R))? = DP (Er BR)? {2.48} 2.1.7 Use of Standard Deviation and Normal Distribution Wehave studied the examples where distribution of probability was discrete or returns had limited number ofoutcomes. However,in practice distribution ofstock returns is more likely to bé continuous as the stock returns can take values from a very high positive numberto negative number. Such a continuous distribution of returns is called normal distribution. Norma! distribution is a symmetrical, continuous, bell shaped curveas shown in Fig. 2.1.1. Finance St yt (MU 28 Return and Risk = A 3 -2 4 0 1 2 3 Standard deviations Fig 2.1.1 : Norma! Distribution Curve Normaldistribution curvehas following properties: 1. Area under the curve is equal to 1 and represents the probability ofall the outcomes. 2. Maximum valueof probability underthe curveis at the expected valueofdistribution. 3, 50 percentofthearea falls within (+/-) 0.67 standard deviation (right and left), 68 percentof the distributionfalls within (+/-) 1 standard deviation (right andleft) of the expected return; 95 percentfalls within (+/-) 2 standard deviations(right andleft); and over 99 percentfalls within (+/-) 3 standard deviations (right andleft). Blustration Let’s take the case where average expected return or mean return is 15% and standard deviation is 10%. As per normaldistribution, 68% of all returns will fall within 1 standard deviation right andleft of the mean return i.e. (+/-) 10% of 15% i.e. between 5% and 25%. This also means that there is a 68% probability that returnswill fall between 5% to 25%. The normal probability table (given at the endof the book) can bereferred for determining area under normal curve for various standard deviations. For example, the probability of returns having 1 standard deviation higher than expected return i.e. 25% (10% higher than expected return of 15%) will be represented by the area ontherightof 1 standard deviation i.e. 35%. Normal distribution can be standardized usingfollowing formula Ss R-E(R) < (2.1.7) Where Sis the difference between actual return and mean return expressed as multiple of standard deviation ility of negative returns4, on to calculate probab ett use the concept of standard deviat urn or mean return of Xyy :, . ret ed ect exp 2, 2.1. le Tab the in d ione ment As Ltd security XYZ 11% and the standard deviation is 11.35 Answer First, we need to calculate distance S of 0% from the mean return of 11% in terms Of standary deviation S= ou =-097 Above value indicates that 0% return will fall area equivalent to 0.97 standard deviations o, left of from the mean return. Asdiscussed above, area covered 1 standard deviation is 34%. Hence area corresponding to 0.97standard deviation 1s 0.97times 34% Le. 32.98% ‘Area on the curve ontheleft of 0.97 standard deviation will indicate the probability of Negative returns Le. 17.02% (50 - 32.98). 2.1.8 Two Security Portfolio Wehave seen how to measure risk and returnsfora single security.In practice, investors don’, invest all fundsin a single security butin multiple securities with primary objective of diversifying their investment. We have heard of an old idiom ‘Don’t putall your eggs in one basket’, which effectively mean don’t put all investmentin one bucket. Weall intuitively know thatdiversification reducesthe risk. Let’s see it mathematically. 2.1,8(A) Returns in Two Security Portfolio - Historical Whenweinvest funds in a portfolio consisting of two securities, rate of return is calculated based on proportionofeach security in total investment andrate of return for each security. Such rate of return is called rate of return onthe portfolio and expressed as R, Ry = w,R,+ wR, Where, w,- Weightageofsecurity in the portfolio R, - Rate of return forsecurity 1 w2- Weightage ofsecurity 2 in the portfolio R, - Rate ofreturn for security 2 1 at (MU Oro Return and Risk zie vested funds in a portfolio consisting of two securities A and B in the proportion Let's say we IN 24% while shares of 30% respectively. Shares of company A provided a return of bof 30% and company 6 Pr ovided 8% returns. Calculate the rate of return for the portfolio. R, = (0.30) (24) + (0.70) (8) oe = 7.2+5.6=128% urity Portfolio Expected Return of Two Sec (B) 8 2.1. e rtfolio by adding the weightage averag rly, we can calculate expected return of po simila . ferent scenarios f i o d i n l i o f t r o p e h s turn of t 018) -w) E(Re) E(R,) = wE(R,) + (1 re ty A in the portfolio - Weightage of securi j-w- Weightage of security in the portfolio rity A - Expected return of secu - Expected return of security B )- Expected return ofportfolio ected Return Wecan extend the above formula for Exp justration of Portfolio for any noof securities. n ntin security A and 70% of the amount‘i Weare planning to invest 30% of the amou returns of security A and security B under ity B. Table 2.1.3 provides expected rate of rate of return ofthe portfolio. t scenarios. . Let’s calculate the expected Table 2.1.3 te of Return| | Seenarfo Probability] Rate of Return Ra curity B (Pd : | | | 7 of Security A (30%) 3 of Se (70%) Portfolio Return Expected Rate of |Return ofPortfolio (PdR,) 4 (0.30) (3) + 4.0 0.80 (0.70) (4) Negative 0.20 -10 10 Stable 0.30 10 20 17.0 5.10 High 0.50 20 4 8.80 4.40 Total 1.00 |_growth |_growth 10.30 Vv 2.1.9 Return and Ris, ae. = 2-11 Finance Management (MU) tfolio Measuring Portfolio Risk for Two Security Por returns of individua, While the return of the portfolio is equal to the sum of weighted average different, although measures ofrisk ie. standarg little is folio ofport ation calcul risk the y, securit t of variance of portfolio depends on the co-movemen deviation and variance is same. This because ties. The co-movement or relationship securi dual indivi of ce varian the to on additi the securities in e. ressed by the term called as covarianc exp is es riti secu the of rns retu e nth betwee to which the variables move togethe,, ree deg the of e sur mea cal isti stat a is Covariance when one rities movein similar direction meaning secu the of rns retu ns mea ce rian cova tive Posi havepositive returns and vice versa. Negative value of security has positive returns other will also riance meang es move in opposite directions. Nil cova riti secu two of rns retu ns mea ce rian cova security with other. there is no relationship between returns of one Variance ofthe portfolio is expressed as 0”, (2.1.9) Variance (02,) = w2, 07, + W2p 079 +2Wa Wy (COVan) where Wa We represent weightageof security A and B in portfolio respectively 0, Og represent standard deviation ofsecurity A and respectively Covag represent covariance ofsecurity A and B. Illustration security A and 70% in Let's calculate variance of a portfolio consisting 30% investmentin ded below: security B. A table showing probability and returns under different outcomesis provi ‘Scenario Negative growth; Stablegrowth High growth [Probability] Ry] Re [Ra-E(R,)} Re- E(Ra) 1 2/3 4 5 0.2 - 10} 10 -21 0 0.3 os 10| 20} 20] 4 11| 10 ” o, Pp -1 9 1o -6 o% 7s |Covariance| |mMer|wer| ME) 88.1 03 405 128.9] 0 30 18 48 0 -3 -27 -30 (0.30)? (128.9) + (0.70)? (48) + 2 (0.30) (0.70) (- 30) (0.09) (128.9) + (0.49)(48) + 2 (0.21) (- 30) 11.60 + 23.52 - 12.60 22.52 Standard deviation of portfolio a,is V2252= 4.74. The relationship between Covariance of two securities can be expressed in terms of standard deviation of security A and asfollows: to ation coefficient is used el rr co e Th nt: cie ffi coe s The term Cory, is called as correlation tive correlation indicate si Po 1. (0 1 n ee tw be es negative measure between two vartables. Itt akes valu gative value indicates ne ile wh d, ate rel cor y vel iti that movement of A and B are pos t the covariance of tes tha B. This express jon indica and A of nt eme mov n wee bet correlation the correlation rd devial tion of A and B and nda sta of on ati lic tip mul is B portfolio consisting A and coefficient Cov, Cotas = (a4)(a8) The varianceofportfolio can now be expressed as at, = wy ott wie oe +2 (wala) (04)(6a)( Coras)ww (2.1.10) varianceof the The above formula can also be usedto calculat te ‘returns. In thatcase the variance ofsecurity A portfolio based on historical {.e. o®,and variance ofsecurity i .e. 075 will be ‘calculated based onhistorical returns. s d variance and standard deviation depend Kindly notethat therisk of the portfolio measure t in rities ani \d 2) Proportion of investmen upon three factors 1) Correlation of the two secu ch security 3) standard deviation of each security. 2.1.10 Diversification and Reduction of Risk ive correlation and Securities having a correlation coefficient + 1 means there is perfect posit tion. combiningthese securities may notresult in meaningfulreduction in standard devia A correlation coefficient - 1 means a perfectly negative correlation and combining these securities mayoffer highest reduction in risk. In general, combining securities with negative correlation will have highest impact in reduction ofrisk, while combining securities with positive correlation will be lower andwill be impacted more bythe standard deviation ofeach security. illustration In the above example wecalculated expected returns and risk ofsecurity A, . security B an and Particulars Security A Security B Portfolio Expected Return 11.00 10.00 10.30 Standard Deviation 11.35 6.93 4.74 213 lio deviation of portfo r security 4 , red to 11.35 fo uch lower compa at 4.95 is m ceg nd es, risk has redu wo securiti that by combin, 2 t table suggests versification ofinves tmen, di at th es ov pr y ll ca This mathematt compromising ptt al markets. rs in the ca can reduce sk of recu ce portfolio Minimum varian create a portfoj,, to sh wi w no d an nt me vest ty, nalized 2 securities for in fi ve ha we me l su as s t' Le will change dependingon e ce an ri va o li fo rt Po m. be mi nimu o variance will standard deviation and . Le s or ct fa r he ot o tw o secu rities as of the inv restment in tw such that the portfoli proportion securities. Portfolio rrelation are fixed for the co having minimum variance {s called as variance portfolio. minimyy, ow ty A can be calculated using bel lio, weight age of securi In a minimum variance portfo formula al > Formula: Wa =x e (e+ 0% — 2COVA8) = iy | -(—_(48 2 (128.9 + 48 - (- 30)) 78 256.9 = 0.30 A and 70 Hence, the portfolio consisting of 30% of investment t in security yaa the minimum variance portfolio. Mein cariee 2.1.11 Solved Examples Bee i ee ni eee ea capocied we conus came ta seer Sous rot anna Captalexpected ec 2 ywcapa Suewo ne ann market, share price of Mahatma Capital expected reach in " . = ° . at the end of the year, Calculate following returns for Mr. Prasad. 1 Capital gain amount 2. Capital gain yield 3. Dividend amount 4. Dividend yield 6. Total retum in Percentage ge retums. . 5. Total return amount oom: Capital gain per share = Market Valueof investment (expected)1) - Valueof original investm = 275-250 = 25 ” ™ OY fina Management (MU) 214 Return and Risk Capital gain in amount = (25) (100) « 250 0 75 - 250 Capital gain yield = (2e T = 10% Dividend Income = (Dividend per share) (No of shares) = (5) (100) = 500 Dividend yield = (35) = 2% Total return = Capital gain amount+ Dividend amou nt = 2500+500 = Total return in percentage | 3000 Total return amount Orieinat investment Capitalgain yield + Dividend yield 10% + 2% = 12% Ex. 2.1.2 :Calculate Expected Returnsand Risk for Security A. Outcome Probability Rate of Return (R) Good 30% 15 Normal 50% 10 Bad 20% 5 Soin. : loutcome|Probability|Rate ofReturn (R)|PiRi|R~E(R)| (R-E(R))* |p(E-E(R)) Good 30% 15 45 45 20.25 6.075 Normal 50% 10 5 -05 0.25 0.125 Bad 20% 5 1 -55 30.25 6.05 50.75 12.25 Expected Return 10.5 Variance 12.25 Standard Deviation! 3.5 100% 10.5) rate of Return (R)| PR /R-E(R)| 145 | |7s| m% i550] -05 -2.0} - 20.5 -10 (R-E(R))? 210.25 PCE ey, 8300 420.25 84.05 0.25 01 147.25 630.75 10.5 Expected Return 103 Variance 147.25 Standard Deviation 12.13 ty A and 50%, Ex. 2.1.4 :Caiculate expected return and risk for Portfolio consisting of 50% of Securi Security B. Outcome Probability (p) (Ra) (Ra) Good 30% 15 25 Normal 50% 10 10 Bad 20% 5 |-10 Soin.: E(R,) (Outcome|Probal e| bility (p) (Rd/Ra) Portfolio} (R) pR, Good Normal Bad 30% 50% 20% 100% 15 25 1o|10/ S |-10] 20 10 -25 6.0 5.0 -05 10.5 P(E-£ RE (R,) (R-{- E(Ry)) 2 my? 9.5 -0.5 -13.0 90.25 27.08 Expected 108 Variance 61 Standard 78 | 0.25 169 259.5 Return Lt Deviation 0.13 33.8 61 | | |__| Return and Risk 16 Finance Management (MU standard ex 215 An asset has an expected return of 25% ond the deviation of possible retums 125% What is the probability of the retum of asset will be zero or negative? Son. s - SEqR) o-25 12.5 = -2 Negative returns are2 standard deviations onthe left side from the mean. Innormal distribution area underthe curve upto +/- 2 standard deviation from meanIs 95%. Remaining area ts 5% and is divided between high positive returns on the right side and negative returns on the left Probability = sh. 2.5% @.1 What is retum? Explain the components of returns. @.2 Define holding period return and show how it is calculated. @.3 Explain the concept of risk. How it is calculated? @.4 Whatis normal distribution? How it can be used for calculating probability of stock retums? @.5 What is coefficient of correlation? What is the relatioriship between covariance and coefficient of @.6 Explain how diversification reduces risk. correlation? dceteaa Time Value of Money y f Time Value of Money : Future Value of 2 Lump Sum. Ordinary Annuity, and Annuit Due: Preser Vatue of @ Lump Sum, Ordinary Annuity, and Annuity Due Continuous Compounding arg | Continuous Discounting, our childhood. in this ‘Time is Money’ is one of the most commonly heard proverbs since andlearn various chapter we will understand the value of time in the context of investment concepts as mentioned. Learning Objectives © Concept of Time Value, Future Value, Rate of Return, Compounding. © Future Value of a Lump Sum, Ordinary Annuity, and Annuity. © Present Value of a Lump Sum, Ordinary Annuity, and Annuity Due. Continuous Compounding and ContinuousDiscounting. 3.1 Concept of Time Value of Money © If we are given a chance to choose between receiving Rs.10000 today Vs Rs.10000 a year later,” most of us will choose to receive today. There may be multiple reasonsfor this choice such 3 | need for consumption i.e. meeting expenses at present or avoiding uncertainty ofreceiving money at the end of one yearorto avoid loss of investment opportunity. © The requirement for consumption may be subjective to each individual and uncertainty a investment will depend on the type of investment. However, the loss of investmest | opportunity will apply to all the situations. ' ' ! Finance Management (Mu) 3-2 Time Value of Money. This is because we can always invest the money and expect to earn a positive return over this nvestment. Simplest example of investmentis creating a fixed deposit in a bank for 1 year. Hence, most of the rationale human beings will choose Rs.10000 today over receiving the same amount a year later This preference for receiving money now compared to receiving same amountof money at some later period is called the Time Preference for Money or Time Value of Money. 3.1.1 Future Value When we chooseto receive money in future over present, we will naturally expect higher amount than what we would wereceive today. Future Value refers to this higher amountthat we expect to receive in future. Future Valueis the amountto whicha currentor a present asset would grow overtime. Investors can evaluate future value expected from different investment avenues and take informed decisions. This Future Value is importantfor investors andit allows them to take decisionson their investment. Illustration Let us continue with our exampleof Rs.10000 and assumethat we decide to invest the amount ina 1-year bank deposit earninganinterestrate of 7% p.a. In 1 year,at the rate of 7%,we will earn interest amount of Rs.700 and wewill have Rs.10700 at the end of year 1. Let us represent the future value at the endofyear 1 as FV;. In terms of mathematical formula FV ofRs. 10,000 after 1 year at 7% p.a. can be calculated as below: FV, = 10,000 + 10,000 x 7% = 10000 x (1 + 7%) = 10, 700. 3.1.2 Simple Interest and Concept of Compounding In the above example by investing Rs.10,000 for 1 year, we earnedan interestof Rs.700 which is simple interest. Whatif we choosereinvest interest along with principal at the end of 1 year? ‘Wewill earn the interest over the principal of Rs.10,000 and on Rs.700 interest. Interest earned ‘onthe principal is called as simple interest, while the interest income earned on the principal and interest amountis called as the compoundinterest. This process of earninginterest on principal and interest is called as compounding. Ailustration Whatif we reinvest Rs.10,700 for one moreyear, the amountreceivable after year 2 will be as lows: FV, = 10,700 x (1+ 7%) = 10,000 x (1 + 7%)? = 11449 Total interest earned in 2 yearswill be 1449 (the difference between 11,4¢9 and 10,000) Finance Management (MU 3.1.3 Time Valueof 33 Rate of Return M ing rned Rs.700 as an interest Provid ea is equivalent to a investing ig Rs.10,0! 00 for 1 year In the above example byin ay, s that receiving Rs. 10,000 tod us a return of 7%. This also mean our moneyin fixed depos' it. Rs.10,700 a year later provided weinvest ¢ unt © So if we are offered an amount of any amo more than Rs.10700at the end of1 year, we wil prefer to receive money after 1 year, provided there is no uncertainty. What if there js an from the investment will depend on therisk andis called as required rate of return. The ? Will we expect similar return as 7%? We will element of risk in receiving moneyafter 1 year nty orrisk. This rate of return expected expect a higher return to compensate for this uncertai required rate of return by an investoris the rate of return offered by investing in asset having equivalentrisk and is sameas opportunity cost ofcapital, which. © Whatif we had invested this amountRs.10,000 in share market. Wewill expect a higherreturn of may be 15% per annum onthis investment. This expectation of higher return is due to higherrisk involved in share market investment. This 8% difference betweenreturns of 15% and 7% is called the risk premium. Risk premium refers to the extra return demanded by investors overrisk free rate of return for the additionalrisk taken for investing in riskier assets. © Whatif we are asked to choose between receiving Rs.10,000 today and Rs. 12,000 to be received in 2 years, assuming opportunity costof capital of say 7% p.a. As seen invested at 7% will becomeRs. 11,449 and less than Rs. 12,000.In this scenario to receive Rs. 12,000 after 2 years than Rs. 10,000 today. above, 10,000 we will choose Thusif we know required rate of return we cash choo different periods. Let's take one more example. se between different cash flows at Tilustration t To compare Rs.50 Lakh toda years using required rate of y and Rs.70 Lakh after 2 yea 15% pa. rs, let's ‘Time Value of Mon 34 8 FV, 50(1 + 15%)? 4 nance Management (MU) 50(1.15)’= 50(1.323) = 66.125 As propertyoffers higher appreciation, Mr. Shah should take favorable decision to invest in commercial property. 3.1.4 One-time Investing/Lump Sum Investing *, vals of time. Investors have an option of investing moneyin one go or at different inter When ng or onetime investing. Future value the fundsareinvested in one go, it is called lumpsuminvesti of lumpsum investment can be calculated as below: ‘The Future Value FVn can be expressed as Px (1+i)" FV, e311), where ” n = No.ofperiods Rate of return per period FV, = Future Valueat the end ofperiod n P Principal amountororiginal investment amount The factor (1 + i)” is called as Future Value Interest Factor (PVIF) or CompoundValue Interest Factor (CVIF). It represents Future Valueof Rs.1 invested for a period of n at therate ofi So if we substitute (1 + i)” with CVIF, the Future Value formula can be expressed as FV, = PXCVIFpy (3.1.2) where CVIF,,, is the compound value interest factor for period of n at an interest of i and it represents ue future value of Rs.1 invested for a period of n years at the rate of i% per period. CVIF or CompoundValue Factor makes it easy for calculation of Future Values involving large umber of years without using computer orscientific calculator. CVIF table provides values for ferent combinations of interest rate and noof years. Finance M: Time Value of 35 t (MU Titustration r 7 years at the rate of 5% p.a? Rs. 5000 invested fo What will be the Future valueof Answer ars can be calculated by Future valueat the end of 7 ye | using formula | FV, = Px(1+i)" FV, = 5000x(1+5%)’ | FV, = 5000 x CVIF75% e Future Value in this example We can refer to the CVIF or PVIFtable below to calculat FV, = 5000 x 1.407 = 7028 Table 3.1.1 : CVIF/FVIF Table | ds, FVIF(, ») Puture value interest factor of Rs.1 per period at 1%for n perio 9% 8% 7% 6% 5% 4% 3% Period] 1% 2% 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1} 1.020 1.040 1.061 1.082 1.103] 1.124 1145 1.166 1.188 2 |1030 1.061 1.093 1.125 1.158] 1191 1.225 1.260 1.295 3 1.041 1.082 1.126 1.170 1.216 1.262 1311 1360 1.412 4 1.051 1.104 1.159 1.217 1.276 1.338 1.403 14691539 5 1.062 1126 1194 1.265 1340/1419 1501 1587 1.677 6 |10072 1149 1.230 1.316 1.407| 1504 1606 1.714 1828 7 1.083 1.172 1.267 1.369 1.477] 1594 1.718 1851 1.993 a 9 1.094 1.195 1305 1.423 1.551 1.689 1.838 1.999 2.172 10 [1105 1.219 1344 1480 1.629] 1.791 1.967 2159 2.367 11 1.116 1.243 1.384 1.539 1.710 1.898 2105 2.332 2.580 12 [1.127 1268 1426 1.601 1.796 2.012 2252 2518 2813 13, 1.138 1.294 1469 1.665 1.886 2.133 2410 2.720 3.066 14 [1.149 1319 1513 1.732 1.980 2.261 2579 2.937 3.342 15] 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 16 1.173 1373 1.605 1.873 17 1,184 1.400 1.653 18 1.196 1428 19 1.208 20 1.220 10% | 1.109) 1.210 | 1.331 146 1611) 1.772) 1.949 | 2.144 | 2.358 || 2594 | 2.053 | 3.138 3452 | 3.797 | 4.177, 1.948 2.183] 2.292 2540 2.693 2,952 3.159 3.426 3.700 3.970 4.328 5.054 | 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 1.486 1806 2.191 2.653 3.207 3.870 4661 5.604 Finance Management (MU) 7.0 6.0 5.0 340 @$3.0 s “20 Fig. 3.1.1 : FVIF/CVIF Chart at different interest rates 3.1.5 Future Value of Annuity (Ordinary Annuity) Annuity as the name indicates refers to fixed amountpaid or received at annual frequency. More particularly it refers to stream ofconstant cash flows due every year. Whenthe fixed amount of cash flows is received or paid at the end ofthe year or a periodit is called Ordinary Annuity. In case cash flows are received or paid at the beginning ofthe yearora period it is called Annuity Due. Illustration In the above example, we invested Rs.5000 for 7 years in lump sum orin one go. Suppose insteadif investing 5000 in Lump sum, wedecide to deposit Rs.1000 at the endof each year for 5 years we have created an annuity. Alternatively, when wetake car loan or housingloan, we repay the loan in constant monthlyinstallments, we have created an annuity. To calculate future value of Rs. 1000 annuity we will need to calculate the future value for each investment of Rs. 1000. Thefirst investment of 1000 madeatthe endofyear1, will earn invest for 4 years, while the last investment of 1000 made at the end of 5 years will not earn any interest. This is expressed as below: Fig. 3.1.2 FVAs = 1000 x (1 + 5%)*+ 1000 x (1 + 5%)*+ 1000 x (14 5%)? + 1000 x (1 + 5%)'+ 1000 x (1 + 5%)? = (1000)x (1.216) + (1000) x (1.158) + (1000)x (1.103), + (1000)x (1.05) + 1000 = 1216 + 1158 + 1103 + 1050 + 1000 = 5527 The Future Value FV,, at the end of n yearfor the annuity valueofRs. A, at the rate of 1% can be calculated as below: FVA, = Ax(1+i)"'+Ax(14i)"?+ 4 Ax (141)? " FVA, = Ax Gspet The term Gauren is called as Compound Value Interest Factor ValueInterest Factor for Annuity (PVIFA). ‘Thus a Future Value of Annuity can be expressed as FV, = Ax CVIFA,, (a) for Annuity (CVIFA) or fam | below: Where on (3M A- Annuity cash flow CVIFA,;- Compound ValueInterest Factor fo Per period. r Annuity of Rs.1 for n periods at theinte Table 3.1.2 shows the table of Fut rates. ure value of annui ty of Rs.1 for diff rest erent period and 7 inagement ( (MLu) @ Finance Manag: 7 3-8 Table 3.1.2: Future/Compound Value Interest Time Value of Money Factor Table of Annuity (FVIFA/CVIFA) Future value Interest factorof an ordinary annuity of Rs.1 per period at 1% for n periods, jJ——— period| 1% CVIFA/FVIFA(, 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 1.000 1.000 1.000 1.000 1.000} 1.000 1.000 1.000 2 1.000 2.010 1.000 2.020 2.030 2.040 2.050] 2.060 2.070 2.080 2.090 2.100 3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4506 4.573 4.641 5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6 6.152 6.308 6468 6633 6.802 6.975 7.153 7.336 7.523 7.716 7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8923 9.200 9.487 8 8.286 8.583 8892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 9 9.369 9.755 10.159 10.583 11.027]11.491 11.978 12.488 13.021 13.579 13.816 14.487 15.193 15.937 11 11.567 12.169 12.808 13.486 14.207] 14.972 15.784 16.645 17.560 18531 12 |12.683 13.412 14.192 15.026 15.917} 16.870 17.888 18.977 20.141 21.384 13. [13.809 14.680 15.618 16.627 17.713) 18.882 20.141 21.495 22.953 24.523 14 |14.947 15.974 17.086 18.292 19.599/21.015 22.550 24.215 26.019 27.975 15 |16.097 17.293 18.599 20.024 21.579| 23.276 25.129 27.152 29.361 31.772 16 17.258 18.639 20.157 21.825 23.657] 25.673 27.888 30.324 33.003 35.950 17 |18.430 20.012 21.762 23.698 25.840) 28.213 30.840 33.750 36.974 40.545 18 19.615 21.412 23.414 25.645 28.132/ 30.906 33.999 37.450 41.301 45.599 19 20.811 22.841 25.117 27.671 30.539] 33.760 37.379 41.446 46.018 51.159 20 [22.019 24.297 26.870 29.778 33.066| 36.786 40.995 45.762 51.160 57.275 10.462 10.950 11.464 12.006 12.578} 13.181 Illustration Mr. Mukherjee decides to invest an amountofRs.1,00,000 each yearfor a period of next 20 years to create a corpusfor future. He expects to earn a return of 10% eachyear onthe invested mount. Calculate the Lumpsum amountthat Mr. Mukherjee will receiveat the end of20 years. 3-9 W Finance Management (MU “" Future value Time Value of Mon, ey end of2 0 years can the Rs.1,00,000at of of annuity formula FVAz0 lated using amnuiy be calculated Ax CVIFA20,10% 100,000x57.275 $7,27,500. .20 This means a total investment of Rs the importance of early investment and Lakh have becomeof Rs.5 7.28 Lakh. This also shows the power of compounding. 3.1.6 Sinking Fund ® Sinking Fundrefers to a fund created using a constant amounts deposited at regular interyaj, to accumulate a future fund amount after a certain period. Sinking fund concept is used manyplaces such as creationofrepair fund for a housing society, redemption ofdebentureby companies etc. © Let's say a companyhas issued debentures amounting to Rs.100 Cr to a bank, maturingafter, period of 5 years. Company needs to create a sinking fund to meet the redemption of this debenture after 5 years. Company expects to earn annual return of 7% p.a from the amounts kept aside. How much amountshould a companysetasideat the end of each year. ¢ In this example Future Value of Annuity or FVA is 100 Cr and annuity needsto becalculated Wecancalculate the annuity by using the formula for Future Valueof Annuity. FV, = AXCVIF,, As we CVIF,; 100 A= 3751 A = 17.38Cr 1 In the above example the term ovr, 5 called as Sinking Fund Factor. Time Value of 317 annuity Due . in the above example of anna 2 constant sum was deposited at the end of each period whet ¢ « faxed mem set aside at the start of each period instead of end of the period. «Ths annuity created by Gepositing a constant sum at the start of each period is called as agmsits Dae. Anmsity Due ts a series of fixed payments made at the beginning of each period for specfied sumber of periods . Wresever we buy any item om loan generally the bank will start recovering instalments from the begianing of the loan For example, if we buy a mobile phone in the EMI scheme of 12 smooths, bank will start to recover instalment from the beginning of the month instead of a month. This is called Annuity Due «Let's say we invest Rs 1000 at the beginning of year in each of the next 5 years. In this case the gmoum invested in the last will also earn a return as it remains invested for 1 year. Hence the caicatation of Future Value will become FV, = Ax(i+i®eAx(1+it t++ Ax(1+i) FV, = Ax CVIFA,, (1+) (3.1.5) 3.1.8 Present Value of Money « in previous sections, we understood how to calculate future value of cash flows and compare cash flows received at different periods of time. What if we were to calculate the present value of future cash flows to arrive at the decision? Presentvalue is the value of cashflow available taday, which is equivalent to the future value and is denoted as PV. Present value or PV is also called the discounted value as it is calculated by discounting the future cash flows. Process of discounting is reverse of compounding. © The rate which is used to discount the future cash flows for calculating the present value is called the discount rate. When presentvalue is invested at the discountrate it will match with fuvare value. Tiustration Suppose you were to choose between receiving Rs. 10,000 today or Rs. 12,000, 2 years down he line, using present value concept Assume your discountrate is 7% pa. Time Value of Mong 3-11 Finance Management, (uu, Answer 0,000. 