FINANCIAL MANAGEMENT

MASTER OF BUSINESS ADMINISTRATION
(INDUSTRY INTEGRATED)



TWO YEAR FULL TIME INDUSTRY INTEGRATED
M.B.A PROGRAMME


SELF LEARNING MATERIAL

FINANCIAL MANAGEMENT









Detailed Curriculum
Annamalai University Courses
 

LESSON 1: FINANCIAL MANAGEMENT- : AN OVERVIEW
LEARNING OBJECTIVES:
• To know the meaning and definition of finance.
• To understand the scope and functions of financial management.
• What are the objectives of financial management?
• To understand the role of a finance manger nad his interaction with other functionaries in the organization.
INTRODUCTION: Financial Management is that specialised function of general management which is related to the procurement of finance and its effective utilisation for the achievement of common goal of the organisation. It includes each and every aspect of financial activity in the business. Financial Management has been defined differently by different scholars. A few of the definitions are being reproduced below:-
“Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.”- Weston and Brigham.
Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.”- Joseph and Massie.
From the above definitions, it is clear that financial management is that specialised activity which is responsible for obtaining and effectively utilizing the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial administration and financial control.
FUNDAMENTAL PRINCIPLE OF FINANCE
Before making a decision one has to ask the question whether the investment decision will raise the market value of the firm.
A business proposal –regardless of whether it is new or acquiring an existing business –raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the total cash outlay required initially for the project.
RISK-RETURN TRADE OFF: Normally financial decisions often involve alternate courses of action- may be plant capacity, location of the plant, technology to be adopted, , sourcing the finance required, product to be introduced etc. the alternate courses of action will have different risk return implications. A large part may have higher expected return and higher risk exposition. Thus all major financial decisions like capital structure decision, capital budgeting decision, dividend decision, and working capital decision do have risk and return characteristics. Under these circumstances the finance manager may have to have an appropriate risk return trade off to optimize the return with minimum risk.. The following figure will shows the relationship of each decision with risk and return.
FIGURE 1.1: DECISIONS, RETURN-RISK AND MARKET VALUE


NATURE AND SCOPE:
All business operations involves taking decisions which generally has an finance implications since the primary objective any business entities is to achieve profit or wealth maximization. This is mainly because all business operations are with an intent to earn profit – generate income more than the expenditure- let it be R&D or Production or HR or Marketing or even sourcing and deployment of funds Common thread running through all decisions taken by various managers is money. Objective of the finance manager is to maximize the wealth of the owners through effective financial management.
To achieve this, business operations should ensure that all resources- money, manpower, technology and materials/ equipment are put into effective utilization by having well integrated functions of R&D, Production, Marketing, HR and Finance. The figure below shows the nature and scope of financial management.


Fig1.2 NATURE AND SCOPE OF FINANCIAL MANAGEMENT

EVOLUTION OF FINANCIAL MANAGEMENT: Financial management emerged as a distinct field of study at the turn of the 20th Century.. The evolution can be divided into 3 broad phases – Traditional Phase, Transitional phase and the modern phase.
• Traditional phase lasted for four decades with following important features:
1. Main focus was on certain events like formation, issuance of capital, major expansion, merger, reorganization liquidation etc.
2. The approach was mainly descriptive and institutional.. the instruments of financing, Institutions, and procedures used in capital market and the legal aspects of financial events formed the core of financial management.
3. The outsiders point of view was dominant. Financial management was viewed from the point of view of investment bankers, lenders her outside interests.
• The institutional phase began in early 1940s and continued through early 1950s. Though financial management during this phase remained similar to that in the traditional phase emphasis was placed on the day-today problems faced by the finance mangers in areas of funds analysis, planning and control . The focus shifted to working capital management
• The modern phase began in mid 1950s and has witnessed an accelerated pace of development with the infusion of ideas from economic theory and application of quantitative methods of analysis. the distinctive features of modern phase are:
1. The central concern considered to be of matching the funds to its uses to achieve maximization of wealth of current shareholders.
2. The approach of financial management has become more analytical and quantitative.
Fig 1.3FINANCE FUNCTIONS

GOALS OF FINANCIAL MANAGEMENT:
Maximize wealth of current shareholders.
 In market based economy which recognizes the right to private property, the only social responsibility is to do business legally, ethically and with sincerity.
 It is a profound error to view company’s value enhancement is only for shareholders.
 The question is whether a company should maximise employees welfare, value addition to customers, or maximise contribution to society at large.
 Maximizing contribution to society is through enhancing value of the firm.
ALTERNATIVE GOALS:
 Maximisation of profit- Limitations: - (a) Profit in absolute terms is not a proper guide unless it is expressed in terms of profit per share basis or in relation to investment.; (b) no guide for comparing profit now, profit in past and profit in future; (c) if profits are uncertain and described buy a profitability distribution, the meaning profit maximisation is not clear.
 Maximising earnings per share and Maximisation of return on equity do not suffer from the above limitations.
 Maximisation of current market price.
 Shareholders’ orientation in India:
 Foreign exposure
 Greater dependence on capital market.
 Abolition of wealth tax on financial assets.
 Chairman of Reliance Industries Limited stated in 1993 Annual Report “in everything that we do, we have only one supreme goal,, that is to maximise your wealth as members of India’s largest investors family”
EMERGING ROLE OF THE FINANCEL MANAGERS IN INDIA
 Investment planning.-We now have too many alternatives like bank deposits, company deposits, equity, fixed income securities, real estate, life insurance, mutual funds, precious metals like gold, silver, platinum etc. for investment. The two key aspects of investment is time and risk. Investment is considered as a sacrifice we make today for future benefits. While what sacrifice we make is certain but the future benefits are uncertain.
Investment planning must take into account the following criteria:
 Rate of return.
 Risk
 Liquidity or marketability.
 Time horizon
 Tax shelter
 Convenience
Investment Planning helps the corporate as also individuals to judiciously utilize the resources to derive optimal benefits .
 Financial structure.- The way in which a company's assets are financed, such as short-term borrowings, long-term debt, and owners equity. Financial structure differs from capital structure in that capital structure accounts for long-term debt and equity only.
Framework of various types of financing employed by a firm to acquire and support resources necessary for its operations. Commonly, it comprises of stockholders' (shareholders') investments (equity capital), long-term loans (loan capital), short-term loans (such as overdraft), and short-term liabilities (such as trade credit) as reflected on the right-hand side of the firm's balance sheet. Capital structure, in comparison, does not include short-term liabilities.
 Mergers, acquisitions and restructuring.-
Corporate Restructuring
The corporate restructuring, often compared to medical surgery, is a process of treatment for ailing companies based on the professional diagnosis. Just as the goal of medical surgery lies in the recovery of a patient, the aim of a corporate restructuring is the rehabilitation of a distressed company. As the patient needs a hospital to be recovered, the ailing company requires a restructuring vehicle to be rehabilitated.
Corporate restructuring means the series of process to restructure asset structure, financial structure, and corporate governance, helping the survival and the growth of a corporation. Although the extent of corporate restructuring includes a distressed company as a target in a narrow term, it includes an inefficient company as a target in a broader term.
Mergers and Acquisitions:
The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling and combining of different companies that can aid, finance, or help a growing company in a given industry grow rapidly without having to create another business entity.
Merger is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. There are 15 different types of actions that a company can take when deciding to move forward using M&A.. Usually mergers occur in a consensual (occurring by mutual consent) setting where executives from the target company help those from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market against the wishes of the target's board. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".
Historically, mergers have often failed to add significantly to the value of the acquiring firm's shares (King, et al., 2004). Corporate mergers may be aimed at reducing market competition, cutting costs (for example, laying off employees, operating at a more technologically efficient scale, etc.), reducing taxes, removing management, "empire building" by the acquiring managers, or other purposes which may or may not be consistent with public policy or public welfare. Thus they can be heavily regulated, for example, in the U.S. requiring approval by both the Federal Trade Commission and the Department of Justice. The U.S. began their regulation on mergers in 1890 with the implementation of the Sherman Act. It was meant to prevent any attempt to monopolize or to conspire to restrict trade. However, based on the loose interpretation of the standard "Rule of Reason", it was up to the judges in the U.S. Supreme Court whether to rule leniently (as with U.S. Steel in 1920) or strictly (as with Alcoa in 1945).
Acquisition
 An acquisition, also known as a takeover, is the buying of one company (the 'target') by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target's board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger or longer established company and keep its name for the combined entity. This is known as a reverse takeover.
 Working capital management.- Working capital, also known as net working capital or NWC, is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidityif its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash.
Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:
• Accounts receivable(current asset)
• Inventory - raw materials+ work in progress + Finished Goods-(current assets), and
• Accounts payable(current liability)
The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.
An increase in working capital indicates that the business has either increased current assets(that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.
Working capital management
Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short term assets and its short term liabilities The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
 Performance management includes activities to ensure that goals are consistently being met in an effective and efficient manner. Performance management can focus on performance of the organization, a department, processes to build a product or service, employees, etc. Information in this topic will give you some sense of the overall activities involved in performance management. Then you might enhance your understanding by reviewing closely related library topics referenced from the sidebar.
It is imperative to have a periodical review of performance not only to assess the performance with reference to targets fixed and analyzing variations but it is also critical to have mid-course corrections to improve performance through various decisions like better and effective process control, better input/output ratio, better working capital management, effective pricing, effective marketing etc.


 Risk management.- Risk is defined in ISO 31000 as the effect of uncertainty on objectives (whether positive or negative). Risk management can therefore be considered the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. Several risk management standards have been developed .
The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk.
 Corporate governance. is the set of processes customs, policies, laws, and institutions affecting the way a company is directed, administered or controlled. Corporate governance also includes the relationships among the many stake holders involved and the goals for which the corporation is governed. The principal stakeholders are the stake holder’s management, and the Board of Directors. Other stakeholders include employees, customers, creditors suppliers, regulators, and the community at large.
Corporate governance is a multi-faceted subject.. An important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent-problem. A related but separate thread of discussions focuses on the impact of a corporate governance system in economic efficiency, with a strong emphasis on shareholders' welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view and the corporate governance models around the world (see section 9 below).
There has been renewed interest in the corporate governance practices of modern corporations since 2001, particularly due to the high-profile collapses of a number of large U.S. firms such as Enron Corporation of USA and Satyam Computers.


REVIEW QUESTIONS
1. “Finance is the oil of wheel, marrow of bones and spirit of trade, commerce and industry” – Elucidate.
2. Discuss the role and significance of financial management in the functional areas of modern management.
3. ‘Some of the early concerns of financial management are related to preservation of capital, maintenance of liquidity and reorganisation. Do you think these topics are still important in our current unpredictable economic environment?
4. Who discharges the finance function and what are his specific responsibilities?
5. Contrast profit maximisation and value maximision as criteria for financial management decision in practice.
6. Why is it in appropriate to seek profit maximisation as the goals of financial decision making?
7. “The operative objective of financial management is to maximise wealth or net present worth” – Ezra Solomon. Explain the statement and explain the finance function performed by a Finance Manager to achieve this goal.
8. Explain the scope of finance function and suggest an organisational structure that you consider suitable for an effect financial control of a large manufacturing concern.
9. Discuss the respective roles of “Treasurer” and “Controller” in the financial set-up of a large corporation. Out of these two finance officers who is more important in the modern contest and why?
10. As a Financial Manager of a company, how would you reconcile between financial goals and social objectives of the concern?
SUGGESTED READINGS
1. Chandra, Prasanna :Fundamentals of Financial Management,
New Delhi, Tata McGraw Hill Co.
2.. Pandey, I.M. :Financial Management,
New Delhi, Vikas Publishing House.
3. Van Home, James C :Financial Management and Policy,
New Delhi, Prentice Hall of India

 
LESSON 2: TIME VALUE OF MONEY

Learning Objectives:
understand the Implications of Time Value of Money
leam the procedure to find the future values and present values of cashflows
make use of PV tables for evaluating the cashflows of a project

INTRODUCTION
The economic analysis of a 'project' involves the study of economic data and deciding on whether the given 'project' is acceptable to the firm. In other words, the management needs to decide whether a 'project' should be executed by the firm, hence to become a part of productive assets of the firm or whether, it should be rejected for want of viability. All this requires a stipulation of a decision rule for accepting or rejecting 'Investment Projects'.
Usually, the elementary ideas that revolve in the minds of those who are having little knowledge of basic economics is the evaluation of an investment project in terms of its earning capacity over and above the rate o( investment that one should repay on the use of funds borrowed for financing the investment outlay. Although the interest rates in an economy are generally determined by market conditions the knowledge of its measurement would owe to appreciate the Time Value of Money.' Further, a large project is not always financed from one source of borrowing, therefore, the measurement of costs involved in servicing various sources of finance, nevertheless, adds a new dimension to the process of examining the Projects viability.
In this lesson let us concentrate on the measurement of the interest rate being a factor for adjusting the cashflows of an investment project as well as the issues involved in estimating the overall cost of capital of funds used for financing the projects.
INTEREST, INTERST FACTORS & TIME VALUE OF MONEY
It is well known that most financial decisions associated with acquisition of Investment Projects would affect the cashflows over different time periods. A capital investment decision involves the comparison of present outlays with future benefits, therefore, the problem relating to the timing of receipts always He at the very centre of Capital Budgeting decision. While weighing the desirability of an investment proposal, the timing of cashflows in addition to the magnitude of relevant cashflows. would draw due consideration. How could the Time Value of Money plays, a prominent role ? How to measure and adjust it ? To clear this issue let us consider an example.
Suppose a project requires an initial outlay of Rs. 1,00,000 which would generate Rs. 1,10,000 by the end of its 1 –year life. Is it worth–while project ? Whether project is able to attract an investment of Rs. 1,00,000 against its return of Rs. 1,10,000 after an year ? To find an answer to this issue, one can consider an alternative use of Rs. 1,00,000. Suppose we could earn an interest of 12 percent by depositing in a commercial bank the return from such an investment could be around Rs. 1,20,000 after an year. In such a case, the proposed investment outlay in the proposed project is not worthy enough compared to a bank deposit. Thus a rupee of today is not equivalent to a rupee to be received in future as long as there exists an alternative of earning a positive return on the rupee during the interim period.
A theoretical base for the Time Value of Money has been embodied in traditional interest theory developed by Irving Fisher and extended by J.Hirshleifer, against a backdrop of a set of assumptions like perfectly competitive financial markets with no transaction costs and instant information. Fisher identifies that the Interest rates are being established by capital market for valuing the inter temporal transfer of funds. As an example, one may consider a trade off in the following way. An individual can forgo spending Rs. 100 of this year's Income in exchange of spending Rs. 110 next year. Here the exchange can be thought of as lending present consumption of Rs. 100 .In an Inter temporal capital market in order to receive an Increased Income of Rs.110. Alternatively one can think of foregoing Rs.110 of next years' Income in order to Increase in present consumption through borrowing.
Interest Rate and Compound Amount Factors
It is now clear that the interest rate is simply the market price for inter-temporal exchange of funds. In such a case a project evaluation involving a time horizon needs the use of interest factor while estimating the present value of its future cash flows.
Suppose the relevant alternative return, say the market rate of return from a project as a business man looks at it or the market price for inter-temporal exchange of funds as suggested by an economist. is donated as '1', then we can show the future value of a sum to be
Pn = Po(l+l)n
Where, Pn = Future value of sum after 'n' years,
Po is the sum value at present and
‘1’ is the market Interest rate.
This formula is similar to compound interest rate formula that we have studied at our high school level.
Well! Let us consider a simple Bank loan example to recollect back the calculation of 'compound interest sum'. Suppose you have borrowed Rs. 10,000 from a commercial bank at an interest rate of 10% per annum compounded annually. Say Po is the present amount borrowed (received),'1' is the rate of interest Pn is the amount to be repaid (inclusive of interest) at the end of period.
Then
P1 = Po + Po.i (Total interest = Principle times Interest)
or
P1 = Po(l +i)
Then amount to be paid by the end of 1st year is:
P1 = 10000 + (10000 X 10/100) = 10000 + 1000 = 11000
or
P1 = 10000 (1 +10/100) = 10000(1.10) = 11000
Similarly
P2 = P1 + P1i, Since interest is to be calculated an outstanding balance.
or
P2 = P1 (1 + i)
P2 = Po(1+i) (1+i) Since P1 = Po (1+i)
or
P2 = Po (1+i)
Table Steps Involved in Calculating Compound Amount
End of Period Amount at the beginning of during period Interest during the period Compound Amount at the end of period
1 Po Poi P1 = Po + Po.i = (Po(1+i)
2 Po(1+i)1 Po(1+i) .i P2 = Po(1+i)+Po(1+i) = Po(1+i)2
3 Po(1+i)2 Po(1+i)2.i P3 = Po(1+i) 2+Po(1+i) = Po(1+i)3
–
–
–
N Po(1+i)n–1 Po(1+i)n–1.i Pn = Po(1+i)n–1+Po(1+i)n–1.i = Po(1+i)n
The generalized relationship of Pn= Po(1+i)n indicates that the future amount after ‘n’ number of years would be equal to the principal amount at Po times (1+i) raised to the power of ‘n’ number of years. The term (1+i)n is commonly called as ‘Future Value Factor’.


Table: A Comparison of simple and compound interest
SIMPLE INTEREST COMPOUND INTEREST
Year Starting
Balance Interest Ending Balance Starting
Balance Interest Ending
Balance
1 1000 100 1100 1000 100
5 1400 100 1500 1464 146 1610
10 1900 100 2000 2358 236 2594
20 2900 100 3000 6116 612 6728
50 5900 100 5000 106718 10672 117390
100 10900 100 11000 12527829 1252783 13780612

Future value of single amount:
 Principal Rs.100000
 Interest rate 12%
 Interest due annually (compounding) at the end of:-
 Period : 1 year, 2 year, 3 year, 4,yearand 5 years



1 year 2 years 3 years 4 years 5 years
100000(1.12)¹
=112000 100000 (1.12)²
=125440 100000 (1.12)³
=140492.80 100000 (1.12)4
157351.93 100000 (1.12)5
=176234.16

PRESENT VALUE OR DISCOUNTING TECHNIQUE
 The concept of present value is opposite of compounding.
 While money value increases in compounding due to addition of compound interest, in case of present value of a future cash vlue is less since compound interest is lost. Thus the present value of a rupees is less when received on future date This is commonly called discounting
Let us work out some examples.
The fixed deposit scheme Indian Bank offers the following interest rates.
Period of Deposit Rate per Annum
46 days to 180 days 8.0%
180 days to 1 year 10.5%
1 year and above 11.0%
Suppose an individual has invested Rs.10,000 for 3 years what would be total amount he gets at the time of maturity of the fixed deposit?
(i) Rate of Interest (above 1 yr) = 11.0%
(Po) Principal amount = Rs.10,000
FV = Po(1+i)n
= 10,000 (1+0.11)3
= 13676
Total amount at the end of 3rd year 13,676.
Illustration
South Indian Bank offers a Cash Certificates Scheme, where in deposits are accepted for periods ranging from 6 months to 10 years. Interest, however, will be added quarterly. The rate of interest ranges from 8% for all deposits less than 1 year duration, 9% for one year to two years and 10% thereafter. An individual has deposited Rs. 10,000 for two years. What will be the total sum at the end.
Since the Interest is calculated quarterly, the future value formula is to be adjusted to accommodate this policy.
Let m = number of times interest is calculated in a year.
Then,
FV = Po(l + –i)mn
= 10,000 (1 + ) 4 x 2
= 10.000 (1.025)8
= 10,000 x 1.2184
= 12184
Future value of the deposit is Rs. 12,184.
Present Value Factor
Having recalled the knowledge of High School mathematics especially the 'compound interest formula' let us see its predominant implication on project evaluation. With a slight modification to the said generalized 'compounding formula', one can arrive at a present value of a future sum. It is popularly called 'discounting formula'. Evaluation of an investment proposal require comparison of cash outflows with a stream of cash inflows. Unless the outflows and Inflows (likely to acquire) at different time points)are made comparable by bringing them to a common platform of 'present values' against a time preference discounting rate, such comparison would not be meaningful. Then. the present value of a Future sum could be found out with the help of following formulae.
Po =Pn (l/l+i)n 9.2
or
Po =Pn (l+i) –n
The resulting (1+1) –n factor which is known as 'present value factor' or 'discounting factor'.
An example of the use of this 'factor' to find the present value of a future sum of Rs. 16100 that occurs at the end of 5th year at an interest rate of 10% could be
Po = 16100(1/1+0.10)5
= 10000.
The present values of a future stream of benefits that one can receive from a project proposal would allow one to compare cash flows of different points of time. In order to facilitate the calculations ready–made present value tables are available for different time periods and at different discounting rates. A sample of such a FV table is given below:


Table
Present Value Factors for Re [l/–(1/l+l)n)
Years Discount Rate (i)
1% 5% 10% 15% 20%
1 0.990 0.952 0.909 0.870 0.833
2 0.980 0.907 0.826 0.756 0.694
3 0.971 0.864 0.754 0.658 0.579
4 0.961 0.823 0.683 0.572 0.482
5 0.951 0.784 0.621 0.497 0.402
The above listed present value factors could be better understood if one can carefully observe the Figure 9.1 wherein the present values of a future rupee has been worked out at 10% discount rate.


Figure Present Values of a Future Re 1/– at 10 Percent Discount Rate

Future Values (Pn) at
Present Value (Po)
t1 t2 t3 t4 t5
Re. 1/– Re.1/– Re.1/– Re.1/– Re.1/–
= 0.909
= 0.826
= 0.751
= 0.683
= 0.621

A commonly used present value table with lengthier period for different discounting rates has been provided at the end of this lesson.
Annuities and Compounding
In case of certain project estimates, a series of uniform amounts could have been estimated at the end of each period for several consequent periods. Such a uniform series of flows are often called as 'Annuities'. The calculation of 'future values' and 'present values' for such annuities could be carried out in a simpler way as given below compared to an uneven stream.
When a flow of Rs 'A' occurs at the end of each period t=l to t=n, the future value of the total stream, FVn, at the end of 'nth' period could be obtained by summing the future values of each of the 'n' flows of amounts of 'A' each. .rm65

FIGURE –FUTURE VALUES OF A STREAM OF ANNUITIES
Yearly Annivities Future values

A1 A2 A3 An–2 An–1 An A(1+i)0 = A= /An/FVn
An–1(1+i)1 = FVn–1
An–2 (1+i)2= FVn–2
A3 (1+i)n–3 = FV3
A2 (1+i)n–2 = FV2
A1 (1+i)n–1 = FV1



In the above set of calculation, the size of Annuities are similar. Hence, the equation for a sum of these annuities at a future date is :
FVn = A(1+ (1+i)+(1+i)2 +.............. + (1+i) n–1) 1
The value within the brackets of the above equation looks like a Geometric Series with a variable of (1+1). Multiplying both sides by (1+1) term, the equation could be extended to nth term and then sum of first n terms of this kind of equation could easily be found. Accordingly,
FVn (1+i)= A((1+i)+(1+i)2 +.............. + (1+i) 2
On subtracting 1 from 2
FVn(1+i) – FVn= A((1+i)n–1)
in solving for FVn
FVn = A ..3
The equation 3 could help us In finding a Future Sum of an Annuity. The terms in bracket are called Annuity Interest Factor.

Illustration –
Under postal recurring deposit scheme, a fixed sum could be deposited every month on or before a specified due date for any period of 12 to 120 months. The deposit attracts a rate of Interest of 9% per annum if it is for two years and 10% beyond that. However the interest is calculated quarterly. The depositor is expected to remit the fixed sum before the due date failing which the said quarter's interest will not be added to the sum.
An Individual, in order to meet a lump–sum obligation by the end of next year, has started depositing Rs.500 p.m. Calculate the sum available to him by the end of 12 months.
Monthly recurring deposit = Rs.500p.m.
Rate of Interest applicable = 9% (compounded quarterly)
Let us calculate monthly Interest rate after adjusting for quarterly compounding effect:
i = (1 + ) – 1 = 0.0931
Monthly interest rate = = 0.78%
Since deposits represent annuities, using equation 9.5, (1+1)n–1

FVn = A
= 500

= 500 x 12.53 = Rs. 6.265/–
Therefore, one gets Rs.265 towards interest on his deposit of Rs.500 X 12= 6000
Present Value of Annuity Factors
Certain investments are likely to yield fixed periodical returns. For example, the UTI's Monthly Income Scheme provides fixed returns for its subscribers. Similarly if a Mutual Fund Invests its resources either in the form of debentures or convertibles, the rate of return from such an investment is almost fixed over time. In the same way. if a 'project' is expected to generate a fixed sum of returns, the present value of such a uniform series of annuities could be of importance to the investor to find the worthiness of the investment. An appropriate present value factor or a Discounting factor in case of such annuities could be found as follows:
As per equation we know the Future Value, formula as Pn = Po(1+i)n and similarly in case of Annuities, the same is


FVn = Po (1=i)n = A
Then
Po = A
The equation provides the present value factor for an annuity series.
An example to apply this present value factor would be to find the present value of getting Rs. 1000 annually for 5 years at an interest rate of 10 percent compounded annually, is as follows
Po = 1000 = 3791
In order to quicken the calculation work, annuity present value factor tables are available in which the values for the term [(l+i)n–1/1(1+1)n] are given for different interest rates 'i' and for different periods of time 'n'. A proforma of such Table is given below:

Table Present Value of an Annuity of Re. I/– at the end of 'N' Time? Periods
Years Discount Rate (i)
1% 5% 10% 15% 20%
1 0.9901 0.9524 0.9091 0.8698 0.8333
2 1.9704 1.8594 1.7355 1.6257 1.5278
3 2.9410 2.7232 2.4864 2.2832 2.1065
4 3.9020 3.5460 3.1694 2.8550 2.5887
5 4.8534 4.3295 3.7908 3.3522 2.9906






A clear meaning of these present value annuity factors could be seen in the Figure
Figure
Present Value of Future Annuities of Re I/– each at 10% Discount Rate

An exhaustive Table for these Annuity Factors are provided in Appendix to this Lesson.
PRESENT VALUE TABLES : HOW TO USE THEM?
Illustration: Hindustan Electro Graphite’s at Madhya Pradesh is considering a plan to use the hot gases of 900'C from its two furnaces by capturing these gases to produce steam. It is estimated that such a 'project' would produce
10 MW of power at nil cost except for a Capital Investment of Rs.20 crores. This is likely to reduce its costs and expected to add to Its Bottom line. The expected reduction in costs are over a period of five year is Rs.10 cr, Rs.8 cr; Rs.l2cr; Rs.l0cr, and Rs.7 cr. You are required to find the present value of future cash flows (cost savings) in order to take a decision on venturing into the said project.
Let us find the present value of the stream of cash flows at a time preference market rate of 10 percent.
Po = + + + +
=





Table
Calculation of Present Values for Cash flows Value Using Table Value
Year Cash flow
Rs. (Crores) Present Value Factor @ 10% Present Value of Cash flow (Rs. in Cr.)
1. 10 0.909 9.090
2. 8 0.826 6.608
3. 12 0.751 9.012
4. 10 0.683 6.850
5. 7 0.621 4.347
Total 35.907
The present value of future stream of cash flows from the proposed project is Rs.35.9 Crores.
Illustration: M/s Seshasayee Papers Ltd. of Tamil Nadu has made a break through in the use of 'Lignite* instead of 'Coal' as fuel during recent past. However, the change in fuel is warranting the company to bring a change in its technology by switching over to the Fuddled Bed (FB).technology. It is estimated that this change would cost Rs.7crores (inclusive of installation costs). With this contemplated change in fuel and with new technology, it is expected that there would be a substantial reduction in fuel costs to the tune of Rs.300 per ton of Lignite used. The company is presently using
1 lakh tonnes of Lignite and it is estimated that similar consumption would prevail for next 5 years.
You are required to express the cost savings in terms of their present worth in order to facilitate the design on proposed change in technology used at Seshasayee Paper Ltd.,. As per the illustration, M/s Seshasayee is likely to generate Cash flows equivalent to Rs.300. 1,00,000 tonne of Lignite use i.e. = Rs. 3 Crores cash savings annually for 5 years to come. Considering a discounting rate to 15 percent per annum, the present value of full stream of annual benefit of Rs.3 crores for five years would be
Po = A
= A
Using Present Value Annuity Tables, we can solve it as follows
= Rs. 3 cr x 3.3522 Present Value Annuity
Factor @ 15% for 5 years
= Rs. 10.06 Crores
Thus the present value of fuel ‘cost savings’ due to the use of new technology in M/s Seshasayee Papers Ltd., would be Rs.10.06 Crores.