00 and compare it with Rs.1 alue of Rs, 12,0 Wewill calculate the presentv i count the future have to dis alculate the present value, we Toc ' at the disco unt rate hig valulue is 7% p.a. in this case. Formula for FutureValue is FV, = P(1+7%)? 12,000 = P(1+7%)? 12,000 _ * 10,481 P = 12000 <a oF 11449 ch is 481 higher than Rs.10,000. Thepresent value of Rs.12,000is Rs.10,481, whi Similarly, we can calculate Present Value of FV at the end Present value is represented as PV. Using the of period n at required rate of i% pa above example, we can calculate py by discounting Future Valueattherate of i. PV = G+" (3.15, 1 Pu = Yee aye 1 PV = FVn* CVIF,, The inverse of compound valueinterest factor is called as present value interest factor and denoted as PVIF. It represents presentvalue of Rs.1. PV = FV, x PVIFay Where PV - Present Value FV,, - Future Value at the end ofyearn i - Rate at which future cash flows are discounted is called as discountrate PVIFn,i - Present Value Interest Factorfor a period n and interestrate of | per period Wecancalculate the present values of Rs.1 for different combinations of discountrate B17) Finance Management(MU) Time Value of Mone: Table 3.1.3 : Present Value Interest Factor Table —— ] Present value Interestfactor of Rs.1 per+ period atl% for!aperiods, PVIFins | | Pertod 1% 2% 3% 4% 5% 6% ™% B% 9% 10% 1 0.990 «60.980 (0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0971 0942 0.915 0.889 0.864 0840 0816 0.794 0.772 0.751 4 0961 0.924 0888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 =60.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 Q 0.914 0.837 0.766 0.703 0.645 0.592 0544 0.500 0.460 0.424 10 0.905 0.820 0.744 0676 0.614 0.558 0508 0.463 0.422 0.386 ML 0896 0804 0.722 0.650 0.585 0.527 0475 0429 0.388 0.350 12 0.887 0.788 0.701 0625 0.557 0497 0444 0397 0.356 0.319 13 0879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0577 0.505 0442 0.388 0,340 0.299 0.263 15 0.861 0.743 0.642 0555 0.481 0417 0.362 0.315 0.275 0.239 16 0853 0.728 0.623 0534 0.458 0.394 0.339 0.292 0.252 0.218 7 0.844 0.714 0.605 0.513 0.436 0.371 0317 0.270 0.231 0.198 18 0836 0.700 0.587 0494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0570 0475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0673 0554 0456 0377 0312 0.258 0215 0.178 0.149 Present Value Chart The graph shows the presentvalueof Rs.1 at different discounting rates overdifferent periods. As seen from the graph the present value decreases as the time period increases and discounting rate increases.” Thegreater the interest rate, steeperis the declinein presentvatue. Time Value of M, on W Finance Management (MU) 6 8 7 9 10 Fig. 3.13 3.1.9 Present Value of Annuity (Ordinary Annuity) m offixed cash flows Wehave seen in previous sections that in case of ordinary Annuity strea annuity each ofcash flow will be occur at the end ofthe period. To calculate Present Value of discounted separately. The present value of annuity PVA for annuity amount of can be calculated as below: A A_, ,A_ A 1 1 A and n periods PVAn = ep? aege +d PVAn = (+i) eae +#1) 1 1 PVA, = ax(j Tae) PVA, = AXxPVIFAy, (3.1.8) where PVIFA,, is present value factor of annuity of Rs.1 for n period for an interest rate ofi per period. PVAIs presentvalue of annuity and PVAn for a period n. Finance Management (MU) 3-14 TimeValue of Money Table 3.1.4 : Present value interest factor Table of an (ordinary) annuity PVIFA Present value interest fector of an (ordinary) annuity of Rs.1 per period at 1% for n periods, PVIFA inp Period| 1% 2% 3% 4% «5% 6% 7% 8% 9% 10% | 1 |0990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 | 1.970 1.942 1913 1886 1.859 1.833 1808 1.783 1.759 1.736 2 3 2941 2884 4 3.902 5 4.853 3.808 6 2829 2.775 2.723 2673 2624 2577 2531 2487 3.717 4.713 3.630 3.546 3.465 4.580 3387 4452 4329 4.212 4100 5.795 3.993 5.601 3.890 5.417 3.791 5.242 6472 4.917 7 6.728 5.076 6230 4.767 6.002 4623 5.786 4.486 8 7.652 5.582 4355 7.325 5.389 7.020 5.206 6.733 5.033 6.463 4.868 9 10_ 8566 8162 6.210 7.786 5.971 7.435 5.747 7.108 5535 9.471 6.802 5.335 8.983 8530 6515 8.111 6.247 7.722 5.995 7.360 5.759 7.024 6.710 6418 11 12 6.145 |10.368 9.787 9.253 8.760 8.306 {11.255 10.575 9,954 9.385 8.863 |12.134 11.348 10.635 9.986 9.394 7.887 8384 8853 7.499 7.943 8.358 7,139 7.536 7.904 6805 6.495 13.004 12.106 11.296 10.563 9.899 9.295 ]13.865 12.849 11.938 11.118 10.380] 9.712 7.161 7.487 6.814 7.103 8.745 8244 7.786 7.367 9.108 8559 8.061 7.606 13 14 15 3.312 3.240 3.170 Illustration An investment in a new business is expected to provide guaranteed return ofRs.10,000 each yearatrate of 10% p.a. for next 5 years. Calculate the investment amount. Answer In above example, the investmentis expected to provide an annuity of Rs.10,000. Presentvalueof S-year annuity as represented by PVA can becalculated as below: pva, = AGA A, A A PVAs = Ax PVFAs, 10% PVAs 10000 PVFAs, 10% PVAs 10000 x 3.791 = 37,910 The amountthatneed to be invested is Rs.37,910. Using the above formula, we can also calculate the annuity for a given value of investment, Period of investment. Finance Management (my 3-15 of IMustration XYZ Ltd plans to invest an amount of Rs.1 Lakh in setting up a plant that is expecteg Ben, Me fixed returns every year at an annualrate of 10%. Calculate the value of cash flows expecteg wos generated every year. Answer Here we are provided with the present value of annuity i.e. Rs.1,00,000 and we Need», calculate the value of annuity. PVA, = Ax PVFAs,10% Nowas seen in the earlier example, we know thatthe value of presentvalue factor of annuity for 5 years at 10% is 3.791. Hence 100000 = Ax3.791 _ 10000 = 26,378 A= 3791 Similarly, for given value of annuity, investment and period of investment, we can calculate the implied rate of return. Illustration Let's calculate the implied rate of interest of an investment plan, which Rs.26,378onan investmentof Rs.1,00,000for a period of 5 years. provides annuity 9 100,000 = 26,378 x PVFAs, 100,000 PVPAs = “Sp4ng = 3.791 When we refer to Present Value Annuity Table for a period 5 years and valueo f3.791, we pe an interest rate of 10% p.a. 3.1.10 Present Value of Annuity Due In case of annuity due, cash flows happen at the beginning of the year. Presentvalue of the annuity due amountingto A will be calculated as below: A * Geet A PVA, = fen tA PVA, = Grae wt 1) The above expression can be written as below: ; 1 1 PVA, = AOLe t age ? tte): @_ Finance Management (MU) 3-16 Time Value of Money This effectively means multiplying the present value of ordinary annuity with a factor of (1 + i). Hence present value of annuity due can be expressed as below: PVA, = Ax PVFA,,(1+i) (3.1.9) 3.1.11 Multi Period Compounding /Compounding for more than once a Year Inall our previous examples,the cash flows are compoundedannuallyie. interestis paid once a year. However, in practice we mayreceive interest more frequently than once a year, say semi-annually or quarterly. For example, corporate bonds may provide interest semi-annually or banks maygive quarterly interest paymenton savings deposits. In such cases, the investor is earning interest twice or four timesa year.If this amountis re-invested, total interest earned will be higher than annualinterestrate. « The interestrate is usually mentioned on annual basis irrespective of the paymentfrequency as a commonpractice and is known as nominal interest. The actualinterest rate for the year maybe different depending on the frequency of compounding and is called effective interest rate (EIR). e Let's calculate effective interest rate (EIR) on Rs.100 deposit which provides pay out, semiannually atan interestat the rate of 10% p.a. Amount after 6 months = 100x2*3°%- 195, Amountavailable after 1 year = 105 x joj. 105 x 1.05 = 110.25 Interest income in 1 -year will 110.25 - 100 = 10.25, which isalsothe effective interestrate. « Effective interest rate can also be calculated by compounding 100 for 2 semi-annualperiods at rate of 5% as shown below: EIR @ + 40%) 1 3 EIR = (1.05)*-1 EIR 10.25% Similarly, in case quarterly paymentthe interest would be compounded 4 times in a year. EIR of i% nominal interest rate will be iy EIR = (1-4) -1 © Based on above understanding we cancalculate the future for a given a periodoftime for a multi period compounding.Let's calculate the Future value of P invested for n years that pays interest m times yearat the rate of 1% p.a. Finance M: 3-17 ment (MU. FVn = P (i “B14 Where 1 -rate of return per annum m- number of compounding per year n- numberof years same © The presentvalue canbe calculated by discountingthe future value by the factor FV, ma” 1+ COMPOUNGlay . 3.1.12 Continuous Compounding In the above examples, we have seen compounding happen at discrete intervalse.g. an, semi-annual, quarterly etc. Theoretically interest can be compounded at infinite intervals continuously. As seen in the above example mee Ko As m the frequency of compounding in a year approaches infinity (00) we Bet continuoys compounding and the term (a +b)approaches (e)™ where e is approximately 2.7197, Therefore the future value of investment P where interest is compounded continuously at the interest rate of i is FV, = P(e)" (3.1.11) Example Let's calculate future value of Rs.100 deposit at the end of 3 years with continuow compounding at8 percent will be FV3 = 100(e)°83) = 100(2.71828)°* = 127.12 How does this compare with the annual comp ounding? FV; = 100 (1 + 8%)? = 100 (1.08)? = 125.97 3.1.13 Present Value Using Continuous Discounting Finance Management (MU) 3-18 Time Value of Money The ‘Rule of 72” and Double the money Aquick way to calculate interest or time required to double your money is the use of the “Rule| of 72.” This rule states that if the number of years, n, for which an investmentwill be held is| divided into the value 72, wewill get the approximateinterestrate, | required for the investment to double in value. For example, if we wantto calculate the time required to double money if weinvest in fixed deposit thatyields an interest rate of 8% p.a. 72 No. ofyears = “g =I years Alternatively,if want to double our money in 6 years, what should be the interestrate. Rateof interest = Bw Please note Rule of 72 does notgive the exact answer, but provides an easy wayto calculate approximate value. Using Excel for Time Value of Money Excel provides easy tools for calculation of terms used in Time Value of money problems. We need to know following terms used while using excel formulaefor time value of money problems FV - Future value NPER - Numberofperiods (e.g. for 4 years with quarterly compounding NPERwill be 16) RATE Interest rate per period (e.g. 10% p.a. with quarterly compoundingRATE will be 2.5%). PMT- Periodic payment, used only for annuities. PV - Presentvalue Functions maybe entered directly or a function wizard may be used for input. If the functions are entered directly, the required inputs andstructureare below. Future Value = FV(rate, nper, pmt, pv, type); type refers to the timing of payment Le.0 for beginning of the period and 1 at the endofthe period Present Value = PV(rate, nper, pmtfv, type) NPER =NPER(rate, pmt, pv,fv, type) RATE =RATE(nper, pmt, pv,fv, type, guess); here guess means estimated valueofinteres: expressed in decimal e.g. 0.1 for 10%. ANNUITY (PMT) = PMT(rate,nper,pv,fv,type) Excel uses a sign convention that indicates whether an amountis a cash inflow or cash outflow For example, for calculation of present when we inputpositive future value, it will provid: negative presentvalue, indicating the valueofupfrontinvestment. For example, Present Value of Rs.1000 ordinary annuity at the rate of 10% for next 20 year becalculated as = PV(rate, nper, pmt. fv, type) = PV (10%, 513 Time Value of Mo, Th (MU Wr Finance Management les (Refer t p m a x E d e v l o S 4 3.1.1 Tables) Present Value re value of (1) Fi Ex. 3.1.1 :Calculate the futu _ 5 years atrate of interes o 100 invested for 4 period of of 10% p.a the end of each sted annually at 0 inve 10% p.a. (2) Ris.10 Soin.: Jumpsum (a) Future value of year at interest rato 000 investment of Rs.1 10%)° FV = 1000(1+ i investment of ture value of annual (b) Fu 11) = 1611 (1000) (1.6 = 1000 (CVIFs om) = ity Rs.100 ie. FV of annu 5 pa = aitiowl=2 0)°- 4 2 100 (CVIFAs,:0%) = (100) (6.105) (1+0.1 = 100°—910 = 610.50 Rs.1,000 Ex. 3.1.2 :Calculate the present value of quarterly (c) continuously. Opportunity (b) ally annu ue (a) en ree . n a a n Soin. : car Present Value PV == + mn Where FV,- Future valueatthe end of yearn i -rate of return per annum mi - number of compounding per year n- numberofyears (a) Present Value for annual compounding PV = —1000_ {1+10%)° _ 1000 920.73 Teri = (b)PVformula for Quarterly Compounding PV = —122 0__ )" (1-208 1000 1000 e 10 = o (1+ 2.5%)" 1.639 = 610.27 res: receivable at the end of 5 years, if inte ‘ cost ofof capital (required rate g Teme Value of More: 3-20 ince Management (MU FV {c) PY formula for Continuous compounding PV = oy 1000 PV for future value of Rs. 1000 =1000/e°* = 16497 606.42 ex. 3.1.3: Mr. Patil plans to invest an amount ofRis 25,00,000 to purchase an annuity that will provide him with a steady income over the next 10 years. He has heard that an insurance plan provides guaranteed 8 percent compound interest on an annual basis. If he were to invest his funds, what the ‘amount that he would be able to withdraw annually such that he would have a zero balance after his last withdrawal 10 years from now? Soin. : In this example, present value of the investment is provided and the investor wants to purchase 10-year annuity offering him annualinterestrateof 8. 25,00,000 = (A) (PVIFAio9%) 25,00,000 = (A)(6.710) A= 25,00,000 6.710 = 3,72.578 Ex. 3.1.4:You have inherited a debenture investment having residual maturity period of 6 years and pays an amount Rs. 3,000 atthe end of each year. Prevailing market price of debenture is Rs. 13,869. What is the implicit rate of return? Soln.: PVA (A)(PVIFA,, ) 3,000 (PVIFAg,) PVIFAs, = 13869 “3090 13,869 PVIFAg ; 4.623 After referringto the table Present Value of annuity, value 4.623 corresponds to interest rate of 8% pa. Q.1 Explain various motive for time preference for money. Q.2 Explain why the interestin multi period compounding is higher than annual compounding? Q.3 What is an annuity? Whyis present value of annuity due is higher than ordinary annuity? nll Financial Management Overview of Corporate Finance : Objectives of Corporate Finance; Functions of Corporate Finance-Investment Decision, Financing Decision, and Dividend Decision. Financial Ratio Overview of Financial Statements-Balance Sheet, Profit and Loss Account, and Cash Flow Staterneng Purpose of Financial Ratio Analysis; Liquidity Ratios; Efficiency or Activity Ratios; Profitability Ratog Capital Structure Ratios; Stock Market Ratios; Limitations of Ratio Analysis. Very oftena difference between success and failure of a business can be attributed to efficiency the financial management. A company having a highly successful product can slowly BO iney oblivionif it fails manage its finances properly. On the other hand, a companylosing market ca survive and make a comeback ifit has strong finances. This chapterintroduces the reader to work to the corporate finance. Learning Objectives ¢ Financial Management, Functionsof Financial Management © Objectives of Firm and Corporate Finance e Financial Statements - Balance Sheet, Profit & Loss, Cash Flow ¢ Financial Ratios - Liquidity Ratios; Efficiency or Activity Ratios; Profitability Ratios; Capitd Structure Ratios; Stock Market Ratio ¢ Limitations ofRatio Analysis 4.1 Introduction to Financial Management © Assuccessful business is built on thepillars of three critical functions ie. production, andfinance. * Production and marketing functions work towards creation and delivery of products services desired by the customers, while the finance function ensures uninterrupted support for these functions. Financial Management Finance Management (MU) of everyactivity of «Finance ts like life blood of company and needed for efficient functioning business from initial investmentto selling goods and services on credit to customers. The finance function in the businessis also called Corporate Finance and the managementof this function is knownas Financial Management « Traditionally financial management was only tasked with raising funds; however, it has evolved over a period to coverfunctionsof investment managementand profit distribution. According to Guthman andDougal, financial management means, “the activity concerned with the planning, raising, controlling and administering of funds used in the business.” 4.1.1 Financial ManagementDecisions Finance management covers three main responsibilities of the business Le. arranging finance, investment offunds into assets and distributionofprofits. These functions involve three decisions mentioned as below 1. Investment Decisions 2. Financing Decisions 3. Dividend Decision In addition to the above functions, Financeis also responsible for managingliquidity position for the company to ensure uninterrupted funding for day to day operations. 4.1.1(A) InvestmentDecisions © Onan ongoing basis, finance manager needsto take decisions on creation or acquisition of long term and short-term assets. These decisions include selection of projects/assets for investment, periodof investments, period for investment etc. © The decisions of investmentin long term assets involve large sums of money and are expected to provide returns over a longer period. These decisions are also called capital budgeting decisions. « Every long-term investment decision will involve an elementofrisk. Risk and returns from investments are interrelated and the financial manager need to strike an optimal balance keepingoverall objectiveofthe firm in mind. © This balanceofrisk and reward is called as the risk reward trade-off. © A finance manager needs to evaluate multiple investment options before finalizing the optimum investmentfor the company. © Capacity expansion, purchase of equipments, land and building, mergers and acquisitions are examples of capital budgeting decisions. Divestmentorsaleofassets also fall in the domain of capital budgeting decision. W_Finance Managernent (MU). estment Fi nance mal nageris expected to take inv ° Financial Ma; 43 maximize e th the value of decisi decisi ons that at will will company, ¢ Short involve investment in term investment decisions cul rrent assets such as stock, debtor decisions. tained, credi l ta g pi in ca rk ed he wo ll level afstock to be maina ca rt and fo _ e ar ts . and si etc fixed depo create policies © Afinance managerneeds to f Shorttery w mate! rial on cash orcredit, investmento ra of se ha rc pu , ers buy to d to be grante tetc. to mutual funds, fixed deposi d requi ct on profitability an impa are taken kee ping in mind ons isi dec l ita cap g g n in rk i Wo r © w ing uncertainty in business in the backdropofs l ow gr to e Du ss. ine bus e th ofliquidity for r leye a s, a large business prefers highe logical change economic cycles and rapid techno liquidity. s 4.1.1(B) Financing Decision investment requirements of the fim © Finance manager needs to raise funds to meet the inationof both. The ma, Funding can be raised by taking on debt(loan funds) or equity or comb between equity and debtis called as the capital structure. will remain same and may © Use of more debt will mean that the number of shareholders increaseprofit available for shareholders. However,it also leads to higherrisk as debt involve fixed expenses towards interest and repaymentofdebt irrespective of the performanceof th firm. ¢ Use of equity provides flexibility; howeverit comes at higher cost as the shareholders demant higher return compared to debtholders. ¢ Finance managerneeds to maintain optimum capital structure that helps to maximize value ¢ thefirm for acceptablelevel of risk. A finance managerwill look at multiple factors befor choosing a funding such as rate ofinterest, availability of external funding, risk profile of | Project, estimated timeframe of returns from the project etc. 4.1.1(C) Dividend Decisions ¢ Third important decision for a finance manager is distribution of profits, decision. This decision involves decision on how much Profit to be avis distribution to shareholders. || known as divide! | retained in the business ¥5 * Depending on growth opportunities availabl e for the company, cash balance of the compa and requirementoffunds, finance manager will take decision on retention ofthe prof its. * Shareholders of the company having good o} Pportunities for growth, will prefer to retain hight | share ofprofits in the company, which higher returns. it can reinvest the profits in the business to gene™| Finance Management(MU ‘ + Dividends are generally taxed at higher rate in most of the countries, hence companies choose to buy back shares to reward shareholders instead ofdeclaring large d ividends. 4.1.2 Objective of Corporate Finance «Effectiveness of financial management decisions can be gauged from its successto achieve the objective. Itmay seem that maximization ofprofit and dividendsare natural object ives of the corporate finance. Every businessis set up to make money or earn profit from sale ofits products and services. Hence, one mayargue that Profit maximization is the most obvious object company. ive of the « Profit maximization can be defined as the management of financial resources aimed at increasing the profit ofthefirm. Profit maximization can be achieved through rangeof actions such asraising the prices of product and/or Producing more for samecost by cost reduction or more efficient production If a firm goes on to increase prices to take advantages of high demand, market will attract more sellers and once demand supplyare in equilibrium, price will stabilize. * These actions will provide short term profits for the company. Company can also achieve higher profits in short term by avoiding investments and saving on interestcosts. However,it may impact future prospect of the company. On the contrary what if it makes large investments that has providesreturns after a very long period? The goal of profit maximization mainly suffers from following shortcomings: 1, Short term or long-term profit : Profit maximization objective does not specify short- or long-term profit maximization, hence is ambiguous in guiding actions ofthe firm. 2. Time of Value of money : Profit maximization objective fails to consider the time value of money. 3. Risk management: Profit maximization objective does not considerthe risk and uncertainty in the business. © Maximization of profit was considered main objective of the firm till the concept of shareholders wealth maximization came into being overcome the shortcomings ofprofit maximization. Vv Finance Management MU) ncial Manage ames Financial 4-5 tive of corporate fina Finance managers are the agents of the shareholders and the objec function is to maximize shareholders wealth. Shareholders are the ae m thefirm here, the maximization of shareholders wealth is synonymous with maximization of owners’ Weal, 4.1.2(A) Shareholders’ Wealth Maximization imization of returns on their investment whi max © Shareholders of the firm are interested in zed. is maximized when the valueof the firm is maximi V) ofall the cash flows ofthefirm. (NP © Valueof the firm is sumof net presentvalue ent, time value Pi © NPV considers actual cash flows overcoming flaws of accounting treatm riate ray ’ money, uncertainty or risk profile offuture cashflows by considering an approp discounting. All those projects with positive net present value (NPV) are considered for investmentFinan, manager will prioritize projects thatoffer the best returns for the acceptablelevel ofrisk © Objective of shareholders wealth maximization provides a framework for taking decision e investment, financing orprofit distributions as finance will choose decisions that Maximize the NPV ofthe firm. © Mostof thelarge companies are publicly listed andtheir shares are traded on stock exchange, Hence,for listed companies, shareholders’ wealth maximization also means maximization marketpriceofits shares. 4.1.3 Agency Problems In large companies, generally the ownership and managementof the companyisdivorce. Shareholders own the companyand professional managers are responsible for running t business and take decisionsfor the company. _ * Relationship between shareholders and the mangers is that of Agency in which managers x: as agents for shareholders with objective of maximizing shareholders’ wealth. The separation of ownership from management may giverise to situationswhere manage met | may actinits own best interests rather than those ofthe shareholders. Managers may prioritize to maximize their wealth in the form salaries and perks, ut decisions that may subordinate shareholders’ interests in favorof other stakeholders or 9 | altogether avoid every risky Project to safeguard their position in the company, leading to ks ofpotential opportunities for the company. * This conflict between the interests of shareholders and managers is called as theAge® Problem. The agency problem leads to agency costs, which includes the cost incurred # monitoring and controlling actions Price of the company. of managers and possibility of less than optimum st#* | Hnance Management (MU 46 Fin Management ¢ Many companies give stock options to the managers to ensure that the interests of shareholders and managers are aligned. However, still there maybe situations of conflict in the interest of managers and shareholders * Shareholders appoint directors on the Board of the company, The company’s board has a primary responsibility to keep an oversight on the managers’ actions, performance, remuneration etc. and guide the management. Scrutiny of outside analysts or corporate governance advisory firms also help reducing the risk of conflict of interest between shareholders and managers. 4.1.4 Organization of Finance Function © Finance function (s very critical functionfor the organization;inefficient financial management can also lead to failure of the companies; Hence, the finance function directly reports to the managing director or head of the company. The executive heading the financefunction in an organization {s known as Chief Finance Officer (CFO)or sometimes directorof finance. © In large companies,-CFO will delegate the responsibilities to the Finance Controller and Treasurer. Following chart explains the functions and responsibilities of these officers. Chief Executive Ofticar (CEO) , ; f ; Preparation of Budget and Forecast Taxation ‘Accounting Glanking Relationship Investor Relations Risk Management Mergers and Acquisitions financial d n a e c n a m r o f r s of financial pe e the record ar Financial statements position of the on makers the decisi l al r fo n io at rm fo in financial | od ic peri company ina specif gulators, ta source of re n i a m s, or e th it e ed ar cr ts s, Financtal statemen ors, S! hareholder st ve in , nt me ge the mana and are used by departmentsetc. ow statement count and Cash Fl eet, Profit & Loss ac e Balance Sh clud Financial statements in year. andare prepared each April 01 to March 31. om fr ts ar st a di In n lled as fiscal year andi ies Financial year is also ca riod. In India, compan pe is th r fo t en em at st ed to prepare financial y quarter. Companies are requir ncial statements ever e fina anges are req| uired tofil listed on main stock exch t— Assets ’ abilities }— Turnover Gross Profit }— Operating Profit \— Profit After Tax 4.2.1 Cash Flow from g g Activities | Operatintin |__ Cash Flow trom Investing Activities Cash Flow from ~~ Financing Activities Balance Sheet of s and owners’ equity at a point Balance sheet is a summary statem: entof assets, liabilitie r value owned andcontrolled by the individual or an entity t is a resource with economic Asseee les o! of assets are plant and machine! ry, , cash. expected to provide future benefits. Examples that . ii dual or r anentity to external parties such a5 indivi Liability is edat financial obli igation owed by the indiv ee Balance sheet provides a picture ofthe financial position at that pointof time for example balance sheet as on March 31, 2020 will provide least a statement ofassets andliabilities 0 in chat it (MU) +8 Financial M: Balance sheet of the companyprovides following important information 1. How much assets are owned by the company? 1. How is company financingthe assets? 4. How isthe company’s liquidity position? ‘4, Whatis the owners’ equity in the company? Let's take an example ofbalance sheet and understand importantitems of thebalance sheet. Particulars (Amount in Rs Lakh) 31-Mar-20 31-Mar-19 Equity and Liabilities Shareholders’ Funds 6,000 6,000 2,000 1,250 3,250 2,000 1,250 3,250 3,200 2,700 1,500 7,400 22,525 3,000 2,500 1,250 6,750 18,500 Tangible Assets Intangible Assets 11,000 - 10,000 - Non-Current Investments Current Assets Inventories - - Share Capital Reserves and Surplus Total Shareholders’ Funds Non-CurrentLiabilities Long Term Borrowings Long Term Provisions Total Non Currentliabilities CurrentLiabilities Short Term Borrowings Trade Payables Short Term Provisions Total Current Liabilities TOTAL Assets Non-Current Assets Fixed Assets Total Fixed Assets Trade Receivables Cash and cash equivalents OtherCurrentAssets Total Current Assets TOTAL 5875 11,875 11,000 2,500 8,500 10,000 3,000 2,250 4375 3,000 3.950 250 3,000 250 11575 | 8,500 18,500 22,575_| rinanciat ¥ Assets ent assets ary rr Cu . ts se as t cay ts and non-curren se as t en rr it A855 cu E ER n TT ee CU MNO , hed betw Canney sh wit thin a period of 1 year assets“athwatccaannbbee converted into ca converted into cash “ easily. Current assets include © ts, treasu! ry bills etc. as fixed deposi Cash and cash equivalents such d debt © Marketable securities such as listed equity an securities. d goods etc. she + Inventory which include raw material,fini credit to customers, on e sal to e du es abl eiv rec e lud inc h ic wh s © Debtor © Other current assets such as tax claims etc. Non-current assets include d, furniture, IT assets etc. Foui lan ng, ldi , bui ery hin mac d an nt e pla lud inc ch whi ets ass ed ix «F valueof fixed assetsis the e, nc He r. tea d an ar o we rg de un d an life ful use ite fin e hav ets ass r. This expene amortized overthe period of useful life of asset by allocating expense each yea is called as depreciation. ‘© Investments thatcannot be easily liquidated in 1 year or notintended to be liquidated within year such as investments in other companies, securities etc. © Intangible assetssuch patents, brand, goodwill. These typically arise in case ofacquisitions Liabilities Liabilities are categorized into current, non-currentliabilities and shareholders’ funds. Curret abilities include the obligations that are due and payable within 1 year. Non-currentliabilities include obligations are payable after 1 year. Current Ilabilities include © Trade payables arising due to purchases on credit. © Short term borrowings such as cashcredit, overdraft, loans repayable in one year etc. © Other current liabilities such as provisions fortaxes, dividends etc. Non-current liabilities include «Long term borrowing repayable after 1 year. Tax abilities payable overlong term also called as deferred tax labitties Shareholders’ Funds is owners’ capital and reserves and company’s operations. su plus accumulated over a perio?! «Profit & Loss account ts a statement of company’s financial performance for a given period . Profit & Lass account is also called as P & L account and provides a summary of the sales, expenses and profits/loss in each period of time «The period for which P & L statement is prepared ts called as accounting period. Accounting period is generally a period of 1 year and in India spans between April 01 to March 31. « Listed companies are required to report P & L account every quarter and file the same with stock exchanges. « P&Laccountis prepared using ‘matching concept’. Matching conceptrefers to the principle of accounting expenses against the revenues earned during that period. « For example, expenses incurred for purchase of stocks to be sold next year will not be accounted this year butwill be accounted in next year’s P & L statement Let's take an exampleofP & L statement of ABC Pvt Ltd. Particulars (Amount in Rs.Lakh) Net Revenue Otherincome Total Revenues Operating Cost 2020 2019 34,000 29,000 2,000 1,800 36,000 30,800 Cost of Materials Consumed 24,500 21,000 Employee Benefit Expense Other Expenses Depreciation and Amortization Expense Profit Before Interest and Tax Finance Costs : Profit Before Tax Income Tax 3,000 2,500 S00 5,500 1,000 4,500 1125 2,500 2,000 450 4,850 850 4,000 1,000 3,375 Profit After Tax Main categories of P & L statement ofa company include : 3,000 nues. * Revenues from sale ofgoodsservices also referred to as operating reve ait = income received from interest, rent aividends. operating revenues. ale of equipments etc. also called as «Expenses incurred on consumption of naterials inistration etc. ascowt of goods sold. as operating expenses. © Interest expense on the borrowings. © Profit before tax. © Tax expenses. © Profit after tax. Profit has following main categories n sales and cost of goodssold. Cost of wee bet ce eren diff the is This : ) (GP it Prof ss Gro od. Material consumed sold is the material consumed for the goods sold during the peri unsold goods becomes part of inventory reported in the balance sheet. © Profit before depreciation, interest and taxes (PBDIT) : This refers to the equivalent to revenues minus all operating expenses after excluding de Depreciation is excluded as it is only an allocationoffixed asset cost. ‘© Operating profit (PBIT/EBIT) : This refers to profit/earnings before interest and tax the difference between revenues andall operating expenses. . aoe 1 This refers to difference between operating profit and int =jenses ani excluding osshow-operating incomes. PBT means thedifference between I © Profit after tax (PAT) : This refers to the difference between PBT and taxes. 4.2.3 Cash Flow Statement Cash flow statement is a statement of change in cash balance sheet dates. It summarizes the sources i between and uses ofeach Teeth categor sponties e Le. activities, investing activities and financing acti vities. Sum of the three categories is the cash position of the company. Analysis of cash flow Importance insights about the quality of the s “Stement of the company company’s earnings, Financial M 2020 2019 3.375 3,000 Cash Flows from Operating Activities Net Profit before tax Adjustment for Depreciation Interest expenses non-operatingincome Operating profit before working capital changes changes in working capital Net cash flow from operating activities 450 500 850 1,000 4875 4,300 = 1,500 - 1,300 3,378 3,000 Cash Flows from Investing Activities Purchase ofFixed Assets Sale ofFixed Assets Non-operating income Net Cash Flow InvestingActivities -1,000 = -1,000| 500 500 Cash Flows from FinancingActivities Interest Paid Dividend Paid -1,000 - -850 - Repaymentfrom Long Term Borrowing, - = Net cash flow from Financing Activities ~1,000 - 850 Net increase/decrease In cash and cash equivalents 1,375 2,650 Cash flow from operating activities This refers to the sources and uses of cash from operations of the business. In simple words it ‘S the difference between cash received during the period from sales and the cash payment made ‘wards operating expenses. Mu) CIAL May 413 rofit after tax as starting point and adjys aren t assets and current liabillties. Operating cash flow is calcul oe 1 change? expenses, and noo-operating incomes Cash flow from investing activities s investments. This inclyey y’ an mp co om fr sh ca © of es purchase and sey Thisrefers to the sources and us , ts en pm ui eq building, as purchase and sale of fixed assets such nd, investments, interest and dividend income ete Cash flow from financing activities uses ofcash to s refers to thesources and Thi banks, financial institutions, investors etc Ty, paymen Includes repayment of loans, payment of interest. additional borrowings etc. 4.3 Financial Ratio Analysis © Financial statements of a firm are analysed by the internal and external stakeholders ie management, investors, bankers, suppliers and customers for taking important decisions. For example, suppliers use them to decide whether to give more credit or reduce the credit tothe company. ‘¢ Investors may use it to decide on holding on to shares,sell or purchase the shares. Bankers wil like to decide whether to extend new loans or cap the exposure to the company. Customers like to see if companyis capable of investing required resource to fulfill a large project Management will like to analyse the financial statements to benchmark against competit and identify areas of improvement. -eNo Financial Ratio analysis is the studyof ratios of the financial parameters of the company. It used to understandfinancials of the company on many parameters as mentioned below Liquidity Efficiency Profitability Capital Structure 5. Valuation orstock market ratios 4.3.1 Liquidity Ratios ° As the name cusses liquidity ratios are use d to ‘studyliquidity position of the Uquidlty ratios helps to understand the company’s ability to meet current liabiit® obligations that are payable within 1 year, = " OG fone MU) 14 Financial ment Lack of adequate liquidity may lead to company defaulting on its payment obligations. financial and trade creditors can becomejittery, stop extending fresh credit or may start demanding early repayments of existing credit. If liquidity doesn’t improvein time, it can result in loss ofbusiness and can also lead to bankruptcy situations in the worst case. «Excess liquidity may not have such negative impact butcan have less than optimum returns. ‘The most commonliquidity ratios are currentratio and quick ratio. 4.3.1(A) Current Ratio « Current ratio Is the ratio of currentassets to the current liabilities of the company and represents company’s ability to repay currentliabilities using current assets. Current liabilities are the financial obligations that are repayable within one year. Frm:Curns =A « Current assets include those assets that can be converted into cash within one year without adversely impacting valueof the assets and include stock of raw materials, finished goods, work in progress, debtors, cash and marketable securities. ‘Current ratio ofless than 1 is considered unsatisfactory and Indicate that currentassets don't fully cover current liabilities. Current ratio between1 to 2 is considered satisfactory, while more than 2 indicate company’s funds maybe locked in unproductive assets. In additionto the ratio, it is important to understand the composition of current assets as it will affect the company’s ability to liquidate them andconvert to cash. * Forexample, non-moving stocks or debtors appearing in current assets maybe very difficult to convert to cash. 4.3.1(B) Quick Ratio Quick ratio also called as acid test ratio is the ratio ofliquid assets to the current liabilities and used to measure company’s ability to service current liabilities using liquid assets. While of Calculating quick ratio Inventortes are subtracted from current assets as early clearance ‘oventory may lead to loss of value. aa se = Quick ratio (acid test ratio)) =As a ts ‘Current Liabilities —_— W_rinance Ma 4-15 Inustration 31-Mar-19 0 ar-2 —T3____ . d Lt rT ——_s, tena R a Equity and Liabilities Shareholders’ Funds Share Capital Reserves and Surplus 6,000 5,875 71675 6,000 2,500 3.500 Seeores Long Term Provisions Total Non Current liabilities Current Liabilities 2,000 1,250 3,250 2,000 1,250 3,250 Short Term Borrowings 3,200 3,000 Short Term Provisions 1,500 1,250 Total Shareholders’ Funds 2,500 2,700 ‘Trade Payables 7,400 22,525 6,750 18,500 Non-Current Assets Fixed Assets Tangible Assets 11,000 10,000 Total Fixed Assets Non-CurrentInvestments 11,- 000 10,= 000 ~ - 3.000 2,250 Total CurrentLiabilities TOTAL Assets Current Assets Inventories Trade Receivables . Cash and cash equivalents 3,950 Total Current Assets TOTAL 20 11575 22,575 Other Current Assets . . Intangible Assets 4375 | | | | O_fane -¢ Management (MU) 416 Financial Management Current ratio = Assets Current Liabilities = 11575 * "7.400 = 156. Quick ratio = SUETERE Assets - Inventory Current Liabilities = 1575S - 3,000 B = 16 4.3.2 Efficiency or Activity Ratios Company invests funds in creation of fixed and current assets in the normal cour se of business. Eficiency or activity ratios are used to study how efficiently a company is using its assets. 4.3.2(A) Inventory Turnover Inventory turnoverratio indicates number times companyturns overthe inventory each year and provides information on how quickly companyis able to sell its inventory. For example, inventory turnoverratio of 9 indicates that the company is able to sell its inventory nine times a year. t > Formula: Inventory tumover rato =Reeds - ‘The averageinventory is the average of opening and closing inventory. We can calculate inventory holding period of Inventory daysby dividing no of days of the year by inventory turnover ratio. For example, if a firm has an inventory turnoverratio of9, inventory days will be as 40.5 days. 365, [> Formula : inventory days = invent ory inventory. = 365 Cost of goods sold Forthe external stakeholders. such as analysts cost of goods may not be available. In such Cases, they canuse sales in place of cost of goods sold to calculateinventory turnoverratio. Sales Formuta : inventory tumover ratio = Average inventory Sometimes in place of average inventory they useclosing inventory in the denominator. Sales Inventoryturnover ratio = jpyentory handily note that the most approprat ntory turnover Fatio is of cost e nd inventory are mentioned on the cog, mate to average inventory a8 both the ory What isthe appropriate value of wae industry of operations and inventory turnover Inventory turnover 1300 depends *ies in past and other firms in the indy Further ol company needs to be compared inventory {s calculated as average monthly Mogg frmhaving high seasonality. avera8e | inventory to even out the effect of seasonally Inustration Gost of goods sold Inventory turnover ratio * Average inventory 9, (cost) _ _ . 9.33 : 24,500 3658 365 5 . 3 6 3 12 days Inventory days = Fayentory trunover ratio” 9.33 39 Where cost ofsalesis not available sales can be used in place of cost ofsales. 4.3.2(B) Debtors Turnover «Debtors represent the amount receivables by firm from its customers. A firm sells its goods: cash or credit. Debtors turnover ratio provides a measure of numberoftimes debtors ¢ turnover each year and is used to calculate efficiency of the collection of receivables. It calculated as follows: > Formula : Dabiors tumover rato =prea where ‘Average debtors i the average ofopening and closing debtors. @rrosncs Ma ment v (MU) $18 Financial Management «if the collection period much higher compared to 30, let's say 45 days, then company’s colection efficiency is low. It also means company’s customers are not gre needed to be watched carefully very credit worthy and mustration Sales pebtors turnover ratio = pepo = ———34.000__ 34,000 (is 30001) ="y475 = 978 360 65 Debtor daY5 = Debtors turnoverratio ‘9.78 = 37:32 days 4.3.2(C) Ageing Schedule This refers to the analysis of debtors based on numberof days for which they are outstanding, Inthis, outstanding debtors are categorized as per the ageing of receivables i. number of days since when they are outstanding. Ageing analysis provides a pictureof slow-moving debtors. ageing (no ofdays) Outstanding Amount (Rs.) Percentage ofTotal Debtors | 0-30 50,00,000 50.0% | 31-60 22,50,000 225% | 61-90 22,50,000 225% | More than 90 days | Total 5,00,000 100,00,000 5.0% 100.0% 4.3.2(D) Asset Turnover Ratio It the measure used to calculate theefficiency of total assets of the company.It is the ratio of sales to total assets. Higher the ratio betteris theefficiency of the assets. io St b amie: see noe no rag on Sometimes, analysts use Sales/Total Assets to calculate asset turnover ratio > Formuta _Seles_ : Fixed assets turnover ratio = —_ Zrerage Fixed Asses on Sometimes, analysts use Sales/Fixed Assets to calculate fixed asset turnover ratio —_) oe =1.66 _—_ 000 ___340 S « 18500 Asset turnover ratio = ( ST Profitability Ratio proffitit and loss statement, we have seen different typesof profit me‘asures such a, In the vide absolute vay Pro es ur as me fit pro se the le Whi . etc T PB , fit pro ing rat . ope r rofifit, ab iciency of company’s operat profitfits,s, they don't provide us the information about the eff the efficiency. Profitability ratios help in measurementof 4.3.3(A) Gross Profit Margin It s the ratio of gross profitto the sales of the company and is expressed in percentage tem Itis the amount ofgross profit earned by the companyfor each Rs.100 sales. Gross Profit Margin = f goods sold Sales - Costo Soles Gross Profit Sales 4.3.3(B) Operating Profit Margin It is the ratio ofoperating profit to the sales of the company.It is the amountofoperating pr earned by the companyfor each Rs.100 sales. se Operating Profit Margin = Operating = Operat ing Sales {tisthe ratio of profit before interest depr eciation and tax to the sales of the comp any. It amount of operating profit earned by the company for each Rs.100 sales. Operating Profit M; sero Margin ~ PBDIT Soles = expe nses Sales | che ratio of profit after taxto the sales of the companyand is expressed In percentage shows the information us the amount of gross profit earned by the company for each 00 sales Net Profit Margin = afer tiastration | particulars (Amount in Rs, Lakh) [Net Revenue Other income | Total Revenues (A) i Operating Cost Cost of goodssold (B) Gross profit (C) = (A-B) Gross profit margin (C)/(A) Employee Benefit Expense(D) OtherExpenses (E) PRDIT/EBITDA(G) = C-D-E EBITDA margin(G)/(A) Depreciation and Amortization Expense (F) EBIT (H)= (C-D-E-F) EBIT Margin (H)/(A) Finance Costs (1) Profit Before Tax (J) | 2020 34,000 2,000 36,000 24,500 11,500 31.94% 3,000 2,500 6,000 16.67% 500 5,500 15.28% 1,000 4,500 Income Tax L125, Profit AfterTax (K) 3,378 Net profit margin (K)/(A) 9.38% 434 Capital structure Ratios wasel structure of a companyis the composition oftotal capital of the companybetweendeo: r “qulty, Debt to equity ratio and total debt ratios are commonly used <apita! tr "vides us the information how is company financing the assets. rmancaal M; angee tDebt -equity Ratio 4.3.4(A) Total debty * Total equit io 4.3.4(B) Total Debt Rat Total Debt Total debt t ‘+Total Equity al Deb = Fotal Capital ~ Tot s financing its he companyi t at th s an me o ti ra t deb er low or io rat ity ebogg: ar sh ty Low debt to equ ui eq to ts en ym pa d xe fi y an to make using own sources. As companydoes not have levels of assets and operating, It ts less risky source of funding. Hence, companies with lowto finance their assets using competitive or uncertain business environment will choose h flows will choose highs than debt. Companies having large asset base and having predictable cas anies, raw material etc usedy level of debt financing, Utility companies, power generation comp er debt are tered high ng havi ies pan com and rage leve ed call is Debt g, as main source offundin leveraged companies. 4.3.5 Return Ratios investments. Anas Return ratio are used to calculate the efficiency of the company’ess and company’s havieg compare the return ratios ofdifferent companies to compare efficienci higher return ratios generally command higher market value. 4.3.5(A) Return on Equity (ROE) It is the ratio of profit after taxto the average equity and is expressed in percentage terms t shows how much return companyis earning on the shareholders equity. Profit after tax Return onequity (ROE) = Average equity ‘OR Sometimes, Return onequity = Srarcholdesssoul 3.5(B) Return on Investment (ROI) It is the ratio of earnings before interest and taxes and average of total assets. It shows much return company can generate on total assets. et Return on Investment (RON) = f Average total asse where, EBIT is earnings before interest and tax OR Sometimes, Return on Investment (ROI) TH ts ¥ (au) Finance, 422 eancial saustration pebt to Equity Ratio pefer to Balance sheet of ABC Ltd for 2020, Total Debt = Short term debt + Long term debt = 2,000 + 3,200= 5,200 Total Equity = 11,875, Debt to equity ratio = 3 oss, 4.3.6 Stock Market Ratios (Valuati on Rat ios) Stock market ratios are used to calculate the val uation of the company’s shares using certain benchmark financial parameter. Analysts, investors use these ratios to compare with other companies in the industry or with the historical valuation of the company. 4.3.6(A) Price to Earnings Ratio (P/E Ratio) This is the ratio of market price ofshare to the earnings per share of the company.Earnings per share is the net profit of the company divided by total numberofshares. Pp Share price E Earnings per share 4.3.6(B) Price to Book Ratio (P/B Ratio) . This Is the ratio of market price of share to the book value per share ofthe company. Book value per share is shareholders’ equity of the company divided by the total number ofshares. P Share price Bratio = Book value per share 4.3.6(C) Price to Sales (P/S Ratio) * This is the ratio of market price of share to the sales per share of the company.Book value per share is total sales of the companydivided by the total number of shares. Share price Pp grado = Sales per share el cheaper * Lower the value of these ratios means that the share price i trading comparnv "i s may Compared to the denominator value, which may signify that the share price toby, attractive tating vabuation rates oe© st the finangai ca re fo ts ys al an l x ed financia T CU g in us os ti ra e 4 calculate th nerally 23 98 an share price (P) | sales per share (5) } 10 0 150 | ) s e r a b s t o (roa also (E) 25 40 | Earnings per share (Net Profit/No. of shares) 200 125 Book value per share (B) ) (Shareholders’ equity/No. of shares 10 P/E 2 PB 25 P/S 4.3.7 Use of Ratio Analysis 875 1.75 233 ers etc. It helps in following Ratio analysis is very useful tool for investors, management, lend manners. L Trent aalyss : Financial ratio analysis helps to compare current performanceofcompat} oan errs helps in study of different trends. For example, a company selingS , Compare gross profit margins of these product with each other and a with their|historical performance and feform opinion opin! emai withee on tre nd: Ils on demand, ¢ -ompetit® t: Performance of one compan} 2. Benc ked wit i i com;ipetitioncomp anteswith hmar conpking benc oerhmar be can y n a p the g arin in industry by ver, it ts important to cons? companies of similar size for more useful com, ratios. Howe Parison. 3, Areas of improvement :: Study offinan lal ratios can help management wentfy 27% ¢ improvement. { | oS Pheancial Management | 4.3.8 Limitations of Ratio Analysis patio analysis ts used an tant tool for analysis a company’s performance However. it should not be osed as the only source for anatysis, as it has limitations and that need to before judging company's performance based on the ratio analysis. Important bm tations of rao analysis are as below 4. Historical information : Ratio analysis is based on historical financial information. For major stakeholders such as Investors, lenders etc future performance of the company ts more relevant performance. Company's future financial results may not be in line with the past performance 2, External Factors : Company's financial performance depend on the external environment such as competition, regulatory changes, global recession etc. Ratio analysis does not consider the impact of these factors. 3. Operational changes : Ratio analysis does not factor impact of internal changes ofthe company. For example, new product launch, appointment of newmanagementetc. 4, Changes in accounting policy : Companies can change accounting policy and procedures. In such cases, reported financial numbers for that period may not be comparable with financial results of the past. Hence, comparison offinancial ratios for two periods will become different. Further, accounting policies of two companies may be different, making the comparison between the two difficult. Analysts are expected to adjust the reported numbers while calculating the ratios and comparing the ratios. $. Manipulation offinancial statements : Financial statements of companies are required to be audited by the chartered accountants, However, chartered accountants rely on the financial information provided to them by the management. In fact, preparationof financial statements many times involve interpretation of accounting standards and an element of judgment Management can interpret such policies as per their convenience. For example,in some cases, large numberof debtors may be not being recoverable and need to be accounted as loss, but management may certify that these amounts are recoverable In such cases, financial statements andthe ratio analysis may not provide true and fair picture of the company’s Performance. 6 Seasonality : Large number of businesses are dependentof seasonal changes in demand and supply. In such cases performance of company in accounting period can be substantially different from performance in other accounting period. Analysts need to consider the effect of Seasonality while using ratio analysis. 00,000 and aap at d sol s od go aw 85,00.000, c08t of . Calculate the gross Prot may, (000 00! 45. assets of Fis les - Cost of sold) 00.-40,00.000) 227.2% (ss,90,955,00, Sales 55,00,000 2 Inventory turnover = Tpeantory ~ 5.00: 11 times 55,00,000 les 0 ~ +7? Assetturnover * Fayah assets ~ 40,00,00 total shareholders’ 00, 0,0 5,0 s.5 of es sal al tot has y an mp Ex. 4.3.2 :A co equity of Fis.20,00,000 ant d market price per shaw shares outstanding an 000 50, s ha y an mp co e ‘Th 00. 0,0 5,0 Fs. of tax er aft profit ings ratio, price to book ratio. is Rs.75. Calculate retum on equity, price to ear Soin. : Return on equity = Net m profit ed 5,00,000 20,00,000 25% ——Netprofit_ng_ Earni ling per share = <— No. of shares outstandi 5,00,000 50,000 = 10 Frodo = -iacepershare— 15 10775 Book value pershare = Net worth or Shareholders’ No. of shares outstanding = 20,00,000 = “50,000 = 40- P Fratio = —Pricepershare * 40 75, = 1.87 5 Book value per share | eros a ay ‘ Financ ment 33 .Fotoerng 9 0 ertractIESof he balancedesheet Sumitomo Electr: and Samara Electc Calculate 6.07 anon tor Bon COMPAN ANd Conclu which has better net profit margins, return on equity. oeark 1280. MVATHOLY UTOVET TAO np Current assets. 1, Currentratio = Current liabilities 40,00,000 Sumitomo Electric current ratio = 359900 = 133 Samara Electric currentratio =. D860? « 1.09 2. Inventory turnover ratio Sumitomoinventory turnover ratio = aes +50 Samara inventory turnover ratio = 100800 = 387 3 Net profit margin -“StBESAt Sumitomo Electric net profit margin = Fesfgg = 10% Samara Electric net profit margin = <22ye9g0" 11% Net rof profitit__ etp § Return equity = ——N Shareholders equity on Sumitomo Electric ROE = 7épH.900 7 10% 750,000 9,90,000 Samara Electric ROE = 799,009,000 ° 990% 427 Financial Ma, et at a2 a3 ae as a m ce ran fee oso teo ona brc ran ne ami er than Profit maxima vnt bett ng bei e ctiv obje n atio jmiz th weal ' dos rol Wy is sha objective? Wate the agency problem and wy does & aise? What are the mitigants to resolve agency problems? How does ratio analysis help in financial analysis? a7 What are the ratios to measure liquidity of the fir? t tumover ry asse d fixe o, rati r ove tun ts asse ent curr s doe how s: ratio ity activ the are t Wha as ‘What are the limitations of ratio analysis? as indicate? Capital Budgeting capital Budgeting : Meaning and Importance of Capital Budgeting: Inputs for Capital Budgeting Decisions: Investment Appraisal Criterion-Accounting Rate of Return, Payback Period, Discounted payback Period, Net Present Value (NPV), Profitability Index, Intemal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR). s Long term investmentdecisions are probably the mostcritical of the corporate finance decision as they have the potential to shape thefutureof the business. Investment in new technology at the right time or a wrong acquisition can make or break a company’s fortunes. In this chapter we understand how to evaluate the long- term capital decisions. Learning Objectives + Capital Budgeting - Meaning, Importance, type of projects InvestmentDecision criteria - capital budgeting appraisal techniques ° 5.1 Capital Budgeting Decisions ¢ The investment decision involves decision to invest funds in creation of long term andshort- term assets (current assets). Among the twotypeof assets decisions on investmentin long term assets are more critical as they typically involve large sums of money and provide returns over a longer period. Examples of long-term investments are purchase of equipment, land, building, acquisition, joint venture, divestment etc. The long-term investment decisions are called as capital budgeting decisions. The investment decision in short term assetsis called as workingcapital decisions. «The primary objective of anyfirm is to maximize shareholders’ wealth. Hence,finance manager needs to assess multiple proposalsbefore finalizing projects for investment. Capital budgeting is the process of capital allocation andrefers to the decisions on the investmentin long term assets and projects of the company. ¢ Capital Bug 5-2 Finance Management (MU, Capital budgeting process involves 1. ts, Identification of investment projec 2. . Evaluation of investment proposal © 3. Selection of investment proposals tation 4 |. Preparation of capital budget and implemen estment projects. 