SUMMARY:
 Money has time value. This is based on the concept of erosion in value of money due to inflation
 Other reasons for need to reach present value is desire for immediate consumption rather than wait for the future. The greater the risk in future the greater the erosion. Extent of erosion in the value of money is an unknown factor. Hence a well thought out discount rate helps to bring the future cash flows to the present.This helps to decide on the type of investment, extent of return & so on.
 All three factors that contribute to the erosion in value of money have an inverse relationship with the value of money i.e. The greater the factor the lower is the value of money
 The process by which future flows are adjusted to reflect these factors is called discounting & the magnitude is reflected in the discount rate. The discount varies directly with each of these factors. The discount of future flows to the present is done with the need to know the efficacy of the investment.
 N P V is the net of the present value of future cash flows and the initial investment. If N P V is positive then we accept the investment and vice versa.
REVIEW QUESTIONS
1) Bring out the importance of Time Value adjustment of Future stream of cash flows in project evaluation exercise.
2) What is cost of capital? Explain its importance in capital budgeting decision making.
3) Ms. Padmini wants to invest Rs.25,000 in either of the two plans available. Plan A offers 14% rate of interest calculated semi–annually for a period of 3 years while plan B offers to double the amount invested by the end of year 5. Calculate the effective annual rates of interest implicit in plans A and B .
4) What is the relationship between effective interest rate and stated interest rate?
5) A firm’s earning has grown from Re. 1 to Rs.3 over a period of 10 years. The total growth was 200% but the annual compound growth rate was less than 20%. Why/
6) State the formula for calculating present value of a single amount and an annuity for 3 years. State Rule and how it compares with Rule 72.
7) Ms. Kusum has retired recently. She has received Rs.5 lakhs as retirement benefits. She has invested this amount in a bank @15%interest per annum. She expects to live for another 15 years. She wishes to draw a fixed amount at the end of every year so as to leave a ‘nil’ balance in her account on maturity.
8) Sri.Arun has deposited Rs.1,00,000 on retirement in a bank . He can draw Rs.16274 annually for a period of 10 years. What was the interest rate offered by the bank?
9) Hi-Tech Limited is offering a scheme under which an investor has to deposit Rs.1500 per year for a period of 10 years. On maturity the investor will get Rs.23905. wht was the interest rate offered by the company?
10) Ms. Smitha needs Rs.10,00,000 at the end of 10 years. Two schemes are offered to her. Under scheme I she has to invest Rs.10, 000 at the end of every year for the first 4 years. Under scheme II she has to invest Rs.5000 at the end of the year for the first 8 years., calculate implied interest rate in both the schemes .
11) Mr. Vasanth wants to have an annual income of Rs.60,000 staring fro 11th year which should increase to Rs.90,000 from 16th yearend shall continue till perpetuity. At 15% interest per annum how much he should invest annually for 10 years.
12) You want to take a world tour which is estimated to cost Rs.10, 00,000. Assume that the the cost remain unchanged in nominal terms. You are willing to save RS.80, 000 annually to fulfill your desire.. How long you will have to wait if your savings earn an interest rate of 14%. Per annum?

Suggested readings
1. Chandra, Prasanna : Fundamentals of Financial Management
New Delhi, Tata McGraw Hill Co.
3. Khan M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill Co.
4. Pandey, I.M. : Financial Management, New Delhi, Vikas Publishing House

 
LESSON 3: COST OF CAPITAL
LEARNING OBJECTIVES
• To understand the concept of cost of capital and weighted average cost of capital (WACC)
• To understand methods of calculating cost of debt, cost of retained earnings, cost of equity , cost of preference capital.
• Discuss the importance of cost of capital for managerial decisions.
1. INTRODUCTION: The cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the expected return on a portfolio of all the company's existing securities It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
For an investment to be worthwhile, the expected (= risk-adjusted) return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous
The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparables) with similar risk profiles to determine the "market" cost of equity.
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.

2. DISCOUNTING RATE AND COST OF CAPITAL
Investment appraisal through the use of discounted cash flow method requires a time preference rate to be employed in finding out the present value of cash flows. The time preference rate used to discount the future expected cash flows is called as ‘discount rate’ or ‘market rate of return’ on alternative investments. But the question regarding considering an appropriate discount rate is quite complicated issue. Could it be determined arbitrarily? Should it be the rate at which the firm can borrow to invest in a project? Should it be the current rate of return on capital employed? These are some of the issues which require close observation.
A firm may naturally set a ‘target rate of return’ in appraising the investment proposals which ordinarily be not less than the cost of funds invested in a project. In addition, it is prudent to believe that such a rate of return should be at least equal to the opportunity cost, what can be earned if the funds were invested elsewhere with similar risk. Higher the risk of the project being undertaken it is logical to expect higher rate of the return to compensate the additional risk. Then the target rate of return or the required rate of return from a project could be the sum of risk–free rate of return plus a ‘risk premium’. Therefore, investment projects are to be evaluated against a minimum required rate of return which would mostly be equal to the average cost of funds. The cost of funds or ‘cost of capital’ is the cost that the company has to pay to the market for different sources of finance. Such cost would simple be the interest rate in case of borrowed funds (LT debt, Debentures Loans or Bonds); specific rate of dividend in case of preference share capital; expected ‘cash dividend’ during current year and 'growth in dividends' plus a 'capital gain' in future to the tune of expectations of share holders in case of equity capital; and an opportunity cost in terms of average earnings that share holders could earn in case the firm pays cash dividend instead of ploughing back of profits in the cost of retained – earnings or reserves. Although the determination of cost of capital in case of borrowed funds and preference share capital is easy.
The estimation of cost of equity and retained funds is quite difficult as the later depends on the relative changes in market prices of shares.
As most projects are financed through varied sources of funds mobilized by the firm, the cost of capital required to be used as a discounting rate is not be the source–wise cost. It should be equal to the weighted average of cost of all sources, the weights being the proportion of each source in the total capital structure of the firm. However, in order to measure the firms' overall cost of capital, it is necessary to consider the costs of specific methods of obtaining capital to begin with.
Costs of Capital for Specific Sources
The specific sources from which a firm principally derives funds include debt, preference, equity and retained earnings. Although no firm employs a specific source of financing for one project and another specific source for another project, the calculation of overall cost of capital presupposes the calculation of cost of specific sources of funds. Cost of capital of any source of financing is to be viewed as the interest rate that a lender expects for his investment. In such a case the explicit cost of any source Is the discount rate which equates the present value of funds received by the firm (net of flotation costs) to the present value of future outflow of funds. Such cash flows may be in the form of interest. repayment of principal, dividends or redemption at premium. Then cost of capital of any source can be found out by solving the following equation for ‘r’.
Sc = Fc + + + +
Sc = Amount of funds received from specific sources
Fc = Flotation costs of underwriting, brokerage etc.
CFt = Cash outflows in the form of service cost t=0, l......n.
= Redemption value of funds from specific source. If any.
r = Explicit cost of capital for the given source.
Further, the estimation of incremental cost of capital in addition to historical average cost is of prime importance to a firm which Is planning to raise new capital for financing all new ventures.
Cost of Debt Capital
Use of borrowed capital in addition to the funds mobilized from equity holders has had a strategic importance in Financial Management. Use of fixed interest bearing or less costly sources of funds In the capital structure of a firm likely to magnify the earnings of the firm through leverage benefits. Firms borrow from varied sources. While short term loans are often obtained from Commercial Banks either in the form of Open lines of Credit or Overdraft or from Money Market from short term instruments like 'Commercial Paper'; the long term. loans are raised from public through different forms of debentures or from Financial Institutions like IFCI, SFCs, IDBI, etc. The major cost that a firm incurs to this source of financing its investment projects is the 'interest' expenditure. However, the 'interest' cost is an eligible business expenditure for Income Tax purposes. Then the major outflows associated in estimating 'Cost of Debt Capital' (Kd) include the after tax cash flow of interest payments, plus the 'Principle* repayment at the end of the life of the instrument. The net proceeds of the loan, however, to be adjusted for floatation and underwriting costs, if any. Incorporating these inflows and outflow in equation and solving for 'r' yields the required cost of borrowed capital.
In more general terms, the Cost of Debt Capital (Kd) can be arrived at from following equation, where
i = Compound rate of Interest
m = number of compounding periods per year
Kd = after tax cost of debt capital
T = Tax rate
Then
Kd = ((1 + i/m )m – 1 ] (1–T)
Illustration–Velvette International Pharma Products Ltd., the third largest Shampoo manufacturers has mobilized funds from debentures at a coupon rate or 12 percent per annum, and interest to be paid quarterly over seven year life of the investment. If the company is in a tax bracket of 45 percent what is the effective after tax cost of such debentures for the VIPP Ltd.
From equation
= ((1+0.12/4)4– 1](1–0.45)
= (0.1255) (1–0.45)
= 0.069
= 7.0%
The debt instruments, often have fixed maturity period. Bonds are sometimes, issued either at premium or at discount or redeemed either at par value or at premium. The issues relating to these aspects are generally made clear at the instance of the very issue of the redeemable debentures or convertible debenture (Debenture holders are given often to convert their loan to the company to equity shares after a specific time at a specific exchange price in case of convertible debentures). When the future redemption value, (F) of a debt instrument differs with the issue price, (P) then the discount or premium components are eligible for annual amortization at a uniform rate of 1/N over the life of the instrument.
Then net cash outflow, including interest becomes
COF= [I + 1/N (F–P)) (1–T)
The approximate after–tax cost of debt capital would be
Kd =
Where (F + P) Vi is average amount debt of outstanding.

Cost of Preference Shares
Until recently many Indian companies used to raise capital by issuing preference shares. Preference share holders generally assured of a pre–fixed preferred dividend, whenever the company makes a profit. Although the prominence of the use of preference capital has reduced" substantially, few companies still carry preference capital in their capital structure. Two important issues Involved in measuring the cost that the firm incurs to service preferred stock is the preferred dividend and it is not tax deductible as interest expenditure. Further, many a time. preference shares are issued without a stated maturity date. In such a case the cost of funds mobilized from this source is just the rate of pre–fixed preference dividend..
Although it is not mandatory to pay preference dividend firms prefer to pay it promptly to maintain the Informational value and consequent market rating.
The cost of preference capital (Kp) thus becomes the rate of preferred dividend (Dp) paid over the net proceeds of capital mobilized after adjusting for flotation costs (f).
Kp =
For example, if a firm raises 12% preference capital (Rs.100 par value) and could realise net proceeds of Rs.96 per share, net of flotation costs, then the cost of preference shares would be
Kp = = .125
The Kp is not to be adjusted for taxes, unlike Kd. as preference dividends are not tax deductible.
Cost of Equity Capital
Firms finance a major part of their capital requirements through equity capital. Equity constitutes the owners; stake. Unlike interest payment on debt capital, the firm has no fixed or legal obligation to pay dividends to equity holders. However, shareholders invest in a company with an expectation to receive dividends either in cash or in stock. The rate of expected dividend vary between industries as well as at different market swings. Further, the expected returns on their investment decides the market price for an equity at market place. Therefore, the cost of equity would be the required rate of return which would equate the present value of the expected dividends with the market value of each share. Many a time, the expected stream of dividends may not be a constant sum but may include a growth component. Incorporating these expected dividends there are few theoretical models to construct the cost of equity capital.
i) Simple Dividend Valuation Model
If one believes that equity shareholder is willing to invest to the extent of the intrinsic worth of the investment, the presently traded price (value) of a share (PJ should be equivalent to a stream of future dividends (Di). i.e.
Po = + +
If uniform dividends are assumed for an Infinite horizon, then
or


D
Ke = –––––––
Po
Thus, the cost of equity capital approximates to dividend – price ratio.
ii) Growth in Dividend Models: No company pays the entire earnings in the form of dividends. A specific proportion of earning are generally retained for future growth and expansion without resorting to outside borrowings. Even the policy of retention of earnings are expected to increase the earnings of the shareholders in future years. If a firm retains a constant proportion of its earnings (let 'b') and hopefully reinvests at an rate (r) internally, the future dividends could be expected to grow (g) at a rate equivalent to the product of the percentage of retention and internal rate of return i.e. (g = rb).
More specifically the future dividend is expected to grow at a rate i.e.,
Pi = Do(i+g). If the rates of retention and reinvestment rates are assumed constant over a period of time, the equation (9.11) can be rewritten as
A……
or
……
Multiplying both sides of the above equation we get,
……B
When equation A is subtracted from equation B, we get

When the Ke>g, and n the terms in brackets on RHS of above equation tends to 1.



or

The cost of equity under the expectations of growth in dividend, thus simply contains an additional term of ‘g’ to equation B. This explanation has been developed by Garden and Shapiro as well as Solomon in their research.


Cost of Retained Earnings
As noted earlier, every firm retains a portion of its annual profits for future expansion and growth. The retained funds could freely be used for financing, rebuilding of existing assets or for undertaking newer projects. At the outset, these funds totally free of cost to the firm, since the retained earnings are internally generated. However, If one carefully looks at/at these funds do any an implicit cost In the form of opportunity benefit that the shareholders have lost for having allowed the firm to retain the earnings which are otherwise belong to them.
In the absence of corporate and individual taxation and brokerage costs, the cost of retained earnings is the cost of equity capital itself. i.e., Ke, since in the absence of internal funds, a firm is made to obtain the necessary funds either through rights Issue or new public issue of equity. In such a sense, the firm is expected to generate returns equivalent to the opportunity benefits that the shareholders could have presumably found in stocks of other companies with the retained part of their earnings. However, although the said argument sounds theoretically well, the presence of personal taxation on cash dividend income and brokerage costs involved in acquiring new share capital leave lower investible income in the hands of shareholders for alternative courses to retention by the firm. Then the cost of retained earnings (in terms of alternative benefits) would definitely be lower than the 'Ke'. But in the absence of any closely measurable taxation effects and opportunity rates of return, cost of retained earning is almost regarded as equivalent to 'Ke'.
Overall Cost of Capital (Ko)
As noted earlier the ultimate cost of capital for use in capital budgeting is not the individual source wise 'cost' but the overall cost of capital for the firm.
Such overall cost of capital is generally arrived at by combining individual sources by weighing each source to their respective proportion In the total capital structure.
Ko = Wd Kd + Wp Kp + We Ke + Wr Kr M 9.14
Where Ko = overall cost of capital
Wi = Weightage of its Individual sources of capital
(weights being their relative proportions)
Illustration
The following is the capital structure of M/s Hindustan Polymers Ltd., as on March 1994. The estimated costs for different Sources computed based on a scientific way are given here under. Calculate the weighted average cost of capital
Source Amount After tax cost
Debentures Rs. 15,00,000 6.00%
Preferred stock Rs. 15,00,000 12.00%
Equity share capital Rs. 60,00,000 16.00%
Earnings retained Rs. 10,00,000 16.00%
The historical cost of capital of the firm using weighted average method, weights being relative proportions of each source in total capital could be calculated as follows:
Table3.1 Calculation of Weighted Average Cost of Capital (K°) in M/s. Hindustan Polymers Ltd.
Source Amount Proportion Explicit Cost Weighted Cost
Debentures Preferred Stock
Equity Share
Capital
Retained Earnings 15,00,000
15,00,000
60,00,000
10,00,000 0.15
0.15
0.60
0.10 0.0600
0.1200
0.1600
0.1600 0.009
0.018
0.096
0.016
0.139
Overall cost of capital (Ko) 14%
The above method of computing combined cost of capital helps in arriving at the historical cost of raising capital. However, in capital budgeting decisions, Finance Manager is much concerned about the cost of new funds to be raised to finance newer projects. In such a case, the average cost arrived is based on historical book values may not really provide an answer. Hence, It is desirable to estimate the incremental or marginal cost of capital as and when the firm Intends to rise additional investments. The calculations of marginal cost of capital can be shown with the help of following illustration.
Illustration
Usha Martin Industries Ltd. of Calcutta, a manufacturer of Carbon Alloy Steel billets has the following capital structure as on 1990
Rs. in (lakhs)
Source Amount
Equity Capital (50 lakh shares @ 10/- each 500
Preference capital (12% Pref. shares of Rs. 100 each) 60
Reserves and Surpluses 1000
12% Debentures 1200
Long term loans from Financial Institutions(@ 18%) 240
Total 3000
The EPS = 6 and share price is around Rs.50. The company 1 planning to raise Rs. 2000 lakhs to finance its expansion programme. No that Rs. 1000 lakhs of reserves are available with the firm. the company proposing to raise the remaining capital requirements from preference and debenture holders equally. Assuming the component costs are not like to change, estimate the average (historical) cost of capital.
Table 3.2
Computation of average and Incremental Costs of Capital in Usha Martin Industries Ltd.
Source Amount Proportion After Tax Weighted
(Rs. in Lakhs) Cost Cost
Equity Capital 500 0.17 0.12 0.0204
Pref. Capital 60 0.02 0.12 0.0024
Reserves and Surplus 1000 0.33 0.12 0.0396
12% Debentures 1200 0.40 0.06 0.0240
LT loans 240 0.08 0.09 0.0072
3000 1.00 Ko = 0.0936
Incremental Cost
Equity/reserve 1000 0.50 0.12 0.060
Pre. Capital 500 0.25 0.12 0.030
Debenture 500 0.25 0.06 0.015
2000 1.00 Ko 0.105
* Cost of equity is calculated as EPS/MPS = 6/50 = 0.12
Thus the estimated marginal cost of capital is relatively higher than the average cost of capital. A firm can use its marginal cost of capital as the minimum required rate of return while evaluating the investment proposals.
SUMMARY
In this chapter, we have understood the simple concepts of Time Value of Money. The concept of Future Value and the Present Value basically depends on compound Interest rate computation procedure. Estimation of present value of future stream of benefits would be helpful in project evaluation as projects involve generation of a stream of cash flows over their life at different time periods. The discounting rate that one has to use in bringing down the future cash flows to their present value is called the cost of capital. Since a project's viability is to be judged against a minimum cost that the company has to pay for the sources from which project is financed; estimation of individual source–wise cost as well a combined cost needs close observation. The cost of debt is simply the explicit interest rate. Cost of preferred stock is the coupon rate of dividend; cost of equity, however is the expected dividend as well as the growth in it commensurate to the market going rate. The overall cost is nothing but the combined cost of each of these sources in the capital structure and the averaging is to be done based on their relative proportions. Further, the estimation of incremental cost of capital is likely to provide more meaning in project evaluation exercise.

REVIEW QUESTIONS
1. Define cost of capital? Explain is significance in financial decision – making.
2. How is the cost of debt computed? How does it differ from the cost of preference share capital?
3. Explain the different approaches to the computation of cost of equity capital.
4. “The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally irrational to a firm to sell a new issue of stock and to pay dividends during the same year”. Comment upon this statement.
5. State briefly the assumptions on which the Gordon model for the cost of equity8 is based. What does each component of the equation represent?
6. Discuss the various approaches to determine the cost of retained earnings. Which approach do you consider better and why? Also explain the rationale of treating retained earnings as a fully subscribed issue of equity shares.
7. How is the weighted average cost of capital calculated? Explain with a numerical example.

PRACTICAL PROBLEMS
1. The cost of capital (after tax) of a firm of the specific source is as under :
Capital Structure of the Firm Sources Amount
Rs.
Cost of Debt
Cost of Preference shares
Cost of Equity Capital
Cost of Retained Earnings 4.50%
10.50%
15.60%
15.00% Debt
Preference Share Capital
Equity Share Capital
Cost of Retained Earnings 2,00,000
3,00,000
4,00,000
1,00,000
(assuming external yield criterion) 10,00,000
Calculate the weighted average cost of capital using ‘Book-Value weights’.
[Ans.: Weighted Average Cost of Capital 11.79%].

2. From the data contained in problem No.1, calculate the weighted average cost of capital bearing in mind that the market value of different sources of funds are as under :
Sources Market Value Rs.
Debt
Preference Shares
Equity and Retained Earnings 1,75,000
3,50,000
7,25,000
12,50,000

[Ans.: Weighted Average Cost of Capital = 12.55%]

3. A company issues 10,000 irredeemable debentures of Rs.100 each @ 15 per cent. The company has to incur the following floatation charges or issue expenses : Underwriting commission 1.5%, brokerage 0.5%, miscellaneous expense (for printing, advertising and counselling fees etc.) Rs.10,000. Assuming that the tax rate for the company is 50%, compute the effective cost of debentures to the company if the debentures are issued :
(i) At par, (ii) At a discount of 10%, and (iii) At a premium of 10%.
[Ans.: (i) 15.46%, (ii) 8.64% and (iii) before tax 14.02%]

4. Determine the cost of equity shares of company X from the following particulars:
(i) Current market price of a share is Rs.140.
(ii) The underwriting cost per share on new shares is Rs.5.
(iii) The following are the dividends paid on the outstanding shares over the past five years:
Year Divided per Share (Rs.)
1 10.50
2 11.00
3 12.50
4 12.60
5 13.40
(iv) The company has a fixed dividend payout ratio.
(v) Expected dividend on the new shares at the end of 1st year is Rs.14.10 per share.
[Ans.: 15.44%]

SUGGESTED READINGS
1. Chakraborthi, S.K. : Corporate Capital Structure and Cost of Capital,
New Delhi, Vikas Publishing House.
2. Chandra, Prasanna : Fundamentals of Financial Management
New Delhi, Tata McGraw Hill Co.
3. Khan M.Y. and
Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.
4. Pandey, I.M. : Capital Structure and Cost of Capital,
New Delhi, Vikas Publishing House
 
LESSON 4: CAPITAL BUDGETING
LEARNING OBJECTIVES
• After reading this chapter, the student should be able to:
• Understand the methods of Evaluating Capital Budgeting Projects.
• Workout a ranking procedure for all evaluated projects.
• Appreciate the controversy associated with the use of NPV and IRR methods.
• Examine the issues relating to Capital Rationing Procedure.

INTRODUCTION: Since the primary goal of a firm is shareholders wealth maximization, an appropriate goal for a capital budgeting decision is the identification of investment projects which maximize the future value of a company. Any economic analysis has to start with appropriate measurement criterion on costs and benefit flows, in addition to the implicit constraints, if any, existing on the final selection and inclusion of such a project Into the productive assets of the company.
Final selection and execution constraints broadly relates to the issue of evaluating projects either as independent candidates or mutually exclusive units. While the projects under first category need only determination of economic desirability isolation, the second set demands for incremental analysis among competing alternative projects. Further, the evaluating techniques do differ under a set of essential assumptions of certainty about investment outcomes, stability in risk perception and equilibrium in interest rates, calling for perfect capital market to exist.
This chapter presents the popular capital budgeting techniques and highlights the issues Involved in evaluating Investment projects essentially under conditions of capital rationing. While the primary focus of each of the techniques is to arrive at an acceptance criterion, the ultimate selection of the project generally depends on consideration of strategic importance.
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.
METHODS FOR EVALUATING INVESTMENT PROJECTS
• The methods of appraising capital expenditure proposals can be classified as (1) Traditional and (2) Discounted Cash flow techniques. The techniques under each category are
(1) Traditional techniques
1. Pay back method.
2. Accounting rate of return method.
(2) Discounted Cash flow Techniques
1. Net present value method.
2. Internal rate of return method.
3. Profitability index method.
Pay Back Method
Pay back method is a simple and an easy project evaluation technique.
This method concentrates on the time taken by the project to recover back the capital invested in it. Under this method projects are evaluated and compared by working out the pay back period of the cash flows expected from the project.
----- 10.1
For example, if an investment project of Rs. 10,000 is expected to generate cash flows of the size of Rs.2,500 per year for seven years, then the pay back period is

Suppose, some other project costing Rs.12,000 is able to generate annual cash flows of the size of Rs. 4,000 per annum the pay back period of such project is 3 years. These pay back periods would signify the number of years that the projects would take to repay themselves.
However, the above said formula is not suitable for projects whose cash flows are uneven. In such a case the pay back period could be worked out by observation in most of the cases or by accumulating cash flows over time. The pay back period would be the number of years when cumulative cash flows become equal to the original initial outlay. To illustrate this method, let us consider the investment proposal as given in Table

Table4.1: Calculation of Payback Periods through Cumulative Cash flow
Year Annual Cash flows Cumulative Cash flows
Project A Project B Project A Project B
0 15,000 10,000 –– ––
1 5,000 2,500 5,000 2,500
2 8,000 3,500 13,000 6,000
3 6,000 3,000 19,000 9,000
4 5,000 2,000 24,000 11,000
5 3,000 1,000 27,000 12,000
It can be observed that in case of project A, the Pay Back (PB) period would lie at two years plus few months and in case of project B it is after three years. More specifically, the Pay Back (PB) period of A is
2 years + 4 months i.e., (2000/6000 x 12)
and in case of project B 3 years + 6 months, i.e. (1000/2000 x 12)
Evaluation
As pay back period indicates time taken to recover the initial outlay, the projects with lowest payback would be considered. Sometimes, the management sets a ‘standard payback’ period to be maintained on all investment projects. Then the decision on project selection would be
PB (specific project) < PB (standard): Accept
PB (specific project) > PB (standard): Reject
Sometimes individual projects could be ranked based on the payback periods for necessary consideration.
Illustration
A company is considering the following projects requiring a cash outlay of Rs.15,000 each. Suggest your evaluation decision if standard payback period is
3 years.
Year Cash flows
Project A Project B Project A Project B
1 5,000 3,500 2,500 8,000
2 5,000 4,000 2,500 6,000
3 5,000 4,500 2,500 6,000
4 5,000 6,000 2,500 5,000
5 5,000 6,000 2,500 5,000

calculation of payback period:
Project A: = 3 years
Project B: 3years x 12 months = 3 years 6 months
Project C: = 5 years
Project D: 2 years + months
= 2 years 2 months.
Selection of projects
Project A : PB –– 3 years < PB (standard) : Accept
Project B : PB –– 3 years 6 months PB (standard) : Reject
Project C : PB –– 5 years < PB(standard) : Reject
Project D : PB –– 2 years 2 months PB (standard) : Accept.
Among the projects acceptable, ranking can be made as follows
Project D = PB : 2 years 2 months I Rank
Project A = PB : 3 years II Rank.
Implications of Payback
Pay back method is in wide usage inspite of new sophisticated methods, due to the following advantages.
13) Calculation of pay back period is simple and easy to understand. It is simply a measure of time required for a project to return the investment.
Pay back period reflects the liquidity of a project and there by an element of riskiness associated with covering the investment made in project. As this method suggests for selection of a project with lower pay back period,
it ensures for considering the projects with good liquidity and there by less risk.
However, this method suffers for following serians limitations.
14) It fails to consider the cash flows earned by the projects subsequent to the recovery of the investment. Therefore, it ignores the profits of the projects.
15) It ignores the value of money. The initial outlay and the cash flows generated over different years are considered at the same Rupee value, which hardly comparable in true sense due to inflation and falling rupee value in any economy.
16) It is difficult in respect of evaluating the pattern, size and magnitude of cash flows generated in different years during the pay back period itself.
For example, suppose there are two projects – Project A and Project B with necessary details of as follows:
Project A Project B
Initial Outlay 10,000 10,000
Cash flows : 1 7,000 1,000
2 2,000 2,000
3 1,000 7,000
In such a case the pay back period of the both the projects is 3 years. But the pattern of cash flows differs. Although both the projects are considered by payback method, it is by observation project A is superior to the other as it recovers sizable portion of capital very early.
This method is further endowed with difficulties in determining the standard payback period for comparison of projects. Since the method of evaluating projects ignores the cost of capital and profitability, this method is not consistent with the objectives of maximizing the market value of a firm’s share.
In spite of these limitations this payback method is very popular in usage due to its simplicity. The reasons for its popularity are:
17) As payback method considers those projects with high liquidity, it ensures quick turnover of capital resources which can be employed in new projects without resorting to the raising of new finances.
18) Selection of projects with high liquidity reduces the risk of recovering capital especially when the future is uncertain, inflationary, unstable governments and consequent business risks.
19) Payback method is also helpful to evaluate the projects by using sophisticated techniques like internal rate of return. Payback period acts as a good approximation to the reciprocal of internal rate of return of projects.
Accounting Rate of return Method
Under this method, projects are evaluated following the principles and practices commonly used in accounting by estimating a rate of return. There are two types of measures. one is the original investment measure and the other average investment measure. Under the first measure, the accounting rate of return is found by dividing the average income by the original investment. This is simply a ratio of earnings to investment.

However under the second measure, average investment is considered in place of original initial outlay. The average investment is the initial outlay plus salvage value (if any) divided by two. Sometimes the average investment is also calculated by dividing the book value of the project by it’s the period. The basic assumption of using ‘average investment’ is the regular recovering of capital over the life of the project.