5, . Performancereview of the inv tn estment, estimated cash flows inv of nt eme uir req as h suc uts inp Capital budgeting uses of return etc. to evaluate Vato jected financials, expected rate period of cash flows, pro investment proposals. 5.1.1 Importance of Capital Budgeting ure and has following characteristics Whig Capital budgeting differs from current expendit make them mostimportant investment decisions for a company. 1 2. 3, stment amounts. Capital budgeting decisionsinvolve outlay of large inve It helps to control costs of the projects by optimizing expenses. eof the company Capital budgeting decisions havelong term impact on the performanc 4. Capital budgeting decisions are generally irreversible in nature. 5. Capital budgeting decision involve an element of uncertainty or risk. 6. Capital budgeting decisions are critical for shareholder wealth maximization. 7. It involves review ofthe performance of projects and feedback. 5.1.2 Types of Investment Projects Investment projects can beclassified into following 3 types based on their dependenceon eat other. Independent Projects These projects are not related to each other and decision of selection of the projects can & done independentofanother.A firm if deems fit can chooseorreject all the independent projec based onthe investment appraisal. Mutually exclusive projects These are mutually exclusive projects, which means that when a company chooses oneprojec! otherprojects automatically get rejected. Examples of mutually exclusive projects are selection semi-automatic or fully automatic manufacturing set up,in house manufacturing or outsourcing wo roans Mans .5-3 ement (MU) Capital Budgetiny complementary projects - mes two projects ; under evaluation are complementaryto each other, meaning atone project requires selection of another project selection ing Techniques 5.2Investment Appraisal - Capital Budget investment proposals are carefully appraised before finalization using capital budgeting techniques. Most commonly used capital budgeting techniques are as mentioned below. Accounting Rate of Return (ARR) - wn 1 payback Period (PB) Net Present Walue Method (NPV) RR) internal Rate of Return (I 5 Modified Internal Rate of Return (MIRR) 6 Profitability Index (PB) Inall the above methodologies, except for Accounting Rate of Return (ARR), cash flows and not nt in the the accounting profits/losses are considered as basis to calculate returns and investme projects. 5.2.1 Accounting Rate of Return (ARR) res profitability Accounting Rate of Return (ARR)is also called as Average rate ofreturn measu of the investment using financial accounting information. Accounting rate of return is the ratio of e investment. The average average annual profit after tax for the projected period to the averag and valueat the end of thelife investmentis calculated by taking an average of initial investment maybe fulfy depreciated, or it may of the project. At the endof project life, the value of investment some salvage value. Average net profit = R __Average netprofit ~ Average investment for thelifesof the project Total netprofitNo. of year Average Investment= $ (initial Investment+ Salvage value) ntworking capital is also added. Some times in the calculation of average investme Acceptance Rule ided ARR higher than minimum hurdle rate dec * In this method, all projects having an managementare accepted. 2¢cePred ghestS O © Incase of mutually exclusive projects, hi ‘wllr Techiiemtetet a! Bia 54 nd Y are provided in the Table 5.2.1 Calovigy Illustration Following details of the ewe profects . warn Te 5.2: 1 accot unting rate oftable “thavi highest the having project Average Net profit for ¥ = Average investmentfor Xe Average investmentfor Y= ARRfor X= a 00. = 5,000 3500 + 4500 + 5500 + 65 4 soon $000, = 27,500 £40000+ $000) 2 22,500. + $500. a 35-600 ae 20% 000 ARR for ¥ = BON» 2286 Project Y has higher IRR compared to project X Merits and Demerits Merits 1. {tas very simple method as it accounting statements are readily available. 2. ARRincorporates accounting profitability that is used by analysts. Demerits 1 tt ignores the cash flows and only rely onthe accounting profit: s 5 5 ce Management (MU 2L irdoes not consider time value of money, 3 1 doesn't provide the value added to the shareholders. 4, Itdoes not takeinto accountthe risk profiles of different projects, 5.2.2 Payback Period payback period is the amount of time taken by the firm to recover the inves tment in the project. It is generally expressed in numberof years. In other words,it is the time taken by the firm to achieve breakeven. Methodology for using paybackperiod as mentioned below 1, Calculate the cash inflows and outflowsfor each period 2, Calculate cumulative cash flow at the end of each period 3, Calculate the pointoftime in year at which the cumulative cash flows equalzero. Iiustration A firm decides to invest Rs.5 Crin setting up of garment manufacturingplant. It is expected to take 1 year to set up the plant and start the production. Cash flows after the start of production are as mentioned in the below table. Whatis the payback period? CFy =- 500 Lakh ; CF, = 100 Lakh,CF, = 175 Lakh, CF; = 225 Lakh, CF,= 225 Lakh, Cumulative cash flows at the endof each year. Table 5.2.2 Year Cash Flow Cumulative Cash Flow o | 1 | -s00 100 | | - 500 - 400 2 175 | 225 3 225 | 0 From the Table 5.2.2, we understand that cumulative cash flows becomezero at the end of year 3. Hence, payback period is 3 years. Acceptance Rule for Payback Period * Managementcan decide on maximum payback period for accepting any investment projects. All projects having paybackperiod less than the threshold paybackperiod are accepted. * Incase of mutually exclusive projects, projects with lowest payback period is chosen. 5 ement (MU W Finance -6 Merits and Demerits of using PaYDSN Merits Itis very 1. 2. If focuses on near term returns, 3. Itmay be easier Sp ° investmen! simple technique to 10 select payback period. it projects. thus avoid unce! rtainty associated with projects wit Ii ackperiod. yb with lower pa s t c e j o r p r o f to obtain fut nding Demerits the payback r te af s ow fl sh ca It ignores 1, . Capita 1B of 2. It ignores thetime val ue period. money. projects. 3, It ignores therisk element in the with 4. It is not consistent payback period are rejected riod. lows over longer pe fl cash higher despite yback 5.2.3 Discounted Pa In the discounted projects having e maximization, as the shareholder Vv: ralu Period lay bstituted by discom, mple cash flows are su payback period method, si olving in s method all the cash flows inv thi In y. ne mo of ue val me ti for cash flows to account typically the Opportunity, is ch whi , te ra nt cou dis te approp! ria project are discounted using an trisk. om a project having equivalen fr ed ect exp urn ret of e rat or of capital Iiustration %. firm has required rate of return of 10 the me su as ’s let e, mpl exa e ov ab the In Table 5.2.3 | ounted Cash Flow, Cumulative discounted Year Cash Flow Disc _ Cash Flow ? - 500 100 -500 91 j__222255 3_ 4 1649 15 0 1 2 175 ax -500 — 409 | =95 1| 264 145 | | ; rom ime Table 5.2.3, we understand that cumulative cash flows become zero bem year and 4. end of The payback period for the project falls betwee: aren Senda Atul cumulative cash flows equal -95 Lakh. 95 No.of years required for recovery of Rs.95 Lakh = J54 = 0.62 Discounted payback period = 3+ 0.62 = 3.62 years. || it (MU 5-7 Capital Bu posits 204 Demerits of using Discounted Payback Period qffocuses on Mi ear term retui ims, th thus avoid uncertain 1 payback period. ty associated with projects with longer 2 Disco!unted payback period takes into consid eration time value of money, pemerits Ltt ignores cash flows after the payback period. 2 Itinvolves estimation of additionalvariable i.e. discounting rate. 4. It is not consistent with the shareholder value maximization, as projects having payback period are rejected despite highercashflows over longerperiod. longer 5.2.4 Net Present Value Method (NPV) Net present value or NPV is the sum ofpresentvalueofall current and future cash flows. In this method, NPV for each investmentproject is calculated. Projects having positive NPV are “expected to enhance shareholders value and can be selected for investment. If the firm must choose between mutually exclusiveprojects,then the project having a maximum NPV is selected. steps to calculate NPV 1. Calculate the opportunity cost of capital depending ontheriskof the project. 2. Calculate net cash flows in each period. All cash outflows carry negative sign, while cash inflows have positive sign. 3. Calculate present value by discountingthe cash flows. 4. Calculate sum of presentvaluesofcashflows. > Formula :NPV = — Fy + Se oe > Formula: NPV = — CFo + CF; (PVIF;,) + CF:{PVIF,,) + CFa(PVIFa,) + ... + CF, (PVIF,) cy” (rip Where, CF - Net Indicates cash flowsin each period i- Discounting rate n- No ofyears PVIF - Present valueinterest factor Mustration In the above example involving Rs.5 Cr investment Jet’s calculate the NPV ofproject. Finance Management (MU) a 5y 225225 175_ NPV = -500+9. 49 * (1.10)? * (1.10) (10% Foy = -5004+91 +145 + 169 + 154 +93 = 152 ‘The NPVof the aboveproject is Rs.152 Lakh and can be considered for investment. Acceptance Rule 1. Projects having positive NPV are accepted forinvestment. 2. Incase of mutually exclusiveprojects, the project with highest NPV is chosen. Merits and Demerits of using NPV method Merits 1 . NPV method provides the absolute value addedto thefirm by choosingan investmentprojec. 2. NPV method considers time value of money and riskof investment. 3. NPV method considers the cash flows over the completelife of the project. 4. NPV method provides unambiguous methodology forselection of projects. Demerits 1 NPVcalculation can vary substantially depending on the assumption ofdiscountrate. 2. NPV method considers same discount rate for cash flows in near and longerfuture of the project, which may have differentlevels of risk. NPV method is not very useful for selecting among projects having materially different investment requirement. 5.2.5 Internal Rate of Return (IRR) Internalrateof return is the rate of return received by the company by investing in the projec. It ts the discountrate for which NPV of the project becomes zero. Internal rate ofreturn is als? termed as IRR. For decision making purpose, IRR of the Project is calculated and compared with the required rate of return. All projects having an IRR morethan the required rate considered for investment. If a firm has to choose between mutually having the highest IRR is selected. of return art | exclusive projects, projec Steps to calculate IRR ) 1. 2. Calculate the initiate investment outflow. Calculate net cash flows in each period. Cash outflows Carry negativesign, while have positive sign 3. Calculate the discounted cash flows using IRR as discountingas rate. cash inflow’ parce Managernens (MU) ai Budgetiny CP ——S CR, CP, CARRY!" ChsiRRY ** TPiRRps —oeee f |, "CF Coe & —te Formula: CFo= © aay —_ tnustration ‘ se, (1+1RR)? CF, (1+IRR}* Ca | | In the above example involving Rs.5 Cr investment 500 = a10 175 o0e, 1 S 2222 5 52225 2550 (1+1RR) (+IRR}? * (sIRR) * (+R)! * IR R) Solving above example using excel formula provides us the value of IRR as 20 3%. acceptance Rule « Management will decide a cut-off or hurdle rate for acceptance of projects. All project s having IRR greater than the hurdle rate are accepted. « Incase of mutually exclusive projects, investmentproject having highestIRR is chosen. Merits and Demerits of using IRR method Merits 1. Investors can compare IRR with the required rate of return and take decision on the selection of projects. }, 2, IRR measure can be used to compareprojects having different investment requirements. Demerits 1. Selection of projects based on IRR method does not consider the overall value added to the }, firm. 2. IRRassumes thatall future cash flowsare reinvested at the IRR. 3, IRR can be used only when there is requirement ofinitial investment involving cash outflow at : initial period. For the projects involving multiple net cash outflows, the IRR formula can provide more than one value.In such cases, use of IRR becomes confusing. 5.2.6 NPV Profile ¢ NPV method and IRR method generally provides sameresults while selecting conventional projects havinginitial outflows followed by net positive cash flows in subsequent periods. In the aboveproject involving Rs.500 Lakh investment, NPV waspositive and the IRR of 20.3% was higher than discounting rate of 10%. Both the methods concluded acceptance of the Project. NPV is inversely related to the required rate of return. For a given set of cash flows, NPVis maximum whenthe required rate of return or discountingrateis zero, as it will be simply sum _totalofall Positive and negative cash flows. 10 Finance Management (MU) NPV will go 0 a ses, n reducing and will become 2et5 . of return incre: than IRR NPV will become her As the required rate hig es rat g tin oun l to IRR For dis c required rateis equa i wh oy ES 30 25 20 15 2 16 Discounter rate (%) file Fig. 5.2.1: Example of an NPV pro 5.2.7 rn (MIRR) Modified Internal Rate of Retu on of internal rate of retum » Modified Internal Rate o! f Return (MIRR) is the modificati ogy. ‘overcometwo shortcomings ofthe IRR methodol (a) One shortcoming of the IRR methodology is the assumption that the positive cash flows ay thepositive ag invested at the rate of IRR which may notbe practical. MIRR assumesthat flows are reinvested at reinvestmentrate, which is taken at the company’s costof capizi Presentvalueof cash flows is calculatedusing financing. (b) IRR formula provides multiple values of IRR in projects involving investmentoutflows in mo: thanperiod ' > n Formula: MIRR = [ENCE — 1 FVCF- Future valueof positive cash flows. PVCF - Present value of negative cash flows. n- No. of periods. os ce Ma ment (MU) 1) pital Budge and pemerits of using MIRR method }' { i wert addresses the shortcomingsof IRR, by distinguishing betweenIRR andreinvestmentrate. se uses rate of financing for discounting the negative cash 2 ‘ funds and may vary for different companies dependi flow: 's which reflects the act ual cost ng on modeof financing. For example, vempan using debtfunding for project will useinterest rat f e as financing rate ® comparing MIRR and cut-off or hur dle rate managementcan take decisi selection. ons on Project | pig more complicated method and difficult to unde rsta nd for persons without financial ‘ ackground. + Like IRR it also doesn’t provide the value addedto the shareholders, 5.2.8 Profitability Index (PI) profitability Index (Pl!) is the ratio of present value of future cash flows and initial cost of the ject profitability index of more than 1 indicates that companyis making money from the La after considering time value money and the project viable. All projects havin g PI of more than 1 can bE selected. In case of mutually exclusive projects, projects having maximum PI are selected. PI = PV CFo pr = eh | Ch (1+i)?” (asi)? (asi? ee CF, — > n Formula : Pt A So-it CFo Eample In the above example involving Rs. 5 Cr investment, Profitability Index will be calculated as below: 100 _175_ _225_ _225_ _150 P= 710° G10)? * (1.10) * (1.10)(1.10) _= $52 500 1.30 500 12 BH Finance Management (MU) © ance Rule AcAccceeptpt the the projects Capita ital l Budge, the prj where PI > Lor Pl= ! and reject ects where PI <1 the highest Pl projects, one wi ith Incase of mutually exclusive of using MIRR method Merits and Demerits © is accepted. Merits ney. 1. Pl considers timevalue of mo ated wi th the projects. 2. Pl considers risk assoct “sahalers’ vate an that NPVis positive ojects with PI >1 also me 3. Pr 4. and add to sharebo s, g intermittent cash investment uationof projects requirin Pi method can be used for eval Demerit ded to the shareholders. ad 1. Itdoesn’t provide the value 5.2.9 Capital Rationing A firm keeps on evaluating multiple projects all the time. If a firm has access to unlimitey shareholders value will p. capital, all the investment proposals that are expected to enhance d capital for investment, furtheselected. However, in practice a firm will have only limite unchecked capital investment may pose problem of efficient monitoring and management. In suc l investment cap cases, projects that are providing highest return over investment within overal are chosen. The profitability index is a proxy for the return over investment and canbeused t» decide on projects in case of capital rationing. Tiustration Let's take an example, where managementonly has capital budget of Rs. 10,00,000 and it has evaluated multiple projects with different investment requirements, based on IRR, NPV and profitability index (PI) as below ee Investment IRR (%) T ' A {600000 | 16 | 240,000 | 1.40 K—+— B | 8.00,000 18 | 2,00,000 | 1.25 | Project eeu its Cc | 400000 | 2 j2e0emn [21 |p E || 20000 2.0 4 0 |{21 | 2,00,000 17 Management can make multiple com to Rs. 10,00,060 as below «18 | 180,000 | |re 1,20,000 || 1.45 | 170) 1.70 } 100,000 | 1.50 | binations based on each criterion for projects amoun0™’ .“4 ancae Manageement (MU) Capital Budgeting [TOTAL |__| 1,000,000 ProjectPI Inveaun 170 200,000 200,000 1401 600,000 A |__| 1.000,000460,000 | Project | PI 240,000 | : TOTAL | ~ Investment 600,000 400,000 420,000 1,000,000 profitability index provides combination of projects that maximize returns for given investment and management will choose projects D, E and A. Factor (PVIF) for disc INote : Use Present Value Interest inting the future cash ao CVFIFVIF) for Compound Value Interest Factor also called Future interest Factor (CVIFI ) calculating future cash flows. dit 5.2.10 Project Monitoring and Au 5.2.10(A) Solved Example fx 5.2.1 : Management is evaluating options of buying a new welding machine. A new machine of Schumak Machines company hastotal investment requirementof Rs. 2,50,000 and has net cash flow of Rs. 250,000 for 9 years. An alternative to Schumak is another machine of Honto Intemational costing Rs. 15,00,000 and has cash flows of Rs. 250,000 for 11 years. The required rate of return is 12 percent. Calculate the IRR, NPV and PI of both projects. Soin. : ‘ NPV of Schumak " (A) Schumak Machines - 12,560,000 + 250,000 x PVAFsoi2 ~12,50,000 + 250,000 x 5.328 = ~ 12,50,000 + 13,32,000 = 82,000 5-14 MU: Finance Management k ts IRR of Schuma nt at which equivalent discou NPV ts nil AF sien = 0 00 x PV - 12,50,000 + 2500 250.00 PVAFoien = 1 PVAF enn = 5 e, PVAFsa1+ Referring to PVAF tabl = 4.946 5.132 and PVAFso14 = g to Hence, IRR correspondin % = 13714 = 14% - 0.29 E S E % 4 1 5 = 13,32,000 _ 1.06 * Plfor Schumak = jpyestment ~ 12,50,000 (B) Honito International 0,000 x PVAF11.012 NPV of Honito = -15,00,000 + 25 -15,00,000 + 250,000 x 5.938 - 15,00,000 + 14,84,500 - 14,500 NPV © IRR of Honito is equivalent discount at which is nil -15,00,00 + 250000 x PVAFitinr = 0 15,00,00 PVAFiLie = “250,000 Referring to PVAF table, PVAFi::9n = 6 PVAFi1012 = 5.938 and PVAFiion = 6.207 Hence, IRR corresponding ding to S = 12% - (6207 S$ - 5.938 - 5.938) = 12% - 0.23% = 11.77% Honita == £4:84:500 + Plforfor Honito 15,00,00 = 0.98 From the comparison of hence IRR less that afenptanaesn leesth understand that Honito’s NPV is seP" is than 1. Hence, Honito is rejected. | | eon the importance of capital budgeting decisions. FT { of ru of : pagan te aference between intemalrate of return and Accounting rae of reu mn. xian merits and demerits of payback 'YDack period methodology for capital budoet: nett? the shortcomings of IRR methodology? budgeting and explain wh 'y NPV methodology is the most appropriate st differen t capital Pp : ‘tal budgeting technique. goa Working : t n e m e g a n a M l a Capit Sl MBs of Working g Capital; Importance kin Wor g in an Me of Concepts Capital Management : Estimation of Working s; ed Ne l ta pi Ca g in ’s Work ctors Affecting an Entity Capital Management, Fa and Managemen, gement of Receivables; nt of Inventories; Mana l Requirements; Manageme Capita ties. of Cash and Marketable Securi cashare the sh is king’ meaning those who have ‘Ca ike sIi ase phr the es tim ny We have heard ma s signify 1, el I] on credit. These phrase ’ts don we g in an me ar’ Udh kings or ‘Aaj Nagad Kal wil g capi ital management of firms. We in rk wo ng gi na ma of le sty d importance ofcurrent asset an rking capital management. study the various components of wo Learning Objectives important of working capital management © Working Capital - concept, meaning, factors affecting working capital © Operating cycle, types of working capital, © Managementofinventory © Managementof receivables © Management of cash and marketable securities. 6.1 Introduction to Working Capital Management © in the normal course of business, a firm need to hold a stock of goods to fulfil sae requirements in timely manner; provide credit period to customers and maintain cash balance to meetpayments. © This requirementto hold investmentin current assets leads to large portion of a firm's ass locked in current assets. Hence, it’s important to study the management of working capi There are two major concepts of working capital. 1. Gross working capital 2. Net working capital. 62 ment (MU) nce! pt off Gross Working os ng capital refers to ndtude qhe requirement of wi Working Capital Man Capiital ang N et Working ca the total of CUrTentass ets invol ving pI ita! 4 inventory (also known as orki apaersanid working capi oneoP dependson the operatingcycle of the company. Hence, to ‘tter, we need to first understand the concept gi2 Operating Cycle . ment of operating cycle operating cvele refers to time Period elapsed betweenthe time of purchaseof raw materia ls to tion of cash from selling the goodsorservices bythefirm. cycle consists of manyactivities such as purchase of raw materials, conversion of =, material into WIP or work in progress, conversion to WIP to finished goods, sale of fished goods and collection ofcash from customers, post-sale. | | pe time period from purchase of raw materialto sale of goods is the inventory conver F sion vod for the company. Ly The time period from sale of goodsto collection ofcashis the debtor conversion period. The ¢ inventory conversion period of the companyisalso called inventory days and the age collection period as debtordays, as calculated infinancial ratio analysis. Sale of inventory Purchase of inventory [ Inventory woo Account receivable penod —» 7 Acoourts payabie__| Cash cycle period \ (Net operating cycie) Cash paid for inventory ° — Cashreceived trom sale Operating cycie 4 Fig. 6.1.1 Operating Cycle = Inventory Conversion Period + Debtor Conversion Period inventory conversion period consists of raw material conversion period OR Operating Cycle = Inventory Days + Debtor Days v Puparic Working Capital 63 nt (MU), 360 0 36ss old * operating Cycle © ZostofegoInodventory Averag 360 __Credit Sales Average Debtors r Paymen, it and get time fo rms: in praction, many fi purchase raw materials on cred keq for % . Hence, t cash blocked in current assets will not be blocpe riog te, me referred to credit pertod he ti the to rs refe e cl cy g in at er op t ne or e sh cycl entire operating cycle Ca ation of cash from Sale, is al re e th to s ial ter ’ ma w hase of ra payment of cash for purc g following formula: in © The cash cycte Is calculated us od + Debtor Conversion Pe! riod sion Peri Cash Cycle = Inventory Conver ~ Creditors Deferral Period. Cash Cycle = Inventory Days + Debtor Days Account Receivabl les Days. ment nage 6.1.3 Importance of Working Capital Ma Current assets form a significant portion ofthe total assets of a firm. In case of trading firms working capital contribution is very high and may contributeto even 80-90% to total assets : Current assets such as short term investments provide lower returns comparedto fixed asser, in curren, tnventories and debtors don’t provide any direct returns. Hence large investment assets can result in sub-standard return on investment. ma, Excessive accumulation ofinventory can result in problem of non-moving inventory and lose value in future. Large accountreceivables may pose problemsofcollection and in some cases result in loss due to non-collection. Qn the other hand, low level of currentassets canlead to delay in fulfilment of orders and may Jead to temporary loss of business. This may also result poor utilization offixed assets. @ Inadequate current assets can lead to inefficiencies in day to day operations andcan lead tp higher cost and affect profitability and competitiveness of the company. © Shortage of liquid current assets can lead to delay in repayment to operational and financial creditors and loss of reputation. Continued shortage of current assets can exacerbate these problems and may even also lead to bankruptcy if companycannot arrange financing in time to meet obligations. . Eicient working capital management is required to maintain balance between retum ob investment and optimum liquidity for smooth operations of the company. Working capi management requires day to day monitoring of current assets to ensure smooth business operations and occupies large portion of finance manager's mindshare. wnt (MU 614 mr ermanent and Va 4 Working Capital M rlable Working Capital inttain adequate level of current assets A eompany need: Is to main for smooth running of of ththe ness However, the amount of current assets is not consta i gopendin® on the seasonal [actors, Curr ee aee two com Shane ‘ent assets of the company have ecmanent or fixed working capital and Variable (temporary or fluctuating) work ringtea capi t “ tor fixed working capital refers to the minimum amount of current asset ts, equtred by the company. Permanent working capital is akin to fixed wil asset investment, as i romail fixed for long term. Further as in case offixed assets company permanent working capital gradually with growth in sales. need . my ° or fluctuating working capital refers to the additional current assets required gue to seasonal requirements. For example, a companyneeds to stockpile large finished goods to meet demand in peak season and will have current assets. The temporary working capital amount keeps fluctuating depending on the seasonal requirement. In the peak season, temporary working capital will be high while in slack seasonit will be non-existent. Temporary working capital Time Fig. 6.1.2 Needs 6.1.5 Factors Affecting Working Capital tinfluence on the workingcapital « Nature of Business : Nature of business has most significan ed to carry inventory ofvariety of requirementof the company. Trading orretail companiesne companies hold majority of assets products and has substantial investmentin inventory. Such construction companies need to carry in the form of inventory i.e. current assets. Similarly, especially in government sector, in turn inventory and also have to deal with high receivables other hand, utilities such as telecom deal with high working capital requirement. On the in fixed assets and low requirement of companies, electricity have very large investment working capital. role » Seasonal Factors : Seasonality plays a very important company need to maintain. During the peak period, in det ermining currentassets that firm will need to maintain large inventory inventory will be lower. to meet high demand and duringthe slack season substantially company it may not be feasible to increase production constraints of capacity, impact on quality and price. For a manufacturing at a short notice due to Hence to avoid loss of business level production throughout the year maintain to choose companies manufacturing _— _ Se _ W Finance Management (MU Working Capital Mana, en 6-5 ond to the demandsituatigy, ang resp © Cyclicality : Companies operating in cyclical industries hig ical upturn, when one is wanessing cycl adjust current assets accordingly. In the tal ize on ntain high current assets to capi demand, companies will like to mai the opportuni, ,, bs imum investment in Current asse to work with min In downturn, companies will like overhead andfinancing costs. he credit policy adopteq by byt ven dri y gel lar s yi pan com the © Credit Policy : Debtor days of dit to their customers, While need not extend cre the company.Large established com panies : blish, t extend credit as a tool to esta mi ay chooseto ket mar into ate etr pen o ingt look ies pan com y influenced by the prevalent industry themselves. Credit policies of the companies are largel practices. For example, retail shops need not extend credit to the customers, howeve; it to achieve thesales targets. wholesalers and distributors may have to extend cred ess used by company impacts the © Manufacturing Cycle/Technology : Manufacturing proc less automation may manufacturing cycle and in turn requirementof currentassets. Useof help companyto save on fixed asset investments, but will require large inventories due to longer manufacturingcycle. Further, flexibility of manufacturing technology also importantrole. Companies having flexible manufacturing operationscan use their manufacturing different products during slack period. Companies plays an capacity for with _inflexibie manufacturing technique may choose to maintain steady level of production to avoid underutilization despite lower demandand can add to inventory levels. © Availability of Credit : Firms that are able to procure input materials on credit from suppliers can reduce their net working capital requirement and cash cycle by utilizing such credit Liberal credit terms from suppliers can even allow some firms to operate with negative working capital. For example, some large retailers can easily a credit period of 60-90 daysfrom their suppliers, maintain inventory of 30 days orless and sell in cash to retail customers and thusoperating with negative working capital. © Operating Efficiency : Firms running operations in efficient manner can reduce the requirementofcurrent assets. Operatingefficiency has manyfacets. The factors such as easy availability of input materials, accurate sales forecasting and planning, utilization of resources etc. can substantially reduce need to carry inventory atall levels and reduce working capital requirements. Inefficient operations will require higher investment in currentassets. Scale of operations : Requirementof working capital generally reduces with increasedscale of operations, as company has more flexibility. Sub-optimal operations require maintain higher of current assets. Smaller firms also find it easier financing compared to long term loans. a firm to to obtain working capital Fluctuation in input prices : Investment in current assets are highe exposed to fluctuation in input Prices. In such cases, cost of raw r when the firm material prices fluctuating howeverfirm has only limited flexibility to pass on price increases to end customers. In su cases, firm may need to invest large amountin current ass ets to take advan tage of tavorablt input prices. pital Manageme: em ( e in Workin g Capital Manag r t Working ent on ¢, capital manage! ment involves decision on n fofo}llowin ‘Owing g ttw ot level of woo a: ar"eeaas: ‘si current assets an d , ont . : a!cing mix between short term and long term fi nancing i. om working capital - Trade off ‘! and obligations . los of Me and loss of sales pence, in determining appropriatelevel of current assets, " a trade. - offbe ween profittability vs pquidity must be considered. foitustrate this trade-off let's consider3 alternative workingcapital policies, prescr ib ing use ofdifferent levels of current assets for achieving same output. The relationship between out gad current assets is as depicted in the below chart. : m ‘The requirement of current asset increases with increase in output however the relationship perween current assets and output is not linear. Current assets increase at slower paceat hugher level of output. This is due to improved operating efficiency at higher level of output Policy A has the highest investment in current assets for a given output. As current assets are aso proxy for the liquidity, policy A can be considered as the most conservative Policy C has the lowerlevel of currentassets, meaning lowestliquidity and can be considered as the most aggressive, while policy B is average. How do the policies compare in term of profitability calculated using return on investment (ROI)? Rol Net Profit Total assets Net Profit Current assets + Non-current assets t assets, the policy C « ifcompany can maintain level of sales while reducing the level of curren ROI or profitability. while having lowest level of current assets will have the highest conservative policy A having highest level of current However, with increase in profitability company also assets, will have lowest profitability faces higher risks | delay in payment dissatisfied cust obligations due to lower cash,lost sales due to lower stock and ‘ower credit period etc. inv ersely related to each are ity uid liq and y lit abi fit pro t tha de clu con can we ‘ Thus ated with higher nsk crease profitability or return is associ duet other and Working Capita} Mang Finance Ma’ ment (MU) Re profitability ang f betw: of ead tr s thi ge na ma carefully ts. © Hene «, management need to vel of curr ent asse le m u m i t opt the in . ciding 0! risk and return, while de ’ Lewel of current weno Conservative policy Fixed asset level Output Fig, 6.1.3 : Chart Mix of short term and long term financing Generally, interest rates on short term funding are lower than long funding. Further, shox term debtcan be repaid back duringthe times of lower requirement. Hencehighertheproportic, ofshort term debt, lowerthe interest cost and highertheprofitability. 6.1.7 Estimation of Working Capital Requirement Operating cycle of a companyprovides most appropriate methodology to calculate the work capital requirement. However, in practice other methods are also be used. Three importax methodologies to estimate working capital requirements are asfollows : 1, Current assets holding period : This method is derived from operating cycle conceptax involvescalculation of working capital based on holding period ofindividual current assets 2. Ratio of sales : In this method currentassets as a Percentageofsales is estimated based © assumptions and past experience and accordingly currentasset s are calculated.This is commonly used method in practice as it with increase in sales and is easier to 3. Ratio of fixed investment : use. assumesthe requirement of higher wor king ap ital estimation, 2020 __|| 2020 | Matertal Cost | Raw Materials Consumed | | Manufacturing Cost | 36,000 | | Labour | 12,000 | Power and Fuel | 10,000 | Factory Overheads 7,500 | Other Expenses | 1,500 | Depreciation 5,000 AnnualSales 108,000 Fixed Assets Investment 75,000 Finance Costs 1,000 Profit Before Tax 4,500 Total Fixed Assets 25,000 Profit After Tax 3,375, Assumptionsforcalculating working capital under each metho disas follows: Method 1: Inventory : 1 month supply raw materials and 15 days supply offinished goods. F Debtors : 1 month, Operating Cash: 1 month of total cost . Method 2: 20% of annualsales. " Method 3: 40% of fixed asset investment. | Method 1 Calculation : Raw materials inventory = 36,000 _ Rs. 3,000 Lakh Finished Goods Inventory = cost 36,000 +0 12,000 , + 10,0000 + 7,5000 1 + 1,5000 + 5,000 24 72,000 24 Rs. 3,000 Lakh 6-9 ment (MU Working Capital Mang Annual Sales _ 108,00: Debtors = “y7 = 12 Total Cost 72,000 = Rs. 9. 000 Lakh 3,000 Lakh Cash balance = ““"y7 = “T7 Rs.3i Total Current Assets = Raw material inventory + Finished goodsinventory + Debtors + Cash balance = 3000 + 3000 + 9000 + 3000 = Rs. 18,000 Lakh Note : hy cases where semi-finished goods or WIP inventory also need to be calculated, agg dire} labor, power and fuel expenses and maintenanceif provided to raw material consumptic,, fel || —_ estimating cost of semi-finished goods. Method 2: 30 CurrentAssets at 30% annualsales = 108,000 x joo = Rs. 32,400 Lakh Method 3 : 40 CurrentAssets at 40% oftotal fixed asset investment = 75,000 < 700 = Rs. 30,000 Lakh In the previous sections, we discussed the importance of working and proces current assets. Now let’s understand the techniques to managecurrent inventories, management ofreceivables, management of cash and s for estimation assets i.e, management of marketable securities. 6.2 Managementof Inventories Inventory forms probably the largest portion companies. Trading companies need to hold of current assets of manufacturing and trading finished Boods inventory for timely fulfillm customer requirements and loss of customers. ent Manufacturing companies also need to hold 12 materials and Work in Progress (WIP) inventor materials inventory is required to production cycle. The main objectives of holding y in addition to finished goods. While mw ensure smooth production, WIP inve ntory arises due inventory can be Categorized as below Transaction motive is the main objectiv e of holding inventory * involves holding inventory to ensure smooth pro duction an d supplies for sales acti Inventory is held depends on man yfactors such as th. € producti on capacity. demand et 1. Transaction motive ; to O sirance Ms ment (MU) 2. Precautionary motive : According king Capital Management ing to this motive, businesseshold inventory to guard against ’ s leading to disruption in production d| ctable event ynforeseen al ind unpre predi or supply of materials. is motive, businesses hold inventory or reduce to take tive motive : U: nder this ver advantage the. price price movement. For example, retailers may stock up certain goods in anticipation 0) price increases, while manufacturers may stock up raw materials if the prices navefallen. 4 other motives : These include motives such as availing discounts associated with bulk purchases, reduce ordering costetc. "6.2.1. Inventory ManagementTechniques © There are many motives and advantagesof holding inventory viz. flexibility in production, take price advantagethat comes with bulk purchase, smooth fulfilment of customer demandetc. « The disadvantagesofholding excessinventory are costof storage,cost of funds onthecapital blocked in inventory, dangers of obsolescenceetc. ce As long as the benefits of holding inventory outweigh thecostof inventory, managementwill prefer to hold inventory. + Let’s study the principles of inventory control that help in taking important decisions in inventory managementsuch as how much to order? when to order? what to control? What is safety stock? 6.2.1(A) Economic Order Quantity (ECQ) (How muchto Order?) © One of the important considerations in inventory managementis to determine how much inventory should be ordered. © Incase of raw materials, it is the quantity of raw materials to be ordered in each order or in case of production of finished goods it’s the decision on how much to manufacture in a two major type of production run. Whenever a firm buysandstores inventory it has to bear costs namely ordering costs and inventory carrying costs. ! © Ordering Costs are the costs associated with placing the order andinclude costs to prepare a t of order, storing, cost of issuing purchase order, cost of transportation, inspecting, movemen payments etc. These costs are fixed per order andincrease and reduce with increase is size per order. * Carrying Costs are the costs associated with with increase in number of order holding and storing unsold goods. These include costs of warehousing, salaries, transportation and handling, shrinkage etc. The inventory carrying cost increases with taxes, and insurance, depreciation, the increase in the level of inventory. Working Capital Manageman 611 o! : quantity ¢ on ec st mo e at ul lc ca scientific method to a I s ty nti qua r de or ic om on Ec ts. There are 3 variablesinvolve ordering and cal rrying cos e total of inventory that minimize th e the: incalculation of ECQ. These ar forecasted to be mber ofunits of the prot duct e nu 1, Demand of product : Th sold over a given pressed as A. time period (usually a year), ex O. se order expres: sed as ha rc pu r pe st co ng ri de Or : 2. Ordering cost riod, em is in stock for entire pe it e th ng mi su as t, uni r pe cost 3. Carrying cost : Carrying expressedas Cc. ll be ror, thenthe total ordering cost fora yearwi If Q is the order quantity per purchase orde Ax0 TOC = “Q If the usage of inventory is constant for each period, then average inventory can be expressed as g ory t per unit x Average invent Total carrying cost (TCC) = Carrying cos rec = SKE Total Inventory Cost (TC) is the sum of total ordering cost TC = TOC+TCC and total carrying cost. TC = Al, ae) As discussed above, EOQ refers to the quantity Q, where TC is minimized. We can use calculus to find the lowestpointon thetotalinventory cost curve. The resulting EOQis, > Formula :0 =» [242 Mustration Let'stake an example on use of EOQ method. Suppose that usage of an inventory itemis 2000 in a year and ordering costs and carrying costs are Rs. 100 per order and are Rs. 10 per unit respectively, The EOQ expressed as is calculated as below: 9 = «/7zo00Li00} 10 = 2 {2000)(100} = 200 units. Finance Management (MU i 612 Working Capital Manage \ Fig. 6.2.1 « Inthe Fig. 6.2.1, we haveplotted total ordering casts costs (which is sum of thefirst two costs). : total carrying costs; and total inventory » We see that whereastotal carrying costs vary directly with the size : ofthe order, total ordering costs vary inversely with order size. The total inventory costs sum total of ordering and carrying costs declineatfirst as the fixed costs of ordering are reduced with larger orders. However, the total inventory costs start rising when the additional carrying costs start offsetting decreasein total ordering costs due to a larger averageinventory. « The point EOQ, represents the economic order quantity, which minimizes the total cost of inventory. 6.2.1(B) Reorder Point (When to Order?) « In addition to knowing how much to order, when to order or reorder point is‘ another important decision in inventory management function. To calculate the reorder point, we need to consider the time elapsed between placement of order of an item to receipt in the inventory, also called as Lead time. Reorderpoint can be calculated as below Reorder point = Lead time x Average usage © Suppose it takes 5 days between the placement andreceipt of an order. The EOQ ordersize was 200 units and a daily usage of 20 units, resulting in an order being placed (andfilled) every 10 days. The reorder pointfor the firm will be expressed as, Reorder point = $x 20 = 100 units. * So the firm needsto place an order whenthe inventory falls to 100 units, as it will take 5 days to receive inventory by whichtime the existing stock will be exhausted. 6.2.1(C) Safety Stock © The calculation of reorder point assumes that the known with certainty. lead time and average usage are always nance : Manaj ement (MU) In pracuice, © Working Capital Mana Remeny d by usage and the lead time are 9, , the lead time is higher th an estimated 4 or if oduct as describe' however the demand for pr tual usageis higher th entirely certain. If the ac a situation of stock out expected, a firm may face Therefore, it « intain a safety stock to becomes imperative to ma ount {o, r point need to recalculated to acc Hence, reorde for inventory as well as in lead time. the satety stock. demang allow for uncertainty in erage usage * Safety stock Reorder Point = Lead time x Av ts per day. Then the reorder ed stock out quantity ts 5 uni «In the above example, if the expect ty stocks point will be 100 units plus safe of 25 (5 5) ie. 125 units. 6.2.2 Inventory Control Systems ask, hence @ firm need to have formally tedt lica comp a is ory ent inv tof men age man and Control t popular with its scale of operations. The mos able suit tem sys rol cont y ntor inve monitored w: inventory control systems are as mentioned belo trol 6.2.2(A) ABC Method of Inventory Con ntory of a variety of items depending on the A manufacturing firm needs to maintain inve number of items can be in thousands of product. In some cases,like automobile firms, the inventory value is typically accounted parts depending on models. However, most of the total firm to focus more attention in byrelatively small proportion of (tems. It advisable for the ° controlling the more valuable items. d inventory © This is accomplished by using ABC method ofinventory control. In this metho items are classified in A, B and C categories. © A category items are most valuable and account for majority of inventory value. These items are monitored strictly and more frequently. © Category B items account for lower portion of total inventory value and involved moderate control and monitoring. Category C contains large number of items, even smaller portion of inventory value and hence involve minimal monitoring. For the firm described by below Fig. 6.2.2, “A” items reflect the fact that roughly 15 percent of the items in inventory account for 70 percent of inventory value. The next 30 percent of the tems, group “B,” ” account for 20 percent of inventory value Aad more than haif, or 55 percent, of the items explain only10 percent of total inventory value anaganvent MT Workin Mere) ' = g wl ” ~ ol | *| I 810 4 feo Fa TH “* C analysis Fig. 6.2.2 Graphic presentation of AB in Time 6.2.2(8) Just (JIT) ota n system wa pioneered by Toy tio duc pro ota Toy as n ow kn a fart fa cme (HT) alo ded at aims to maintain just enough inventory nee Caorginrsal be BO 1970 As the name implies !F ane Hine OF MAN TACHIDR, ir agement aligns raw-material orders with the In [EE eyatont at taventory Management Man peel On achedules se 4 {hetthem to HHCbedne efficiency, decrea ing waste and reduce inventory cost by receiv tion process. which reduces inventory costs. geviele only a they yeod thenfor the produc entory information system and very efficient inv 8 LT requires a very accutate production and and yottable ebain to muceed. fer ded, which seems to suggest that ]IT will suf + {IT prescrthes ordering quantities [st as nee trum very bigh order Hig casts taken to reduce ordering costs by reducing ps ste h wit ed ani omp acc abo ia JEP k, wor + tv eeal ficient supplier base. Otherwise it can Cause hlyef g hig pin elo dev bY: ts s Cor stic Logi , tion or sanp eat the d with last minute arrangements and def dock ouls and Increayed costs associate t sophisticated Supply Chain Managemen hly hig use ms fir ge lar ce cti pra In HP of Parpaws m and eduling. estimate requirement of each ite (YOM) Syatoma which belp in production sch iidering ayatenn ed in the management of inventories. Due to A liManeial manager in not directly invelv r must be aware of inventory ance Manage setaively fargo ryveatment of funds in inventory, fin HAHagEMONE and control Lechniques Finance Management © The Working Capital Ma, 6-15 Mu s invested i nay Len in inventory, the lower the optimal vg nds im order q uantity, all other things held Constant yy of fu cos! she optimal greater the opportunity r average inventory and the lows , the lower the sa fe ty stock needed, and the lower the © Thelower the averagelead time things held constant. To. reflect change in .cost of abi% her investment in Invenio shad higher or lower. Accordingly, EOQ value will also deena,. carrying cost need to be a lower. ables ceiv 6.3 Management of Re © to Sale g ° t assets and arise due ren cur of nt tue sti con i ables is second maj jor Receiv also called as account receivables or trade stomers. These are product/service on credit to cu receivables or trade debtors. t raises invoice for sale on Customer es as soon asi * Acompanyrecords thesale of ‘goods/sel rvic the time howeverthe transaction is not complete ti 11 it realises consideration for the same. mpanytosell products o, © One may arguethatunlike inventory itis en tirely the choice of the co credit and in fact there are manybusinesses like retail whoneednotsell any product on creqiy © The amountof trade receivables for a company will depend on percentage ofcredit sales ty the company and credit period. For example, if a company has an average dailysales Rs. 50,000 and sells 50% of products on credit at an average credit period of 45 days, The accountreceivables will be 50000 x 50% x 45 = 11,25,000. © There are many reasons for a business to sell products on credit like prevalent industy practice, meet short sales target, expansion in new area of business/geography etc., clearance of non-moving stocketc. The funds blocked in receivables need to be financed which implies cost for the company. Further, company need to incur additional costs like collection and potential bad debts due non-repayment. Hence, receivables need to be managed carefully. © There are three major aspects to management ofreceivables: 1. Credit Policy 2. Credit Evaluation and Decision 3. Receivables Monitoring eo at 63-4 ole Working Capital Management Credit Policy The amountof trade receivables. period oftrade receivables and terms related to credit are rned by the credit policy ofthe firm. Thecredit policy of a companyis based on following variables 1 Credit standards 2, Credit terms 3, Collection policy. Credit policy are expected to have bearing onsales of the company, bad debt, discounts etc. Le’s examine these variable independently. The goal of the credit policy is to enhance shareholders’ wealth by striking a balance between highersales andrisk. 6.3-1(A) Credit Standards » Credit standards define the minimumcriteria for extending the credit to customers. Based on credit standards company will decide which customers can avail credit from the company. Tight credit standardswill limit the numberof customers eligible for credit sales, but will also reduce the probability of bad debt and collection costs. Lenient credit standards will increase numberof customers andsales butwill also increase risk of bad debtand collection costs. Finance manager plays role in credit analysis to determine credit worthiness of a customer. Creditworthiness dependson 3Csi.e. Character, Capacity and Collateral. Collateral or security for granting the credit is generally provided by customers to banksfor availing loans and may notbe relevant for granting trade credit in mostcases. © Character refers to willingness of customer to pay and is moral factor responsible for repayment. Capacity refers to the ability of the customer to pay and is determined by the financial strength of the customer. Company can use tools such as credit references, credit rating, analysis of financial statements, past repayment track record etc. for determining the creditworthiness of a customer. Thisis explained in more details in later part ofthe chapter. 6.3.1(B) Credit Terms y © Credit terms refer to the terms on which trade credit provided by the compan to its nt customers. These include credit period, cash discount, penal charges or delayed payme charges. credit © Credit period refers to the length of time period for which credit is provided. Longer sales for the period means higher flexibility for customers and hence can lead to higher n receivables company. Higher sales and longer credit will also leadto increasein investmenti amount nce Manage! * ¢ (MU) . 6-1 Working Capital Management set increased cost due to higher t m highe! r sales can offset i i ase in opera ting profit frot If the incre. . ll have a favourable impact on profit Of the is! wi period dit cre les, higher ‘ investment in receivab company -Credit period is mentioned as. ‘net dat te’ a 30 a days for Payment 30" means customer has a maximum credit period of t For example, ‘net 3 tom 0ihcus y pay ment earla meers fore e so a S t a ny mp co e th ou by y sc d di re e fe th of is nt nt scou discou Ca : sh di to! Company mayneed to provide credit to cus * d reduce in ‘ discount to custom ers it encourages customers to pay ea: rly an mn ing cash provid Ear \ investment in receivables. Credit terms having cash discount and credit period will be state cash discountrate, period ofcash discount for example,‘2/5, net 60 refers to thecredit the term offering a cash discount of 2% for payment made within 5 days and credit period of 60 days, delay in repayment by Credit terms sometimesalso mention delayed payment charges to avoid t charged by customers. Penal rate or delayed paymentchargesreferred to rate of interes companies to customers for any delay in payment. 6.3.1(C) Collection Policy and Efforts . Collection policy refers to the set of collection procedures to ensure collection of trade receivables on due date. Having provided credit to customers, companycan't simply expect all customers to pay on due date. Some customers delay the payments due to genuine or maybe habitual late payers. The policy should be explicitly fix the responsibility of collection andfollow up.Collection can be handed as a part of accounts or sales team. In anycase efficientcollection requires coordination between sales and accounts department. Sales department should use inputs from accounts department while granting credit to customers. * Accounts department should coordinate with sales for recovering delayed companies offer cash discounts to encourage customer to make also charge penal interest charges in case of delay in payment. © The policy should Prescribe setof actions for payments. Some payments before due date and reminding customers to make regular payments, follow upfor delayed payments and separate Process to collect old and delinquent dues. Some customers have thehabit of delaying the payments, regular follow up can discipline such customers to pay on time. * Some customers mayhave genuine issues due to business downturn etc. and hadto be handled carefully. An email should be promptly sent to Customers the payment immediately. in case of delay requesting to make (Mu) vi 6-18 e | Te sam e can befollowing oY by mem,ail from senior memb er ronal visits and legal notice if required, Direct 4 le Bal Working Capital M: lanageme nt team, letters and S ef collecti action is generallyoncostly and may not eve the real purpose of collection. Wh,neen Papar yments cannot be co llected, a comprom ise ettlement can be made tocollect a percen Be o f to s tal d ue amount. 6.3-2 trade-off cost-benefit analysis. . Manageme net ed to con: sales vs additional . < sider a trade-off between the returns from additional sales or lost cost or savings dueto increase or decrease in receivables, impact on bad debts etc. The below chart explains the trade-off between tight andloose Costs and benefits Cost of administration and credit policy. bad-debit loss Opportunity Tight «— Credit policy —» Loose Fig. 6.3.2 Let’s take an example. Mustration - Changein credit standards before A firm is selling product for Rs. 100 per unit, of which Rs. 80 represents variable costs 240 Lakh and credit taxes. Currently, annual credit sales to select customers are at a level of Rs. terms include credit period of 1 month. Therelaxation in credit standards is expected to increase sales to Rs. 300 Lakh annually. Current bad debtratio is 2%, whichis expected to increase to 3%. Rate of tax is 25% and post-tax opportunity cost of carrying additional receivables is 20%. Let us evaluate the trade-off between the expected additional profitability sales and the opportunity costof theii increased investment dueto the additional in receivables. * Contribution from additional sales = Contribution margin x Additional sales ~ 100-80 Too * 60 = 0.20 x 60 = Rs. 12 Lakh oss on existing sales + Additional cost dueto increase bad debt losses = increase in bad debtl bad debt on additional sales = 3% ~ 24 x 240 + 3% * 60= 24 + 18-42 Lakh. . ment (MU) Net changein ope ting profit gher Contributior © After tax change in operatingprofit = 7.8 (1 © Additional receivables = 25) = Rs. 5.85 Lakh O01 Rs 5 Lakh © Investment in additionalreceivables = Expense ratio x Additional receivables = 08<5=4Lakh Required Return on investment= Cost of capital x Additional investment = 0,2 x 4 ~ 08 Ly Profitability from additional sales is substantially higher than the required return on Alten, investment,hence it is advised to provideto additional customers. Illustration 2 - Change in credit terms ‘Let's assume in the above firm has an option to increase credit period forexisting Customer 60 days, which is expected to result an increase in sales from Rs. 240 Lakh to Rs, 360 lak, Current bad debt ratio is 2%, which is expected to increase to 4%. Rate of tax is 25% and Poste, Opportunity cost of carrying additional receivables is 20%. Let's evaluate the trade-off based on proposed changein credit terms * Contribution from additionalsales = Contribution margin x Additional sales = fo. 360,00 - 240,00 = 0.20 x 120,000 = Rs. 24 Lakh. Additional cost due to increase bad debtlosses = 1% x 240 + 4% x 120 Increase in operatingprofit = 24 - 7.2 = 16.8 Lakh. =7.2 Lakh. After tax change in operatingprofit = 16.8 x 1 - 0.25 = Rs. 12.6 Lakh. | Investmentin additionalreceivables associated with newsales Variable cost Selling price = ~atiable x Additional sales x “edit period in months _ 390% 1202 = 0.80 x 120 «B= 16 lath Investmentin additional receivables associated with changein credit period onexisting sales | Variabl = Satine ee x Existing sales x Additi | onal credit period iin months 12 = 0.80% 240x25 = 16 Lakh, * Total increasein receivables = Rs. 32 Lakh, © Expected return at 20% = 0.20 x 32 = Rs. 6.4 Lakh. After tax change in ‘operating profitis higher than the expected return, hence, the trade-of's favourable. | | | | | os nce Mana jement (MU) 63°3 0 ‘orking Capital Management evaluation of Individual Accountfor Credit fore offering credit terms to any customer, company should perform credit evaluation Be juat customer The credit evaluation involves following steps of width credit Information 4 creait Analysts credit Decision and Credit Limit 63 3(A) Credit Information The first step for credit evaluation is to obtain credit information. Commonly edit information in India are asfollows : used sources of financial statement: Financial statements are one uf the most sourcesoffinancial position of the company. In India public limited companies andprvatelimited companies are required tofile fnancial statements with the registrar of companies. These can be accessed by the firm planning to grant credit for paymentofcertain fees. In addition, there are some third party providers that provide the financial information in moreuser friendly format. Companycan usethis information. jn case of proprietorship, partnership firms financial information is not publicly available, companyneedto seekthe financial informationfrom the customer willing to avail thecredit. Trade references : Company can ask customers to provide reference of other parties having trade relationships. Companycan check from these references track record of the customers. This isan easy and free resourcefor checking credit worthiness. Credit rating : Companies can check the credit rating of the customers if available. Credit rating are the ratings on thecredit worthiness provided by third party credit rating agencies such as Dun & Bradstreet, CRISL, ICRA etc. These are used by companiesto avail financing, but may not be available for all customers. Past track record : Company can check the record of past dealings for existing or old customer. 