Illustration
Determine the average rate of return for the following projects.
Project A Project B
Initial Outlay 50,000 50,000
Life 5 years 5 years
Salvage value 3,000 3,000
Annual Income after depreciation and Income Tax
I st year 3,000 12,000
II nd year 5,000 9,000
III rd year 7,000 7,000
IV year 9,000 5,000
V year 12,000 3,000
36,000 36,000
Then

= = 7,200
Average Investment of each project
= (Salvage value + Initial outlay)/2
= 3,000 + 50,000
= 53,000 + 2
= 26,500

= x 100
= 27.17%
Average rate of return in case of both the projects would be 27.2. A variation of this ARR method by using average income divided by original outlay would yield a more consistent result of 7,200 – 50,000 which is generally considered to be an approximation to be internal rate of return earned by a project.
Selection Criterion
Projects are selected based on the size of ARR in case of mutually exclusive projects. However, the selection of independent project be done if the ARR of a project is highest that the minimum rate of return expected by management from all its investment projects.
ARR> Predetermined or minimum rate of return: Accept
ARR> Predetermined or minimum rate of return: Reject
Alternative proposals could be ranked based on the magnitude of ARR from each of the proposals.
Implications of ARR
The ARR as an evaluation measure of selecting investment proposals could be appreciated against the backdrop of the following pros and cons.
20) It is very easy to calculate and the data from accounting records would be sufficient to estimate the rate of return from a project.
21) ARR considers all the cash flows generated by a project and due weight age is given to the recovery of initial outlay through the depreciation cover.
However, this method suffers from the following drawbacks:
22) ARR method considers accounting profits in place of cash flows. Generally accounting profits ignore the reinvestment potential of a project’s income flows while cash flows take into account, those additional cash flows and consequently total benefits from a project.
23) ARR criterion does not differentiate projects based on their lives, sizes of investments and patterns of cash flows.
24) It ignores the time value of money. Both cash flows generated over years and cash outflows are not strictly on comparable rupee value.
Thus, the two traditional techniques suffer with specific limitations like non–consideration of all the cash flows generated by the project and the pattern of cash flows. In addition they do not attempt at adjusting the time value of money to make cash inflows and out flows more comparable.

DISCOUNTED CASH FLOW (DCF) METHODS
Three popular methods of project evaluation, which would consider the discounted cash flows are:
1. Net present value (NPV) method
2. Internal Rate of Return (IRR) method
3. Profitability Index (PI) method.

NET PRESENT VALUE (NPV) Method
Net present value method evaluates the investment projects by deducting the initial outlay (IO) from out of discounted stream of cash inflows i.e. Present value of stream of cash flows (PVCF). In other words, it makes a comparison of cost–benefits, benefits being the sum of present value of future stream of cash flows expected from a project. The investment appraisal procedure consists of:
i) Estimation of present value of each cash inflow, discounted of at an appropriate cost of capital.
ii) Adding the discounted cash flows and deducting the initial outlay, to determine the Net Present Value (NPV)
iii) If the NPV is a positive figure the project would be accepted and if the NPV is a negative, the project is rejected; and it projects are mutually exclusive type the project with higher positive NPV could be accepted.
Therefore, the NPV method involves calculations of present values of cash flows of an investment proposal using the cost of capital as the discounting rate, and determining the net present value by subtracting the initial outlays from the sum of present value of cash inflows Symbolically.
NPV = + + + ………. – I.O
Where
CF = Cash flows over the life of the project
IO = Initial outlay
i = Discounting rate or cost of capital
n = Life of the project.

Illustrations
A company is considering to invest in two mutually exclusive projects each one of it would cost an initial outlay of Rs. 25,000. The expected cash flows over their lives are as follows:
Project A Project B
CF1 Rs.10,000 CF1 7,000
CF2 Rs.10,000 CF2 10,000
CF3 Rs.10,000 CF3 12,000
CF4 Rs.10,000 CF4 15,000
CF5 10,000
Life=4 years Life=5 years
Evaluate the projects if the required rate of return is 10%. The net present values of the two projects would be calculated as for the following formula:
NPV A = + + + – I.O A
NPVB = + + + + – I.O B
Table4.2: Calculation of NPV in case of Two Projects
Year Project A Project B
Cash flows expected PV factor @ 10% PV of cash flows Cash flows expected PV factor
@ 10% PV of cash flows
CF1 10,000 0.909 9090 7,000 0.909 6363
CF2 10,000 0.826 8260 10,000 0.826 8260
CF3 10,000 0.751 7510 12,000 0.751 9012
CF4 10,000 0.683 6830 15,000 0.683 10245
CF5 10,000 ––– –––– 10,000 0.621 6210
PVCF 31,690 PVCF 40090
IO 25,000 IO –25,000
NPVA 6690 NPVB 15,090
Selection Criterion: Projects would be selected based on the size and sign of NPV that they generate. In case of a single project, it would be accepted only if the NPV is positive. In case of mutually exclusive projects, projects are compared basing on the absolute values of NPV.

Further, the independent projects could be ranked based on the absolute size of NPV generated by each.
Implications of NPV
The size of NPV represents the present value of the benefit that the firm could realize if it accepts the said project, provided the expected cash flows are materialized. Therefore, the NPV is something like ‘unrealized capital gain’ from a project. Further, the NPV method examines the project from the point view of
(i) Repayment of original investment in the project; (ii) Interest on funds invested towards the original investment; (iii) interest on the surplus being generated.
This point could be illustrated as follows:
In case of project A, suppose the firm has borrowed Rs.31,690 (Rs. 25,000 towards cost of the project + Rs. 6690 towards the present value of surplus being generated by the project) at an interest rate of 10% from a Financial Institution, the following table shows how firm’s cash flows would help in repaying the entire amount.
Table 4.3: Pattern of Utilization of Cash flows from Project A
Years Loan at beginning Interest @ 10% Total outstanding Repayment through cash flow Balance outstanding
1 31690 3160.00 34859.0 10000 24856
2 24859 2486.00 27345.0 10000 17345
3 17345 1735.00 19080.0 10000 9080
4 9080 908.00 9088.0 10000 (12)*
*Rounding off error
Illustration
The management of a company desires to invest surplus funds of Rs. 25,000. They are having three projects before them. You are required to rank the three projects under NPV method at a market rate of 10%.
Natural of Investment Cost Form of return Annual Cash in Flow Duration in years
1. Automatic Equipment 6,000 Savings in labour cost 2,000 5
2. Purchase of small machine
shop to add 18,000 Profits after tax 6,000 6
3. New boiler 10,000 Cost savings fuel consumption and Maintenance 3,000 5
1. Automatic Equipment
I0 = Rs.6,000
CFt = Rs.2,000
Life = 5 years
NPV = + + + + –– 6000

Table 4.4 : Calculation of NPV of an Automatic Equipment Project
Year Cash flow PV Factor @ 10% PV of Cash flow
1. 2,000 0.909 1818
2. 2,000 0.826 1652
3. 2,000 0.751 1502
4. 2,000 0.683 1366
5. 2,000 0.621 1242

7580

6000
NPV 1580
2. Small Machine Shops
n = Rs. 6,000
I.O = Rs. 18,000
CFt = Rs. 6,000


Table 4.5 Calculation of NPV for Small Machine Shop Project
Year Cash flow PV Factor @ 10% PV of Cash flow
1. 6,000 0.909 5454
2. 6,000 0.826 4956
3. 6,000 0.751 4506
4. 6,000 0.683 4098
5. 6,000 0.621 3726
6. 6,000 0.564 3384

26124

18000
NPV 8124



3. New Boiler
n = 5
CF = 3,000
I.O = 10,000

Table4.6 : Calculation of NPV for New Boiler Project
Year Cash flow PV Factor @ 10% PV of Cash flow
1. 6,000 0.909 2727
2. 6,000 0.826 2478
3. 6,000 0.751 2253
4. 6,000 0.683 2049
5. 6,000 0.621 1863

11370

10000
NPV 1370
Ranking pf Project based on size of NPV Rank
1. Automatic Equipment NPV = 1580 II
2. Small Machine shop NPV = 8124 I
3. New Boiler NPV = 1370 III
Implication: In the light of above two illustrations, let us evaluate the merits of NPV methods.
1. One significant advantage of NVP methods is the recognition of time value of money. Evaluation of projects under NPV method ensures greater comparison of benefits and costs at current rupee and the cost of capital mobilized to finance the project is well taken care off.
2. NPV considers all the cash flows generated by the project. In addition the pattern of cash flows are recognized. Suppose two projects are similar expecting the pattern of cash flows, the NPV method ultimately selects that projects which could generate sizable cash flows in the initial years. Selection of such a project ensures liquidity in addition to early profitability.
3. NPV method helps in selecting the project which would be helpful in selecting profitable ones as the accept-rejection criterion indicates to select projects with NPV>0. Therefore, the NPV method facilitates in achieving the objectives of Financial Management in maximizing the shareholders, wealth.
However, NPV has certain limitations, some of them are,
1. Compared to the traditional methods like Payback, and Accounting Rate of return, the calculation of NPV is endowed with difficult calculations.
2. Determination of appropriate discount rate in project evaluation is certainly a complex issue. Whether to consider firm’s overall cost of capital or cost of project finance is an issue. Further, ascertaining the cost of capital is a separate aspect making the entire method so complex.
3. comparison of different projects with varying degrees of life, initial outlay, pattern of cash flows, risk comparison poses a clear problem on the adoptability of this NPV method for project appraisal and ranking of projects.
Internal Rate of Return
The NPV method evaluates projects by computing the net present surplus of a project. Mostly this amount would be expressed in absolute terms which may not be able to convey any sizable information to investor with respect to the ‘rate’ of profitability of the project. But it is well known a common businessmen or an investor wishes to express the return on investment as ‘rate’, rather than in absolute figures without referring to the size of investment made. Therefore, a need aroused to ascertain the profitability of a project in specific way as ‘rate’. Therefore, the calculation of Internal Rate of Return (IRR) of a project has become another popular capital budgeting technique using the DCF methodology. This rate of return of a project is also known as ‘yield’ on investment, marginal efficiency of capital, time of return and so on.
The IRR could be that discount rate which equates the present value of cash inflows with that of initial outlay. The rationale lies on the fact that the NPV’ decreases from a project if one goes on increases the ‘discounting rate’. At a particular discount rate, the entire NPV of a project would become ‘zero’. In other words, the surplus expected from a project is fairly converted into a discount rate at that point. Therefore, such discount rate is called as ‘Internal Rate of Return’. It can be determined by solving an equation all most similar to that of NPV excepting solving it for the discount rate.

or

where
r = Internal rate of return
I.O = Internal outlay
CF = Cash flows over the life of the project
n = Life of the Project
In case of NPV method the discount rate represents the cost of capital, mostly the minimum required rate of return of interest on the funds utilized for funding the project. Whereas the ‘r’ in case of IRR represents the return from a project in terms of a ‘rate’.
The calculation of IRR involves a tedious process. Mostly, it should be worked out by trial and error approach. One generally starts the process of funding out that discount rate which makes the NPV of a project ‘zero’ by assuming a certain discount rate is positive the trial is to be done with increased discount rate.
The process should continue until NPV becomes zero, and ultimately the said discount rate which yielded zero NPV would become the IRR of a project. Let us consider an illustration ‘to work out the IRR.
Illustration
A project cost Rs. 19,828 and it is expected to generate cash flows for five years at 5000 in first, Rs. 6000 in sound year Rs. 7000 in third year and Rs. 8000 in fourth year and Rs. 9000 in fifth year. Find the IRR.
Let us select a discount rate of 10% to start with and process on
Table 4.7: Calculation of NPV at an assumed Discount Rate of 10%
Year Cash flow Discounting factor @ 10% Present Value NPV
1 5,000 0.909 4545
2 6,000 0.826 4956
3 7,000 0.754 5257
4 8,000 0.682 5464
5 9,000 0.621 5589
PVCF 25811
IO 19828
NPV 5983

Table 4.8: Calculation of NPV at a Discount Rate of 16%
Year Cash flow Discounting factor @ 15% Present Value NPV
1 5,000 0.870 4350
2 6,000 0.756 4536
3 7,000 0.658 4606
4 8,000 0.572 4576
5 9,000 0.497 5473
PVCF 23541
IO 19828
NPV 3713

Table 4.9 : Calculation of NPV at a Discount Rate 20%
Year Cash flow Discounting Factor @ 20% Present Value NPV
1 5,000 0.833 4165
2 6,000 0.694 4164
3 7,000 0.579 4025
4 8,000 0.482 3856
5 9,000 0.402 3618
PVCF 19828
IO 19828
NPV 0
Therefore, IRR = 20 percent
Illustration
A project costs Rs.20,500 and is expected to generate cash flows of Rs.5,000 annually for 5 years. Let us calculate the internal ate of return.

Table 4.10: Calculation of IRR at a Discount Rate of 10%
Year Cash flow Discounting factor @ 10% Present value
1 5,000 0.909 4545
2 5,000 0.826 4130
3 5,000 0.751 3755
4 5,000 0.683 3415
5 5,000 0.621 3105
PVCF 18950
IO 20500
NPV -1550

Table 4.11: Calculation of IRR at a Discount Rate of 8%
Year Cash flows Discount rate @ 8% PV of cash flow
1 5,000 0.926 4630
2 5,000 0.857 4285
3 5,000 0.794 3970
4 5,000 0.735 3675
5 5,000 0.681 3405
19965
IO -20500
NPV -535


Table 4.12: Calculation of IRR at Discount Rate of 7%
Year Cash flow Discount rate @ 7% PV of cash flow
1 5,000 0.935 4675
2 5,000 0.873 4365
3 5,000 0.816 4080
4 5,000 0.763 3815
5 5,000 0.713 3565
20500
IO 20500
NPV 0
Therefore, IRR = 7 percent
The above two illustrations show that the determination of IRR is a repetitive process and may not be able to find the exact IRR from a project when the rate lies in between two whole numbers. Say, suppose the calculated NPV value from a project lies:
At discount rate NPV
17% +843.00
18% -572.00
Then the actual IRR must be slightly higher than 17% but less than 18%.
To find the value, the following interpolation formula is in wide usage.

Where
= Lower Discount Rate
= NPV of the profit at Lower Discount Rate
= Different in calculated present values of cash flows (in absolute sums of NPV)
= Different in Discount Rates
IRR in above case

= 17 + (0.5986)
= 17.59

Selection Criterion
Since IRR method gives the profitability of a project in terms of a ‘rate’, project with higher rate of return compared to the cost of capital could be accepted. The cost of capital ‘k’ may be the minimum required rate of return that a firm is expected to generate from out of its investment projects. Therefore ‘k’ becomes the cut off rate or target rate in project appraisal. Then the acceptance rejection criterion would be
IRR > K = Accept
IRR > K = Reject
It is generally known that the project with returns higher than the cost of capital, if accepted would raise the market value of a firm.
Implications of IRR
IRR method helps in examining the profitability of a project in terms of generating necessary cash flows to reply the loan the interest on it if project is financed through borrowed capital. Further, IRr > k indicates that the rate of return in terms of its present value. In other words, the IRR is the maximum interest rate that the firm can generate in case the entire projects is to be financed by borrowed funds. Consider the following example to understand the full implications of IRR.
Illustration
Suppose the cost of the project is Rs.28,550 (fully borrowed at 15%) with the cash flows of Rs.10,000 for four years yields on IRR of 15% then verify whether project could be able to reply the cost of the project.

Years Loan outstanding Interest @ 15% Total Amount Cash flow to repay Balance at the end
1 28550.0 4282.5 32832.5 10000 22832.50
2 22832.5 3424.8 26257.4 10000 16257.4
3 16257.4 2438.6 18996.0 10000 8696.00
4 8696.0 1304.4 10000.4 10000 (0.4)*
*Rounding off error
Certain specific advantages of IRR over NPV are:
i. Project profitability is more easily understandable in case of IRR than the absolute size of NPV
ii. Determination of cost of capital is not required in case of IRR for project appraisal as was needed in case of NPV.
iii. Comparison of projects would be more easier in case of IRR, irrespective of the sizes of initial outlays.
However, the following are some serious limitations of this method.
i. Calculation of IRR is difficult and it involves tedious exercise of finding the exact discount rate which equates cash flows of initial outlay.
ii. IRR method yields absolutely different results compared to NPV method when projects differ in respect of initial outlays, pattern of cash flows, project lives.
iii. IRR method assumes that the intermittent cash flows are reinvested at the same rate as the internal rate of return generated by the project. It would always be on higher side as the funds in circulation may not be that profitable ad that of the investment.
A Practical Approach to Find IRR
As the trial and error method of finding IRR is a tedious process, there is a practical approach to ascertain IRR easily by using the reciprocal of payback period. Such reciprocal value is observed to be a good approximation of the IRR mostly when the cash flows of a project are even. However even in case of un-even cash flows, this method is used after ascertaining annual average cash flows.
Under this method present value of annuity tables, (Given in Annexure 9.B) will be used to find the approximate IRR of the project. The steps involved in determining the IRR value under the payback reciprocal approach starts with the calculation of PB period for the project. The calculated PB period would become the PV factor for the given life of the project. In the annuity table, one has to look for a PV factor which would be closure to the calculated PB value for the said years of life of the project. Roughly the closest rate of discount which yields similar PV factor to that of PB period would be the IRR.
Suppose, the life of a project is 5 years and its payback value is 3 years then, we have to search for a factor closest to 3,000 in ‘present value of annuity’ tables for 5 years. The factor closest to 3,000 would be 2.991. this would occur where the rate of interest is at 20%. Next nearer figure is 3058, it is at 19%. Then the project’s IRR would be in between 19% and 20%. By observation, we can consider 20% as approximate IRR. However, for exact IRR an interpolation similar to the one adopted earlier would be helpful.
Deviation from
PV factor
3,000
At 19% 3,058 0.050
20% 2,991 0.009
Then IRR = 19% +
¬¬¬¬0.067
= 10 + 0.8656
= 19.8656

Illustration
The management of the company has two alternative projects under consideration. Project A requires a capital outlay of Rs. 1,20,000 but Project B needs Rs. 1,80,000. both are estimated to provide cash flows for five years. A – Rs. 40,000 per year and B – Rs. 58,000 per year. Show which of the two projects are preferable using IRR method.
Project A:
Payback period = = 3 years
PV annuity factors nearer to 3.000 for 5 years are
3.058% at 19%
2.99 at 20%
By interpolation, IRR would be
IRR = 19% +
= 19.86%

Project B:
Payback period = = 3.1034 years
PV annuity factors nearer to 3.1034 for 5 years are
3.127 at 8%
3.058 at 19%
By interpolation, IRR would be
IRR = 18%+
= 18% + 0.3420
= 18.34
Project A is preferable to Project B as the IRR is slightly the greater in case of Project A.
Profitability Index
Profitability index (PI) is the third popular project evaluation method which uses DCF methodology. PI method is almost similar to NPV method. In case of NPV, the present value of cash flows from a project are ascertained by deducting the initial outlay (IO) from the sum of PV’s of all cash flows expected to be generated.

Ultimately the NPV would be an absolute figure which may not be able to permit the comparison of different projects with varying initial outlays. Therefore, the profitability index provides us a solution by constructing a ratio to express the relative profitability of each project to the size of initial outlay. PI is worked out by dividing the present value of all cash inflows expected, by the initial outlay. Symbolically

Illustration
A project costs 1,00,000 and is expected to generate cash flows for five years as Rs. 20,000, Rs. 30,000, Rs. 40.000, Rs. 30.000 and Rs. 20,000. calculate profitability index.



Table 4.13: Calculation of profitability index assuming a discount rate of 10 percent
Year Cash flows Discounting Factor Present Value
1 20,000 0.909 18180
2 30,000 0.826 24780
3 40,000 0.751 30040
4 30,000 0.683 20490
5 20,000 0.621 12420
 PVCF 105910
Profitability Index (PI) =

Selection Criterion
Since PI method provides a ratio of benefit-to-cost, the project could be profitable only when the benefit is higher than the cost of the project. In such a case the calculated PI should be greater than ‘I’. It follows the similar logic as that of NPV. As long as present value of cash flows are larger that the IO, the NPV would be positive. Therefore, whenever the NPV of a project is positive it is certain that PI results more than one. Therefore, the selection of a project would be done as follows:
PI > Accept
PI > Reject
Implications of PI
The PI method although depends on similar methodology of that of the NPV, is more suited for comparison of projects especially under conditions of capital rationing.
FEW ADDITIONAL ILLUSRATIONS
Illustration 1
An oil company proposes to install a pipeline for the transport of crude from wells to refinery. Investments and operating costs of the pipeline vary for different sizes of pipes (diameter). The following details have been collected:
Pipeline diameter 3” 4” 5” 6” 7”
Investment required (Rs.lakhs) 16 24 36 64 150
Gross annual savings in operating
costs before depreciation 5 8 15 30 50
Estimated life of the installation is 10 years. Tax rate is 50%. If the company desires a 15% after tax return, indicates the proposal that is viable.

Table 4.14 : Determination of Cash flows
(Rs. in lakhs)
Pipeline Diameter
3” 4” 5” 6” 7”
Savings before Depreciation Tax 5 8 15 30 50
Less Depreciation (@ 10% on investment) 1.6 2.4 3.6 6.4 15
3.4
5.6
11.4 23.6 35

Less Tax @ 50% 1.7
2.8 5.7 11.8 17.5
Net savings after tax 1.7 2.8 5.7 11.8 17.5
1.6 2.4 3.6 6.4 15.0
3.3
5.2
9.3
18.2 32.5
Payback period =
=

= 4.85 4.61 3.87 3.52 4.62
Therefore 6 inches has lowest payback period.
Table 4.15: Determination of NPV when Company’s required Rate of Return is 15%
Diameter of Pipeline
3” 4” 5” 6” 7”
Annual cash flows expected 3.3 5.2 9.3 18.2 32.5
Life Years 10 10 10 10 10
PV factor for annuity at 15% discount rate 5.019 5.019 5.019 5.019 5.019
PVCF (Rs. in lakhs) 16.56 26.10 46.68 91.35 163.12
Initial outlays 16.00 24.00 36.00 64.00 150.00
NPV 0.56 2.10 10.61 27.55 23.12
6” Pipelines gives highest NPV.
Illustration 2
A company is thinking of illustration a computer. It has to decide whether the computer is to be hired or bought outright. The following data are available.
Purchase of Computer:
Purchase Price Rs. 40,00,000
Annual maintenance Rs. 50,000 (to be paid in advance every year)
Life of the computer 10 years
Depreciation 15% per annum on the reducing balance method
Residual value is written
off/salvage value after 10 years Rs.4,00,000
Hiring of Computer:
Initial one-time cost Rs.40,000
Annual hire-charges Rs.7,00,000 (Payable in advance each year)
Rate of discounting 10%

Ignore Tax
You are required to advise the company as to whether it should purchase the computer or hire it.
Since the projects are mutually exclusive, let us try to find differential NPV.
To ascertain such a value we have to find differential initial outlay and differential cash flows.
i) Differential Initial Outlay:
Computer Cost Price = Rs. 40,00,000
Hire Charge (Initial Cost) = Rs. 40,000
ii) Differential Annual Cash flow:
Hire Charges = Rs. 7,00,000
Annual Maintenance if purchased = Rs. 50,000
Rs. 6,50,000 (for ten years)
iii) Salvage Value (10th year) = Rs. 4,00,000
Table 4.16 : Calculation of NET Present Value


Years Differential Cash flow (Savings) Rs. PV Factor @ 10% Present Value of Cash flow Rs.
0* 6,50,000 1,000 6,50,555
1 6,50,000
2 6,50,000
3 6,50,000
4 6,50,000
5 6,50,000 (Annuity Factor) 5.759 37,43,350
6 6,50,000
7 6,50,000
8 6,50,000
9 6,50,000
10 4,00,000 PV factor 0.386 1,54,400

45,47,750
(-)
36,00,000

9,47,750
Therefore, purchasing the computer is advisable.
Depreciation and Taxation are ignored.
Illustration3
A job which is presently done entirely by manual methods has a labour cost of Rs. 46,000 a year. It is proposed to install a machine to do the job, which involves as investment of Rs. 80,000 and an annual operating cost of Rs. 10,000. assume the machine can be written off in 5 years on straight line depreciation basis for tax purposes. Salvage value at the end of its economics life is zero. The tax rate is 55%. Analyse the economic implications of the proposal by the Internal rate of Return Method.
Since, the new machine is likely to replace the entire manual method, it saves the labour cost of Rs. 46,000. However, the machine maintenance operating cost is expected be Rs. 10,000 per annum.
Net savings of machine 36,000
Tax on the savings (55%) 19,800
After Tax Savings 16,200
Add Tax advantage on depreciation
(80,000 – 5) = 10,000 + (1 – 0.55) 8,800
Cash flow 25,000
Alternatively
Net savings of the machine 36,000
Less Depreciation (80,000/5) 16,000
Taxable Savings 20,000
Tax @ 55% 11,000
9,000
Add Depreciation 16,000
Cash flows 25,000
IRR calculated by payback reciprocal method:
Payback period =
Present value of Annuity of Re. 1/- table shows that
PV factor IRR
3.274 16%
3.199 17%
By Interpolation



If the firm’s cost of capital is lower than the IRR the project is acceptable.
NET PRESENT VALUE VS INTERNAL RATE OF RETURN
The Net Present Value (NPV) and Internal Rate of Return (IRR) are two similar methods in evaluating Capital Investment proposals. Both these methods use the similar procedure of discounting the future cash flows, with almost similar Mathematical formulae. Under NPV method a project is acceptable when it possess positive NPV (NPV>0) and in case of IRR method all projects with internal rate of return higher than the required rates of return (r>k) are acceptable. In case of economically independent projects if a project which adjudged as acceptable under NPV criterion is automatically founds acceptable under IRR criterion as well. It is basically true due to the fact that any project which can generate positive NPV when future cash flow are discounted at a minimum required rate to return or cost of capital (k) is likely to process a higher IRR (r>k).
Let us recall formula for NPV and IRR for possible equivalence between them

or

The IRR is that discount rate (r) which satisfies the following equation

The discounted value of cash flows on the left hand side of equation 10.4 which equals to IO must be smaller than the left-hand side of inequality in equation 10.3 which is greater than IO. Since CFS are identical, ‘r’ must be greater than ‘k’. further the said equivalence can be shown as in Figure


Figure: NPV Profile at Different Discounting Rates

The figure indicates that use size of NPV is positive when the project is evaluated at the rate of ‘k’. for the sane and said project the IRR or ‘r’ which is defined to be the discount rate which makes NPV = 0, is greater than ‘k’.
Against the above said proof, the project selection is likely to be similar under NPV and IRR method. If a project is found acceptable under NOV, it automatically gets selection under IRR. However, this equivalence ends in confrontation when projects are mutually exclusive type.
Conflicting Ranking by NPV and IRR
The NPV and IRR methods are expected to rank all independent projects similarly. However, this dictum is found to have been contradicted at times especially when projects are dependent type. A business enterprise is often to decide upon one of the alternatives among two or three mutually exclusive investment projects. For example, a firm has to decide on one of the two alternatives like (a) Installing a conveyor belt or (b) Purchasing a fleet of trucks in order to transport mineral ore to furnace. Similarly most make or buy decisions involve mutually exclusive alternatives. In case of such projects NPV and IRR are likely to differ in selecting the profitable project. To illustrate, consider the following projects:
Projects Initial outlay Annual cash flows Life of the project NPV @ 15% IRR
I 14,000 2745 20 3181 19%
J 19,000 3550 20 3210 18%
If I and J are independent, both are acceptable due to positive NPV as well as IRR being greater than K in both the cases. But is case these projects are dependent on one another clear cut decision can be taken on acceptability of anyone of them being superior to the other. The NPV and IRR methods rank them differently. If one follows NPV method project J is acceptable based on longer Net Present Value. But the size of IRR is found larger in case of project I. Thus a conflicting ranking, is evident under both the methods.
The following ranking is attributed to some of the following situations.
1. When projects involve different cash outlays.
2. When projects under comparison are with different lives.
3. When the pattern of expected cash flow differ among the projects.
i. Different Project Sizes
The NPV and IRR criterion are likely to provide conflicting ranking of projects when the size of outlay differs among the said mutually exclusive projects. Consider the following illustrations:
Illustration
Tantex Knitwear Ltd. Is considering two equally efficient spinning machines. Lakshimi Machine Tools (LMT) machine is expected to cost Rs. 48,700. it is supposed to work for 5 years with Rs. 17,000 annual cash savings compared to the present practice of buying the ready-made output form suppliers. The machine being sold by HMT on the other hand expected to last Rs. 31,600 and cash savings are estimated to be around Rs. 12,000 per annum for 5 years to come. The flow of cash flows from both alternatives are as follows
Years t0 t1 t2 t3 t4 t5
LMT 48700 17000 17000 17000 17000 17000
HMT 31600 12000 12000 12000 12000 12000
Calculate the NPV and IRR
Table 4.17: Calculation of NPV and IRR for the Said Machine
Machine NPV @ 10% IRR
LMT 15747 22%
HMT 13892 26%
If one goes by NPV criterion LMT’s machine is acceptable compared to HMT’s spinning Machine. On the other hand, if one uses IRR method the HMT’s machine is found to earn higher IRR and hence acceptable. Thus the methods rank the projects conflictingly.
ii. Different Lives of Project
IRR and NPV method are likely to tank the projects differently when project with different life spans are compared. Some investment projects are likely to generate cash flows from the very next year of its implementation while other exhibit an initial gestation period and subsequently a sizeable returns. A comparison between such projects pose the problem of confiscatory ranking by NPV and IRR.
Illustration
A tree plantation company has acquired the rights of collecting ‘Timber from the Standing Casuarinas trees from a social-forestry development agency.
The plantation company has two alternatives: first alternative is immediate cutting of the timber and make a cash flow of Rs. 6.25 lakhs by the end of the year against a deal price of Rs. 5 lakhs, second alternative is delay the logging for Rs. 5 more years, and the larger plants would produce Rs. 10.37 lakhs at the end of 5th year for the same deal price of Rs. 5 lakhs.
To present the details
Project alternative Cash outlay Rs. lakhs cash inflows
T1 t2 t3 t4 t5
A Immediate cutting of trees 5.00 6.25 - - - -
B Delayed cutting of trees 5.00 - - - - 10.37
Assuming a cost of capital of 10%
NPVA = (6.25 x 0.909) - 5.00 lakhs = Rs. 68,125
NPVB = (10.37 x 0.621) - 5.00 lakhs = Rs.143,977
IRR4 = -5.00 + 6.25/(l+r)l = 0
r = IRRA = 25%
IRRB = -5.00 + 10.37 /(l+r)5 = 0
r = IRRB = 16%
If one looks at the calculated NPV @ 10% discount rate, the size of NPV is large with second alternative. But IRR shows that the project A records higher IRR of 25% against just 16% in case of alternative B. Thus, NPV and IRR found conflicting in evaluating projects with different lives.
iii. Timing of Cash flows
Certain projects are likely to generate sizeable cash flows in the initial years while others are likely to record larger cash flows in the later years. Such projects are said to differ in their timing of cash flows. The NPV and IRR methods are likely to conflict in ranking the projects with such differences in timing of cash flows.
To illustrative, two projects requiring same cash outlay are having the following pattern of cash flows:

t0 t1 t2 t3
Project A (16,800) 14000 7000 1400
Project B (16,800) 1400 .8400 15,100
Table 4.18: The Net Present Value of these Two Projects at Different Rates are as Follows
Discounting Rate (k) NPV
Project A Project B
0% 5600 8100
5% 4090 5200
10% 2760 2760
15% 1590 700
20% 530 (1060)
25% (400) (2570)
30% (1250) (3880)




Figure: NPV Profile for Two Projects with
Different Pattern of Cash flow Generation


The size of net present value of both the projects are similar at 10 percent discount rate, indicating that any on of the projects is acceptable. However, an estimation of IRR for the said projects by plotting the sizes of NPV at discounting rates reveals that (See Figure 10.2) the IRR of project A is 23% and IR of project B is 17% (IRR being the discount rate where NPV became zero). Thus the IRR criterion conflicts with NPV and attaches superiority to project A over Project B.
The difference in Projects’ profitability can be attribute to the pattern cash flows over their lives.
Reasons for Conflicting Ranking
The NPV and IRR methods are basically relied on same principle of comparing the time-value adjusting cash flows. However, they found to differ in ranking the projects especially when projects differ with respect to their lives, size of outlays and pattern of generating cash flows. One common explanation put forth in ‘Finance literature’ towards their conflicting ranking by the two DCF methods is the assumption on Reinvestment Rates. The NPV method implicitly assumes reinvestment of the intermediate proceeds at the rate equal to the cost of capital. However, the IRR method is expected to assume that the reinvestment at project internal rate of return. The investment assumption made under NPV fairy explains that interim cash flows are expected to generate minimum opportunity rate elsewhere. This implicit assumption looks logical. Expecting a rate of return equivalent to the projects’ IRR from the intermediate cash flows under IRR method is really on higher side. Definitely the liquid from cash flows may not be a position to earn such high rate. Thus the assumption has no economic basis. The alternative use of intermediate cash flows cannot earn IRR. Then the NPV method could be ranked as fairly dependable is providing an optional solution to capital budgeting.

REVIEW QUESTIONS
1. What is capital budgeting? Explain its importance in Financial Management.
2. Discuss the characteristics and relative merits and demerits of different methods of appraising capital investment proposals.
3. What do you mean by time value of money? Bring out the superiority of capital budgeting methods which adjusts their cash flows to changes in time value of money.
4. ‘Despite its weaknesses, the payback method is popular in practice’. What are the reasons for its popularity?
5. The management of a company has two alternative projects under consideration. Project A requires a capital outlay of Rs. 1,20,000 but project B need Rs. 1,80,000. both are estimated to provide a cash flow for five years A Rs. 40,000 per annum and B Rs. 58,000 per annum. The cost of capital is 10%. Show which of the two projects is preferable from the point of view of (i) Net present value and (ii) Internal rate of return.
[NPV : 31640,39878; IRR : 19.8, 18.5]
6. The following is a summary of financial data in respect of five investment projects.
Initial outlay Net annual cash flow Life in year
A 60,000 18,000 15
B 88,000 15,000 25
C 2,150 1,000 5
D 20,500 3,000 10
E 4,25,000 1,50,000 20
Rank these project according to
i) Payback period
ii) Accounting Rate of Return
iii) Net present value at a cost of capital of 10%
[C,E,A,B,D]

7. A company is considering the purchase of a Delivery Van and is evaluating the following two choices:
(a) The company can buy a second-hand van for Rs. 80,000 and after five years sell the same for Rs. 20,000 and replace it with another second-hand van which is expected to cost Rs. 1,20,000 and last 5 years with a terminating value of Rs. 20,000.
(b) The company can buy a new van for Rs. 2,40,000. the projected life of the van is 10 years and has an expected salvage value of Rs. 30,000 at the vans under both the choices are the same. Assuming that the cost of capital 10% which choice is preferable.
[Alternative A]
8. The Philips Corporation which has a 50% tax rate and a 10% after tax cost of capital is evaluating a project which will cost Rs.1,00,000 and will require an increase in the level of inventories and receivable of Rs.50,000 over its effective life. The project will generate additional sales of Rs.1,00,000 and will require cash expenses of Rs. 30,000 in each year of its 5 year life. It will be depreciated on straight lines basis. What are the net present value and IRR of the project?
[ NPV = 51650 IRR 21% ]
9. A firm needs a component in an assembly operation. If it wants to do the manufacturing itself, it would need to buy a machine for Rs. 4 lakhs which would last 4 years with no salvage value. Manufacturing costs in each
of the four years would be Rs. 6 lakhs, Rs. 7 lakhs, Rs. 8 lakhs and
Rs. 10 lakhs respectively. If the firm had to buy the components from a supplier the component would cost Rs. 9 lakhs, Rs. 10 lakhs, Rs. 11 lakhs and 14 lakhs respectively, in each of the four years. However, the machine would occupy floor space which could have been used for another machine. This better machine could be hired at no cost to manufacture an item, the sale of which would produce net impossible to find room for both the machines. Should the firm make component or buy from outside?
[ Buy – beneficial ]
CASE
After returning from a seminar, the President of M/s. My Fair Lady Cosmetics Limited, posed the following question to his managers. “We have traditionally evaluating new products for our company using the payback method and a maximum acceptable payback of 2 years. At the seminar, I attended, they said the present value analysis is better way to evaluate capital projects. Now, we have been in business for 15 year and the pretty successful. Obviously, the evaluation of capital projects is important to our business. If we have been using the wrong method all these years, why have not we failed?”
The managers are now requested to answer the President “whether the present value analysis would have lead the company to select a different set of product?” To answer this question a detailed list of products accepted or rejected during the life of the company has been compiled. It is discovered that most of the products launched by the company had an average life of 4 year. Most products required an initial outlay of Rs. 1,00,000 to Rs. 2,00,000. Further most products resulted in the same amount of cash flows during their life. These observations found true for all the products either accepted or rejected.
Required:
a) Determine the approximate discounting ate use in present value analysis which would cause the company to accept and reject the same projects that they have accepted or rejected under currently practiced payback method. Illustrate with examples.
 
LESSON 5 LEVERAGE IN CAPITAL STRUCTURE
Lesson outline
• Meaning of Leverage
• Classification of Leverage - Financial Leverage-Operating Leverage – Combined Leverage
• Financial Leverage and Trading on Equity-Limiting Factors
• Characteristics of Operating Leverage
• Illustrative Examples
Cost structure, capital structure and asset structure are very important factors in maximising earnings per share (EPS) or return on equity (ROE) of a company. Cost structure in terms of fixed and variable costs, gives rise to ‘operating leverage’ and the (optimal) capital structure, in terms of fixed cost and variable cost securities, to financial leverage. The optimal capital structure is the one that strikes a balance between these risks and returns and thus maximises the price of the stock. The capital structure decision is significant managerial decision which influences the shareholders return and risk and ultimately the value of firm. Before discussing operating and financial leverages let us consider the concept of leverage first.
Meaning of Leverage: The term ‘leverage’ has been borrowed from physical science where it refers to device (lever) by which heavy objects (weights) are lifted with a small force. In business parlance, it refers to the relationship between percentage changes in fixed cost and in earnings before interest and taxes (EBIT) viz. operating profit. Thus, leverage may be defined as the employment of assets out of funds for which the firm pays a fixed cost or fixed return. The fixed cost or fixed return may be thought of as the fulcrum of a lever. When the revenues less variable costs (or earnings before interest and taxes) exceed the fixed cost or fixed return, positive or favourable leverage results. When the operating income is less than the fixed cost or fixed return, the result is negative or unfavourable leverage.
Leverage belongs to the category of capital-gearing. This is an American term which has approximately the same meaning as “gearing”. It is one of the important tools in the hands of corporate financial managers. If used judiciously it can maximise the return to equity shareholders.
Classification of Leverages
Leverage may be of five kinds: (i) Return of Investment Leverage, (ii) Asset Leverage. (iii) Financial Leverage (iv) Operating Leverage, and (v) Combined or Composite leverage.
Return on Investment Leverage: It is an index of operational efficiency.
ROI Leverage =
Assets Leverage: Assets turnover is the ratio of sales to total assets. Sales divided by Total Assets aspect of ROI leverage is often referred to as Assets Leverage.
Financial Leverage
Financial Leverage (also known as Capital Leverage or Capital Structure Leverage) refers to the use of funds obtained by fixed cost securities such as debentures, bonds, preference shares etc., in the hope of increasing the return to equity shareholders. It simply indicates the changes that take place in taxable income as a result of changes in operating income. It signifies the existence of fixed cost securities in the capital structure of a company. Debentures, bonds, preference shares etc., whose rates of interest or dividend as the case may be are prefixed and do not change with the level of profit. When in the capital structure of a company fixed cost securities are greater as compared to equities the leverage factor or degree of leverage is said to be large. That is a favourable or positive financial leverage which arises when the company earns more from assets purchased with the funds (raised through fixed cost securities) than return or costs payable for the use of the funds. An unfavourable or negative financial leverage arises when the earnings from such assets are less than the fixed cost payable on such funds.
Financial Leverage causes change in the earnings before interest and taxes (total earnings before interest and taxes may remain the same). When there is change in operating profit there will be a sharp change (i.e. at a greater rate) in the Earnings per (Equity) Share (EPS). Increasing EPS is one of the reasons for higher market price of shares. Thus, a favourable financial leverage causes the EPS to rise faster if other things remain the same.
By using an indifference chart, one can study the relationship between earnings before interest and taxes (EBIT) and earnings per share under various alternative methods of financing. The degree of sensitivity of earnings per share to EBIT is dependent upon the explicit cost of the method of financing, the number of common stocks to be issued, and the nearness to the indifference point. Although an EBIT-EPS chart is useful in analysing the explicit cost of various methods of financing, it does not take into account any implicit costs inherent in the use of a specific method of financing.
Degree of Financial Leverage =
Alternatively,
Degree of Capital Structure Leverage =
Financial Leverage and Trading on Equity: Quite often the terms financial leverage and trading-on equity are used inter-changeably. Although the concepts try to explain the impact on Return on Equity (ROE) of the capital structure there is a subtle difference between the two. As pointed by one authority on financial
management, financial leverage explains the impact on EPS (ROE) of changes in operating profit, given the capital structure proporations of debt, preference and equity. Trading-on-equity, on the other hand, explains the impact of ROE of change in capital structure proportions, given the level of operating profit.
Financial Break-even: Financial Break-even is defined as the value of EBIT that makes EPS equal to zero.At financial breakeven, the firm’s EBIT is just sufficient to cover its fixed financing costs (Interest and Preference dividend) on a before tax basis, leaving no earnings for common shareholders. Above the financial breakeven the EBIT the firm produces a positive level of earnings available to common shareholders and a positive EPS. Below this level, profit available to common shareholders and EPS are both negative. It is thus possible for a firm to earn a a positive level of EBIT even though its EPS is negative. This will happen when the firm’s EBIT is positive but less than its financial breakeven level. If financial leverage is calculated at financial breakeven, the resulting coefficient of financial leverage has an undefined value i.e., zero value.
Significance of Financial Leverage
Financial leverage is employed to plan the ratio between debt and equity so that earning per share is improved. Following is the significance of financial leverage:
(i) Planning of Capital Structure: The capital structure is concerned with the raising of long-term funds, both from shareholders and long-term creditors. A financial manager has to decide about the ratio between fixed cost funds and equity share capital. The effects of borrowing on cost of capital and financial risk have to be discussed before selecting a final capital structure.
(2) Profit Planning: The earnings peer share is affected by the degree of financial leverage. If the profitability of the concern is increasing then fixed cost funds will help in increasing the availability of profits for equity stockholders. Therefore financial leverage is important for profit planning. The levels of sales and resultant profitability is helpful in profit planning. An important tool of profit planning is break-even analysis. The concept of break-even analysis is used to understand financial leverage. So financial leverage is very important for profit planning.
Limiting Factors
Increased debt has a psychological impact on investors who consider investment in the company more risky. This financial risk offsets the increasing market price and brings down the price-earning ratio (P/E). What should be the premium for this financial risk (known as implicit cost)? It will depend on the nature of the industry and the image of the organisation.
Another checking factor for this increase in market price of shares is the cash outflow over a period of time and limits the debt capacity of the firm.
A large amount of borrowed capital will require increased cash inflows to meet the fixed charges of interest and repayment of principal. The inability to generate sufficient cash flows to meet the fixed obligations may cause cash insolvency in the
firm and thus put it in a higher risk-class. Even a possibility of cash inadequacy will increase the explicit cost of debt and thus bring down the rising trend of EPS and P/E ratio.
While introducing leverage to get a higher EPS, cash budgets should be prepared so that the probability of being out of cash with the increment of debt is negligible.
Another limiting factor on increased EPS due to financial leverage is the scarcity of loan able funds at the prevailing rate of interest. The firm moves to a higher risk class and, therefore, a higher interest rate will be demanded. The rate of gains from leverage will certainly be checked but not stopped till the marginal rate of interest is equal to the average cost of capital. When debts are not available at a reasonable rate of interest, it is a point of caution for the firm. The investors view the concern more risky and ultimately bring down the P/E ratio. Risk is a dynamic condition and the position can be improved by paying off debts from the surplus earnings, thus improving the debt-equity position. The optimum leverage situation will be the point where the marginal cost of debt is equal to the company’s average cost of capital.
With the introduction of financial leverage, the cost of debt remains fixed over a period of time and, therefore, the weighted average cost of capital falls, which encourages the firm to take up such projects as were previously above the cut-off rate. Expansion of business due to low cost of capital offers the advantage of growing bigger and stronger in a competitive market. The cost of equity automatically goes up which means a higher market price for the shares.
Need for caution: From the above discussion, a few conclusions can be drawn for successfully introducing financial leverage in a firm to maximise the wealth of shareholders. Introduction of cheaper fixed costs funds rapidly increases the earnings per share, thereby pushing up the market price of the shares and boosting the firm’s image. Leverage also brings down the overall cost of capital and thus induces the firm to expand and become stronger. But this tool must be used cautiously so that the debt is not increased to the extent where the firm is put in a very high risk class offsetting the gains of leverage with a decrease in the Price-Earning ratio.
Financial leverage can be harmful in the hands of a novice as over-enthusiasm to boost the market price of the shares can lead to insolvency in adverse times if long-term cash budgets with justificable probability distribution are not prepared. The rate of gains is checked by the demand for higher rate of interest due to increased risk in the firm, but this should not be treated as a halting point as the situation can be improved y paying off debts from surplus earnings and by following a low pay-out policy.
Illustration : 1
A company has choice of the following three financial plans. You are required to calculate the financial leverage in each case and interpret it.

X
Rs. Y
Rs. Z
Rs.
Equity capital
Debt
Operating Profit (EBIT)
Interest @ 10% on debt in all cases 2,000
2,000
400 1,000
3,000
400 3,000
1,000
400

Solution
The financial leverage will be computed as follows in case of each of these financial plans:
X
Rs. Y
Rs. Z
Rs.
Operating profit (OP)
Interest (10% on debt) 400
200 400
300 400
100
Profit before Tax (PBT) 200 100 300
Financial Leverage




= 2 = 4 = 1.33

Financial leverage, as explained earlier, indicates the change that will take place in the taxable income as a result of change in the operating income. For example, taking Financial Plan X as the basis, if the operating profit decreases to Rs.200, its impact on taxable income will be as follows:
Rs.
Operating Profit (OP or EBIT) 200
Less : Interest 200
Profit before tax (PBT) Nil
Financial leverage in case of plan X is 2. It means every 1% change in operating profit will result in 2% change in the taxable profit. In the above case operating profit has decreased from Rs.400 to Rs.200 (i.e., 50% decreases), as a result the taxable profit has decreased from Rs.200 to zero (i.e., 100% decrease).
Illustration : 2
A company has the following capital structure:
Rs.
Equity share capital 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000
The percent EBIT is Rs.50,000. Calculate the financial leverage assuming that company is in 50% tax bracket.
Solution

Rs.
Operating Profit 50,000
Less : Interest on debentures
Pref. dividend (pre-tax basis) 10,000
20,000
30,000
Profit before tax 20,000

Financial leverage =
Illustration : 3
The capital structure of a company consists of the following securities.
Rs.
10% Preference share capital 1,00,000
Equity share capital (Rs.10 per share) 1,00,000
The amount of operating profit is Rs.60,000. The company is in 50% tax bracket. You are required to calculate the financial leverage of the company.
What would be new financial leverage if the operating profit increase to Rs.90,000 and interpret your results.
Solution
Computation of the Present Financial Leverage
Rs.
Operating profit (OP or EBIT) 60,000
Less : Preference dividend (after grossing up) 20,000
PBT 40,000
Present Financial Leverage =
Computation of New Financial Leverage
Rs.
New Operating profit 90,000
Less : Preference dividend (after grossing up) 20,000
PBT 70,000
Present Financial Leverage =
The existing financial leverage is 1.5. It means 1% change in operating profit (OP or EBIT) will cause 1.5% change in taxable profit (PBT) in the same direction. For example, in the present case operating profit has increased by 50% (i.e., from Rs.60,000 to Rs.90,000). This has resulted in 75% increase in the taxable profit (i.e., from Rs.40,000 to Rs.70,000).
Operating Leverage
The concept of operating leverage was in fact originally developed for use in making capital budgeting decisions. Operating leverage may be defined as the tendency of the operating profit to vary disproportionately with sales. The firm is said to have a high degree of operating leverage if it employees a greater amount of fixed costs and a smaller amount of variable costs and vice versa. Operating leverage occurs where a firm has fixed cost that must be met regardless of volume of value of output or sales. The degree of leverage depends on the amount of fixed costs. If fixed costs are high, even a small decline in sales can lead to a large decline in operating income. If it employs more fixed expenses/costs in its production process, greater will be the degree of operating leverage. A high degree of operating leverage, other things held constant, implies that a relatively small change of sales results in large change in operating income.
Higher fixed costs are generally associated with more highly automated capital intensive firm and industries, the relationship between the changes in sales and the changes in operating income. Operating leverage may be studied with the help of a break-even chart or Cost-Volume-Profit analysis.
Firm A has a relatively small amount of fixed costs. Its variable cost line has a relatively steep slop, indicating that its variable cost per unit are higher than those of other firms. Firm B as considered to have a normal amount of fixed costs, in its operations and it has a higher break-even point than that of Firm A. Firm C has the highest fixed costs of all and its break-even point is higher than either Firm A or Firm B. Once Firm C reaches its break-even point, however, its operating profits rise faster than those of the other figures.














Fig. 12.1. Selling Price Rs.2 per unit; Total Fixed costs Rs.20,000
Variables cost Rs.1.50 per unit
 
Untied sold Sales Rs. Operating costs Rs. Operating profit Rs.
20,000
40,000
60,000
80,000
1,00,000
1,10,000
1,20,000 40,000
80,000
1,20,000
1,60,000
2,00,000
2,20,000
2,40,000 50,000
80,000
1,10,000
1,40,000
1,70,000
1,85,000
2,00,000 -10,000
0
10,000
20,000
30,000
35,000
40,000
















Fig. 12.2 Selling price Rs.2 per unit Total Fixed costs Rs.40,000 Variable cost per unit Rs.1.20.

Untied sold Sales Rs. Operating costs Rs. Operating profit Rs.
20,000
40,000
60,000
80,000
1,00,000
1,10,000
1,20,000 40,000
80,000
1,20,000
1,60,000
2,00,000
2,20,000
2,40,000 64,000
88,000
1,12,000
1,36,000
1,60,000
1,72,000
1,84,000 -24,000
-8,000
8,000
24,000
40,000
48,000
56,000

 

















Fig. 12.3. Selling price Rs.2 per unit; Total Fixed costs Rs.60,000 Variables cost Re.1 per unit

Untied sold Sales Rs. Operating costs Rs. Operating profit Rs.
20,000
40,000
60,000
80,000
1,00,000
1,10,000
1,20,000 40,000
80,000
1,20,000
1,60,000
2,00,000
2,20,000
2,40,000 80,000
1,00,000
1,20,000
1,40,000
1,60,000
1,70,000
1,80,000 -40,000
-20,000
0
20,000
40,000
50,000
60,000

In general, higher a firm’s operating leverage, the higher its business risk. If sale price, cost and the like are held constant but output varies, then the higher the degree of operating leverage the greater is the degree of business risk. For most part, operating leverage is determined by technology. Electrical utility firms, telephones, airlines, steel mills, chemical companies, cement companies etc., have heavy investments in fixed assets. This produces high fixed costs and operating leverage Grocery/trading stores, on the other hand, generally have significantly lower fixed costs, hence lower operating leverage.

The degree of operating leverage can be measured with the help of the following formula:
=
or =
Characteristics of Operating Leverage
(a) the degree of operating leverage depends upon the amount of fixed elements the cost structure. Operating leverage is a function of three factors (i) the amount of fixed cost, (ii) the contribution, and (iii) volume of sates.
(b) The concept of operating leverage cannot be applied at the Break even level, because the denominator (i.e., operating profit) becomes zero.
(c) The operating leverage is a number (integer or fraction) and if the activity is increased by a stated percentage the operating profit will be increased by the product of that percentage and the operating leverage,
(d) The operating leverage decreases as the level of production or activity increases, provided that other things remain the same. So near about the break even volume of production or sales, a small increase in the level of activity gives rise to a rapid increase in profits. Companies acting just above the break-even capacity find it greatly profitable to increase the activity.
(e) For levels of activity below the Break even level, operating leverage is negative. In that case if has to be interpreted that a given percentage increase or decrease in activity will give rise to operating leverage times that much percentage reduction or increase in losses correspondingly.
(f) The operating leverage is the reciprocal (inverse) of the Margin of Safety. In view of the reciprocal relationship, the inference is that the higher the operating leverage, the lower will be the margin of safety and higher risk to the company.
Illustration : 4
The installed capacity is 6oo units. Actual capacity used is 400 units. Selling price per unit is Rs.10. Variable cost is Rs.6 per init. Calculate the operating leverage in each of the following three situation:
1. When fixed costs are Rs.400
2. When fixed costs are Rs.1,000
3. When fixed costs are Rs.1,200

Solution
Statement Showing operating Leverage
Situation 1
Rs. Situation 2
Rs. Situation 3
Rs.
(i) Sales
(ii) Variable cost
(iii) Contribution (i-ii)
(iv) Fixed cost
(v) Operating profit (iii) – (iv)
(vi) Operating leverage
4,000
2,400
1,600
400
1,200

4,000
2,400
1,600
1,000
600

4,000
2,400
1,600
1,200
400


= 1.33 = 2.67 = 4

The above example shows that the degree of operating leverage increases with every increase in share of fixed cost in the total cost structure of the firm. It shows, for example, in situation ‘3’ that if sales increase by rupee one, the profit would increase by Rs.4, This can be verified by taking situation ‘3’ when sales increase to Rs.8,000, the profit in such an event will be as follows:
Rs.
Sales
Variable cost 8,000
4,800
Contribution
Fixed cost 3,200
1,200
Profit 2,000

Thus, the sales have increased from Rs.4,000 to 8,000, i.e., a hundred per cent increase. The operating profits have increased from 400 to 2,000, i.e., by Rs.1,600 (giving an increase of 400 per cent). The operating leverage is 4 in case of situation ‘3’ which indicated that with every increase of one rupee in sales, the profit will increase four times. This has been verified by the above example where a hundred per cent increase in sales has resulted in 400 per cent increased in profits. The degree of operating leverage may, therefore, be put as follows:

As a matter of fact, operating leverage exists only when the quotient in the above equation exceeds one.

Composite or Combined or Total Leverage
Operating and Financial leverage combined themselves in a multiplicative form to bring about a more proportionate change in EPS (ROE) for a given percentage change in activity. This is because the dispersion and risk of possible earnings per share are increased. The two types of leverages may be combined in different ways to obtain the desired degree of overall leverage and risks, i.e., a compromise between the total risk and the expected return.

Overall Breakeven: Overall Breakeven is defined as the level of output that makes EPS equal to zero. At this level of output the combined or composite leverage has an undefined value i.e., zero value.
For both operating and financial leverage one can determine the degree of leverage. In the first case related the change in profits that accompanies a change is output; secondly the change in earnings per share that accompanies a change is earnings before interest and taxes. By combining the two formulae, one can determine the effect of a change in output upon earnings per share.
The operating leverage and financial leverage are the two quantitative tools used to measure the returns to the owners viz., earnings per share (EPS) and market price of the operating shares; of the two tools, financial leverage is considered to be superior because it focuses attention on the market price of the share.
Between operating and financial leverage, operating leverage is less amenable to managerial control. This is so because operating leverage for a company is influenced by to a greater extent by the magnitude of fixed costs. But fixed costs are very much linked to the nature of industry, choice of technology and the asset structure employed. Thus manufacturing (capital –intensive) industries like cement, steel and heave engineering are likely to have higher fixed costs and a high operating leverage when compared to a trading industry. The super imposition of a high financial leverage on an already high operating leverage will result in a higher combined leverage which is likely to expose the company to a greater risk and putting the interests of shareholders in danger.
From the above discussion it is evident that there is less scope to exercise greater control in respect of operating leverage, one can exercise control in regulating the degree of financial leverage. To sum up, companies having a high operating leverage should plan for a capital structure having more equity and less debt to bring down the combined leverage to a reasonable level. Similarly, companies with a low operating leverage can bring up combined leverage to a more reasonable level by planning for a high financial leverage, thereby management can secure for the shareholders the benefits of leverage without exposing them to great risk.
Illustration : 5
Calculate the Operating and Financial leverages from the following information:
Rs. Rs.
Interest
Sales (1000 Units) 5,000
50,000 Variable Cost
Fixed Cost 25,000
15,000

Solution
Statement of Revenue, Cost & Profit
Rs.
Sales 1,000 units at Rs.50
Less : Variable cost 50,000
25,000
Contribution (C)
Less : Fixed Costs 25,000
15,000
Operating profit or EBIT
Less Interest 10,000
5,000
Profit before Tax (PBT) 5,000

Operating leverage =
Financial leverage =
Note : Combined leverage = Operating leverage x Financial leverage
= 2.5 x 2 = 5 or
Alternatively,
Illustration : 6
A firm has sales of Rs.10,00,000 variable cost of Rs.7,00,000 and fixed costs of Rs.2,00,000 and debt of Rs.5,00,000 at 10% rate of interest. What are the operating, financial and combined leverages? If the firm wants to double up its Earnings before Interest and Tax (EBIT), how much of a rise in sales would be needed on a percentage basis?
Solution
Statement of Present Profit
Rs.
Sales
Less : Variable cost 10,00,000
7,00,000
Contribution (C)
Less : Fixed Costs 3,00,000
2,00,000
Operating profit (OP) or EBIT
Less Interest at 10% on 5,00,000 1,00,000
50,000
Profit before Tax (PBT) 50,000


Operating leverage =
Financial leverage =
Combined leverage = 3 x 2 = 6 or
Statement of Sales needed to double EBIT
Operating leverage is 3 times i.e., 331/3 % increase in sales volume causes a 100% increase in operating profit or EBIT will become Rs.2.00.000 i.e., double the existing one.
Reconciliation Rs.
Sales
Variable cost 13,33,333
9,33,333
Contribution (C)
Fixed Costs 4,00,000
2,00,000
Operating profit (OP) or EBIT 2,00,000

Illustration : 7
(a) Calculate degree of Operating leverage, degree of Financial leverage and Combined leverage from the following date:
Sales 1,00,000 units @ Rs.2 per unit = Rs.2.00.000
Variable cost per unit @ Re.0.70 Fixed costs : Rs.1,00,000
Interest charges: Rs.3,668
(b) Which combinations of operating and financial leverages constitute:
(i) risky situation and (ii) an ideal situation.