6.3.3(B) Credit Analysis Havingcollected credit information,the firm must makea credit analysis of the applicant. Ratio _ alysis offinancial statements, credit rating etc. are used to understand repayment capacity. Information on Management of the customer and trade reference can be used understand -feputationof the customer. Some companies have developed internalcredit scoring system based 0m financial ratio analysis, management analysis, past payment track etc. to decide on credit Worthiness. 6.3.3(C) Credit Decision an Once credit analysis, ad ecision must d Credit Limit be reached about thi e grant of credit. The decision, company € anset a the credit can befor a single transaction or a in, credit limit for a customer, whi unt the firm n will permit to be owed at anyonetime represents a maximum limit onthe amo 6.3.4 Monitoring of Receivables A firmneed to regularly monitor the receivables to ensure the bad debt collected as per the credit term and minimize that the receivables are Rett, losses. Following methogs * monitoring of recetvables are commonly used. Receivables Monitoring Average Coliectionl Pernod aging cea | Collection Experience Matrix weet | 6.3.4(A) Average Collection Period (ACP) © In this method.firm computesthe average collection period ofcredit same with the credit policy. ~ sales and compares the Debtors x 360 Average Collection period (ACP) = “Credit © © Average collection period is compared with the credit period as perthe policy to judgethe credit period as efficiencyof collection policy. If the average collection period is morethan the perthe policy, then the collection policy and efforts needs to improved. The above method provides an overall pictureof the efficacy of collection efforts. However, are due for average collection period suffers from lack ofspecific details on amounts that Jonger than averageperiod to takeaction. The early paying accounts can mask performanceof slow paying accounts. Impact of seasonal variations in sales on the collection period is not factoredin. 6.3.4(B) Aging Schedule @ Inthis method, receivables are classified into different bands of aging or aging buckets. Agia refers to the length of time for which receivables is outstanding. pinance Ms 6-22 nagement (MU) Working Capital Management sre agin analysis provides a clearer picture of the slow moving accounts and provide early * yorms 0” risk of default. Following is the aging schedule of receivables having credit period of 30 days the table shows 6% amount he averabe collection period may be close 35 days. However, i. outstanding for more than 45 days and 3% of the amount is outstanding for more than 60 days, ng schedule provides an idea Agi tion. collec s. ion act which may Pose risk for remedial | . about the amount atrisk of take default and help Aging schedule does not compare the receivables with the sales. Aging (Days) Outstanding Percentage 0-30 5,00,000 61 31-45 2,50,000 30 46-60 50,000 6 61 and above 25,000 3 Total 8,25,000 | 6.3.4(C) Collection Experience Matrix In this technique, receivables arising from the sales are plotted againstthe sales of period. helps to compare collection experienceofreceivables with the sales of the collection experience matrix sales are plotted horizontally andreceivables Following table shows an example of collection experience matrix Amountin Rs. Lakhs Months Sales This same period. In the are shown horizontally. January February March April 6000 6000 7500 $000 Receivables January 3500 February 2000 3500 March | 1000 2500 5000 April | 500 1500 3000 4000 | May | 200 500 2000 2500 june —_| 200 0 1000 2000 ina nce cnn (mt) 623 Thereceivables are also expr essedas a Working Capital Mang, % sales ap March Apri Amount in Rs. Lakhs 5000 Sales a Receivables | 58% | February | 3% March 17% 42% 67% 0% April 8% 25% 40% 80% | May 3% 8% 27% 50% June 3% 0% 13% 40% _ 6.3.4(D) Credit Utilization Report In this report, details of the total limit of credit offered to each customer andtheextentto whichit is utilized is plotted and reviewed on periodical basis. This provides the information on the extent to whichtotal limits being utilized. Customer | Credit Limit (Rs. Lakh) 6.3.5 Limit Utilized (Rs. Lakh) % Utilization A 2000 1500 75 B 1500 1400 93 c 1000 800 80 Total 4500 3700 Sale of Receivables/Factoring © Assignmentorsaleofreceivables is one of the most commonly used methodsforrealisation of early payment and reducereceivables. In this transaction, company sells its receivables to banks or specialised financial institutions. This transaction is called Factoring or assignment of receivables. There are specialised financial institutions who engaged in purchaseof receivables called as Factors. A Factor or bank deducts discount and factoring charges from the receivables amount and pays the balance amountto the company. On the due date Factor collects.the moneydirectly from the customers.In a typical factoring transaction,to mitigaterisk ofdefault or delay, factors require companies to compensate the™ up to fixed percentage ofreceivables. utntanding receivabl of Rs 500 Lal pinto a factoring transaction with» Factor or a beok e after 60 ount charges of say Rs 12 Lakh (about 2.4%) and pay Rs. 488 Lakh to disc ct dedu wil spe vane company 0 due date, the bank or factor will collect the payment directly from the o poeoe! os +“ management of Cash and Marketable Securitie nt assets, as idle cash does not os probably the least productive asset among Curre ate any return Even in cases where cash is Invested in the bank deposits or short term canvetable securities returns are generally much lower than cost of capital, However, it is sbably most critical IN many aspects, as it used to meet payment obligations We have seen ds of BrowINR cash balances on the balance sheets, This can be attributed to many reasons ch as increasing uncertainties, shortened business cycles, rapid disruption in business and black van events like global financial crisis of 2008, demonetization, pandemiclike COVID 19 etc. 642 Motives for Holding Cash Companies hold sufficient cash balance for various reasons, There are three major motives for holding cash + Transaction Motive : In the normal course of business, company need to make various such as purchase of goods, salaries to employees, utility payments, instalment of loans, interest expenses, dividend etc. Companyalso receive cash from sale of good, however the need to hold cash arises because the timing mismatches betweencash receipts from sale and expenses. This is motive for holding the cash in transaction motive. Company can choose to maintain cash for immediate payments and balance in the marketable securities and time the conversion of securities to cash with the payments. + Precautionary Motive : A firm may hold cash to meet contingencies of the future. These amounts to guard off against unexpected fund requirements. These mayarise due to sudden sharp fall in sales or higher than expected payments etc. As these funds may notbe required in normal course companycan invest such funds in liquid marketable securities such as short term fixed deposits, money market mutual funds. If the company has an access to short term funds or unutilized credit lines etc. it can choose to borrow the funds instead of holding the cash. Speculative Motive : Sometimes companies hold cash to take advantage of investment prices, holding opportunities such as advance materia! purchase in anticipation offall in input funds to invest in marketable securities or borrowing andholding cash in anticipation ofrise in Interest rates in near future. Speculative motives are generally not common. Working Capital Manage, 6.4.2 s Cash Management Proces management of cash and cash equivalents, the, e th lves e r invo s ces pro t men manage The cash uidated into cash quickly, Cash Managemen, urities that can be liq’ investines, includes marketable sec s hort term deficits and g in nc na fi h, cas of t n concerned with collection of cash, paym en process. nt me ge na ma sh ca e of cash surplus. Followingpict ure captures, th Cash collection Business operations L Information and control Deficit Surplus Borrow Invest Cash payment Fig. 6.4.1: Cash managementcycle Cash management processconsists of following steps 1. Forecasting cash flows 2. Managingcash collections and disbursements 3. Investmentin marketablesecurities 6.4.2(A) Forecasting Cash Flows © Thisis the starting point of the cash managementprocess. Cash forecasting is donefor various periods. Companies prepare cash forecast for daily, weekly, monthly, quarterly and annual period and these are considered short term forecasts also called as cash budget. « Cash budget helps company 1. To determine requirement of operating cash 2. Plan and negotiate short term borrowings 3. Invest surplus cash * Accurate cash forecasting can help companytoprioritize payments, borrowings, minimize idle cash and borrowings. * Long term cash flow forecasting of 3 to 5 years helpsin finalizing financing and investment strategies. * Daily, weekly and monthly cash budget are prepared by forec astingal disbursements (payments). The receipts operating activities. l the receipts and consist of cash inflows from operating and nom ng Capital Management | sand ac nities consist of collections from business activities 5 such as sales and services yerating cash inflowsconsist of other collections such as renta l income, interest 000-0P cSaie some, 10 me from sale of asset such as land, building etc. Disbursals consist of all the 5 such as payments to be madefor ) OP erating activities such as purchaseof material, taxes, salaries, overheads etc jyNon-operating, activities such as capital expenditure, interest payment, principal repayment " © oflong term loansetc rhe difference between receipts and disbursals is the net cash shortfall or surplus. Followingis snexample of monthly cash budget of company having 90% sales on credit and 10% on cash. company collects 80% of credit sales in next month and 20% in the monthafter. Further, company also buys raw materials on credit with credit period of 30 days. So the purchase of th the current month is paid in next month. nt in Rs. Thousands irotal Sales February| March} April/May |June|July |August|Sept] 375 525 450 |525/375/300| 375 |450 38 53 45 30 38 45 45 152.5/37.5| 30 37.5 378 |324|378]270| 216 67.5 |94.5| 81 [94.5] 67.5 |270 54 491 |471| 497/395] 321 |369 270 |315|225|180] 225 |270 100% last month purchases Salaries and Wages 315 |270|315]225| 45 |52.5]37.5| 30 180 37.5 |225 45 {Total Operating disbursals 405 |375|390|285| 255 |315 reat sales @90% 338 473 \go% of last month'scredit sales [20% of 2-monthold credit sales total sales receipts |Purchases 225 315 405 [473]338|270] 338 53 38 405 45 Disbursement for purchases and other} joperating expenses (Other expenses 45 |52.5]37.5| 30| 50] (Capital expenditure \dvancetax (Total Cash disbursal Net cash flow Beginning cash balance 37.5 45 75 37 45 405 |425|510|285} 255 [352 86 46 |-14]110] 66 17 150 |236] 282|268] 378 |444 [Total cash 236 |282|268|378| 444 |461 dc - - ~ Typ - - 7 yy ye - ~ Porrowing -|}rpr Interest on, borrowings Fepayment of borrowing {losing balance 236 |282|268|378| 444 |461 Finance Management (MUJ Working Capital Mana, men, 62 adjusteq net ti ion of cash flow statements using . prepara involves atement prepared using forecasted Profit an «Long t erm cash for ecasting 1B w st projected cash flo income method. IC is 4 loss. © Net profit, depreciation, interest etc. are used j p rofit and loss Statemeny from the projected capital budget. Capit al expenditure is taken from the sales in the pi pa estimated using ratio of working capital to The working capital changes ane st and the same is extrapolateq for term cashforecas ts future periods. Long term cash forecast is madefor 2 to 5 years. Long future and finalize financingstrategies, usedfor estimating financing requirements in the sements 6.4.2(B) Managing Cash Collections and Disbur Finance manager need to carefully manage cash flows in accordance with the cash budget cash Finance Manager need to prioritize or accelerate the collections and delay or postpone disbursals whereverfeasible. 1. Accelerate Cash Collection . © Thefirm will like to speed up collection of accounts receivable so that it can use the cash earlier to make paymentor conserve for future payments. Someof the methods to speed up the collections are 1. Expedite preparing and mailing of the invoice. 2. Reduce time forcollection of payment instruments from customers- This helpsto reduce mailfloat i.e. the time taken by the customer chequesto reach thefirm. 3. Reduce the time for processing the payment - The time required for Processing the Payments internally as well as with the bankiscalled as processing float. Companyneeds to expedite the processing of collected cheques or payment instruments to reduce the Processing float. The mail float and processing float are together known as collection or deposit float. Companycan use decentralizedcollection system,lockbox system to reduce the deposit floats. ¢ Decentralized collections: Company can have decentralized collection centresthat collects the paymentinstruments such as chequesordrafts from the nearby customers anddeposit the same in the local bank accounts. * This helps to reduce mailing and Processing time forrealisation bank accounts to centralized orconcentration bank accountus of payments. Funds from local ing electronic fundtransfer. ¢ penance Management (MU) 6-28 with the advent of electronic fund transfers and online ba inking 1g th the use of cheques etc. for the nents coming down drastically. 7 control Disbursements seme is essential for success of efficient : cash . Control of disbursements management. This involves in slowing down payments to conservecash and reduce borrowing requirements. The company shouldutilize the tradecredit available for purchase and delay the payments to the duedate. » Company should make the payments early only where it earns the cash discounts. Unlike collection which involves decentralized collections for accelerate collections, the disbursement is centralized from one bankaccount. « This helps the companyto effectively control payments.The disbursementbank accountis also the concentration bank account where all the balances are transferred from the local bank accounts. Sometimes the companies have issued chequesand the books of the company shows the payment, however due to mailing and processing time the cheque may notprocessed. In such cases company’s bank balance will be higher than the book balance, because as per accounting books entry is passed when chequeissued. This difference is called as payment float or disbursement float. - 6.4.2(C) Investment in Marketable Securities Generally, firms try to maintain target level of cash or optimum levelof cash. Excess cash over and above optimum level is invested in short-term marketable securities. In this section wewill understand the firm’s use of marketable securities. Investmentin marketable securities held for cash needs for precautionary motive,controllable outflows such as dividend, tax payments etc. In choosing the marketable securities the firm should examinebasic features of security such as * Safety : The firm is investing cash in marketable securities for use at a later date on short notice. Hencethe firm will invest funds onlyin very short term securities offering high degree of safety and very low defaultrisk. * Marketability : Marketability refers to the liquidity of the marketable security; it indicates the speed and convenience by which security or investmentis converted into cash. The securities for investment should be highly marketable. Finance Management (MU) Working Capita} 6-29 tne ment of principal and interest Ast for repay ¢ Maturity : Matunty refers to the time pr eriod s. Theprice of long term secu dity reduce ul liq nd the and s ease incr risk the s ease maturity incr ility in price volat varies with interest rates. To avoid cash surplus into short termsecurities. ensure safety, thefirms invest Types of Short term instruments © Treasury Bills (T-bill) : These are short term government securities and regardeq a8 the safest and one of the most liquid security. Treasury bills issued by central government and haveoriginal maturity of 91 days, 182 days. 364 days. © Commercial papers (CP) : These are short term unsecured debt instruments generally issueq by large companies. Theseinstrumenthavehigh liquidity. In line with Treasury bills these ate alsoissued ata discount and redeemed atpar. © Bank deposits : These are fixed deposits held with the bank and varies between 7 days to 365 days or more. * Certificate of deposits (CD) : These are unsecured debt instruments issued by the banks t raise short term funds. These are issued at discount and redeemed at par. They are highly liquid instruments. * Inter-corporate deposits (ICD) : This is short deposit parked by one corporate entity with another. Generally, companiesinvest the ICDs with their sister concerns or subsidiaries, On the due date companyreceivesprincipal andinterest. ¢ Money Market MutualFunds : This is one of the most popular instruments for parking short term funds. Money market mutual funds invest funds in the money market instruments such as treasury bills, commercial papers,certificate of deposits. Companies can invest fundsin money market mutual funds and redeemthe units as and when required. 6.4.3 Cash Balances to Maintain * Most companiesestablish an optimum targetof cash balances to maintain. Excess cash can be invested in marketable securities and interest can be earned, Idle cash meansloss of opportunity to earn interest from investment. Higher the interest rate, larger will be opportunity cost of maintaining idle cash. At the same time the company needs to meetday to day requirements. © The optimal balance should balance the twin objectives the ability to invest a return and ensure sufficient liquidity for future needs. There are two methods for estimating optim um cash. eee sufficient cash the excess cash for How much cash is optimum cash” nance Mana ement (MU) 6-30 termining rel) CDe ertainty - WilOptimal Cash Balanc lia . the B ac gumol’s model m Baumol’s C The ash Model is based on th curately and the payments . e assum, are made Unifory mly company incurs transaction cos Worki over a Period of t when "ver it co ital Management er Conditions of ‘ash needs are forecasted time. nverts marketable s ecurities to cash and jso incurs holdingcost for keeping the idle c ‘ash balance also « The company’s holding cost is interest forgone on the average cash balance i.e. is the interest rate for the period. Let's assume per transaction. Cc k (§). where k that the companyincurs a transaction costo f¢ i « Then cost for making total payment ofT is c x ®) Total Cost = kx Using calculus, the C is minimum when = > Formula :¢* =» [2 Where £- Optimal Cash balance T-Total cash needed during the peri S- Cost per transaction od ‘Opportunitycast holding cash for the period Mastration AAfirm firm estimated a cash s requirement of Rs. 40000 over a month, wheredis “constant rate. Opportunity interest rate is 8 percent bursement are made ction cost is Rs. 100 per annum. The transacti Finance yement (MU) OptimumCash Balance C Cappital m, Working Ca 64 65 000) ee ss 32 000) (4“B = 0.75 12 40000 43 7 3265, No. of transactions ina month = Total costs 3 3 Minumum Cash balance Transaction costs c Cash balance Fig. 6.4.2 : Optimal cash balance 6.4.3(B) Determining Optimal Cash Balance Under Conditions y Uncertainty - Miller-Orr’s Cash Model © Baumol’s model is based on the assumption that payments can be accurately Predicted, However,in practice cash inflows and outflows are uncertain. The model assumescash inflows and cash outflows are stochastic i.e, each day a business may have both different cash payments anddifferent cash receipts and the daily cash balanceis normally distributed. ' The Miller-Orr modelplaces an upper and lowerlimit for cash balances. Whenthe upperlimit is reached,a transferof cash to marketable securities is made. Whenthe lowerlimit is reached, a transfer from securities to cash occurs. A transaction will not occur as long as thecash balancefalls within the limits. Securities are sold for the value such so thatthe cash balance rises to the Return Point Return Point = Lower Limit + ix Spread UpperLimit = Lower Limit + Spread The equation forcalculation spreadis as follows : 3 Spread = 3x Where C- cost pertransaction cost k- opportunity cost of holding cash o° - variance ofa daily cash balance. ee 3) (0) (c) ‘Axk | nae ' t management (MU) 6-32 w plainedby 'Y bel below ch, . forking chart of cash b; mille Capital Management n balance with time } Upper trenit +~ Sale of securities Return point Lowar limit Time: Fig. 6.4.3 : Chart When the actual cash balance drops to the lower limit, cash balanceis increased return point, which can be done byselling inve stments in marketablesecurities, + When the actual cash balance touchesthe upper limit. In mente te such cases, it is necessary to bi ° marketable securities and restore the cash balance down to the return point. The am 101rn tte be invested is the difference between the upper limit and return point. mone tiustration The management of a company has set a-safety cash balanceof Rs. 750,000. The standard deviation (0) ofthe daily cash balance during the last year was 375,000, andthe transaction cost was Rs. 1000. The company also hasthe opportunity to invest idle cash in marketable securities at anannualinterest rate of 8%. 365 = 0.022% Daiily interest rate = 8% Spread = 3x 3 3) (375000: S500 (gs) Spread = 506481 Return Point = Lower Limit + 4x Spread 750,000 + Soest = 918827 Upper limit Lower Limit + Spread 750,000 + 506481 = 1,256,481 1000) inance Mat gement (MU) Q.1 Working Capital Man, 6 Explain the concept of working capital, gross working capital and net working capita), a2 Explain the concept of operating cycle and cash cycle. a3 Explain the importance of working capital management. a4 List the tactors affecting working capital and explain in bref as Explain the trade-offs in optimum working capital management, inve aé econ Whatis economic order quantity and whatis the trade-off for deciding or EOQ? Q.7 Whatare the motives for holding cash balance? as Whatare the three elements of credit policy in receivables management? ag What are the different types of short-term investments available for finance Manager fc investmentof excess cash? . ntory management, oat management, receivables management. omic order aun, Qag Sources of Finance and Capital Structure A of Finance : Long Term Sources - Equity, Debt, and Hybrids; Mezzanine Finance: Sources of got TTD Finance - Trade Credit, Bank Finance, Commercial Paper, Project Finance. structure : Factors Affecting an Entity’s Capital Structure; Overview of Capital Structure and Approaches - Net Income Approach, Net Operating Income Approach; Traditional n, and Modigliani-Miller Approach. Relation between Capital Structure and Corporate vebes Concept of Optimal Capital Structure. company needs to survive the down cycle andbeagile enoughto seize growth opportunities anupcycle. Debt capital can be easier and faster to arrange than equity, however long-term pact on the flexibility and survival needs to be well understood. This chapter provides standing about the conceptofcapitalstructure anddifferent sources offinancing. ing objectives Long Term Sources of finance -Equity, Debt, and Hybrid, Mezzaninefinancing Sources of Short-term finance - Trade Credit, Bank Finance, Commercial Paper Project Finance .1 Introduction to Sources of Finance In the previous chapter we discussed in detail the long term and short-term investment decision considerations for carrying out the investmentfunction offinance manager.In this section, we will discuss the various sources offinancing and financing considerations to carry outthe financing function. Sources offinancing can beclassified into two broadcategories i.e. 1. Short term financing 2 Long term financi ing. Sources of Finance & Capital Siructure Management (MU © a period of finance that al re repayable within e maturity of more than includes the sourc es of finance that hav Short term financing includes the sources of 1 year. Long term financing 1 year and include sources that have nofixed maturity © such as equity, perpetual debt etc, Fig, 7.1.1 shows the typesof financing. Fig. 7.1.1 : Types of financing 7.2 Long Term Sourcesof Financing © Long term sources of financing are used by the companies to fund their long term or permanentfund requirements. These are the mostcritical source offinancing for business as these provide the necessary capital for investment required for sustained growth of the company. © Long term sources of finances are typically costlier than the short-term financing, however provides more flexibility to the company. © These are used for funding long term outlays such as purchaseofplant and machinery,land, building, investment in permanent working capital, expansion, acquisition of companies, assets, providerisk capital for new ventures etc. The most commonlyused sources for long term financingare as below. 7.2.1 © Equity Equity capitalis also called as the ownership capital or shareholders capital. It consists of funds raised from existing and new shareholders of the company and earnings retained in the company. (MU) q ~ qt ‘ , ' Se eS! are re also known _—— ordi nary share: 's/common hare premium and retained earnings Finance & Capital Structure stock Shareholders capital is sum of " from Rs. 1, Rs. S. Rs. 10 oF Rs. 100. — company raise ise funds and Issue s! shares, equity capital that has been wythe shareholders of the company iscalled asissued shares that have been issued andthe face value subscribed and paid and paid capital. It is equal to number of of shares. «Generally, company issues new sharesto investors it issues at a Premium to the face value to rect the perceived market value of the company. Share Premium represents the difference the issue price and the face value of shares, For example,issue price of IRCTC share was Rs. 320 per share vs face valueof Rs. 10. « Another important component of share capital is retained earnings.It represents the total profits retained by the companyin the business after paying outthe dividend to shareholders of the company. Retained earnings are not a source of new capital; however, it forms part of ownership capital. As company has retained the earnings instead of distributing it to shareholders it is considered asa part of shareholders’ capital. 