Solution

Rs.
Sales
Less : Variable cost 2,00,000
70,000
Contribution (C)
Less : Fixed Costs 1,30,000
1,00,000
Operating profit or EBIT
Less Interest 30,000
3,668
Profit before Tax (PBT) 26,332

(a) (i) Operating leverage =
(ii) Financial leverage =
(iii) Combined leverage =
or 4.33 x 1.14 = 4.9.
(b) (i) High operating leverage combined with high financial leverage will constitute risky situation.
(ii) Normal Situation: One should be high and another should be low i.e., if company has a low operating leverage, financial leverage can be higher and vice versa.
Illustration : 8
Calculate the degree of operating leverage (DOL), degree financial leverage (DFL) and the degree of combined leverage (DCL) for the following firms and interpret the results:
Firm A B C
Output (Units)
Fixed costs (Rs.)
Variable cost per unit (Rs.)
Interest on borrowed capital (Rs.)
Selling price per unit (Rs.) 60,000
7,000
0.20
4,000
0.60 15,000
14,000
1.50
8,000
5.00 1,00,000
1,500
0.02
Nil
0.10

Solution

Firm
A B C
Output-units 60,000 15,000 1,00,000
Rs. Rs. Rs.
Selling Price per unit
Variable Cost per unit
Contribution per unit 0.60
0.20
0.40 5.00
1.50
3.50 0.10
0.02
0.08
Total Contribution (60,000 x 0.40)
Less : Fixed Costs 24,000
7,000 52,500
14,000 8,000
1,500
E.B.I.T. or Operating Profit
Less : Interest 17,000
4,000 38,5000
8,000 6,5000
Nil
Profit Before Tax (P.B.T) 13,000 30,500 6,500
Degree of Operating Leverage = 24,000 52,500 8,000
17,000 38,500 6,500
= 1.41 = 1.36 = 1.23
 
Degree of Financial Leverage = 17,000 38,500 6,500
13,000 30,500 6,500
= 1.31 = 1.26 = 1.00
Degree of Combined Leverage = 24,000 52,500 8,000
13,000 30,500 6,500
= 1.85 = 1.72 = 1.23

Interpretation : High operating leverage combined with high financial leverage will constitute risky situation. One should be high and another should be low. Low operating leverage combined with low financial leverage will constitute an ideal situation. Hence, firm ‘C’ is an ideal one because it has low fixed cost and no interest P/V ratio also is highest i.e., 80%.
SUMMARY
Cost structure, capital structure and asset structure are very important factors in maximises EPS or return on equity (ROE) of a company. Cost structure in terms of fixed and variable costs gives rise to ‘operating leverage’ and the capital structure, in terms of fixed & variable cost securities to financial leverage. The capital structure decision is significant managerial decision which influences the shareholders return and risk and ultimately the value of firm. This lesson provides an understanding about the concept of leverage. It identifies ‘business risk’ and financial risk and explain and calculate financial and operating leverages. It also examines the impact of leverages on EPS.
Technical words used
EPS – EBIT (Earnings before interest and taxes)
ROI – Capital structure leverage.
REVIEW QUESTIONS
1. What is meant by the term ‘Leverage’? What are its types? With what type of risk is each leverage generally associated?
2. Why is increasing leverage also indicative of increasing risk? State the situation when there is neither a financial risk nor business risk.
3. What is meant by the concept ‘Finance Risk’? What is the relationship between leverage and the cost of capital, Explain.
4. Why must the financial manager keep in mind the firm’s degree of financial leverage in evaluating various financial plans? When does financial leverage become favourable?
5. How does break-even analaysis help in profit planning and capital structure planning? Explain with suitable illustration.
6. Explain the significance of operating and financial leverage analysis for a financial executive in corporate profit and financial structure planning.
7. What is combined leverage? What does it measure? What would be the change in the degree of combined leverage, assuming other things being equal, in each of the following situation?
(a) the fixed cost increases, (b) the firm’s EBT level increases (c) the firms sales price decreases, (d) the firm’s variable cost per unit decreases.
8. What is the “indifference Point” and why is it so called? What is the usefulness of it in capital structure planning?
PRACTICAL PROBLEMS
1. The following information is available from the records of a company:
Selling Price Rs.28 per unit. Variable Cost Rs.18 per unit Break-Even point 4,000 units.
You are required to find out the degree of operating leverage for (i) 5,000 units of output (ii) 6,000 units of output and (iii) 8,000 units of output.
[Ans.: (i) 5 times or 500% (ii) 3 times or 300% (iii) 2 times or 200%]
2. Below is given the profitability statement of Kamath & Company Ltd. for the year ending 31st December, 1994:
(in Rupees)
Sales
Variable cost 4,80,000
2,80,000
Contribution (C)
Fixed Costs 2,00,000
1,20,000
Operating profit or EBIT
Interest 80,000
30,000
Profit before Tax (PBT) 50,000

From the above data, you are required to compute (i) Degree of Operating Leverage, (ii) Degree of Financial Leverage, and (iii) Degree of Combined Leverage. [Ans. : (i) 2.5 of 250% etc.)
SUGGESTED READINGS
1. Pandey I.M. : Financial Management,
New Delhi, Vikas Publishing House.
2. Rathnam, P.V. : Financial Advisor,
Allahabad, Kitab Mahal
3. Sharma R.K. & Gupta S.K. : Financial Management
Ludhiana, Kalyani Publishers

 

LESSON 6: CAPITAL STRUCTURE THEORIES

LEARNING OBJECTIVES
• To understand concept of leveraging in financial decision.
• To understand the concept of working capital management.
• To understand the basic approaches in financing mix .
INTRODUCTION: In finance capital structure refers to the way a company finances its assets through some combination of equity, debt and hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage.In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy cost , agency costs , taxation, information assymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.
The capital structure of a company refers to a containation of the long-term finances used by the firm. The theory of capital structure is closely related to the firm’s cost of capital. The decision regarding the capital structure or the financial leverage or the financing wise is based on the objective of achieving the maximization of shareholders wealth. To design capital structure, we should consider the following two propositons :
(i) Wealth maximization is attained.
(ii) Best approximation to the optimal capital structure.




CONCEPT OF LEVERAGING IN FINANCIAL DECISION
The term leverage may be defined as the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return. Consequently, the earnings available to the shareholders as also the risk are affected. If earnings less the variable costs exceed the fixed cost, or earnings before interest and taxes exceed the fixed return requirements, the leverage is called favorable. When they do not, the result is unfavorable leverage. There are two types of leverages – financial leverage and operating leverage. The leverage associated with investment activities is called as operating leverage and that associated with financing activities is called as financial leverage.

Factors Determining Capital Structure
(1) Minimization of Risk:
(a) Capital structure must be consistent with business risk.
(b) It should result in a certain level of financial risk.
(2) Control: It should reflect the management’s philosophy of control over the firm.
(3) Flexibility: It refers to the ability of the firm to meet the requirements of the changing Situations.
(4) Profitability : It should be profitable from the equity shareholders point of view.
(5) Solvency : The use of excessive debt may threaten the solvency of the company
PROCESS OF CAPITAL STRUCTURE DECISION


ASSUMPTIONS’ AND DEFINITIONS: Generally the following assumptions are made to establish and examine relationship between capital structure and cost of capital or firm value:
• There is no corporate or personal tax or Income tax though one-can examine the tax implications.
• The firm pays all its earnings as dividends.- 100%b dividend payout radio
• Investors have identified subjective profitability distribution of operating income (EBIT).
• The EBIT (operating income) is not expected to grow oe decrease over time.
• A firm can change its capital structure instantaneously without incurring transaction costs.
• In discussing the theories of capital structure, we will consider the following notations :
E = Market value of the Equity
D = Market value of the Debt
V = Market value of the Firm = E +D
I = Total Interest Payments
T = Tax Rate
EBIT/NOP = Earnings Before Interest and Tax or Net Operating Profit
PAT = Profit After Tax
D0 = Dividend at time 0 (i.e. now)
D1 = Expected dividend at the end of Year 1.
Po = Current Market Price per share
P1 = Expected Market Price per share at the end of Year 1.

Different Theories of Capital Structure
(1) Net Income (NI) approach
(2) Net Operating Income (NOI) Approach
(3) Traditional Approach
(4) Modigliani-Miller Model
(a) Without taxes
(b) With taxes.

Net Income Approach
As suggested by David Durand, this theory states that there is a relationship between the Capital Structure and the value of the firm. According tp approach the cost of debt rD and the cost of equity rE remain unchanged when D/E varies. The constancy of rD and rE with respect to D/E means that rA the average cost of capital measured as
rA = rD (D/D+E) + rE (E/D+E) declines as D/E increases. This happens because when D/E increases rD which is lower than rE receives higher weight in the calculation of rA
According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weightage in the calculation of the cost of capital.
The formula to calculate the average cost of capital is as follows:
Ko = Kd (B/ (B+S)) + Ke (S/(B+S))
Where:
Ko is the average cost of capital
Kd is the cost of debt
B is the market value of debt
S is the market value of equity
Ke is the cost of equity
Assumptions
(1) Toil Capital requirement of the firm are given and remain constant
(2) Kd < Ke
(3) Kd and Ke are constant
(4) Ko decreases with the increase in leverage.

ILLUSTRATION.
FIRM A FIRM B
Earnings before Interest of Tax (EBIT) 2, 00,000 2, 00,000
Interest — 50,000
Equity Earnings (E) 2, 00,000 1,50,000

Cost of Equity (Ke) 12% 12%

Cost of Debt (Kd) 10% 10%

Market Value of Equity= E/ Ke 16, 66,667 12, 50,000

Market Value of Debt =I /Ke NIL 5,00,000

Total Value of the Firm [E+D] 16, 66,667 17,50,000

Overall cost of capital (K0) EBIT/E+D 12% 11.43%
Net Operating income Approach (NOI)
According to this approach:
• The overall capitalisation rate remains constant for all levels of financial leverage
• The cost of debt also remains constant for all levels of financial leverage
• The cost of equity increases linearly with financial leverage
ILLUSTRATION:
FIRM A FIRM B
Net operating income (O) 10000 10000
Overall capitalization rate (rA) 0.15 0.15
Total Market Value (V) 66667 66667
Interest On Debt (I) 1000 3000
Debt Capitalization rate (rD ) 0.10 0.10
Market value of Debt (D) 10000 30000
Market value of Equity (E) 56667 36667
Degree of Leverage (D/E) 0.176 0.818
The equity capitalization rate of Firm A and Firm B are as follows:
Equity earnings/ market value of equity
Firm A 9000/ 56667 =0.159 =15.90%
Firm B 7000/ 36667 =0.191 =, 19.10%
Using the equation: rE = rA+ (rA - rD) (D/E) , we can get for
Firm A = 15+(15-10) × 0.176= 15.90%
Firm B = 15+(15-10) ×0.818 = 19.10
Traditional or Intermediate Approach
This approach is midway between the NI and the NOI approach. The main propositions of this approach are:
The cost of debt remains almost constant up to a certain degree of leverage but rises thereafter at an increasing rate.
• The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter.
• The cost of capital due to the behaviour of the cost of debt and cost of equity
o Decreases up to a certain point
o Remains more or less constant for moderate increases in leverage thereafter
o Rises beyond that level at an increasing rate.
MM Approach
According to this approach, the capital structure decision of a firm is irrelevant. This approach supports the NOI approach and provides a behavioural justification for it
Additional assumptions of this approach include:
• Capital markets are perfect. All information is freely available and there are no transaction costs
• All investors are rational
• Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk
• There are no taxes
MM approach has two propositions and they are:
Proposition 1 : “ the value of the firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure.” This is identical to NOI (Net operating Income approach)
In symbols: V = D+ E = O/r
Where V is the market value of the firm, D is the market value of debt , E is the market value of equity, O is trhe expected operating income and r is thediscount rate applicable to the risk class to which the firm belongs.
Proposition II:” The expected return on equity is equal to the expected rate of return on assets plus a premium. The premium is equal to Debt-Equity ratio times the difference between the expected treturn on assets and the expected return on debt.”
This approach indicates that the capital structure is irrelevant because of the arbitrage process which will correct any imbalance i.e. expectations will change and a stage will be reached where further arbitrage is not possible. .
Criticism of MM theory::The leverage irrelevance theorem of MM is valid provided 0market assumptions underlying the ir analysis are satisfied. The real world , however, is characterized by various imperfections:
• Firms are liable to pay taxes on their income.
• Bankruptcy costs are quite high.
• Agency costs exist because of conflict between managers and shareholders and between shareholders and creditors.
• Mangers prefer to have a certain sequence of financing.
• Informational asymmetric exist because mangers are better informed than investors.
• Personal leverage and corporate leverage are not perfect substitution.
REVIEW QUESTIONS
1. Explain “Net Income approach” to the problem of capital structure.
2. Explain “Net Operating Income Approach” as suggested by Durand to capital structure planning.
3. Explain briefly the view of traditional writers on the relationship between capital structure and the value of the firm.
4. Give a critical appraisal of the traditional approach and the Modigliani-Miller Approach to the problem of capital structure.
5. Is the M.M. thesis realistic with respect to capital structure and the value of a firm? If not, what are its main weakness?
6. How can the effect of profitability on designing an appropriate capital structure be analysed? Illustrate your answer with the help of EBIT-EPS analysis.
7. “The total value of a firm remains unchanged regardless of variations in its financing mix”. Discuss this statement and point out the role of arbitraging and home made leverage.
SUGGESTED READINGS
1. Pandey, I.M. : Financial Management,
New Delhi, Vikas Publishing House.
2. Rathnam, P.V. : Financial Advisor,
Allahabad, Kitab Mahal.
3. Sharma R.K. & Gupta S.K. : Financial Management,
Ludhiana, Kalyani Publishers.

 
LESSON 7: WORKING CAPITAL MANAGEMENT
LEARNING OBJECTIVES
• Concept of Working Capital
• Classification of Working Capital
• Elements of Working Capital
• Assessment of Working Capital Requirements
• Problems of Inadequacy of Working Capital
• Reasons for inadequate of Working Capital
• Excessive Working Capital
• Working capital forecasting Techniques.

Concepts of Working Capital
There are two concepts regarding the meaning of Working Capital. Net Working Capital and Gross Working Capital. According to one School of thought supported by distinguished authorities like Lincoln, Doris, Stevens and Saliers) Working Capital is the excess of current assets over current liabilities, as designated in the followed equation:
Working Capital=Current Assets – Current Liabilities
According to the other School of thought working capital represents only the current (capital) assets. There is basis for both these contentions. To understand them, correct conception of current assets and liabilities is essential. Current Assets are those assets that in the ordinary course of business can be or will be turned into cash within a brief period (not exceeding one year, normally) without undergoing diminishing of value and without disrupting the organisation. Examples of current assets are given below; (i) Cash in hand and in bank; (ii) Accounts receivable from customers (less reserve); (ii) Promissory Notes and Bills receivable from customers (less reserve); (iv) Inventories comprising of raw materials, work-in-progress, finished goods (of manufacturers) (v) marketable securities held as temporary investment; (vi) Prepaid expenses; (vii) Maintenance materials, (viii) Accrued income.
Current Liabilities are those liabilities intended at their inception to be paid in ordinary course of business within a reasonable short time (normally within a year) out of the current assets or by creating another current liability or the income of the business. Its examples : (i) Accounts payable to creditors; (ii) Notes or Bills payable; (iii) Accrued expenses, such as accrued taxes, salaries and interest; (iv) Bank over draft, cash credit; (v) Bonds to be paid within one year; (vi) Dividends declared and payable.
The arguments of the first school of thought in regarding working capital as the excess of current assets over current liabilities are as follows : (1) It is an established definition of working capital which is in use since long; (2) This concept of working capital enables the shareholders to judge the financial soundness of the concern and the extent of protection afforded to them. It is particularly because with an increase in short-tem borrowings the working capital does not increase; it will increase only by following the policy of sloughing back of profits or conversion of fixed assets into liquid assets or by procuring fresh capital from shareholders; (3) Any concern with an excess of current liabilities can successfully tide over periods of emergency, e.g., depression; (4) Further, there is no obligation on the part of the company to return the amount invested by the shareholders; (5) such a definition is of great use in ascertaining the true financial position of companies having current assets of similar amount.
Classification of Working Capital
Generally speaking, the amount of funds required for operating needs varies from time to time in every business. But a certain amount of assets in the form of working capital are always required, if a business has to carry out its functions efficiently and without a break. These two types of requirements – permanent and variable are the basis for a convenient classification of working capital:









1. Permanent or Fixed Working Capital
As is apparent from the adjective ‘permanent’ it is that part of the capital which is permanently locked up in the circulation of current assets and in keeping it moving. For example, every manufacturing concern has to maintain stock of raw materials, works-in-progress (work-in-process), finished products, loose tools and spare parts. It also requires money for the payment of wages and salaries throughout the year.
The permanent or fixed working capital can again be subdivided into (i) Regular Working Capital and (ii) Reserve Margin or Cushion Working Capital. It is the minimum amount of liquid capital needed to keep up the circulation of the capital from cash to inventories to receivables and back again to cash. This would include a sufficient cash balance in the bank to discount all bills, maintain an adequate supply of a raw materials for processing, carry a sufficient stock of finished goods to give prompt delivery and effect the lowest manufacturing costs, and enought cash to carry the necessary accounts receivables for the type of business engaged in. Reserve margin or cushion working capital is the excess over the need for regular working capital that should be provided for contingencies that arise at unstated period. The contigencies included (a) raising prices, which may make it necessary to have more money to carry inventories and receivables, or may make it advisable to increase inventories; (b) business depression, which may raise the amount of cash required to ride out usually stagnant periods; (c) strikes, fires and unexpectedly severe competition, which use up extra supplies of cash; and (d) special operations, such as experiments with new products or with new method of distribution, war contracts, contractors to supply new businesses, and the like, which can be undertaken only if sufficient funds are available, and which in many cases mean the survival of a business.
2. Variable Working Capital
The variable working capital changes with the volume of business. It may be sub-divided into (i) Seasonal and (ii) Special Working Capital. In many lines of business (e.g., Gur or sugar and Fur industry operations are highly seasonal and, as a result, working capital requirements vary greatly during the year. The capital required to meet the seasonal need of industry is termed as Seasonal Working Capital. On the other hand, Special Working Capital is that part of the variable working capital which is required for financing special operations, such as the inauguration of extensive marketing campaigns, experiments with new products or with new methods of distribution, carrying put of special jobs and similar to the operations that are outside the usual business of buying, fabricating and selling.
This distinction between permanent and variable working capital is of great significance particularly in arranging the finance of raw enterprise. Regular or fixed working capital should be raised in the same way as fixed capitals is procured, through a permanent investment of the owner or through long-term borrowing. As business expands, this regular capital will necessarily expand. If the cash returning from sales includes a large enough profit to take care of expanding operations and growing inventories, the necessary additional working capital may be provided by the earned surplus of the business. Variable needs can, however, be financed out of short-tem borrowings from the Bank or from public in the form of deposits.




The position with regard to the ‘fixed working capital’ and ‘variable working capital’ can be shown with the help of the following figures:











Fig. 1. Steady Firm’s working capital requirement
From the above figure it should not be presumed that permanent working capital shall remain fixed throughout the life of the concern. As the size of the business grows, permanent working capital too is bound to grow. The position can be depicted with the help of the following figure:













Fig.2 Growth Firm’s working capital requirement

So unlike a static concern, the fixed working capital of a growing concern will increase with the growth in its size.
Elements of Working Capital
(i) Cash : Management of cash is very important from firm’s point of view. There must be balance between the twin objectives of liquidity and cost while managing cash. There must be adequate cash to meet the requirements of all segments of the organisation. Excess cash may be costly for the concern as it will increase the cost in terms of interest. Less cash may also be harmful to the concern as it will not be able to meet the liabilities as the appropriate time. Thus the requirements of the cash must be estimated properly either by preparing cash flow statements or cash budgets. This will help the management to invest the idle funds remuneratively and shortages, if any, may be met timely by making different arrangements. Therefore, it is necessary that every segment of the organisation must have adequate cash in order to meet the requirements of that segment without having surplus balances. Cash management is highly centralized whereby cash inflows and outflows are centrally controlled but in multi-divisional companies it may be possible to decentralize cash requirements so that every company may have cash for its requirements.
(ii) Marketable (Temporary) Investment : Firms hold temporary investment for surplus cash flows arising either during seasonal operations or out of sale of long term securities. In most cases the securities are held primarily for precautionary purposes – most firms prefer to rely on bank credit to meet temporary transaction or speculative needs, but to hold some liquid assets to guard against a possible shortage of bank credit. The cash forecast may indicate whether excess cash available is temporary or not. If it is found that excess liquidity will be temporary, the cash should then be invested in marketable but temporary investments. It should be remembered that even if a substantial part of idle cash is invested even though for a short period, the interest earned thereon is significant.
(iii) Receivables : Management of receivables involves a trade off between the gains due to additional sales on account of liberal credit facilities and additional cost of recovering those debts. If liberal credit facilities are given to the customers, sales will definitely increase. But on the other hand bad debts, collection expenses and interest charge will increase. Similarly if the credit policy is strict, the sales will be less and customers may go to the competitors where liberal credit facilities are available. This will result in loss of profit because of less sales but there will be saving because of less bad debts, collection and interest charges. Management of debtors also covers analysis of the risk associated with advancing credit to a particular customer. Follow up of debtors and credit collection are the remaining aspects of receivables management.
(iv) Inventories : Inventories include all investments in raw materials, work-in-process, stores, spare parts and finished goods; they constitute an important part of the current assets. The purchase of inventory involves investment which must be properly controlled. There are many issues of inventory management which must be taken into consideration as fixation of minimum and maximum level, deciding the issue of pricing policy, setting up the procedures for receipts and inspection, determining the economic ordering quantity, providing proper storage facilities, keeping control on obsolescence and setting up an effective information system with reference to inventories. Inventory management requires the attention of stores manager, production manager and financial manager. There must be adequate inventories in order to avoid the disadvantages of both inadequate and excessive inventories.
(v) Creditors : Management of creditors is very important aspect of working capital. If the payment of creditors is delayed there is a possibility of saving of some interest but it can be very costly because it will spoil the goodwill of the concern in the market. As far as possible, the credit manager should try to get the liberal credit terms so that payment may be made at the stipulated time.
Assessment of Working Capital Requirements
The following factors are considered for a proper of the quantum of working capital requirements:
(i) The Production Cycle : There is bound to be time span in raw materials input in manufacturing process and the resultant output as finished product. To sustain such production activities the requirement of investment in the form of working capital is obvious. The lesser the production cycle (or the operating cycle) the lesser will be the requirements of working capital. There are enterprises due to their nature of business will have shorter cycle than others. Further, even within the same group of industries, the more the application of technological advances in, will result in shortening the operating cycle. In this context the choice of product requiring shorter or greater operating cycle will have a direct impact on the working capital requirements. This is a factor of paramount importance irrespective of whether a new industry is venturing production of the first time or an on-going business. Hence it can be said that the time span for each stage of the process of manufacture if geared to improve upon will lead to better efficiency and utilization of working capital.
(ii) Work-in-Process : A close attention is to be given to the accumulation of work-in-progress or work-in-process. Unless the sequences of production process leading to conversion into finished product is kept under close observation to achieve better production and productivity, more and more working capital funds will be tied up. In this context, proper production planning and control is vital.
(iii) Terms of Credit from Suppliers of Materials and Service : The more the terms of credit is favourable i.e., the more the time allowed by the creditor’s to pay them, the lesser will be the requirement of working capital. Hence, the negotiation with the suppliers in respect of price and the credit period is an important aspect in working capital management. In this process the impact of the requirement of finance is shared by the creditors for goods and services.
(iv) Realisation from Sundry Debtors : The lesser the time span between selling the product and the realization the more will be the quicker inflow of cash. This, in turn, will reduce the finance required for working capital purpose. A realistic credit control will reduce locking up of finance in the form of sundry debtors. The impact of better realisation will not only help in reducing the working capital fund requirement but also can boost up the finance needed for other operational needs. The important factors in credit control will be : (a) volume of credit sales desired; (b) terms of sales and (c) collection policy.
(v) Control on Inventories : The decision to maintain appropriate minimum inventories either in the form of raw material, stores materials, work-in-process or finished products is an important factor in controlling finance locked up. The better the control on inventories the lesser will be the requirements of working capital. The following vital factors involved in inventory management are to be considered fro an effective inventory control : (a) volume of sales, (b) seasonal variation in sales, (c) selling ‘off the shelf”, (d) stocking to gain from higher price under inflationary conditions, (e) the operating cycle, i.e., the time interval between manufacturing, selling and realization, and (f) safety or buffer stock. A minimum policy levels of stock may have to be maintained to seize the opportunity of selling when there is spark in demand for the product.
(vi) Liquidity versus Profitability : The management dilemma as to the optimal balancing between liquidity (or solvency) and the profitability it another factor of great importance on the determination of the level of working capital requirement. In other words, the level of liquidity and the profitability to be maintained according to the goals of financial management.
(vii) Competitive Conditions : The whole question of cash inflow depends as to the quickness in selling the products and the realisation thereof. In this context, the nature of business and the produce will be the two important contributory factor as the policy on the quantum of working capital requirements.
(viii) Inflation and the Price Level Changes : In an inflationary trend, the impact on working capital is that more finance is needed for the same volume of activity i.e., one has to pay more price for the purchase of same quantity of materials or services to be obtained; Such raising impact of prices can be fully or partly compensated by increasing the selling price of the product. All business may not be in a position to do so due to their nature of product, competitive market or Government’s regulatory price.
(ix) Seasonal Fluctuation and Market Share of Product : There are producer which are mostly in demand in certain periods of the year. In other words, there may not be any saler or only a fraction of the total sale in off-season due to seasonal nature of demand for the product. There may be shifting of demand due to better substitute of the product available. This means the company affected by this economics, attempts to plan diversification to sustain profit, expansion and growth of the business. In certain businesses, demands for products are of seasonal in nature and for certain businesses, the raw materials buying have to be done during certain seasonal timings. Naturally the working capital requirements will be more in certain periods than in others.
(x) Management Policy on Profits, Retained Profit, Tax Planning and Dividend Policy : The adequacy of profit will lead to strengthen the financial position of the business through cash generation which will be ploughed back as internal source of financing. Tax planning is an integral part of working capital planning. It is not only the question of quantum of cash availability for tax payment at the appropriate time but also through tax planning the impact of tax payable can be reduced. Dividend Policy considers the percentage of dividend to be paid to the shareholders as interim and / or final dividend. There must be cash available at the appropriate time after the dividend is declared. This way the dividend payment is connected with working capital management.
(xi) Terms of Agreement : It refers to the terms and conditions of agreement to repay loans taken from bankers and financial institutions and acceptance of ‘fixed deposits’ from public. The questions of fund arrangement whether for working capital needs or to long term loans is to be decided after taking into account the repayment ability. The cash flow projection will have to be made accordingly.
(xii) Cash (Flow) Budget : In order to meet certain cash contingencies it may be necessary to have liquidity in form of marketable securities as cash reservoir. This extra cash reserve may remain as an idle fund. This type of cash reserve is necessary to meet emergency disbursements.
(xiii) Overall Financial and Operational Efficiency : A professionally managed company always applies appropriate tools and techniques to achieve efficiency and utilization of working capital fund. Adequacy of assessment and control of business will lead to improve the ‘working capital turnover’. Management also will have to keep itself abreast of the environment, technological and other changes affecting the business so that an effective and efficient financial management can play a vital role in reducing the problems of working capital management.
(xiv) Urgency of Cash : In order to avoid product becoming obsolete or to under-cut the competitors to hold the market share or in case of emergency for cash funds, it may be necessary to sell out products at a cheaper rate or at a discount or allowing cash rebate for early realisation from sundry debtors (customers). This situation may boost up the cash availability. However, this sort of critical situation should be avoided as this results in reducing profit.
(xv) Importance of Labour Mechanisation : Capital intensive industries, i.e., mechanized and automated industries, will require lower working capital, while labour intensive industries such as small scale and cottage industries will require larger working capital.
(xvi) Proportion of Raw Material to Total Costs : If the raw materials are costly, the firm may require larger working capital while if raw materials are cheaper and constitute a small part of the total cost of production, lower working capital is required.
(xvii) Seasonal variation : During the busy season, a business requires larger working capital while during the slack season a company requires lower working capital. In sugar industry the season is November to June, while in the woollen industry the season is during the winter. Usually the seasonal or variable needs of working capital are financed by temporary borrowing.
(xviii) Banking Connections : If the corporation has good banking connections and bank credit facilities, it may have minimum margin of regular working capital over current liabilities. But in the absence of the availability of bank finance, it should have relatively larger among of net working capital.
(xix) Growth and Expansion : For normal rate of expansion in the volume of business, one may have greater proportion of retained profits to provide for more working capital; but fast growing concerns require larger amount of working capital. A plan of working capital should be formulated with an eye to the futures as well as present needs of a corporation.
Problem of Inadequacy of Working Capital
In case of inadequacy of working capital, a business may have to face the following problems:
(i) Production facilities : It may not be possible to have the full utilisation of the production facilities to the optimum level due to the inability of buying sufficient raw material and / or major renovating of the plant and machinery.
(ii) Raw material Purchases : Advantage of buying at cash discount or on favourable terms may not be possible due to paucity of funds.
(iii) Credit Rating : When financial crisis continues, the credit worthiness of the company may be lost, resulting in poor credit rating.
(iv) Seizing Business Opportunities : In case of boom for the products and for the business, the company may not be in a position to produce more to earn ‘opportunity profit’ as there may be inadequacy of finished products availability.
(v) Proper Maintenance of Plant and Machinery : If the business is on financial crisis, adequate sums may not be available for regular repair and maintenance, renovation or modernization of plant to boost up production and to reduce per unit cost.
(vi) Dividend Policy : In the absence of fund availability it may not be possible to maintain a steady dividend policy. Under such financial constraint, whatever surplus is available will be kept in general reserve account to strengthen the financial soundness of the business.
(vii) Reduced Selling : Due to the constraint in working capital, the company may not be in a position to increase credit sales to boost up the sales revenue.
(viii) Loan arrangement : Due to the emergency for working capital the company may have to pay higher rate of interest for arranging either short-term or long-term loans.
(ix) Liquidity versus Profitability : The lower liquidity position may also result in lower profitability.
(x) Liquidation of the Business : If the liquidity position continues to remain weak, the business may run into liquidation.
To remedy the situation of working capital crisis, the following steps are required :
(a) An appraisal and review is to be conducted to minimize the operating cycle.
(b) Adequate credit control measures are to be adopted for early and prompt realization form the debtors.
(c) Proper planning and control of cash management through cash flow forecasting.
(d) Whether more credit periods can be obtained for buying is to be explored.
Reasons for Inadequacy of Working Capital
Inadequacy or shortage of working capital may arise for various reasons, of which, the main reason are the following:
(i) Operating losses : This may arise when the cost of production and other related costs are more than the sales revenue, reduction in sales, falling prices, increased depreciation, etc. It is obvious that a company facing losses will not have any ‘cash generation’ to sustain its on-going business.
(ii) Extraordinary Losses: There may be exceptional losses due to fall in price of finished product stocks, government action, obsolescence or otherwise. The effect of such a loss will be a reduction in current assets of increase in current liabilities without any corresponding favorable change in the working capital composition.
(iii) Expansion of Business: the Company during the profitable years might have invested substantially in fixed capital assets, increased production and increased credit sales to make the sales volume grow rapidly. Against those activities, the pitfalls of over-trading may show its ugly face subsequently. That is why a balancing judgment between investment, liquidity and profitability is to be drawn and projected to save the business falling into financial crisis. Thus the continuity and growth of the business may be jeopardized. Along with the increases sales there may be increase in inventories and higher sundry debtors. Such excessive build-up of inventories and receivables may amount to alarming figures.
(iv) Payment of dividend and Interest: The payment of interest for borrowings will have to be made as per terms of agreement. Similarly, the payment of dividend may have to be arranged to keep up the business prestige to the public and to the shareholders. There may be profit to declare dividend but there may not be adequate cash to disburse dividend. In case of insufficient funds to meet the aforesaid liabilities, the mobilising of funds will be necessary.

Forecasting Working capital requirements
Working capital requirements can be determined mainly in three ways; per cent-of sales method, Regression analysis method, and the working capital cycle method
(1) Per cent-of Sales Method: It is a traditional and simple method of determining the volume of working capital and its components, sales being dominant factor. In this method, working capital is determined as a per cent of forecasted sales. It is decided on the basis of past observation. if over the year, relationship between sales and working capital is found to be stable, then this relationship may be taken as a standard for the determination of working capital in future also. This relationship between sales and working capital and its various components may be expressed in three ways: (i) as number of days’ of sales, (ii) as turnover, and (iii) as percentage of sales.
The per cent of sales method of determining working capital is simple and easy to understand and is useful in fore casing of working capital requirements, particularly in the short-term. However, the greatest drawback of this method is the assumption of linear relationship between sales and working capital. Therefore, this method cannot be recommended for universal application. It may be found suitable by individual companies in specific situations.
(2) Regression Analysis Method: As stated earlier the regression analysis method is a very useful statistical technique of forecasting. In the sphere of working capital management it helps in making projection after establishing the average relationship in the past years between sales and working capital (current assets) and its various components. The analysis can be carried out through the graphic portrayals (scatter diagrams) or through mathematical formula.
The relationship between sales and working capital or various components may be simple and direct indicating complete indicating complete linearity between the two or may be complex in differing degree involving simple linear regressions or simple curveilinear regression, and multiple regressions situations.
This method, with a range of techniques suitable for simple as well as complex situations, is an undisputed refinement on traditional approaches of forecasting and determining working capital requirements. It is particularly suitable for long-term forecasting.
(3) The Working Capital Cycle Method: The working capital cycle refers to the period that a business enterprise takes in converting cash back into cash. As an example, a manufacturing firm uses cash to acquire inventory of materials that is converted into semi finished goods and then into finished goods. When finished goods are disposed of to customers on credit, accounts receivable are generated. When cash is collected from customers, we again have cash. At this stage one operating cycle is completed. Thus a circle from cash-back-to-cash is called the working capital cycle. This concept is also be termed as “Pipe Line Theory” as popularly known.


Fig.1. Working Capital Cycle










Thus we see that working capital cycle, generally, has the following four distinct stages:
1. The raw materials and stores inventory stage;
2. The semi-finished goods or work-in-progress stage;
3. The finished goods inventory stage; and
4. The accounts receivable or book debts stage.

Each of the above working capital cycle stage is expressed in terms of number of days of relevant activity and requires a level of investment to support it. The sum total of these stage-wise investments will be the total amount of working capital of the firm.
A series of such operating cycle recur one after another and chain continues till the end of the operating period. In this way the entire operating period has a number of operating cycles. It is important to note that velocity or speed of this cycle should not slacken at any stage; otherwise the normal duration of the cycle will be lengthened resulting in an increased need for working fund. The faster the speed of the operating cycle, shorter will be its duration and larger will be the number of total operating cycles in a year (operating period) which in turn would be instrumental in giving the maximum level of turnover with comparatively lower level of working fund.
The four steps involved in this method are: (i) computing the duration of the operating cycle. (ii) calculating the number of operating cycles in the operating period, (iii) estimating the total amount of annual operating expenses, and (iv) ascertaining the total working capital requirements. Each step is discussed with some detail in the following paragraphs.
(i) Duration of operating cycle: The duration is computed in days by adding together the average storage period of raw materials, works-in-progress, finished goods and the average collection period and then deducting from the total the average payment period. The formula to express the framework of the operating cycle is:
O = (R + W + F + D) – C
Where: O = Duration of operating cycle
R = Raw material average storage period
W = Average period of work-in-progress
F = Finished goods average storage period
D = Debtors collection period
C = Creditors payment period
The average inventory, trade creditors, work-in-progress, finished goods and book debts can be computed by adding the opening and closing balances at the end of the year in the respective accounts and dividing the same by two. The average per day figures can be obtained by dividing the concerned annual figures by 365 or the number of days in the given period.
(ii) Number of Operating Cycle in Operating Period: This is found out by dividing the total number of days in the operating period by number of days in the operating cycle as shown below:
N =
Where: N = Number of operating cycle in operating period
P = Number of days in the operating period
O = Duration of operating cycle (in days)
Suppose the operating period is one year (365 days) and the duration of operating cycle is 73 days then the number of operating cycles in the operating period will be:
N =

(iii) Total amount of Annual Operating Expenses: These expenses include purchase of raw materials, direct labour costs and the overhead costs-calculated on the basis of average storage period of raw materials and the time-lag involved in the payment of various items of expenses. The aggregate of such separate average amounts will represent the annual operating expenses.
(iv) Estimating the Working Capital Requirement : This is calculated by dividing the total annual operating expenses by the number of operating cycles in the operating Period as shown below:
R =
Where: R = Requirement of Working Capital (Estimated)
E = Annual Operating Expenses
N = Number of operating cycles in the operating period
The amount of working capital thus estimated is increased by a fixed percentage so as to provide for contingencies and the aggregate figure gives the total estimate of working capital requirements. The operational cycle method of determining working capital requirements gives only an average figure. The fluctuations in the interventing period due to seasonal or other factors and their impact on the working capital requirements cannot be judged in this method. To identify these impacts, continuous short-run detailed forecasting and budget exercises are necessary.
Illustration 1
The following data have been extracted from the financial records of Prabhakar Enterprises Limited:
Raw Materials Rs.8 per unit, Direct Labour,Rs.4 per unit, and Overheads Rs.80,000
Additional information
(i) The company sells annually 25,000 units @ Rs.20 per unit. All the goods produced are sold in the market.
(ii) The average storage period for raw materials is 40 days and for finished goods it is 18 days.
(iii) The suppliers give 60days credit facility to the firm for purchases. The firm also sells goods on 60 days credit to its customers.
(iv) The duration of the production cycle is 15 days and raw material is issued at the beginning of each production cycle.
(v) 25% of the average working capital is kept as cash for contingencies.
On the basis of the above information, estimate the total working capital requirements of the firm under Operating Cycle Method.
Solution

During of Operating Cycle Days
i.
ii.
iii.
iv. Materials storage period
Production cycle period
Finished goods storage period
Average collection period 40
15
18
60

Less : Average payment period 133
60
During of Operating Cycle 73

Number of Operating Cycles in a year : Total number of Days in a year divided by Duration of Operating Cycle = Cycles in a year.
Total Annual Operating Expenses
i.
ii.
iii. Raw Material
Direct Labour
Overheads 25,000 x 8
25,000 x 4 2,00,000
1,00,000
80,000
Total Operating Expenses for the year 3,80,000

Total Operating Expenses for the year
Estimating Working Capital Requirements
=
Add : 25%m of the above by cash (for contingencies) 19,000
Total Working Capital Requirement 95,000

Illustration : 2
Messrs Senthil Industries Ltd. are engaged in large scale retailing. From the following information, you are required to forecast their working capital requirements of this trading concern.
Project annual sales Rs.65 lakhs
Percentage of Net Profit on cost of sales 25%
Average credit allowed to Debtors 10 weeks
Average credit allowed by Creditors 4 weeks
Average stock carrying (in terms of sales requirement) 8 weeks
Add 10% to computed figures to allow for contigencies.

Solution
Statement of Working Capital Requirements
Selling Price Basis
(Rs. in lakhs) Cost Price
Basis
(Rs. in lakhs)
Current Assets
Stock Rs.1.00 lakh x 8 weeks 8.00 8.00
Debtors
At cost equivalent Rs.1.00 lakh x10=10.00 lakh 10.00
Profit Rs. lakh
12.50
20.50 18.00
Less : Current Liabilities
Credit Rs.1.00 lakh x 4 weeks 4.00 4.00
Working Capital computed 16.50 14.00
Add : 10% for contingencies 1.65 1.40
Net Working Capital required 18.15 15.40

Per annum Rs.
Projected annual sales
Net Profit 20% on Sales or 25% on cost of sales
Cost of sales (65-13) = Sales – Profit
Cost of sales per week (52 weeks in a year) 65 lakhs
13 lakhs
52 lakhs
1.00 lakhs

Note : It has been assumed that the creditors include those for both goods and expenses and that all such creditors allow one month credit on average.
Interpretation of Result : The amount of working capital fund above is to be interpreted as the amount to be blocked up in inventory, debtors (minus creditors) at any time during the period (year) in view, in order that the anticipated activity (sales primarily) can go on smoothly. The amount is not for a period of time but at any point of time. It represents the maximum (or the highest) quantum of locking up at any time during the period.
Illustration : 3
Ramaraj Brothers Private Limited sells goods on a gross profit of 25%. Depreciation in taken into account as a part of cost of production. The following are the annual figures given to you :
Rs.
Sales (two months credit) 18,00,000
Materials consumed (one month’s credit) 4,50,000

Wages paid (one month lag in payment) 3,60,000
Cash manufacturing expenses (one month lag in payment) 4,80,000
Sales promotion expenses (paid quarterly in advance) 60,000
Income tax payable in 4 installments of which one lies in the next year 1,50,000

The company keeps one month’s stock each of raw materials and finished goods. It also keeps Rs.1,00,000 in cash. You are required to estimate the working capital requirements of the company on cash basis assuming 15% safety margin.

Solution
Statement of Working Capital Requirements
Rs.
A. Current Assets
Debtors (cash cost of goods sold, i.e., 14,60,000 x 2/12)

2,45,000
Prepaid sales expenses 15,000
Inventories :
Raw materials (4,50,000 / 12)
Finished goods (12,90,000 / 12)
Cash-in-hand

37,500
1,07,500
1,00,000
5,05,000
B. Current Liabilities
Sundry creditors
Outstanding manufacturing expenses
Outstanding administration expenses
Provision for taxation
Outstanding wages (4,50,000 / 12)
(4,80,000 / 12)
(1,20,000 / 12)
(1,50,000 / 4)
(3,60,000 / 12) 37,500
40,000
10,000
37,500
30,000
1,55,000
Working capital [ (A) – (B)] 3,50,000
Add : 15% for contingencies 52,500
Total Working Capital required 4,02,500

Working Notes :
1. Total Manufacturing Expenses

Rs.
Sales 18,00,000
Less : Gross Profit 25% of sales 4,50,000
Total Cost 13,50,000
Less : Cost of Materials
Wages Rs.4,50,000
3,60,000
8,10,000
Manufacturing Expenses 5,40,000

2. Depreciation
Total Manufacturing Expenses 5,40,000
Less : Cash Manufacturing Expenses 4,80,000
Depreciation 60,000
3. Total Cash Cost
Total Manufacturing Cost 13,50,000
Less : Depreciation 60,000
12,90,000
Add : Administration Expenses 1,20,000
Sales Promotion Expenses 60,000
Total Cash Cost 14,70,000


WORKING CAPITAL FINANCING MIX

In comparing financing plans we should distinguish between three different kinds of financing: (i) permanent source of financing, (ii) temporary source of financing and (iii) the sponteneous short-term financing. A firm’s investment is namely financed by the some of its spontaneous, temporary and permanent sources of financing.
i. A permanent investment in an asset is one that the firm expects to hold for period longer than one year. Permanent investments are made in the firm’s minimum level of current assets as well as in its fixed assets. Permanent sources of financing include intermediate and long-term debt, preference share and equity share.
ii. Temporary investments are comprised of the firm’s investments in current assets, which will be liquidated and not replaced within the current year. For example a seasonal increase in the level of inventory is a temporary investment as the holding up in inventories will be eliminated when it is no longer needed. Temporary source of financing is a current liability. Thus, temporary financing consists of the various sources of short-term debt including secured and unsecured bank loans, commercial paper, factoring of accounts receivables, and public deposits.
iii. Beside permanent and temporary sources of financing, there also exist spontaneous sources. Spontaneous sources consist of the trade credit and other accounts payable that arise spontaneously in the firm’s day-to-day operation examples include wages and salaries payable, accrued interest, and accrued taxes. These expenses generally arise in direct conjunction with the firm’s ongoing operations, they are referred to as spontaneous. Popular example of a spontaneous source of financing involves the use of trade credit. As the firm acquires materials for its inventories, credit is often made available spontaneously or on demand by the firm’s suppliers. Trade credit appears on the firm’s balance sheet as accounts payable. The size of the accounts payable balance varies directly with the firm’s purchases of inventory items, which in turn are related to the firm’s anticipated sales. Thus, a part of the financing needs by the firm is spontaneously provided by its use of trade credit.
The long term working capital can be conveniently financed by (a) owners equity e.g. shares and retained earnings, (b) lender’s equity e.g., debentures, and (c) fixed assets reduction e.g., sale of assets, depreciation of fixed assets etc. This capital can be preferably obtained from owner’s equity as they do not carry with them any fixed charges in the form of interest or dividend and so do not throw any burden on the company. Intermediate working capital funds are ordinarily raised for a period varying from 3 to 5 years through loans which are repayable in installments e.g. working capital term-loans from the commercial banks or from finance corporations.
Matching (or Moderate) Approach
Matching approach is also called Hedging principle. It involves matching the cash flow generating characteristics of a firm’s assets with the maturity of the source of financing used. The rationale for matching is that since the purpose of financing is to pay for assets, when the asset is expected to be relinquished so should the financing be relinquished. Obtaining the needed funds from a long-term source (longer than one year) would mean that the firm would still have the funds after the inventories has been sold. In this case the firm would have “excess” liquidity, which they either hold in cash or invest in low yielding marketable securities. This would result in an overall lowering of firm profits. Similarly arranging finance for shorter periods that the assets require is also costly in that there will be extra transaction sots involved in continually arranging new short-term financing. Also, there is always the risk that new financing cannot be obtained in times of economic difficulty.
The firm’s permanent investment in assets is financed by the use of either permanent source of financing (intermediate and long-term debt, preference shares, and equity shares) or spontaneous source (trade credit and other accounts payable), its temporary investment in assets is financed with temporary (short-term debt) and / or spontaneous sources of financing. Note the matching approach has been modified to state: Asset needs of the firm, not financed by spontaneous sources, should be financed in accordance with the rule : permanent assets investments financed with permanent sources and temporary investments financed with temporary sources.
Since total assets must always equal to the sum of spontaneous, temporary and permanent sources of financing, the hedging approach provides the financial manager with the basis for determining the sources of financing to use at any point in time.
Aggressive Approach
The firm’s financing plan is said to be aggressive if the firm uses more short-term negotiated financing than is needed under a matching approach. The firm is no longer financing all its permanent assets with long-term financing. Such plans are said to be aggressive because they involve a relatively heavy use of (riskier) short-term financing. The more short-term financing used relative to long-term financing, the more aggressive is the financing plan. Some firms are even financing part of their long-term assets with short-terms debt, which would be a highly aggressive plan.
Conservative Approach
Conservative financing plans are those plans that use more long-term financing than is needed under a matching approach. The firm is financing a portion of its temporary current assets requirements with long-term financing. Also, in periods when the firm has no temporary current assets the firm has excess (unneeded) financing available that will be invested in marketable securities. These plans are called conservative because they involve relatively heavy use of (less risky) long-term financing.
Comparison of Conservative, Hedging and Aggressive Approach
These approaches to working capital financing can be compared on the basis of (a) cost considerations, (b) profitability considerations, and (c) risk considerations (probability of technical insolvency). The following statements gives a comparative evaluation.
Comparative Evaluation of Financing Approaches
Financing Approaches of Plan Cost Risk Return of Profitability
Conservative
Hedging
Aggressive High
Moderate
Low Low
Moderate
High Low
Moderate
High

Balanced Policy
Because of the impracticalities in implementing the matching policy and the extreme nature of the other two polices, most financial managers opt for a compromise position. Such a position is the balanced policy. As its name implies, management adopting this policy balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk. The long-term financing is used to support permanent current assets and part of the temporary current assets. Thus short-term credit is used to cover the remaining working capital needs during seasonal peaks. This implies that as any seasonal borrowings are repaid, surplus funds are invested in marketable securities.
This policy has the desirable attribute of providing a margin of safety not found in the other policies. It temporary needs for current assets exceed management’s expectations, the firm will still be able to use unused short-term lines of credit to fund them. Similarly, if the contraction of current assets is less than expected, short-term loan payments can still be met, but less surplus cash will be available for investment in marketable securities. In contrast to the other working capital policies, a balanced policy will demand more management time and effort. Under the policy, the financial manager will not only have to arrange and maintain short-term sources of financing but must be prepared to manage in investment of excess funds.
The Appropriate Working Capital Policy
The analysis so far has offered insights into risk-profitability trade-off inherent in a variety of different policies. Just there is no optimal capital structure that all firms should adopt, there is no one optimal working capital policy that all firms should employ. Which particular policy is chosen by a firm will depend on the uncertainty regarding the magnitude and timing of cash flows associated with sales; the greater this uncertainty, the higher the level of working capital necessary. In addition, the cash conversion cycle will influence a firm’s working policy; the longer the time required to convert current assets into cash, the greater the risk of liquidity. Finally, in practice, the more risk averse management is the greater will be the net working capital position. The management of working capital is an ongoing responsibility that involves many interrelated and simultaneous decisions about the level and financing of current assets. The considerations and general guidelines offered in this lesson should be useful in establishing an overall net working capital policy.

REVIEW QUESTIONS
1. Discuss the importance of working capital for a manufacturing concern.
2. Explain the various determinants of working capital of a concern.
3. What are the advantages of having ample working capital funds?
4. Differentiate between fixed working capital and variable working capital.
5. What are the different principles of working capital management?
6. Summaries the cause for and changes in working capital of a firm.
7. What are the different methods of forecasting working capital requirements?
8. Explain: (a) Core current assets (b) Working Capital Gap (c) Working capital cycle.
9. Evaluate the following statement: “A firm can reduce is risk of liquidity with higher current asset investments, but the return on capital goes down”.
10. What are the risk-return trade-offs involved in choosing a mix of short – and long-term financing?
11. There are four different policies that managers must consider in designing their working capital policy. Explain the salient features of each policy. What are the advantages and disadvantages of each such policy?

PRACTICAL PROBLEMS
1. The Board of Directors of Guru Nanak Engineering Company Private Ltd, requests you to prepare a statement showing the Working Capital Requirements Forecast for a level of activity of 1,56,000 units of production.
A.
Per units Rs.
Raw materials
Direct Labour
Overheads 90
40
75

Profit 205
60
Selling price per unit 265

B. (i) Raw materials are in stock on average one month.
(ii) Materials are in process, on average two weeks.
(iii) Finished goods are in stock, on average one month
(iv) Credit allowed by suppliers one month
(v) Time lag in payment from debtors 2 months
(vi) Lag in payment of wages 1 ½ weeks.
(vii) Lag in payment of overheads is one month
20% of the output is sold against cash. Cash in hand and at Bank is expected to be Rs.60,000. It is to be assumed that production is carried on evenly throughout the year, wages and overheads accure similarly and a time period of 4 weeks is equivalent to a month.
(Ans: Working Capital Required Rs.74,13,000)
Notes (i) Since wages and overheads accrue evenly on average, half the wages and overhead would be included in working progress. Alternatively if it is assumed that the direct labour and overhead are introduced at the beginning, full wages and overhead would be included.
2. A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Raw Materials 40%
Labour 10%
Overheads 30%
The following further particulars are available:
(b) Raw materials are to remain in stores on an average 6 weeks.
(c) Processing time is 4 weeks.
(d) Finished goods are required to be in stock on average period of 8 weeks
(e) Credit period allowed to debtors, on average 10 weeks.
(f) Lag in payment of wages 4 weeks
(g) Credit period allowed by creditors 4 weeks
(h) Selling price is Rs.50 per unit
You are required to prepare an estimate of working capital requirements adding 10% margin for contingencies for a level of activity of 1,30,000 units of production.
(Ans. Working Capital Required = Rs.25,2,5000)
3. From the following information extracted from the books of a manufacturing concern, compute the operating cycle in days-
Period covered: 365 days
Average period of credit allowed by suppliers 16 days
Average total of debtors outstanding 4,80,000
Raw-material Consumption 44,00,000
Total Production Cost 1,00,00,000
Total cost of Sales 1,05,00,000
Sales for the year 1,60,00,000
Value of average stock maintained -
Raw Materials 3,20,000
Work-in-Progress 3,50,000
Finished goods 2,60,000

[Ans : Total period of operating cycle 44 days]

SUGGESTED READING
1. Agarwal, N.K. : Working Capital Management
New Delhi, Sterling Publications (P) Ltd.
2. Kulshrestha, R.S. : Financial Management,
Agra, Sahitya Bhavan
3. Ramamoorthy, V.E. : Working Capital Management,
Madras, Institute for Financial Management and Research.
 
LESSON 8 CASH MANAGEMENT
LEARNING OBJECTIVES
• Nature of Cash
• Motives for Holding Cash
• Cash Planning – Cash Budget
• Factors Influencing the Level of Cash Balance
• Advantages of Maintaining Ample Cash
• Cash Deficit / Surplus
• Techniques of Expediting Cash Collections
• Evaluation of Cash Management
Nature of Cash
Cash is the common purchasing power or medium of exchange. Cash forms the method of collecting revenues and paying various costs and expenses of the business. As such, it forms the most important component of working capital. Not only that, it largely upholds, under given conditions, the quantum of other ingredients of working capital viz., inventories and debtors, that may be needed for a given scale and type of operation. Cash is the most liquid asset that a business owns Liquidity refers to commonly accepted medium for acquiring the things, discharging the liabilities, etc. Cash itself is a barren or sterile asset and in nature. That is cash itself can not earn any profit or interest or yield unless; it is invested in the form of near-cash or non-cash assets
Issues in Cash Management
In a business enterprise, ultimately, a transaction results in either an outflow or an inflow of cash. Its shortage may degenerate a firm into a state of technical insolvency and even to liquidation. Though idle cash is sterile, its retention is not without cost. Holding of cash balance has an implicit cost in the firm of opportunity cost. It varies directly with the quantity of cash held. The higher the amount of idle cash, the greater is the cost of holding it in the form of loss of interest which could have been earned either by investing it in some interest bearing securities or by reducing the burden of interest charges by paying off the past loans, especially in the present era of ever increasing cost of borrowing. Hence, a finance manager has to adhere to the five ‘R’s of financial management. viz., (i) the right quality of finance for liquidity consideration; (ii) the right quantity whether owned or borrowed; (iii) the right time to preserve solvency, (iv) the right source; and (v) the right cost of capital the organisation can afford to pay.
In order to resolve the uncertainty about cash flow prediction, lack of synchronisation between cash receipts and payments, the organisation should develop some strategies for cash management. The organisation should evolve strategies regarding the following areas and facets of cash management.
(i) Determining the organisation’s objective of keeping cash,
(ii) Cash planning and forecasting.
(iii) Determining of optimum level of cash balance holding in the company.
(iv) Controlling flow of cash by maximizing the availability of cash i.e., economizing cash by accelerating cash inflows or decelerating cash outflows.
(v) Financing of cash shortage and cost of running out of cash.
(vi) Investing idle or surplus cash.
Motives for Holding Cash
According to John Maynard Keynes, the famous economist, there are three motives that both individuals and businessmen hold cash. They are (i) the Transaction motive, (ii) the Precautionary motive and (iii) the Speculative motive. Yet another motive which has been added as the fourth one by the modern writers on financial management is compensation motive. Thus, there are altogether four primary motives for maintaining cash balances.
Transactions Motive
This motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchases, wages, operating expenses, taxes, dividends etc. The need to hold cash would not arise, if there were perfect synchronization between cash receipts and cash payments i.e. enough cash is received when the payment has to be made. But cash receipts and payments are not perfectly synchronized. Sometimes cash receipts exceed cash payments, while at other times cash payments are more than cash receipts; hence, the firm should maintain some cash balance to make the required payments. For transaction purposes, a firm may invest its cash in marketables securities. Usually, the firm will purchase the securities whose maturity corresponds with some anticipated payments, such as dividend, taxes etc., in future. However, the transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash receipts.
Precautionary Motive
According to this motive, a firm should maintain sufficient cash to act as a cushion against unexpected events. Even though, by the use of budgets, the financial needs of a firm, can be estimated, yet inaccuracies are likely to occur in predicting the cash flows which require the attention of the management. These inaccuracies may be caused by (a) floods, strikes and failure of an important customer to pay in time, (b) bills may be presented for settlement earlier than expected (c) unexpected slow down in collection amounts receivables, (d) cancellation of some order for goods as the customer is not satisfied, (e) sharp increase in cost of raw materials. That is why it is necessary to maintain higher cash balances. The size of the cash balance to be maintained also depends upon the ability of the firm to borrow funds at short notice. If the firm has the ability to borrow funds at short notice, it is not necessary to maintain higher cash balances. The amount of income that a firm is willing to forego by holding precautionary balances will be criterion for the upper limit for investment in cash.
Speculative Motive : It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While the precautionary motive is defensive in nature, in that firm must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so.
Compensation Motive: Yet another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain minimum balances of cash at the bank. Since this balance cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn a return. To be compensated for their services indirectly in this form, they require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. Such balances are compensating balances. Compensating balances are also required by some loan agreements between a bank and its customers. During periods when the supply of credit is restricted and interest rates are rising, banks require a borrower to main a minimum balance in his account as a condition precedent to the grant of loan. This is presumably to ‘compensate’ the bank for a rise in the interest rate during the period when the loan will be pending.
Cash Planning
Cash Planning involves the formulation of cash policies resulting from normal and abnormal requirements. Normal cash requirements are those which are predictable and occur as a result of routine operations and include cash of such items as raw materials, supplies, interest, wages and salaries, replacement of fixed assets which are worn out through use, dividends, and taxes. Abnormal requirements, which cannot be anticipated in the routine of the business process, include cash for fixed assets which are replaced for reasons other than normal depreciation, purchases resulting from price declines, and interruption of cash flow which reduce cash receipts without a corresponding reduction in cash disbursement. The main purpose of cash planning is to synchronise cash receipts with cash outgo. In most firms perfect synchornisation is difficult to achieve mainly because the inflow and outflow is effected by several factors.
Tools of Cash Planning
(i) Net Cash Forecast through Projected Cash flow Statements which give the estimated receipts and disbursements on a month by month basis.
(ii) Cash Budget as a tool of cash planning and control.
(iii) Statement of Working Capital Forecast
(iv) Cash Ratios like Acid Test Ratio, Turnover of cash etc.
(v) Cash Reports : A cash report showing the monthly position can supplement the cash budget in the task of controlling the cash. The management must try to maintain a balance between cash receipts and payments and cash reporting helps very much in this direction.
(vi) Proforma Statement : In addition to the above tools, Cash Planning requires two additional statements viz., (a) Proforma Balance Sheet and (b) Proforma Profit and Loss Statement. The proforma balance sheet establishes a connection between planning for the use of assets. The proforma profit and loss statement reveals the managements planning regarding sales (revenue), expenses and net profit.
Cash Budget as a Tool of Cash Planning and Control : The cash budget may be used either as a simple forecasting device or as a means of aggressive strategy or planning. When used as a forecasting device, operating projections are made; cash inflows and outflows are matched, deficiencies are provided for and surplus funds invested. Aggressive planning involves estimating different levels of operations and judging the inflows and outflows to obtain then mix that makes the greatest contribution to the profitability of the enterprise without entailing too much risk.
Cash budget is a formalized structure for estimating cash income and cash expenditure over some period of time. The net cash position of the enterprise as it moves from one budgeting sub-period to another, is highlighted. The cash budget includes only cash flow, non-cash items such as depreciation, loss in sale of fixed assets etc., are excluded. The period of time covered by the cash budget may be a year, six months, three months or some other period. The sub-periods may be a day, a week, a month or a quarter, depending upon the needs of the enterprise. If the firm’s flow of funds is dependable and it has a large cash balance, a cash budget covering a period of one year divided into three-month intervals may be appropriate. Where substantial uncertainty is associated with the flow of funds a quarterly a cash budget broken into monthly intervals may be the most suitable. The cash budget since, it shows the size of cash balance at the end of each sub-period as well as the amount and term of financing required, is the key to arranging for needed funds at the most favourable terms available. Adequate time is available to study the needs.
Illustration 1.
Prepare a cash budget with the information provided. Cash balance as on January 1st, 2009 is Rs. 72500. 50% of the total sales are for cash. Assets are to be acquired worth Rs. 8000 in the month of February and worth Rs.25000 in April. Loan amounting to Rs.30000 to be received in the month of May. Dividends of Rs.35000 to be paid in the month of June. Debtors are allowed a one month’s credit. Credit for materials purchased and overheads allow for one month’s credit. Sales commission at 3% on sales is paid each month. Other cash flows include:

Month Sales (Rs.) Materials purchases (Rs.) Salaries & Wages (Rs.) Production Overheads (Rs.) Office & Selling Overheads (Rs.)
Jan. 72000 25000 10000 6000 5500
Feb. 97000 31000 12100 6300 6700
March 86000 25500 10600 6000 7500
April 88600 30600 25000 6500 8900
May 102500 37000 22000 8000 11000
June 108700 38800 23000 8200 11500

Solution:
Cash Budget
Jan.
(Rs.) Feb.
(Rs.) March
(Rs.) April
(Rs.) May
(Rs.) June
(Rs.) Total
(Rs.)
Receipts
Cash Sales 36000 48500 43000 44300 51250 54350 277400
Collection from debtors - 36000 48500 43000 44300 51250 223050
Bank loan - - - - 30000 - 30000
Total (a) 36000 84500 91500 87300 125550 105600 530450
Payments
Material - 25000 31000 25500 30600 37000 149100
Salaries & wages 10000 12100 10600 25000 22000 23000 102700
Prod. Ohs - 6000 6300 6000 6500 8000 32800
Off. & Sell. - 5500 6700 7500 8900 11000 39600
Sales Com. 2160 2910 2580 2658 3075 3261 16644
Capital Exp. - 8000 - 25000 - - 33000
Dividends - - - - - 35000 35000
Total (b) 12160 59510 57180 91658 71075 117261 408844
Net cash flow a - b 23840 24990 34320 (4358) 54475 11661 121606
Add: Op Bal of cash 72500 96340 121330 155650 151292 205767 194106
Closing Bal. 96340 121330 155650 151292 205767 194106 315712

Factors Influencing the Level of Cash Balance to Hold

1. Credit Position : If a firm enjoys a sound credit position, it is not necessary for it to keep heavy cash balances. If a firm wants to purchase its inventories on trade credit, it can keep only small cash balances. It will not be possible in such a case for a firm to synthronise the credit it allows and the credit it awails.
2. Position of Accounts Receivable : The amount of cash required is affected by the time factor viz., the time required for converting the accounts receivable into cash. If the credit term of the firm is longer, the turnover also will be slow. Therefore when the outflow and the turnover could not synchronise, it becomes necessary for a firm to maintain larger cash balance required to meet its requirements.
3. Nature of the product / Business : Nature of the business has also great influence on the cash requirements. If one business was to carry larger inventory as compared to that of similar business, it becomes necessary for the firm to invest additional funds in inventory. Further, cash requirement is influenced by the firm’s demand. If the firm’s demand is volatile, larger cash will be required.
4. Sales in relation to Asset : Another factor affecting the cash requirement is the volume of sales in relation to assets. In the case of firms with larger sales, as huge sums are invested in inventories and accounts receivable they should carry heavy cash balances. When sales increase cash requirements do not increase in the same proportion but there is definite increase in cash.
5. Management’s Attitude : Cash requirement of a firm is influenced by the attitude of the management also. If the management is of conservative type it will hold large cash than that which is less conservative. The demands of such a firm will be more of liquid nature. But a firm which plans its requirements effectively is less conservative. By planning, a firm will be able to predict its requirements accurately.
6. Distribution Channel : Distribution channel refers to the number of middlemen in the process of distribution of service or product. It the distribution channel is long and the credit policy is liberal the level of cash may be higher. If goods and services are sold through departmental stores or chain stores the cash holdings will differ substantially.
7. Size and Area of Operation : Area of operation refers to the geographical area in which the organisation is working. If the organisation working on large scale it is possible that organisation must have to keep higher cash level.
8. Duration of Production Cycle : It refers to the time period taken by the raw material to become finished product. In case of long production cycle the level of cash holding is likely to be high and vice-versa.
Advantages of Maintaining Ample Cash

(1) A shield for Technical Inefficiency : The provides of ample cash funds can prove to be a shield for technical inefficiency of a management.
(2) Maintenance of Goodwill : The goodwill and reputation of a business firm depends to a large extent on this fact that the firm retires all the obligations and meets the payments as and when they mature. It can be possible only when the firm maintains a good cash balance ascertained carefully for normal operations and adjustment for abnormal contingencies.
(3) Cash Discounts can be availed: If a firm has sufficient cash, it can avail cash discounts offered by the suppliers. It will lower down the raw material cost and finally the cost of production.
(4) Good Bank Relations: Commercial banks like to maintain good relations with such firms having high liquidity in funds. Large companies maintaining large liquid balances of cash in excess of their immediate needs, need to borrow very little if at all, on current account.
(5) Exploitation of Business Opportunities: Firms having good cash position can exploit the business opportunities very well. They can take risk of entering into new ventures.
(6) Encourage to new Investments: Firm having good cash position can maintain a sound (cash) dividend policy. It encourages the new investment in the shares of such firm because shareholders like cash dividend more.
(7) Increase in Efficiency : Unless there is an adequate supply of cash to bridge the gap a stringency develops. Operations are slowed, if not paralyzed. Creditors press for their payments. If payments can not be made in time bankruptcy and failure follow.
(8) Overcoming Abnormal Situations : Such firms can overcome abnormal financial conditions also with cash and without causing loss to the interest of existing shareholders.
(9) Other Advantages : Cash is often the primary factor deciding the course of business destiny. The decision to expand the business, the decision to add any new product in the product line of the company, etc., are decided by the cash position of the firm.
Utilization of Cash Surplus : A cash surplus is obviously a more acceptable proposition for a firm than a cash deficit. However, a cash surplus is idle cash and, therefore, unproductive. This surplus may be deployed for the greater benefit of the firm. If it is available permanently, it may be utilized for the purchase of additional equipment, for expansion, for the introduction of a new product, etc. However, it should not be recklessly squandered on hare brained loss-making schemes simply because it happens to be available.
Cash surplus should be utilised in the following ways:
(i) if it is available permanently, it should be deployed profitably in the business by a planned phase of re-equipments, expansion, etc.
(ii) If it is available for a short period, it may be invested in several short-term investments like Certificated of Deposit, Commercial Papers, Money Market Mutual Funds etc. However, short-term cash surpluses should not be used in speculative investments.
(iii) Short-term surplus may be used to qualify for the benefit of discounts from suppliers by prompt payment or by negotiating concessional prices with the suppliers.
(iv) If the cash surplus is permanent, it may be utilised (a) for the repayment of capital borrowed at exorbitant rates of interest; (b) for the extension of loans to subsidiaries; (c) for the investment of funds through mergers and acquisitions; (d) for new plant facilities on order earn a higher rate of return; (e) for the purchase of own securities to be used in acquisitions, stock option plans or other payments; (f) for the investment in the development of a products or the improvement of the old ones, etc.
It is not always desirable for a company or group of companies to build up a reserve or surplus cash funds in order to make a more effective use of money. The group may already have borrowed; it is therefore. far better and more cost effective to reduce such borrowings than to place surplus cash funds in the money market.

Avoiding Cash Deficit Cash Insolvency
Cash deficit, as stated earlier, presents a more difficult problem. A firm may reduce its cash deficit by a closer internal control rather than by resorting to external financing. A cash deficit may be dealt with in the following ways:
(i) The collections from customers and sundry debtors should be accelerated.
(ii) Liquidating marketable securities held by the firm.
(iii) Accounts receivable should be discounted with a bank.
(iv) Factoring the receivables.
(v) Redundant assets should be sold out.
(vi) Payments to suppliers nay be deferred to the extent possible. The firm may also take advantage of liberal trade credit terms.
(vii) Expenditure on wages, salaries, etc., should be brought under control by maintaining the activity at a constant level instead of encouraging cyclical fluctuations. The payment of corporate taxes cannot be avoided. However a firm may pay on the last day of payment so that early payment and late payment can both be avoided.
(viii) Capital investment decisions should be avoided or delayed in order that a firm may be freed for the time being from commitment of funds.
(ix) Interest obligations are contractual. To avoid their payment, therefore, amounts to be default. A firm, however, should ensure that the period of interest payment does not coincide with the payment of inventory or other working capital items.
(x) Dividend payments may not be made in cash. It would be worthwhile to take stockholders into confidence to explain clearly the exigency of cash deficit. Non-payment of dividend might otherwise shatter their confidence.
(xi) Utilising bank credit
The utimate hazard of running out of cash, however, and the one which lurks in the background of every debt decision, is the situation in which cash is so reduced, that legal contracts are defaulted, bankruptcy occurs and normal operations cease. Since no private enterprise has a guaranteed cash inflow, there must always be some risk, however, this event may occur rarely. Consequently, any addition to mandatory cash outflows resulting from new debt or any other act or event must increase that risk.
Costs of Being short of cash Short Costs: The ‘Costs’ of being short of cash come in the form of not being able to take advantage of discounts, and short-lasting special buying opportunities, and that of cost associated with credit impairment are called ‘short costs’ Detailed explanation of these costs are given below;
Loss of Discount : Discounts for paying cash promptly are usually very generous and the effective return on capital employed is often well above that earned on any other asset. To take advantage of discount, cash is required to be paid in very short period of time. For instance, a concern purchases goods worth Rs.10,000 on terms Rs.10,000/2/10, net 30 days. it means if the payment is made within ten days the firm will be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in full. If the concern wants to use Rs,9,800 for 20 days at a cost of Rs.200 and then its actual cost works to 2.04%. Further, taking the discount would mean a lower acquisition price for inventories. Thus, the impact of not being able to take advantage of a cash discount is therefore quite significant.
The quantity discount would require a higher purchase order. As a result, the higher carrying cost might outweigh the advantage of quantity discount. But this may not be true in all cases.
Cost associated with credit impairment
(i) No credit given all dealings for cash; alternatively, the credit terms could be made less generous;
(ii) Creditors could mark-up their prices up in order to compensate for poor payments;
(iii) Suppliers may refuse to deal at all;
(iv) Suppliers may give slow or unreliable delivery times, if there is an excess of demand for supplies, then the poor paying firm may find that it is the last on the list of priority customers.
(v) Short-term and financing will not be easily obtainable on reasonable terms.
(vi) Banks may charge (a) higher (bank) charges on loans, overdrafts and cash credits (b) penalty rates to meet a short fall in compensating balances.
(vii) The attendant decline in sales and profits;
(viii) In some cases the shortage of cash may lead to creditors to petition for a winding up of the firm. This has very adverse publicity effects.
The quantification of credit impairment is difficult and will probably have to be subjectively estimated. Apart from the loss of creditors confidence, a strained liquidity position also places pressures on individual mangers. The amount of time spent by senior executives to satisfy creditors when the cash balances are low is likely to be very costly.
Transaction Costs: These costs are associated with raising cash to tide over the shortage of cash. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities. These represent the fixed costs associated with the transaction. They consist of both explicit and implicit costs.
Borrowing Costs: Interest on loan, commitment charges, and other expensed relating to the loan raised to cover the cash deficit are called borrowing costs. The borrowing or financing costs are closely associated with the opportunity cost.
Techniques of Expediting Collections
Several techniques are employed to reduce the span between the time a customer makes payment and the time such funds are available for use by a firm. The following are the techniques designed to accelerate the collection of accounts receivables; (i) Concentration Banking (ii) Lock-Box System (iii) Playing on the float.
Concentration banking: In this system, large firms which have a large number of branches at different palaces, selects some of these which are strategically located as collection centres for receiving payment being collected at the head office of the firm, the cheques from a certain geographical area are collected at a specified local collection centre. Under this arrangement, the customers are required to send their payments (cheques) to the collection centre covering the area in which they live and these are deposited in a local bank account of the concerned collection centre, after meeting local expenses, if any. Funds beyond a predetermined minimum balance are automatically transferred daily by wire transfer or telex, to a central or concentration banks account. A Concentration bank is the Company’s head office bank i.e., one with which the form has a major account-usually a disbursement account. Hence this arrangement is referred to as Concentration Banking.
On the basis of their daily report of collected funds, the finance manager can use them according to need. However, the Company will have to incur additional cost to man these collection centres. Compensating balances to cover the cost of service are usually maintained with the local or regional banks. An indepth cost-benefits analysis of each region, where the collection centre is to be set up, should be undertaken by the company. Normally, the establishment of collection centres depends upon the volume of business in the area.
Concentration banking, as a system of decentralised billing and multiple collection points, is a useful technique to expedite the collection of accounts receivable. First of all it reduces the time needed in the collection process by reducing the mailing time. Since the collection centres are near the customers, the time involved in the sending the bill to the customer is reduced. Thus, mailing time is saved both in respect of sending the bill to the customers as well as in the receipt of payment. Secondly, the decentralised system hastens the collection of cheques because most of the cheques deposited in the company’s regional bank are drawn on banks located in that area. Thus, a company can reduce the time a cheque takes to collect. This is so mainly because by pooling funds for disbursement in a single account, the aggregate requirement for cash balances were maintained at each branch office
Lock-Box System: Under this arrangement firms hire a post office box at important collection centres. The customers are required to remit payments to the lock box. The local banks of the firm, at the respective places, are authorised to open the box and pick up the remittances (cheques) received from the customers. Usually, the authorised banks pick up the cheques several times a day and deposit them in the firm’s accounts. After crediting the account of the firm, the banks send a deposit slip along with list of payments and other enclosures, if any, to the firm by way of proof and record of collection. Thereafter, depending upon the arrangements made of proof and regional lock-box bank, funds in excess of balances maintained to cover costs are transferred automatically to company head quarters.
The lock-box system is like concentration banking in that the collection is decentralised and is done at branch level. But the main difference between them is that under concentration banking the customer sends the cheque to the collection centres or local branches while he sends them to a post office box under the lock-box system. In case of concentration banking, cheques are received by a collection centre and after processing, they are deposited in the bank. The lock-box arrangement is an improvement over the concentration banking system since the former eliminates the processing time the receipt and deposit of cheques within the firm. This system, reduces the exposure to credit losses by expediting the time at which data can come to know of dishonoured cheques and weak credit situations sooner. The lock box bank performs the clerical task of handling the remittances prior to deposits, services which the bank may be able to perform at a lower cost and consequently the overhead expenses are lowered. Further, it facilitates control by divorcing remittances from the accounting department.
However, the basic limitation of the lock-box system lies in additional cost which the company’s bank will charge in lieu of additional services rendered. Since the cost for these services is directly in proportion to the number of cheques handled by the bank, obviously the lock box arrangement will prove useful and economical too when average remittance is large.
Concentration banking is the most popular technique employed by business firms in India to intensify cash inflows. over three fifth of the firms rely on this technique. There is however, customers resistance to lock-box system and they insist on sending cheques directly to company head quarters, inspite of company’s insistence that remittance should be forwarded to the regional lock-box. The customers have been traditionally used to 7-10 days float (previously involved in making a remittance) and often draw and mail cheques against funds that would not be in their bank accounts for one week. The use of the lock-box system meant that they had to have bank balances to cover such remittances in the bank, later than one day after the cheque had been mailed.
Float : The term ‘float’ refers to the amount of money tied up in cheques that have been written and issued, but have yet to be collected and encashed. Alternatively, float represents the difference between the bank balance and book balance of cash of a firm. The difference between the balance as shown by the firm’s record and the actual bank balance is due to transit and processing delays. if the financial manager accurately estimate when the cheques issued will be deposited and collected, he can invest the “float” during the float period to earn a return. Float used in this sense is called ‘cheque kitting’. There are three ways of doing it: (a) paying from a distant bank, (b) scientific cheque encashing involving the time-lag in the issue of cheques and their encashment, and (c) the issue of bank draft.
If a firm’s own collection and clearing process is more efficient than that of the recipients of its cheques-and this is generally true of larger, more efficient firms then the firm should show a negative balance on its own records and a positive balance on the books of its bank. Obviously, the firm must be able to forecast its positive and negative clearing accurately in order to make use of float.
Cash Management Models
Baumol, Patinkin, Archer, Miler and Orr, and Orgler have developed some interesting models for cash management and to determine the minimum level of cash balances to be held by a business firm. Baumol’s mathematical model is based on the combination of inventory theory with monetary theory. in his model, cash is taken as an inventory item which flows out at a constant rate and is replenished instantaneously by borrowing or by selling securities. It is assumed that the size and timing of cash inflows are fully controllable to which a fixed cost per order(cost of converting the securities into cash) and a variable carrying cost per rupee (in the form of opportunity cost of holding cash i.e., the return on marketable securities) are attached. Since the cash outflow are known the only cash management decision is to decide about the volume of cash and the frequently at which cash is to be procured. Baumol has concluded that generally some cash should be kept even in a state of no change and that the transaction demand for cash will vary approximately in a proportion with the money value of transactions with the object of minimizing total cost. However, since the model is subject to unreal assumptions, it does not provide an applicable tool for cash management.
Patinkin’s model attempts to determine the optimum level of cash balance at the beginning of each period with the object of minimising the probability of cash shortage during the period. This model also assumes that (i) net cash flows in each period are equal to zero; (ii) cash flows cannot be controlled by a financial executive and (iii) all transactions between cash and other assets take place at the beginning of each period. Though this model takes into account both the cash inflows and outflows and is, Baumol’s model, deterministic in nature, the above assumptions limit the practical application of the model.
Mehta observes that as an approach to cash management, the Economic Order Quantity (EOQ) model is less than satisfactory. The assumptions about cash flows create problems. Unlike the physical stock, the cash inflows, will be interspersed with payments and at times receipts may exceed cash outflows. Infact, the cash balance can move in either direction, whereas in the usual inventory model ‘demand’ during any period is assumed to be non-negative.
Archer’s simple probabilistic model aims at determining optimum level of cash and marketable securities together to be held by a business firm. About this model, it has been commented that the model is largely based on a financial officer’s subjective decision.
Merton H. Miller and Daniel Orr developed somewhat different probability model. In this model, unlike Baumol’s model, cash flows are assumed to fluctuate in a completely stochastic manner.
Transaction can increase as well as decrease cash balance. Their main assumption about the model is that only two forms of assets exist; cash and marketable securities. As regards the optimum level of cash balance, Miller and Orr suggest that there is not only one specific minimum level of ideal cash balance but a range of ideal cash balances. Within this range cash balance be allowed to move upwards as well as downwards and no action is needed. But when the balance reaches the upper limit of the range, it is to be reduced to a predetermined level by purchasing marketable securities and when the cash balance reaches the lower limit, it is to be replenished by the sale of marketable securities.
Evaluation of Cash Management : In evaluating cash management, the finance manager has to (i) check all receipts and payments against the projections, (ii) compare the actual performance against predetermined plans and objectives, (iii) find out discrepancy if any analysing these variations in order to pinpoint the underlying performance conforms to the plans and goals of the economy. This means that there should be continuous budget evaluation of the cash position so as to make continuous control through policy decisions.
The following ratios have been used to evaluate different aspects of cash management performance.
1. To test the adequacy Cash:
(a) liquid ratio or Quick ratio:
(b) Net Cash flows to Current Liabilities ratio:
(c) Cash in terms of number of days of current obligations.
2. To assess the effective control of Cash flows:
(a) Cash to current in sales ratio;
(b) Cash turnover in sales ratio;
(c) Rate of growth in cash; and
(d) Absolute Liquid funds to current liabilities.
3. For productive utilisation of surplus cash;
(a) Marketable securities to current assets ratio; and
(b) Marketable securities to absolute liquid funds.
To set a firm’s liquidity and solvency, current ratio and liquid ratio are calculated. Traditionally 2:1 for Current ratio and 1:1 Quick ratio are taken as satisfactory standards for these purposes. The computation of cash in terms of number of days of current obligations is another measure to assess the sufficiency of cash. It is not practical to suggest any standard ratio in this regard to determine the adequacy of cash. It is influenced by the firm’s cash flows pattern, maturity schedule of its current obligations, and its ability to procure extra funds if develops.
The average cash to current assets ratio indicates the firm’s liquidity position. The proportion of cash to total current assets directly affects the profitability of a firm. A down ward trend in this ratio over a period indicates tighter control whereas up ward trend reveals a slack control over cash resources. Greater cash turnover in sales indicates the effective utilisation of cash resources. if a business can turnover its cash larger number of times, it can finance greater volume of sales with relatively lesser cash resources. This will increase the profitability of a concern. Moreover, such a business would not require proportionate increase in cash resources with the increase in sales volume.
The proportion of marketable securities in current assets indicates the firm’s prudence to invest temporary surplus in such short term investments to augment its over all profitability. Firms in India do not normally purchase marketable securities for the purpose of investing idle cash for short durations for two reasons: (i) Most of the firms consider it to be a speculative activity not meant for manufacture and (ii) investment in securities has same element of risk on account of fluctuation in their prices.
Illustration : 2
The following information is available in respect of a firm;
(a) On an average accounts receivable are collected after 80 days; inventories have an average of 100 days and accounts payable are paid approximately 60 days after they arise.
(b) The firm spends a total of Rs.1,81,20,000 annually at a constant rate.
(c) It can earn 8% on investments.
Calculate: (i) the firm’s cash cycle and cash turnover assuming 360 days in a year; (ii) minimum amounts of cash to be maintained to meet payments as they become due; (iii) saving by reducing the average age of inventories to 70 days.
Solution
(i) Cash cycle : 80 days + 100 – 60 = 120 days
Cash Turnover = 360 divided by 120 days = 3 times
(ii) Minimum operating cash =
= Rs.1,81,20,000 + 3 = Rs.60,40,000
(iii) Savings by reducing the average age of inventory to 70 days
New Cash Cycle = 120 days – 10 = 110 days
New Cash Turnover = = 3.2727 times
New Minimum operating cash =
= Rs.55,36,713
Reduction in investments = (Rs.60,40,000 – Rs.55,36,713)
= Rs.5,03,287
Savings = 8% on Rs.5,03,287 = Rs.40,263.


Illustration : 3
A firm uses a continuous billing system that results in an average daily receipt of Rs. 40,000,00. It is contemplating the institution of concentration banking, instead of the current system of centralised billing and collection. It is estimated that such a system would reduce the collection period of accounts receivable Rs.2 days.
Concentration banking would cost Rs.75,000 annually and 8% can be earned by the firm on its investments. It is also found that a lock-box system could reduce its overall collection time by four days and could cost annually Rs. 1,20,000.
1. How much cash would be released with the concentration banking system?
2. How much money can be saved due to reduction in the collection period by 2 days? Should the firm institute the concentration banking system?
3. How much cash would be freed by lock-box system?
4. How much can be saved with lock-box?
5. Between concentration banking and lock-box system which is better?
Solution
(1) Cash released by the concentration banking system
= Rs.40,00,000 x 2 days = Rs.80,00,000
(2) Savings = 8% x Rs.80,00,0000 = Rs.6,40,000. The firm should institute the concentration banking system. it costs only Rs.75,000 = 5,65,000.
(3) Cash released by the lock- box system = Rs.40,00,000 x 4 days – Rs.1,60,00,000.
(4) Savings in lock-box system: 8% on Rs.1,60,00,000. = Rs.13,80,000.
(5) Lock-box system is better. Its net savings Rs.11,60,000 (Rs.12,80,000 Rs.1,20,000) are higher than that of concentration banking.
Net savings = 12,80,000 – 1,20,000 = Rs.11,60,000
Difference net savings = 11,60,000 – 5,65,000=5,95,000
Additional savings Rs.5,95,000 if lock box system is introduced. Hence it is better to go for lock box system.
SUMMARY
Cash means and includes actual cash (in hand and at bank). Cash the blood stream in the human body, gives viability and strength to a business enterprises. The steady and healthy circulation of cash throughout the entire business operation is the basis of business solvency. This chapter provides the learner an idea about the nature of cash & issues in cash management. The motives for holding cash is explained the factors which influences the level of cash balance to be held is discussed. It also examines the strength and weakness of cash surplus / deficit. Techniques expediting collection is also dealt with in this chapter.

REVIEW QUESTIONS
1. Explain the nature of cash and state the scope and objectives of cash management.
2. Since cash does not earn can we still call it a working asset? Why? What are the principal motives for holding cash? How do they relate to cash as a working asset.
3. Enumerate the factors that influence the size of cash holdings of company. Discuss the inventory approach to cash management.
4. Discuss the methods accelerating cash inflows and decelerating cash inflows of a company.
5. Describe how a lock-box arrangement may be used to accelerate cash flow What costs are involved with the use of a lock-box?
6. Discuss the management problems involved in planning and control of cash Explain the main tools of cash planning and control.
7. What is a firm’s cash cycle’? How are the each cycle and cash turnover of a firm related? What should a firm’s objectives with respect to its cash cycle and cash turnover be?
8. Explain the following:
a. Compensating balance
b. Deposit float
c. Lock-box system
d. Cash forecast
e. Cash Budget
f. Cash ratios
g. Cash reports
h. Cash flow statement
i. Payment float
j. Cash losses
PRACTICAL PROBLEMS
1. Kay & sons manufacture summer garments. Sales are highest in the month of May. Prepare a cash budget for Kay &sons for the period January to June. The balance sheet as on the opening day of the accounting year is given:

Liabilities Amount (Rs.’000) Assets Amount (Rs.’000)
Current Liab. 3000 Cash 84480
Other liab. 10800 Debtors 42000
Capital 317280 Inventory 123000
Fixed assets 81600
Total 331080 Total 331080

The following additional information is given:

Sales Estimates
(RS.’000) (RS.’000)
Dec. 60000 April 228000
Jan. 84000 May 288000
Feb. 156000 June 108000
March 132000 July 108000


a) Sales for the month of Dec. were Rs.60,000,000.
b) Credit sales are 70% of the total sales for each month
c) Debtors are allowed a credit period of one month.
d) Gross profit margin on sales is expected to be 25%.
e) Payments for the purchases are made one month in advance.
f) A minimum inventory of Rs.60,000,000 at cost is always maintained. The co. purchase sufficient inventory each month to take care of sales of the subsequent month.
g) A 16% interest on loans ia payable in the next month of every quarter on the outstanding balance. Borrowing is possible each month in the multiples of Rs.1,000,000.
h) Other monthly expenses are:
Salary Rs.9,600,000
Rent Rs.2,400,000
Depreciation Rs.720,000
Other 1% of sales.