7.2.1(A) Salient Features of Equity Shares he| * Ownership and voting rights : Each equity share represents proportionate ownershipoft their shareholding. company. Equity shareholders have voting rights in proportion to ectors on the| Shareholders are expected to vote on multiple matters such as appointment ofdir modern times, board of the company, new fund raising, acquisition or merger’ etc. In s to conduct annual general shareholders can also vote using e-voting option. A company need ed on majority votes. directors elected bas Meeting of shareholders once a year, where t another person to vote called as Investors can vote in person or appoin ers, there are registered guard rights of minority sharehold Safe of mutual fund alf beh on es vot xy pro t cas that s Companie investors, proxy voting. To} investment management] shareholders or high net worth W Finance Management (MU) 7-4 sources of Finance & Capital Strucey e control over the managementth © Control over management : Shareholders can exercis: board ofdirectors, voting on managerial compensation etc. a residualclaim ontheassets of the compay © Claim on assets : Equity shareholders have the case ofliquidation. of © At the time ofliquidation of company, claims debt holders, financiers, gove employees, tradecreditors are first paid off. The shareholders are paid off only the amount. © Limited liability : As a companyis separate legal person, shareholders of the companyare ny required to share any liabilities of the company. So in case offailure of the compa financial distress etc. shareholders are not required to contribute any shortfall etc. shareholderis holding the risk only to the amount that they haveinvested in the shares company. eright © Dividend : Whenever a companydeclares a dividend,all shareholders haveth o to receive dividends in proportion to their shareholding. e Freely transferable : Generally, there are no restriction on sale of equity share of pub! listed companies, henceshareholders caneasily sell equity shares and convert to cash. Advantages of Equity Funding 1. Itis a source of permanentcapital for the company.It provides company flexibility to take up riskier and long gestation projects. 2. Equity shares donotcarry anyfixed paymentsuch as interest or coupon. Paymentof dividend is entirely at the discretion of the company. 3. Equity share capital provides leverage to raise.additional debt at moreattractive terms; well capitalized companies are considered less risky by the financiers. 4. Equity funding allows the companyto increase shareholder base and brand nameof th company. Disadvantages of Equity Funding 1. Fund raising through equity can lead to dilution of the ownership and control ofthe} promoters. 2. Fund raising through equity is costlier due to compliance cost associated with fundraising from public. 3. Dividend paid out to the shareholders are not tax deductible, hence vis-a-vis debtit a less tax efficient sourceoffinancing. 4. Costofequity is generally higher than debt, as investor expects higherreturnsfor the risk. ow roance Management ent ( (MU, z 2-5 Sources of Finance & Capital Structure A 2.1(8) Meansof Raising Equity 1, Public under this method, the companyis raising equity capital by issuing shares to general public. Company prepares a Prospectus containing details such as the purpose for which funds are being raised, past financial performanceof the company, background andfuture prospects of company.This information helps the general public to decide whetherto invest or notin this company. Securities issued by this method are generally listed on stock exchanges and available for sale and purchase on exchanges. There are two typesoffunding through public issuance. a. Initial Public Offering (IPO) : Thisis an offering by an unlisted companyforthe first time in its life to the general public. It contains eithera fresh issue ofshares. p. Follow-on Public Offering (FPO): This is an offer of sale of shares by an alreadylisted companythrough anoffer documentto the generalpublic. 2. Rights Issue This is a method ofraising of funds through issuance of new shares by the companyto existing tion to the shareholders. The shareholders are offered the‘right’ to buy new shares in propor ers may accept or reject the number of shares they already possess. The existing sharehold hts to another right Shareholders who do notwishto take up the right sharescanselltheir rig ir rights, then the er person. If the shareholders neither subscribe the shares nortransf the companycan offerthe shares to public. 3. Private Placement In this method, companyallots sharestoinstitutional investors and someselected individuals. Ithelps to raise capital more quickly than a public issue. This involves less than 50 persons withoutissuing prospectus Jeter of offer for listing for the shares. The issuers could be public issuanceof securities to and without seeking permission limit companies or private limited d. companies. These securities may be listed orunliste 4. Offer for Sale ugh-intermediaries like issuing houses or Under this method, shares are offered for sale thro stock brokers at pre agreed price. These intermediaries This price investors at a market related price. e between is generally higher and the differenc s method is s profit for the intermediaries. Thi price represent the purchaseprice and the issue hot commonin India. resell the securities to the ultimate Sources of Finance & Capital s:, ity an Debi yt capital tal rey represents most common source of long-term finance id consists of debe. ebenty and term loans. 7.2.2(A) Debentures financing for high rated cy, attractive source of long-term Debentures or bone! or”institutig, compi anies to banks . worthy companies. These are generally issu ed by the is are an assified into twobr, investors such as mutual funds, insurance companies etc. Debenturesarecl types Non-convertible Debentures (NCD) and Convertible Debentu res. mon-convert debentures form part of debt financing while convertible debenture are considered hybrid soy of finance. Non-convertible debentures (NCDs) © NCDsare long term debtinstruments and are repayable on maturity. © Interest on the debentures is paid by the issuing company on monthly, quarterly, sey annually or annually at fixed or a variable rate as agreed at the time ofissuance of company. © NCDsare either secured by the assets of the companyor unsecured. ¢ Insomecases,insteadofinterest payment, the NCDsare issued ata discountto thefaceval of the debenture and are redeemed at paror face value. Thedifference betweenissueprice face value represents the incomeforthe investors. © NCDs are freely transferable and traded on stock exchangeor overthe counter market. Advantages of NCDs © © Cost effective sourceoffinancing as NCDstypically lowerinterest rates due to liquidity. NCDscan be structured to suit cash flows of the companysuch as zero coupon bonds, mont or annual interest payment, full repayment on maturity and intermediate period etc. Ownership is notdiluted in NCD issuance. © Interest paid on NCDs is nottax deductible. Disadvantages ¢ NCD is attractive sourceof finance only for highly rated ‘companies. NCD hasfixed interest and repayment obligations. Delay in servicing of NCD inte rest can impact reputation of companyas inform ation ‘onlisted NCDsis freely availabl e. © Many NCDs have terms and condit ion critical decisions. s that m ‘ay impact company’s undertaking flexibility in in unde! pany’s flexibility “7.2(8) Term Loans Sources of Finance & Capital erm loans are oneof the most popularsourcesof long-term financ ing for medium and small companies and are used for purposes such as for business expansion, purchase equipment, land. building, managing cash flow etc |, te rm loans havefixed maturity and repayable over the maturity period in regular payments. Term loan have maturity of more than 1 year and depends on the purpose of financing for example, term loans for capital projects are for a period of more than 5 years, while working capital term are generally for a period of3 years. Term loans can be secured or unsecured in nature. Secured term loansare the ones where the Joan Is secured by fixed asset security such as land, building, plant and machinery etc. and these are most common. In India, term loans are provided by banks and Non-Banking Finance Companies (NBFCs). Unsecured term loansare provided for a smaller amounts and shortertenor. ‘The company taking a loanis called as borrower and bank or NBFC providing theloanis called as lender. In some cases, lenders provide time of 6 months to 2 years, before recovering | | regular repayments called moratorium period, to provide time for construction and commencement of production. Advantages « Term loans are directly negotiated between borrower and lender and are processed faster comparedto otherlong term sourceof financing. « Borrowerneed notrequire creditrating etc. for availing term loan. * Information regarding delay on term loan servicing is confidential between lender and borrower. © Ownership ts notdiluted. © Interest paid on term loansis tax deductible. Disadvantage * Term loans generally carry highercost of borrowing compared to NCDs. * Term loans require regular repayment, hence less flexible. * Lending terms mayinclude restrictive covenants that company mayfind difficult to comply. 7.2.3 Hybrid Financing as well the company andrisk protection for the Hybrid financing refers to the financing instrument thathas some properties of debt ‘uty. These are tailor made to balance flexibility for lnvestors, Bc 78 Finance Management (' of The important forms e & Capit sources of Financ hybrid Financing are 1. Preference shares, 2. Convertible debentures, 3. Warrants etc es 7.2.3(A) Preference Shar Prof dividend, payable from the of e rat ed fix ind a! ty ri tu ed ma mpany Preference shares carry fix idends and assets of the co div on hts rig l tia ent fer pre carry p the made by the company. These does not make profits, it can ski y pan com r yea the In . res sha e led as preferenc he e forthe r the amount is added to dividend payabl dinde ni‘ate preference shareholders, , howeve any. t ofthe net worth of the comp par rm fo res sha e enc fer pre next year. The Advantages pany, hence help improve the leverage © Preference sl hares form part of the net worth of the com position. ¢ Company can skip dividend to preference sharehol ders in the eventofloss, henceis more flexible compared to other sources of debt. © There is nodilution of ownership or voting rights. Disadvantages © Preference shares generally carry higher rate than traditional debt instruments such as NCDs, term loans etc. © Dividend paid on preference shares is not tax-deductible. © In some cases, preference shareholders may have right to convert to equity shares if company skips dividend payment for some period. 7.2.3(B) Convertible Debentures © Convertible Debentures are a type of debentures that can be converted into the equity of the company after a stipulated timeperiod at the option of the debenture holder.In 5] cases, issuer can also haveoption to convert debentures into equity shares. © During the tenor of the debentures,issuer company pays interest or couponatthe pre-at rate ofinterest. The terms ofissuance such as conversion Price into equity share, frequency etc. are fixed at the timeof issuance. Convertible tenor, interest pa debentures are mainly of 3 types: into equity shares at the end of tenor (maturity)of the debenture. For listed companies 5 maximum conversiontenor isfixed at 18 mont h: s. Fe orpriv ate limited the tenor of conve! high be er. can debe er ntur gh es hi be an sc re tu en —teb t (MU ) 7-4 9 Sources of Finance & Capital Structure 2 convertible debentures (OCD) These debentures can be converted into equity pF= x the end of tenor (maturity) of the debenture at the option of debenture holders. For a «nt ° company, the maximum tenor for OCDs is 36 months / convertible debentures : In case of partly convertible debentures, some portion of ar qcres can be converted into equity shares. These are not very popular. poratages a ple debentures help attract funding song for start-ups. during uncertain times. It is a popular source of . cones jsorily convertible debentures help in reducingfinancial leverageof the company. pisodvantages - case of optionally convertible debentures, conversion to equity dependsat the option of deoenture holder and company mayhaveto plan for redemption. conversion to equity can result in dilution of ownership. Golke equity. company has to pay couponon the debentures during the tenor. 7.2.3(C) Warrants « A warrant is a derivative instrument which provides the holder of warrants right to buy the shares of the issuing companyata fixed pricecalled exercise price untilthe expiry date. » Warrants be traded in the secondary market bytheinvestors. ¢ There two main types of warrants known as call and put warrants. Callable warrants entitle investors with the right to buy shares of a companyfrom that companyata pre agreed price at 2 future date prior to expiration. When a warrant holder decides to exercise the right, company issues the shares to the warrant holder. ¢ A Puttable warrants offer investors therightto sell shares of a companybackto that company 2.2 specific price at a future date prior to expiration. * Warrants are sometimes issued with the preference shares or bonds to make the issue tractive for investors and reduce the rate of dividendor interest rate’as applicable. These warrants are detachable meaning they can be separated from preference shares or bonds can sold separately. Advantages * Awarrant does not offer any votingrights to investor.. * isan instrument to attract investors during uncertaintimes. . ° Due to uncertainty on conversion it may not result in new 7.2.4 Mezzanine Finance . nine fnancing is a by ‘on. ; sion. Warrants are dilutive post conver equity infusior debt and equity which provides the financernj, convert mezzanine debt to equity in case of default riskier projects and is typically used in fina Features of mezzanine financing © e loans In terms of seniority of repayment mezzanin are subordinate to senior debt, but in priority over equity shareholders. rate © Mezzanine loans are unsecured in nature and carry higher . . of interest than debt to convert into equity at pre agreed price, in Mezzanine lenders generally receive warrant ty. mezzanine loans are not repaid atthe time of maturi debt by the company. Mezzanine loans can be restructured into senior Advantages . Interest paid on mezzanine debt is tax deductible. n funding in . It is an unsecured source of funding for the borrower and help obtai projects. . Mezzanine financing offer flexibility of structuring repayment as per cash flows. © Owners may not lose control or dilution ifthe company meets obligations. © Many times mezzanine financiers also bring expertise to manage business. Disadvantages © Lender may. put restrictive covenants on the company. © Interest rates on mezzanine debt are typically very high. 7.3 Sources of Short-term Financing Short term sources of finance are repayable within a period of 1 year and are used for day today or working capital requirements such as purchase of inputs for extending credit to customers, paymentof salaries, overheads etc. Finance Management (MU) TAL ommo! used sources of short , The most commonly term 4. Trade credit Sources of Finance C: ital Structure financing are 2. Bank finance 3, Commercial paper. 4 Short term sources of financing are generally cheaper i available, . and easily hence there is a tendency to use short term sources wherever possible. However, this strategy offinancing is fraught with risk. Use of short term sources for funding long term resources can lead to shortage of fundsat the time of repayment. + This leads to mismatch in payment obligationsoffacilities and cash inflows from long term investments.If the sameis not refinanced in timecan lead to financial distress, default and bankruptcy in somecases. » Use of short term sources to provide long term loans havebeenidentified as oneof the reasons for somerecentfailures of the companies. Board of directions and managementshould avoid such temptation. 7.3.1 Trade Credit « Trade credit is an important source of short-term funding and arises due to the credit period availed by the companyfrom their suppliers for payment. * Credit period depends upon the industry norms,credit policy of the suppliers and credit . worthiness of the company. Sometimes suppliers offer cash discount for early payment of trade credit to expedite the collection. * Depending on the amountof cash discount and availability of funding, a companycan decide whetherto avail trade credit or pay in cash. Credit terms include cash discountrate, discount period andcredit period. For example, “2/5, net 45’ meanscredit period of 45 days and cash discount of 2 percent for payment within 5 days. Some companies purchase goods oncredit capital. andsell on cash to end customers, thus operating without any investment in working Advantages * Companies neednotenterinto any formal agreement orprovide anysecurity foravailing trade credit. w sales. gro * Itis can be availed quickly, hence fastest way to or * Ithelps companyto reducefinancial leverage Disadvantages external debt. or credit period interest. ce to accountf * Suppliers may increase pri A Finance Management (MU. * 7-12 Sources of Finance & Capital Structuy New companiesfindit difficult to get credit © Credit period offered in trade credit is generally short. 7.3.2 Bank Finance . Bank finance is the second most common source of short-term finance. Many large cre dit due to cheaper rates. creditworthy companies prefer bankfinance over utilizing © In this modeoffinancing, banks assess the credit requirement of customersafter analyzing sales, current assets and trade credit position and provide a credit limit to the customer y as collateral security. againstthe security of accounts receivables or inventor © ar. Following are the Credit limit is generally set for a period of 1 year and renewed eachye mostused short facilities provided by the banks. 7.3.2(A) Cash Credit Cash credit or CC is a working capital facility offered by the banks. In this, banks sanction a credit limit to the business depending on the credit worthiness and position ofcurrent assets, Followingare the featuresofcashcredit facility. Features of cash credit facility © Cash credit or CC limit is the credit limit granted by banks to business for meeting their working capital needs. ¢ Cash creditlimit is sanctioned for a year of up to 1 year and must be renewed every year bythe borrower. © Generally, banks require collateralin the form ofland, building, fixed deposits etc. for granting © Borrowercan withdrawfunds upto the credit limit and repay as per their requirement. There CCfacility. are norestrictions on the numberof withdrawals or repayments,asthis is a revolvinglimit. © Interest is charged onthe daily outstanding balance andnotontotal limit. Advantages CClimitoffers high degree offlexibility as business can borrow and repay anytime duringthe year. Interest is payable on the outstanding amount andnot on thecredit limit. ¢ Noprincipal repaymentrequired and only interest is charged at the end of every on average outstanding balance. the finance Management (MU (MU) 7-13 Sources of Finance & Capital Structure pissdvantages cash credit limit need to be renewed every year panks generally restrict the limits only upto the extent of net current assets with a margin of 25%. In case of shortfall in the amount of underlying current assets, banks may require companies to repaytheshortfall amount and reducethe limit. Banks may charge a minimum fees or commitment charges to ensureutilization of CC limit. 7.3.2(B) Overdraft Underthis facility banks allow the customerto draw funds over and abovethe balancein the current account upto a certain fixed limit, called an overdraft limit. This limit operates similar to CC facility and need to be renewed every year. The limits granted under this facility are smaller in size and carry higher rate ofinterest. 7.3.2(C) Bill Discounting Underthisfacility a companycandiscounttheinvoiceorbills for the goods orservicesbilled to its customers. Company approaches bankwith thebills accepted by its customers and banks makes the paymentto the companyafter deducting applicable discount charges. « On the due date, bank collects the payments from the customer of the company. Before discounting thebills or invoices bank checks the creditworthinessofthe customerto which the amountis billed. The bank requires thebills to be duly accepted by the customer. ¢ With large scale of implementation of enterprise resource planning or supply chain managementsolutions, thebill discounting has movedto electronic platform and acceptance of this product has increased. 7.3.3 Commercial Paper (CPs) ¢ Commercial paper is a short-term unsecured money market instrument with a maturity ranging from 7 days to 364 days. © Companies having a good credit rating can raise workingcapital funds by issuing commercial papers. * Accompany issuing commercial paper needto obtain credit rating of the proposed issuance from the credit rating agencies. Commercial papers are subscribed by banks, mutual funds, insurance companies etc. Features of commercial paper at © Commercial papers are issued at a discount and red leemed betweentheissue price andface value represent theinterest face value. The difference incomefor investor. Vv Commercial papers © 7-14 Finance Management (MU) of Rs. 5 lakh or are issued in denominatio ns f. multiples thereo . ble © Commercial papers arefreely transfera Advantages : of working capital financ: © Commercial paper is cost effective source e for large companies, e [tis unsecured in nature. i on the req ‘q' uirement ing end dep ar lye o upt s tie uri mat ent © Itcanbe issued for differ ty.. riity i the matutur y interest outflowtill an e ir qu re t no do rs pe pa al ci Commer Disadvantages and rges, stamping charges, issuing cha ng rati lves invo er pap l cia mer com of «Issuance nancing for smaller com panies. agentchargesandis notviable source offi be reported widely and can dent repu © Anydelay in repaymentof commercial paper can of the company. 7.4 Project Finance © Project finance refers to long term financing for infrastructure, industrial projects funding is mainly provided onthe strength ofthe project cash flows and is secured by assets ofthe project, including any long-term revenue agreements. Lenders have noreco! orlimited recourse to the sponsors (investors) of the project, which means thatin casedet lenders cannot ask the sponsors to make payment. Typical examples of project finance airports,roads, mines,oil blocks, power plants etc. © In theproject finance,a separate legal entity called as Special Purpose Vehicle (SPV) is crea by investors (or sponsors). The SPV owns the project and funding is raised by the SPV. Project or pay some fixed penalty f . some of the important Parties involve in the bss of oe 5 of project are are the providers of + sponsors : Thereted *rs Of theinitial capital for the project in the form of equity lo p ina L and/or subordinated loans. The sponsor wil normally and will support the project company by Providing ve experience in the relevant sector skilled personnel 2. Special Purpose Vehicle (SPV): This is also known as project vehicle and Is set up by the sponsor specifically for the purposeof the Project and owns the project 4. Contractors : These are the entities that the Spy appoints to build and maintain the project Sometimes SPV also appoints contractors for operating the projects 4, Offtakers : Off-takers are the parties that purchase output from the project. In most ofthe projects, the SPVs enterinto long term arrangementswith the off takers to sale the outputto ensure viability and reduce the risk. Manya times such long term contracts are executed with the government agencies. 5, Banks/Financial Institutions : These are the lenders to the project and generally form a consortium ofbankers. The cash flows and assets of the project are secured to them. 6. Specialist Advisors : These are the specialists having domain knowledgeof the industry and provide inputs regarding the planning viability and executionofthe project. Risks involved in project financing and management of risks Project financing involves multiple risks such as completion risk, cost overruns, market risk, environmental risk, foreign exchangerisk, political risk etc. Sponsors and lenders need to assess these risks and built suitable mitigants to managetherisks. © Completion risk : Completion risk can be mitigated by awarding turnkey contracts, taking performance bonds from contractors. © Cost Overrun In case of cost overruns a standbycredit, facility can be used, or lenders may require the sponsors to guarantee to fund cost overruns. © Market risks : Market risk refers to the risks associated with the shortfall in demandor off take when production commences. To mitigate these, SPVs are required to enter long term nts contracts with the off takers or take or pay agreements. Long term purchase agreeme ensurevisibility of revenues. In case take or pay arrangement off takers need to pay penalty in case they don’tlift, or off take contacted quantity. * Environmental/Governmentrisks : Many times, the projects are environmentallysensitive and need approval from the relevant environmental agencies and regulators. Hence, the finance documents include necessary representation and warranties regarding the necessary approvals for the project and in case of misrepresentation the sameis treated as default. ct. In such Sometimes change in governmentpolicy can affect the viability of the proje Sponsors may seek Governmentguarantees. 7.16 DG nance Management (MU) where projects a! re fund © Foreign exchange risks Foreign exchange risk arises dep . Sharp ‘oreh currency and revenues of projects are | in domestic currency foreign iB! nt of the project and in such cases dotnestic currency can affect repayme om the government Fol can be covered through convertibility guarante .e fr explains the working of praject finance transaction Financial Sponwors Institutions/Banks Nanted by Shareholders of Parent Company) l Equity I Debt Grants, Subsidies Special Purpose Vehiolg]_Purchasers of Produce (sPv) Hoot Government ondticencen. I otf Ti 1 senn] [some] Fig. 7.4.1 : Working of project finance Advantages of Project Finance © Lenders have Iimited or no recourse on the sponsor. © Ability to undertake projects with long gestation periods, © Project finance \s an off-balance treatmentfor financing for sponsors; so does not sponsor'sfinancial leverage. © Allows better tax treatmentfor the project. © More than one sponsors can be inducted to mitigate therisk of the project. Disadvantages of Project Finance © Due to complex nature of projects project finance involves higher cost of duedill analysis, legal documentation. © Itis very time consuming process to tie up funding underthe Project finance. Generally, the rate of interest Is higher compared to financing with norecourse. Lenders will generally Incorporate number ofrestrictive covenants that operational flexibility of the project vehicles, v Finance Management(MU. Sourcesof Finance & Capital Structure 7.5 Capital Structure Capital structure denotesthe wayof companyfinancesitself. Capital structure of the company js the combination of debt and equity in the total capital of the compa ny. Composition debt petweenlong term andshort term debtis also considered in thecapital structure. The use of debt and preference sharesis described asfinancial leverageortrading on equity, as they are raised on the basis of equity position. Theratio debt to totalcapital is called as leverage. Debt capital andpreference shares need to be serviced with periodic interest and dividend payments. The use of financial leverage is double edged sword.If a firm can earn higherreturnsthat costof debt, shareholders’ earnings will increase and if the rate of return is lower than the costof debt, it will erode shareholders’ earnings. « Popular measuresto calculate capital structure are Debt ratio and debt to equity ratio and are calculated as below: 2 Debt D Debtratio = Totalcapital "D+E Debt D Debtto equity ratio = Equity" E Capital structure has an impact on the shareholders’ earnings and risk and the value of the company. Henceit is importantto have optimum capitalstructure. 7.5.1 Factors Affecting Capital Structure of the Company Whenever a finance manager needs to decide on the financing for the investment, they evaluate multiple financing options and are expected to choose one that enhances the shareholders’ value. There manyfactors thataffect the capital structure of the company. These are internal to the companyaswellas external to the company.Importantfactors affecting the capital structure arelisted below : Cyclicality/Stability of business : Cyclical business are expected to have large and frequent fluctuations in sales, such firms mayfind it difficult to have stable earnings to meetfixed expenses. On the hand,stable businesses with large base offixed assets can have steady stream of revenues and profits. Such firms can choose to have more leverage. Examples of such businesses areutilities as electricity companies, telecom operators etc. Cost : Cost of financing is an important consideration for deciding onfinancialleverage. The Costs ofraising funds throughdifferent sources offinance are considered and cheaper source of finance is chosen. W Finance Management(MU) Sources of Finance & Capital 7-18 ssocl costs associated Floatation Costs : Floatation costs refer to the aes ; Struct i ra isingne of funds su with the prospectus, prospec expenses On processing fees, broker's commission, underwriting fees, ctive. Higher the floatation cost of a source, theless attra q may lead to substantial dilu : tion l Considerations: If the issuance of mo re shares * Contro je equity issuang promoter shareholdingorloss of control, company may notconsider th fund raising and will prefer debt funding. © e, higher the tax rate large is the value ens exp le ctib dedu tax is rest Inte : e Tax Rat r tax cost of debt. Hence a highertax ra afte the is r lowe and e ens exp st ere int on savings makedebtrelatively cheaper and moreattractive. s are booming, fi irms can find it market © Capital market condition : When the capital raise funds through equity and command higher © valuation. Hence, in booming markets} ate placement. firms make a beeline to raise funds through IPO orpriv intense competition are likely Competition : Firms operating in industries with leverage to avoid the ris! pressure on earnings, hence are expectedto limit the financial 7.5.2 Capital Structure Theories Capital structure theories aim to establish relationship between capital structure sedas belo marketvalueofthe firm. Importantcapital structure theories have been discus 7.5.2(A) Net Income Approach © Net income approach proposed by Durand in 1952, suggests that value ofthe fi increasedby increasing the financial leverage. Assumptions © ¢ Cost of debt is generally lower than the cost of equity as the weightageof debtin tote ; increases, WACC goes down. Net income approach assumesthatthe cost of equity and cost debt remains con increase in financial leverage. ¢ Accordingto this approach, cost ofcapital ofthe firm changes with the changein th leverage. Company’s capital structure has two elements i.e. debt and equity. © Weighted averagecost ofcapital also known as WACCis thecostofcapitalfor thefi sum of the weighted averagecost of equity and debt. WACC= Costof Equity x Equity weight + Costof Debt x Debt weight In this approach, Value ofthe firm Value of equity + Value of debt _ _Net income Interest ~ Costof equity Cost of debt Value ofthe firm = -—Net operating income Weighted averagecost ofcapital - No WACC Where x,-Cost of Equity ky- Cost of Debt wACc - Weighted averagecost ofcapital. Iilustration ABCLtd has EBIT(i.e., Net Operating income) is Rs. 50,000;cost of debt (ka) at 8%. Total capital is Rs. 400,000. Calculate cost of ofequity (ke) at 15% and cost capital and valueofthe firm under different combinations ofcapital structure ie. using leverage (debtto totalcapital) of 20%, 50%, 80% and 100%. Answer Investment 400,000 400,000 400,000 Debt ratio 20% 50% 80% Debt Amount 80,000 2,00,000 3,20,000 Interest rate 8% 8% 8% Net Operating Income(EBIT) 50,000 50,000 50,000 Less: Interest 6,400 16,000 25,600 Earnings for shareholders (NI) 43,600 34,000 24,400 Cost of Equity (Ke) 15% 15% 15% Market Value of Equity (NI/Ke) 2,90,667 2,26,667 1,62,667 amount) 80,000 2,00,000 3,20,000 Total value of the firm (Debt + Equity) 3,70,667 4,26,667 4,82,667 Market Value of Debt (Debt From the above example,it is clear that the valueoffirm increases at the proportion of low Cost capital i.e. with increase in debtcapital. Net income approach assumesthatthe costof equity remains the constantwith the change in leverage. ‘Tock! nce & Capit. sources of Fina 7-20 W Finance Management (MU) 7.5.2(B) Net Operating Income ( Net operating income theory states NOI) rm depends on that thevalueof t he fi net operating i e firm. This theory | structure of th s independent oftheca| pital and risk of the business andi developed by Durand. Assumptions sociated business tisk operating incom: e and the as Valueof the firm is dependent on the ected by the financial leverage. firm andboth thesefactors not aff irm are independ lent ofthe fi off e lu va e th d an al pit ¢ The weighted average costof cal leverage. demand © It assumes that the equity investors will k higher returns to compensate tis increase in proportionofleverage. As perthis approach, Total Market Valueof the firm (V) = err V= D+tE E = V-D As costof debtis constant Kw- Overall costoffirm D- Market value of debt E - Marketvalueof equity NOI- Net operating income Illustration Debt ratio 20% 50% 80% Debt Amount 80,000 2,00,000 3,20,000 Net Operating Income(EBIT) 50,000 50,000 Less: Interest 50,000 6,400 16,000 Earnings for shareholders (NI) 25,600 43,600 WACC (kw) 34,000 24,400 11.5% 11.5% 11.5% 4,34,783 4,34,783 4,34,783 80,000 2,00,000 3,54,783 3,20,000 2,34,783 12.3% 1,14,783 14.5% 21.3% Valueof the firm (V) Market Value of Debt (D) Market value of equity E=(V-D) Cost of equity (NI/E) finance Management (MU) 721 Sources of Finance & Capital Structure In the eeeven under the NOI approach valueof the firm remainsconstant with change inleverage as the Proportion of low cost debtis offset byincrease in costof equity. Cost of Equity (k,) zg a 8 é 3 3 3 Weighted Average Cost of Capital (WACC) Costof Debt (Ky) Lei Degree of Leverage Fig. 7.5.1 : Diagrammatic representation of NOI approach 7.5.2(C) Traditional Approach Traditional approach is intermediate between the net income and net operating income approach. As per this approach,it is possible to reduce costof capital by using optimum mix of debt and equity. Cost of capital for the firm will reduce and marketvaluewill increase as the share of debt in the total capital reaches optimum level, after which costof capital will increase and market will decline as equity shareholders more returns for the increased risk. Traditional approach is based on following assumptions : (a) The cost of debt capital remains constantup toa certain level and thereafter rises. er (b) The cost of equity Capital remairis constant more or less up to a certain level and thereaft increases rapidly. Traditional approachcanbe illustrated in Fig. 7.5.2. Cost of Capital Ke waoe Ka x Levelof Leverage Fig. 7.5.2: Traditional approach W Finance Management (MU) +: iP S Sources of Finance & Capital 7.5.2(D) Modigliani - Miller Approach to Capital Structure Modigliani and Miller approach advocates that the change in capital structure does not impact on overall cost of capital and value of the firm. This approachis similar to net op income approach and recognizes only the net operating income and risk of investment as impactingcost of capital and value of the firm. Modigliani - Miller approach is based on following assumptions: © Thereare notaxesi.e, incometax or tax on dividend. © Therenotransaction cost for buying andselling securities. © Thereis no bankruptcy cost. © There is a symmetry of information betweenthe investors and company. Investors will behaverationally. Modigliani- Miller approach in real world In practice however corporations have to pay taxes on income and dividend mayalso be Further, there are transaction costs involved and information asymmetry also prevails. Hen the extentof thesefactors, financial leverage reduces WACCandincreasesthe valueofthe fi 7.5.3 Elements of Capital Structure While planningcapital structure of a company,the finance manager needsto consider va elements ofthe capital structure. Someofthe important elements are as follows : © Capital mix : This represents mix between sources offinancei.e. debt and equity. Comy should decide a target capital mix suitable for its business and try to achieve the same deciding in financing new investment. With additional debtcostoffinancial distress will higher and companywill need to incur floatation cost. For issuance of new shares Com will need to incur floatation costs and may also lead to dilution of control of exi: shareholders. Hence, in terms of preference, companies will first use retained earni followed by debt and fresh equity. e Maturity and priority : This refer to the maturity of debt obliga tions and priority repaymentofdebt holders. Longer maturity debtprovides flexibility to the compan y.Sho! maturity debt is cheaperbutrestrict the flexibility. Companies prefer to match the maturiti of the debt with the cashflows,by financing short term assets using short term debtandlo: term assets using longterm debt. However,thereis not always 100% matching and somet companies use short term debt to finance long term assets for gradually refinance using long term debt. ¢ im a temporary period ai Terms and conditions : This refer to the terms and conditions Prescr providers when a company avails financing. ibed by lenders or . gets, in financial targets, restriction on dividends etc. ani id form part of the agreements. Companies . negotiate and ensure that the operational need to carefully flexibility and strategic objectives of the compan and interests of shareholders are not compromised. pany . currency = Companies need not depend on single currency for its financing needs. Large companies can raise fundsin foreign currencies such as Dollar, Japanese Yen, Euroetc. to take advantage of favourable interest rates and depth of the markets. However,currency risk needs to be keptin mind and needto be managed by hedging the repaymentobligations. Companies having large foreign currency income need not actively hedge repayment, others the exposure in currency market using appropriatefinancial instruments, need to hedge + Financial market segments : This refers to the various market segments which a company can tap for raising finance to suit its requirements. For example, company use domestic or foreign market for a long-term financing. Company can raise financing using bilateral arrangements or consortium of banks. It can choose finance from banks orraise funds by issuing debentures in the capital market. Companies having large funding requirements prefer to diversify the sources of funding to avoid dependence onsingle financier or market. 7.5.4 Optimum Capital Structure The optimum capital structure is that capital structure that leads to the maximization of the value of the firm and minimizing cost of capital. The use of debt capital in capital structure increases the earnings pershare asthe interest on debtis tax deductible. However, higherlevels of debt in capital structure leads to increasein costoffinancial distress and cost of equity, thus adversely affecting the market value of shares. Optimum capital structure balance trade-off between higher earnings per share and costof financialdistress to maximize the marketvalue of the firm. Following theories provide different approachesfor deciding an optimum capital structure : (@) EBIT-EPS analysis : EBIT-EPS analysis is an importanttool for designing the optimal capital structure framework ofthefirm.EPS i.e. earnings per share denotes the earnings available to shareholders. As per this approach, optimum capitalaims to maximize the EPS for a range of EBIT {.e. earnings before interest and taxes. EBIT of the companies fluctuate with change in sales and profit margins. If the interest costs are high for companies havinglarge fluctuations in EBIT, the EPS can turn negative when EBIT fall substantially. Hence, companies having large EBIT canuse relatively fluctuations in EBIT should use less leverage. Companies having stable higher leverage or debt. Financial break-even pointandfinancial indifference points help in deciding the leverage. Finance Management (MU) wv Sourcesof Finance & Capital Stru 7-24 's EPS is about 2 s the level of EBIT for which the firm (b) Financial Break-even : It denote the k-even point, companyc ntially higher than the brea estimatedlevel of EBIT is substa debt to the capital strug e two different capital er wh nt poi a to ers ref is (c) Financial Indifference Point : Thi: EBIT exceeds over the the When . EBIT of ls leve t eren diff produce sameEPS for t financial indifference, company can fund using more deb analysis, company Ww! (d) Cash flow analysis : In the cash flow ing. servicing of debt and accordingly plan the fund flows ie. post-tax EBIT after making adjustment for ayment of debt as per the repayment sch includeinterest on the debt and contracted rep Cash flow analysis is a very important . tool to measure the repayment capacity g that period or decline in profit mi any may be planning higher sale necessarily impact cash generation. For example, comp: funds in higher credit and profits in coming periods, however it may have to bl lock into higher cash generatit inventories. In such cases, higher profit may not transl: late company may not beable service larger debt payments. of the forecast period and debt Cash flows and debt obligations are plotted for each lated. Debt service coveragei.e. coverage and debt capacity of the company is calcu age ratio indicates the capability cash flows to the debt obligations. Debt service cover debt that a companycan sel companyto service debt. Debt capacity represents total Net profit may not always translate into cash duriny the period. Difference between debt capacity and debt companyto raise debtin the case of requirement. position represents room avail Review Questions | Sources of finances a2 a3 Discuss various means ofraising equity financing. a4 Expiain the features of debentures. What are the types of debentures? as Explain the pros and cons of debentures. a6 Explain the advantages and disadvantages ofpreference shares? a7 Whatis the difference between term loan and debentures? . Compare thefeatures of equity shares, debentures and preference shares Whatare the characteristics and advantages of equity financing? Qa @.8 @Q.9 Q.10 Whatis warrant? Enlist different sources of short term financingfora firm. Compare commercial paperwith cashcredit facility. Finance Management (MU) 7-25 Sourcesof Finance & Capital Structure att Why is commercial paper notsuitable for small companies? at Why is project financing suitable for financing infrastructure projects? 13 Howis the risk in project finance is managed? capital structure at a2 @.3 0.4 ‘What is capital structure? Why the value oflevered firm (having leverage)is always greater than the value of unlevered firm when corporate profits are taxed? Discuss advantages and disadvantages of using equity and debt in the capital structure. Total equity capital of ABC Ltd is Rs. 40 Lakh and Debtcapitalis Rs. 60 Lakh. Costof equity of e cost of ABC Ltd is 14%, cost of Debtis 10% and tax rate is 30%. Calculate weighted averag capital. as Discuss factors affecting the capital structure of the firm. @.6 Whatarethe elements of capital structure of the firm? @.7 What are the approaches to decide capital structure of the firm? @8 Whatis the optimum capital structure? Discuss the elements ofcapitalstru cture. Q00 8 Dividend Policy Affecting an Entitys Dividend Policy : Meaning and Ir importance of Dividend Policy; Factors s Theories and Ap} proaches-Gordon' Approach, Policy Dividend of Overview Decision; Dividend Walter's Approach, and Modigliani-Miller Approach. { Learning Objectives Meaning and Importance of Dividend Policy Factors Affecting an Entity’s Dividend Decision ’ Overview of Dividend Policy Theories and Approaches - Gordon's Approach, Walter Approach, and Modigliani-Miller Approach 4 8.1 Introduction to Dividend Policy Dividends are payments made by a company to the shareholders of the company. Most } dividends are paid in the form of cash. Dividends is the most common approach fol distribution of profits to the shareholders, other being buybackof shares or bonusshares. Part of the profitgets distributedto the shareholders. 4 Companies can choose to distribute part of the earnings to shareholders andreinvest the balance in the company. Theratio of the dividend andthetotal profits is called dividend’ payoutratio andtheratio of reinvested amounttototalprofits is called as retentionratio. i Board ofdirectors of a companyformulate a dividendpolicy outlining guidelines of dividend distribution. Dividend policy has the parameters for payment of dividends to shareholders. such as frequency, amount, timing of dividend and depends on thefinancial position of the company. It determines the dividend income that equity shareholders will earn, amountof own equity available for business requirements. Dividend policy also shapes role in attaining desired capital structure for the company. Finance jement (MU; importance of dividend Policy 1. company expects growthin profitsin future. Discipline management: Sound div idend Policy provides guidelines for div restrict management from takingreckless outlan dish investment decisions. Influences stockprice and value : Dividend Payout Is one of the important idend payout and consideration for valuation of companies, hencea changein dividend Policy influences the share price. Influence institutional Investors ; Balanced divided dividend Policy sends strong signals about the company’scapitalallocation policy and helpattract institutional investors. 8.1.1 Types of Dividend Policy Constant dividend policy In this policy, the company decidesa fixed amount ofdividend for the shareholders.In this policy dividend amountdoes not changeperiodically. Constant payoutpolicy : In this policy, the company pays fixed percentage ofprofit as dividends. The dividend amountgrowsordeclines with changein profits. Residual payoutpolicy : In this policy, the company paysresidual amountfrom profits after accounting for planned capital expenditures. Irregular dividend policy : In this policy, the company does not have fixed amount or schedule for dividend payoutandit is at the discretion of the management. No dividend policy : In this policy, company has policy to retain all the profits for reinvestmentand doesnot pay any dividends. 8.1.2 Factors Affecting Dividend Decision Legal rules : Company needsfollow the rules and guidelines per the local government. In India, Companies Act, 2013 lays rulesfor distribution ofdividends. Funding requirements : Thefirm should consider the funding requirements and cash flow position of the companyto decidethe dividend decision. For this purpose, projected cash flows are of particular importance. Investment opportunities : One of the significant factors of affecting dividend decision is availability or lack of investment opportunities. 8 © Dividend poy, Firm having attractive investment opportunities are likely to postpone dividend Payments to future period and reinvest earnings in the business, while firms lacking good investmeng opportunities will like to have higher payouts. « Contractual restrictions : Many times loan agreements with lenders restrict the divideng payment to shareholders, companies need to comply with such restrictions while announcement ofdividends. Liquidity position : Liquidity of a companyis an important consideration in many divideng decisions. Greater the cash position and overall liquidity of a company,the greaterits ability tg pay a dividend. In the low interest rate environment firms mayprefer to borrow funds and be more liberal in dividend payout. * Access to capital market : Firms having easier access to long term capital markets are less dependent oninternal funds and are moreflexible in dividend decisions. Stage of the business : In the growth stage, business needs funds for investment and will like: to reinvest more profits for growth and limit the dividend payout. In the mature stage, company’s investment requirementis limited and they are likely to pay higher dividend payout. Stability of earnings : Companies having stable earnings profile are likely to have larger dividend payout, compared to companies having large fluctuations in earnings. Hence, companiesin the industries such as utilities e.g. NTPC Ltd or fast moving consumergoods companies e.g. Hindustan UnileverLtd arelikely to have larger dividend payout compared to cyclical companieslike Tata Motors Ltd. Type ofIndustry : Someindustries are highly cyclical and show largefluctuations in demand, while some industries have periodic investment requirements due to technological changes. Companies operating in such industries are likely to have low dividend payoutto safeguard against uncertainty. 8.1.3 Dividend Policy Theories © Wehad studied in earlier chapters that equity investors earns returnsin the form of dividend incomeandcapitalgain. © When a company declares the dividend, equity shareholders receive the income in current . period. When a companychooses to reinvest the earnings, equity investors expect to earn from capital gains in future. © Some theories propose that the company’s dividendpolicy has an impact on sharepriceof the company, while Miller-Modigliani proposethe irrelevance of dividend income andshare price. Let’s study. Dividend Where P,- Price per share D,, Dz__D-- Dividendpershare per year r- Cost of capital Dividend discount model has two popular variations i.e. Gordon's model and Walter’s model. 8.1.5 Walter’s Model Walter’s modelof dividend policy proposes that the dividend policy of the compan y has an impact on the share price of the company. According to the model proposed by James Walter, market value of company’s shares depend on dividend payout ratio, internal rate of return and cost ofcapital for the company. Assumptions Walter's model is based onfollowing assumptions. ¢ Internal financing : All investments of the firm are financed from retained earnings of the company. New equity financingis notavailable. ¢ Constantreturn andcost ofcapital : Company'sinternalrate of return and cost ofcapital are constant. e Constant earnings and dividend per share (EPS) and (DIV) : Earning per share and dividend per share of the companyare constant. Infinite life : Companyhasinfinite life. 100% payout or 100% retention : Companyeitherdistributes 100% ofprofit or reinvests 100% profit amount. According to Walter’s model market value per share is sum of presentvalue ofall future dividend per share and presentvalueof gains on investments from retained earnings. > p (E-DxE Formula : Market price per share (Po) = +——____ Financ: ment (MU) 8-5 Dividend p, Where, P- Market price per share D - Dividend per share k Cost of capital of the firm E - Earnings per share r- Internal rate of return ofthe firm. Tilustration The earnings per share of companyare andthe rateof capitalization applicable fs 10 and 12% respectively. The companyis evaluating an to the company option to adopt a payout ratio Of 50% or 75%. Using Walter's formula of dividend payout, calculate the market share if the internal rate of return is 15% value of the company’s Answer Using Walter's formula © For payout ratio 50% and RoE of 15% Dividend pershare = 10 x 0.5 =5 Price per share P = (35) + (os x (10-5) ) 0.12 0.12 =42+52=94 e Forpayout ratio of 75% and RoE of 15% Dividendper share 10 x 0.75 = 7.5 ( 7.5 Price per share P = d1z)* (e18 10 - 7.5 ) 0.12 0.12 =62+26=88 As theinternalrate of return is higher, higheris the retentionratio, higherthe retention higher will be the shareprice. In fact share price will be maximized whentheretention ratio is 100%. Implications of Walter's model ¢ For growth firms : In case of growth firms internal rate of return (r)> cost ofcapital (K), shareholders of such firms will maximize value by reinvesting all the earnings. The optimum payoutratio for suchfirms is zero. ¢ For normal firms In case of normalfirms, internal rate of return (r)is equalto costof capital (k). For such firmsdividendpolicy has no impact on share policy and dividend payoutratio is optimum. Wissen the dividends elsewherefor betterp ymitations of Walter's mode 'ernal rate of eturns, Prefer to have 100% return (r) is less than cost of Payout ratio as they can invest 8.1.6 Gordon’s Model Myron Gordon's model proposesthat the market valueofth all future stream of dividends. fe shares is sum ofpresent value of Gordon's modelis based on the assumption that the stream of future dividends will grow at some constantrate in the future for aninfinite time. The model is helpful in assessing the value stable businesses with strongcashflow andsteadylevels of dividend growth. of Gordon's modelis based on following assumptions: « Internal financing : All investments ofthefirm are financed from retained earnings of the company. New equity financing is notavailable. ¢ Constant return andcost ofcapital : Company’sinternalrate of return and costofcapital are constant. ¢ Constant retention : Company’s retention ratio i.e. ratio of retained earnings to profits is constant. ¢ Constantrate of growth : Company's earnings are growing atconstantrate of growth. ¢ Infinite life : Companyhas infinite life. «Cost ofcapital Is greater than rate ofgrowth : Cost of capital ofthefirm is greater than rate of growth. « Notaxes : There are no taxes on earnings. Po D3 D2 Dy n OW Py = Ten Gb Ge D(1 +g)” 3 , Dii+ g)” D(i+g) Dire, Dies Po = ak) * (tke (1K “aen where, P- Price per share D- Dividend per share Waterss Di ividend Py 8-7 Finance Management (MU) : 4 g- Rate of growth in dividend k - Costofcapital > (kg) y =__D “Kea+g) Formula:. Po = Dit s x Payout ratio Dividend = Earnings per share Payoutratiois 1- retentionratio ie. 1- b, where > bis the retentionratio. J Formula : Po= €, =e} n ratio Growth rate g can be estimated using return on equity and retentio g = ROE~ Retention ratio = ROE xb Earningspershare can be expressed as Assets per share (A) x Rateof return E, (r) or rxA | Illustration value of Rs:10 A Companyhas totalassets of Rs.500,000 divided into 10,000 shares with face on per share. Companyhaspolicy of 50% payout ratio and capitalization rate of 12% and return y’sshare. assets of 15%. Using Gordon's method,calculate the market value of the compan Answer D ko P= price share model, Gordon’s per As : | _ E(l-b) “ (k-g) Ei = rxA= x (500,000) _=75 _ (0.15)70,000 a g = P= bx r=0.50x 0.15 = 00.75 or 7.5% 7.5 (1- 0.5) (0.12 - 0.075) y . . 3.75 * 0.045 P = 83 Price per share is Rs. 83. Implications of Gordon's model ¢ For growth firms : In case of growth firms internal rate of return (r) > cost ofcapital ®, | marketprice of share (Po) will increase with increase in retention ratio (b). ; finance Management (MU Dividend Poli w- For suchfirms,dividendpolicy has no impact on share poll icy. . for declining firms : In case of declining firm: Ss internal rat capital (K),valueoffirm will decline with increase in retention vrata (0) 5 less than cost of umitations of Gordon's model . No external financing : Walter's assumption of no external financingis not practical. 1 1 —! world, companies have access to external financing. . constant t rate of return and Cost of capital : Walter’s assumption of constant costof capital and internal rate of return for the entire life of companyis unrealistic. Company's marginal cost of capital or rate of return are subject to change with more competition in real world. 8.1.7 Dividend Irrelevance - Modigliani- Miller Approach (MM) Modigliani Miller approach putforth by Franco Modigliani and Merton Miller in 1961 states that dividend decisions are irrelevant for the share of the company. According to this theory price of share Is only influenced by earnings per share. assumptionsof the model Perfect capital markets : This model assumes that the capital markets are perfect i.e. all ors are rational, there are noflotation or investor have accessto free information, all invest transaction costs. vely both dividend andcapital gains are taxed ati e No taxes : There are no corporate taxes, altern at samerate. « Investoris indifferent between dividend income and investoris indifferent between dividend income abouttotal income. s ¢ No risk or uncertainty : All the investor capital gains It is assumed that andcapital gain income andonly concerned s can forecast future market prices and dividend exist. This meansthat with uncertainty andrisk of uncertainty does not for all securities and forall periods. discount rate is same ment policy est © Investmentpolicy : Thefirm has fixed inv Price per share as per MM approach is : > Po = Di+Py 44k Formula : Py = Po (1 +k)— D1 where, share P, = Market price ofthe at the end of a period Wren 8-9 Dividend p, og a peri Py = Market price of the share at the beginningof k = Cost of capital period D, = Dividends received at the ehd ofa Limitations of Modigliani - Miller Theory © Perfect capital markets do notexist, information asymmetry exists. Taxes are present in the — capital markets. According to this theory, there is no difference between internal and external financing, However,issuanceof new securities involves floatation costs. Taxes are present, further is most of the markets capital gains and dividends are taxed differently. Qt Why Is it important to have a dividend policy for a firm? a2 Elaborate the factors affecting dividend policy. a3 A firm is expected to declare a dividend of Rs.10 next year and has a payout ratio of 60%, Companyintemal rate of retum is 16% and cost of capital 12%. Calculate the market price of share using Gordon's model. a4 What are the assumptions of MM theory on dividend policy? “7 — gaa