Prepare a cash budget for Kay & sons.


suggested readings
1. Bhabatosh Banerjee : Cash Management
Calcultta, The World Press (P) Ltd.
2. Khan, M.Y. and Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M. : Financial Management,
New Delhi, Vikas Publishing House
4. Van Horne, James C. : Financial Management and Policy,
New Delhi, Prentice Hall of India.


 
LESSON 8 CASH MANAGEMENT
LEARNING OBJECTIVES
• Nature of Cash
• Motives for Holding Cash
• Cash Planning – Cash Budget
• Factors Influencing the Level of Cash Balance
• Advantages of Maintaining Ample Cash
• Cash Deficit / Surplus
• Techniques of Expediting Cash Collections
• Evaluation of Cash Management
Nature of Cash
Cash is the common purchasing power or medium of exchange. Cash forms the method of collecting revenues and paying various costs and expenses of the business. As such, it forms the most important component of working capital. Not only that, it largely upholds, under given conditions, the quantum of other ingredients of working capital viz., inventories and debtors, that may be needed for a given scale and type of operation. Cash is the most liquid asset that a business owns Liquidity refers to commonly accepted medium for acquiring the things, discharging the liabilities, etc. Cash itself is a barren or sterile asset and in nature. That is cash itself can not earn any profit or interest or yield unless; it is invested in the form of near-cash or non-cash assets
Issues in Cash Management
In a business enterprise, ultimately, a transaction results in either an outflow or an inflow of cash. Its shortage may degenerate a firm into a state of technical insolvency and even to liquidation. Though idle cash is sterile, its retention is not without cost. Holding of cash balance has an implicit cost in the firm of opportunity cost. It varies directly with the quantity of cash held. The higher the amount of idle cash, the greater is the cost of holding it in the form of loss of interest which could have been earned either by investing it in some interest bearing securities or by reducing the burden of interest charges by paying off the past loans, especially in the present era of ever increasing cost of borrowing. Hence, a finance manager has to adhere to the five ‘R’s of financial management. viz., (i) the right quality of finance for liquidity consideration; (ii) the right quantity whether owned or borrowed; (iii) the right time to preserve solvency, (iv) the right source; and (v) the right cost of capital the organisation can afford to pay.
In order to resolve the uncertainty about cash flow prediction, lack of synchronisation between cash receipts and payments, the organisation should develop some strategies for cash management. The organisation should evolve strategies regarding the following areas and facets of cash management.
(vii) Determining the organisation’s objective of keeping cash,
(viii) Cash planning and forecasting.
(ix) Determining of optimum level of cash balance holding in the company.
(x) Controlling flow of cash by maximizing the availability of cash i.e., economizing cash by accelerating cash inflows or decelerating cash outflows.
(xi) Financing of cash shortage and cost of running out of cash.
(xii) Investing idle or surplus cash.
Motives for Holding Cash
According to John Maynard Keynes, the famous economist, there are three motives that both individuals and businessmen hold cash. They are (i) the Transaction motive, (ii) the Precautionary motive and (iii) the Speculative motive. Yet another motive which has been added as the fourth one by the modern writers on financial management is compensation motive. Thus, there are altogether four primary motives for maintaining cash balances.
Transactions Motive
This motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchases, wages, operating expenses, taxes, dividends etc. The need to hold cash would not arise, if there were perfect synchronization between cash receipts and cash payments i.e. enough cash is received when the payment has to be made. But cash receipts and payments are not perfectly synchronized. Sometimes cash receipts exceed cash payments, while at other times cash payments are more than cash receipts; hence, the firm should maintain some cash balance to make the required payments. For transaction purposes, a firm may invest its cash in marketables securities. Usually, the firm will purchase the securities whose maturity corresponds with some anticipated payments, such as dividend, taxes etc., in future. However, the transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash receipts.
Precautionary Motive
According to this motive, a firm should maintain sufficient cash to act as a cushion against unexpected events. Even though, by the use of budgets, the financial needs of a firm, can be estimated, yet inaccuracies are likely to occur in predicting the cash flows which require the attention of the management. These inaccuracies may be caused by (a) floods, strikes and failure of an important customer to pay in time, (b) bills may be presented for settlement earlier than expected (c) unexpected slow down in collection amounts receivables, (d) cancellation of some order for goods as the customer is not satisfied, (e) sharp increase in cost of raw materials. That is why it is necessary to maintain higher cash balances. The size of the cash balance to be maintained also depends upon the ability of the firm to borrow funds at short notice. If the firm has the ability to borrow funds at short notice, it is not necessary to maintain higher cash balances. The amount of income that a firm is willing to forego by holding precautionary balances will be criterion for the upper limit for investment in cash.
Speculative Motive : It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While the precautionary motive is defensive in nature, in that firm must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so.
Compensation Motive: Yet another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain minimum balances of cash at the bank. Since this balance cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn a return. To be compensated for their services indirectly in this form, they require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. Such balances are compensating balances. Compensating balances are also required by some loan agreements between a bank and its customers. During periods when the supply of credit is restricted and interest rates are rising, banks require a borrower to main a minimum balance in his account as a condition precedent to the grant of loan. This is presumably to ‘compensate’ the bank for a rise in the interest rate during the period when the loan will be pending.
Cash Planning
Cash Planning involves the formulation of cash policies resulting from normal and abnormal requirements. Normal cash requirements are those which are predictable and occur as a result of routine operations and include cash of such items as raw materials, supplies, interest, wages and salaries, replacement of fixed assets which are worn out through use, dividends, and taxes. Abnormal requirements, which cannot be anticipated in the routine of the business process, include cash for fixed assets which are replaced for reasons other than normal depreciation, purchases resulting from price declines, and interruption of cash flow which reduce cash receipts without a corresponding reduction in cash disbursement. The main purpose of cash planning is to synchronise cash receipts with cash outgo. In most firms perfect synchornisation is difficult to achieve mainly because the inflow and outflow is effected by several factors.
Tools of Cash Planning
(vii) Net Cash Forecast through Projected Cash flow Statements which give the estimated receipts and disbursements on a month by month basis.
(viii) Cash Budget as a tool of cash planning and control.
(ix) Statement of Working Capital Forecast
(x) Cash Ratios like Acid Test Ratio, Turnover of cash etc.
(xi) Cash Reports : A cash report showing the monthly position can supplement the cash budget in the task of controlling the cash. The management must try to maintain a balance between cash receipts and payments and cash reporting helps very much in this direction.
(xii) Proforma Statement : In addition to the above tools, Cash Planning requires two additional statements viz., (a) Proforma Balance Sheet and (b) Proforma Profit and Loss Statement. The proforma balance sheet establishes a connection between planning for the use of assets. The proforma profit and loss statement reveals the managements planning regarding sales (revenue), expenses and net profit.
Cash Budget as a Tool of Cash Planning and Control : The cash budget may be used either as a simple forecasting device or as a means of aggressive strategy or planning. When used as a forecasting device, operating projections are made; cash inflows and outflows are matched, deficiencies are provided for and surplus funds invested. Aggressive planning involves estimating different levels of operations and judging the inflows and outflows to obtain then mix that makes the greatest contribution to the profitability of the enterprise without entailing too much risk.
Cash budget is a formalized structure for estimating cash income and cash expenditure over some period of time. The net cash position of the enterprise as it moves from one budgeting sub-period to another, is highlighted. The cash budget includes only cash flow, non-cash items such as depreciation, loss in sale of fixed assets etc., are excluded. The period of time covered by the cash budget may be a year, six months, three months or some other period. The sub-periods may be a day, a week, a month or a quarter, depending upon the needs of the enterprise. If the firm’s flow of funds is dependable and it has a large cash balance, a cash budget covering a period of one year divided into three-month intervals may be appropriate. Where substantial uncertainty is associated with the flow of funds a quarterly a cash budget broken into monthly intervals may be the most suitable. The cash budget since, it shows the size of cash balance at the end of each sub-period as well as the amount and term of financing required, is the key to arranging for needed funds at the most favourable terms available. Adequate time is available to study the needs.
Illustration 1.
Prepare a cash budget with the information provided. Cash balance as on January 1st, 2009 is Rs. 72500. 50% of the total sales are for cash. Assets are to be acquired worth Rs. 8000 in the month of February and worth Rs.25000 in April. Loan amounting to Rs.30000 to be received in the month of May. Dividends of Rs.35000 to be paid in the month of June. Debtors are allowed a one month’s credit. Credit for materials purchased and overheads allow for one month’s credit. Sales commission at 3% on sales is paid each month. Other cash flows include:

Month Sales (Rs.) Materials purchases (Rs.) Salaries & Wages (Rs.) Production Overheads (Rs.) Office & Selling Overheads (Rs.)
Jan. 72000 25000 10000 6000 5500
Feb. 97000 31000 12100 6300 6700
March 86000 25500 10600 6000 7500
April 88600 30600 25000 6500 8900
May 102500 37000 22000 8000 11000
June 108700 38800 23000 8200 11500

Solution:
Cash Budget
Jan.
(Rs.) Feb.
(Rs.) March
(Rs.) April
(Rs.) May
(Rs.) June
(Rs.) Total
(Rs.)
Receipts
Cash Sales 36000 48500 43000 44300 51250 54350 277400
Collection from debtors - 36000 48500 43000 44300 51250 223050
Bank loan - - - - 30000 - 30000
Total (a) 36000 84500 91500 87300 125550 105600 530450
Payments
Material - 25000 31000 25500 30600 37000 149100
Salaries & wages 10000 12100 10600 25000 22000 23000 102700
Prod. Ohs - 6000 6300 6000 6500 8000 32800
Off. & Sell. - 5500 6700 7500 8900 11000 39600
Sales Com. 2160 2910 2580 2658 3075 3261 16644
Capital Exp. - 8000 - 25000 - - 33000
Dividends - - - - - 35000 35000
Total (b) 12160 59510 57180 91658 71075 117261 408844
Net cash flow a - b 23840 24990 34320 (4358) 54475 11661 121606
Add: Op Bal of cash 72500 96340 121330 155650 151292 205767 194106
Closing Bal. 96340 121330 155650 151292 205767 194106 315712

Factors Influencing the Level of Cash Balance to Hold

1. Credit Position : If a firm enjoys a sound credit position, it is not necessary for it to keep heavy cash balances. If a firm wants to purchase its inventories on trade credit, it can keep only small cash balances. It will not be possible in such a case for a firm to synthronise the credit it allows and the credit it awails.
2. Position of Accounts Receivable : The amount of cash required is affected by the time factor viz., the time required for converting the accounts receivable into cash. If the credit term of the firm is longer, the turnover also will be slow. Therefore when the outflow and the turnover could not synchronise, it becomes necessary for a firm to maintain larger cash balance required to meet its requirements.
3. Nature of the product / Business : Nature of the business has also great influence on the cash requirements. If one business was to carry larger inventory as compared to that of similar business, it becomes necessary for the firm to invest additional funds in inventory. Further, cash requirement is influenced by the firm’s demand. If the firm’s demand is volatile, larger cash will be required.
4. Sales in relation to Asset : Another factor affecting the cash requirement is the volume of sales in relation to assets. In the case of firms with larger sales, as huge sums are invested in inventories and accounts receivable they should carry heavy cash balances. When sales increase cash requirements do not increase in the same proportion but there is definite increase in cash.
5. Management’s Attitude : Cash requirement of a firm is influenced by the attitude of the management also. If the management is of conservative type it will hold large cash than that which is less conservative. The demands of such a firm will be more of liquid nature. But a firm which plans its requirements effectively is less conservative. By planning, a firm will be able to predict its requirements accurately.
6. Distribution Channel : Distribution channel refers to the number of middlemen in the process of distribution of service or product. It the distribution channel is long and the credit policy is liberal the level of cash may be higher. If goods and services are sold through departmental stores or chain stores the cash holdings will differ substantially.
7. Size and Area of Operation : Area of operation refers to the geographical area in which the organisation is working. If the organisation working on large scale it is possible that organisation must have to keep higher cash level.
8. Duration of Production Cycle : It refers to the time period taken by the raw material to become finished product. In case of long production cycle the level of cash holding is likely to be high and vice-versa.
Advantages of Maintaining Ample Cash

(1) A shield for Technical Inefficiency : The provides of ample cash funds can prove to be a shield for technical inefficiency of a management.
(2) Maintenance of Goodwill : The goodwill and reputation of a business firm depends to a large extent on this fact that the firm retires all the obligations and meets the payments as and when they mature. It can be possible only when the firm maintains a good cash balance ascertained carefully for normal operations and adjustment for abnormal contingencies.
(3) Cash Discounts can be availed: If a firm has sufficient cash, it can avail cash discounts offered by the suppliers. It will lower down the raw material cost and finally the cost of production.
(4) Good Bank Relations: Commercial banks like to maintain good relations with such firms having high liquidity in funds. Large companies maintaining large liquid balances of cash in excess of their immediate needs, need to borrow very little if at all, on current account.
(5) Exploitation of Business Opportunities: Firms having good cash position can exploit the business opportunities very well. They can take risk of entering into new ventures.
(6) Encourage to new Investments: Firm having good cash position can maintain a sound (cash) dividend policy. It encourages the new investment in the shares of such firm because shareholders like cash dividend more.
(7) Increase in Efficiency : Unless there is an adequate supply of cash to bridge the gap a stringency develops. Operations are slowed, if not paralyzed. Creditors press for their payments. If payments can not be made in time bankruptcy and failure follow.
(8) Overcoming Abnormal Situations : Such firms can overcome abnormal financial conditions also with cash and without causing loss to the interest of existing shareholders.
(9) Other Advantages : Cash is often the primary factor deciding the course of business destiny. The decision to expand the business, the decision to add any new product in the product line of the company, etc., are decided by the cash position of the firm.
Utilization of Cash Surplus : A cash surplus is obviously a more acceptable proposition for a firm than a cash deficit. However, a cash surplus is idle cash and, therefore, unproductive. This surplus may be deployed for the greater benefit of the firm. If it is available permanently, it may be utilized for the purchase of additional equipment, for expansion, for the introduction of a new product, etc. However, it should not be recklessly squandered on hare brained loss-making schemes simply because it happens to be available.
Cash surplus should be utilised in the following ways:
(i) if it is available permanently, it should be deployed profitably in the business by a planned phase of re-equipments, expansion, etc.
(ii) If it is available for a short period, it may be invested in several short-term investments like Certificated of Deposit, Commercial Papers, Money Market Mutual Funds etc. However, short-term cash surpluses should not be used in speculative investments.
(iii) Short-term surplus may be used to qualify for the benefit of discounts from suppliers by prompt payment or by negotiating concessional prices with the suppliers.
(iv) If the cash surplus is permanent, it may be utilised (a) for the repayment of capital borrowed at exorbitant rates of interest; (b) for the extension of loans to subsidiaries; (c) for the investment of funds through mergers and acquisitions; (d) for new plant facilities on order earn a higher rate of return; (e) for the purchase of own securities to be used in acquisitions, stock option plans or other payments; (f) for the investment in the development of a products or the improvement of the old ones, etc.
It is not always desirable for a company or group of companies to build up a reserve or surplus cash funds in order to make a more effective use of money. The group may already have borrowed; it is therefore. far better and more cost effective to reduce such borrowings than to place surplus cash funds in the money market.

Avoiding Cash Deficit Cash Insolvency
Cash deficit, as stated earlier, presents a more difficult problem. A firm may reduce its cash deficit by a closer internal control rather than by resorting to external financing. A cash deficit may be dealt with in the following ways:
(xii) The collections from customers and sundry debtors should be accelerated.
(xiii) Liquidating marketable securities held by the firm.
(xiv) Accounts receivable should be discounted with a bank.
(xv) Factoring the receivables.
(xvi) Redundant assets should be sold out.
(xvii) Payments to suppliers nay be deferred to the extent possible. The firm may also take advantage of liberal trade credit terms.
(xviii) Expenditure on wages, salaries, etc., should be brought under control by maintaining the activity at a constant level instead of encouraging cyclical fluctuations. The payment of corporate taxes cannot be avoided. However a firm may pay on the last day of payment so that early payment and late payment can both be avoided.
(xix) Capital investment decisions should be avoided or delayed in order that a firm may be freed for the time being from commitment of funds.
(xx) Interest obligations are contractual. To avoid their payment, therefore, amounts to be default. A firm, however, should ensure that the period of interest payment does not coincide with the payment of inventory or other working capital items.
(xxi) Dividend payments may not be made in cash. It would be worthwhile to take stockholders into confidence to explain clearly the exigency of cash deficit. Non-payment of dividend might otherwise shatter their confidence.
(xxii) Utilising bank credit
The utimate hazard of running out of cash, however, and the one which lurks in the background of every debt decision, is the situation in which cash is so reduced, that legal contracts are defaulted, bankruptcy occurs and normal operations cease. Since no private enterprise has a guaranteed cash inflow, there must always be some risk, however, this event may occur rarely. Consequently, any addition to mandatory cash outflows resulting from new debt or any other act or event must increase that risk.
Costs of Being short of cash Short Costs: The ‘Costs’ of being short of cash come in the form of not being able to take advantage of discounts, and short-lasting special buying opportunities, and that of cost associated with credit impairment are called ‘short costs’ Detailed explanation of these costs are given below;
Loss of Discount : Discounts for paying cash promptly are usually very generous and the effective return on capital employed is often well above that earned on any other asset. To take advantage of discount, cash is required to be paid in very short period of time. For instance, a concern purchases goods worth Rs.10,000 on terms Rs.10,000/2/10, net 30 days. it means if the payment is made within ten days the firm will be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in full. If the concern wants to use Rs,9,800 for 20 days at a cost of Rs.200 and then its actual cost works to 2.04%. Further, taking the discount would mean a lower acquisition price for inventories. Thus, the impact of not being able to take advantage of a cash discount is therefore quite significant.
The quantity discount would require a higher purchase order. As a result, the higher carrying cost might outweigh the advantage of quantity discount. But this may not be true in all cases.
Cost associated with credit impairment
(ix) No credit given all dealings for cash; alternatively, the credit terms could be made less generous;
(x) Creditors could mark-up their prices up in order to compensate for poor payments;
(xi) Suppliers may refuse to deal at all;
(xii) Suppliers may give slow or unreliable delivery times, if there is an excess of demand for supplies, then the poor paying firm may find that it is the last on the list of priority customers.
(xiii) Short-term and financing will not be easily obtainable on reasonable terms.
(xiv) Banks may charge (a) higher (bank) charges on loans, overdrafts and cash credits (b) penalty rates to meet a short fall in compensating balances.
(xv) The attendant decline in sales and profits;
(xvi) In some cases the shortage of cash may lead to creditors to petition for a winding up of the firm. This has very adverse publicity effects.
The quantification of credit impairment is difficult and will probably have to be subjectively estimated. Apart from the loss of creditors confidence, a strained liquidity position also places pressures on individual mangers. The amount of time spent by senior executives to satisfy creditors when the cash balances are low is likely to be very costly.
Transaction Costs: These costs are associated with raising cash to tide over the shortage of cash. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities. These represent the fixed costs associated with the transaction. They consist of both explicit and implicit costs.
Borrowing Costs: Interest on loan, commitment charges, and other expensed relating to the loan raised to cover the cash deficit are called borrowing costs. The borrowing or financing costs are closely associated with the opportunity cost.
Techniques of Expediting Collections
Several techniques are employed to reduce the span between the time a customer makes payment and the time such funds are available for use by a firm. The following are the techniques designed to accelerate the collection of accounts receivables; (i) Concentration Banking (ii) Lock-Box System (iii) Playing on the float.
Concentration banking: In this system, large firms which have a large number of branches at different palaces, selects some of these which are strategically located as collection centres for receiving payment being collected at the head office of the firm, the cheques from a certain geographical area are collected at a specified local collection centre. Under this arrangement, the customers are required to send their payments (cheques) to the collection centre covering the area in which they live and these are deposited in a local bank account of the concerned collection centre, after meeting local expenses, if any. Funds beyond a predetermined minimum balance are automatically transferred daily by wire transfer or telex, to a central or concentration banks account. A Concentration bank is the Company’s head office bank i.e., one with which the form has a major account-usually a disbursement account. Hence this arrangement is referred to as Concentration Banking.
On the basis of their daily report of collected funds, the finance manager can use them according to need. However, the Company will have to incur additional cost to man these collection centres. Compensating balances to cover the cost of service are usually maintained with the local or regional banks. An indepth cost-benefits analysis of each region, where the collection centre is to be set up, should be undertaken by the company. Normally, the establishment of collection centres depends upon the volume of business in the area.
Concentration banking, as a system of decentralised billing and multiple collection points, is a useful technique to expedite the collection of accounts receivable. First of all it reduces the time needed in the collection process by reducing the mailing time. Since the collection centres are near the customers, the time involved in the sending the bill to the customer is reduced. Thus, mailing time is saved both in respect of sending the bill to the customers as well as in the receipt of payment. Secondly, the decentralised system hastens the collection of cheques because most of the cheques deposited in the company’s regional bank are drawn on banks located in that area. Thus, a company can reduce the time a cheque takes to collect. This is so mainly because by pooling funds for disbursement in a single account, the aggregate requirement for cash balances were maintained at each branch office
Lock-Box System: Under this arrangement firms hire a post office box at important collection centres. The customers are required to remit payments to the lock box. The local banks of the firm, at the respective places, are authorised to open the box and pick up the remittances (cheques) received from the customers. Usually, the authorised banks pick up the cheques several times a day and deposit them in the firm’s accounts. After crediting the account of the firm, the banks send a deposit slip along with list of payments and other enclosures, if any, to the firm by way of proof and record of collection. Thereafter, depending upon the arrangements made of proof and regional lock-box bank, funds in excess of balances maintained to cover costs are transferred automatically to company head quarters.
The lock-box system is like concentration banking in that the collection is decentralised and is done at branch level. But the main difference between them is that under concentration banking the customer sends the cheque to the collection centres or local branches while he sends them to a post office box under the lock-box system. In case of concentration banking, cheques are received by a collection centre and after processing, they are deposited in the bank. The lock-box arrangement is an improvement over the concentration banking system since the former eliminates the processing time the receipt and deposit of cheques within the firm. This system, reduces the exposure to credit losses by expediting the time at which data can come to know of dishonoured cheques and weak credit situations sooner. The lock box bank performs the clerical task of handling the remittances prior to deposits, services which the bank may be able to perform at a lower cost and consequently the overhead expenses are lowered. Further, it facilitates control by divorcing remittances from the accounting department.
However, the basic limitation of the lock-box system lies in additional cost which the company’s bank will charge in lieu of additional services rendered. Since the cost for these services is directly in proportion to the number of cheques handled by the bank, obviously the lock box arrangement will prove useful and economical too when average remittance is large.
Concentration banking is the most popular technique employed by business firms in India to intensify cash inflows. over three fifth of the firms rely on this technique. There is however, customers resistance to lock-box system and they insist on sending cheques directly to company head quarters, inspite of company’s insistence that remittance should be forwarded to the regional lock-box. The customers have been traditionally used to 7-10 days float (previously involved in making a remittance) and often draw and mail cheques against funds that would not be in their bank accounts for one week. The use of the lock-box system meant that they had to have bank balances to cover such remittances in the bank, later than one day after the cheque had been mailed.
Float : The term ‘float’ refers to the amount of money tied up in cheques that have been written and issued, but have yet to be collected and encashed. Alternatively, float represents the difference between the bank balance and book balance of cash of a firm. The difference between the balance as shown by the firm’s record and the actual bank balance is due to transit and processing delays. if the financial manager accurately estimate when the cheques issued will be deposited and collected, he can invest the “float” during the float period to earn a return. Float used in this sense is called ‘cheque kitting’. There are three ways of doing it: (a) paying from a distant bank, (b) scientific cheque encashing involving the time-lag in the issue of cheques and their encashment, and (c) the issue of bank draft.
If a firm’s own collection and clearing process is more efficient than that of the recipients of its cheques-and this is generally true of larger, more efficient firms then the firm should show a negative balance on its own records and a positive balance on the books of its bank. Obviously, the firm must be able to forecast its positive and negative clearing accurately in order to make use of float.
Cash Management Models
Baumol, Patinkin, Archer, Miler and Orr, and Orgler have developed some interesting models for cash management and to determine the minimum level of cash balances to be held by a business firm. Baumol’s mathematical model is based on the combination of inventory theory with monetary theory. in his model, cash is taken as an inventory item which flows out at a constant rate and is replenished instantaneously by borrowing or by selling securities. It is assumed that the size and timing of cash inflows are fully controllable to which a fixed cost per order(cost of converting the securities into cash) and a variable carrying cost per rupee (in the form of opportunity cost of holding cash i.e., the return on marketable securities) are attached. Since the cash outflow are known the only cash management decision is to decide about the volume of cash and the frequently at which cash is to be procured. Baumol has concluded that generally some cash should be kept even in a state of no change and that the transaction demand for cash will vary approximately in a proportion with the money value of transactions with the object of minimizing total cost. However, since the model is subject to unreal assumptions, it does not provide an applicable tool for cash management.
Patinkin’s model attempts to determine the optimum level of cash balance at the beginning of each period with the object of minimising the probability of cash shortage during the period. This model also assumes that (i) net cash flows in each period are equal to zero; (ii) cash flows cannot be controlled by a financial executive and (iii) all transactions between cash and other assets take place at the beginning of each period. Though this model takes into account both the cash inflows and outflows and is, Baumol’s model, deterministic in nature, the above assumptions limit the practical application of the model.
Mehta observes that as an approach to cash management, the Economic Order Quantity (EOQ) model is less than satisfactory. The assumptions about cash flows create problems. Unlike the physical stock, the cash inflows, will be interspersed with payments and at times receipts may exceed cash outflows. Infact, the cash balance can move in either direction, whereas in the usual inventory model ‘demand’ during any period is assumed to be non-negative.
Archer’s simple probabilistic model aims at determining optimum level of cash and marketable securities together to be held by a business firm. About this model, it has been commented that the model is largely based on a financial officer’s subjective decision.
Merton H. Miller and Daniel Orr developed somewhat different probability model. In this model, unlike Baumol’s model, cash flows are assumed to fluctuate in a completely stochastic manner.
Transaction can increase as well as decrease cash balance. Their main assumption about the model is that only two forms of assets exist; cash and marketable securities. As regards the optimum level of cash balance, Miller and Orr suggest that there is not only one specific minimum level of ideal cash balance but a range of ideal cash balances. Within this range cash balance be allowed to move upwards as well as downwards and no action is needed. But when the balance reaches the upper limit of the range, it is to be reduced to a predetermined level by purchasing marketable securities and when the cash balance reaches the lower limit, it is to be replenished by the sale of marketable securities.
Evaluation of Cash Management : In evaluating cash management, the finance manager has to (i) check all receipts and payments against the projections, (ii) compare the actual performance against predetermined plans and objectives, (iii) find out discrepancy if any analysing these variations in order to pinpoint the underlying performance conforms to the plans and goals of the economy. This means that there should be continuous budget evaluation of the cash position so as to make continuous control through policy decisions.
The following ratios have been used to evaluate different aspects of cash management performance.
2. To test the adequacy Cash:
(a) liquid ratio or Quick ratio:
(b) Net Cash flows to Current Liabilities ratio:
(c) Cash in terms of number of days of current obligations.
2. To assess the effective control of Cash flows:
(e) Cash to current in sales ratio;
(f) Cash turnover in sales ratio;
(g) Rate of growth in cash; and
(h) Absolute Liquid funds to current liabilities.
3. For productive utilisation of surplus cash;
(c) Marketable securities to current assets ratio; and
(d) Marketable securities to absolute liquid funds.
To set a firm’s liquidity and solvency, current ratio and liquid ratio are calculated. Traditionally 2:1 for Current ratio and 1:1 Quick ratio are taken as satisfactory standards for these purposes. The computation of cash in terms of number of days of current obligations is another measure to assess the sufficiency of cash. It is not practical to suggest any standard ratio in this regard to determine the adequacy of cash. It is influenced by the firm’s cash flows pattern, maturity schedule of its current obligations, and its ability to procure extra funds if develops.
The average cash to current assets ratio indicates the firm’s liquidity position. The proportion of cash to total current assets directly affects the profitability of a firm. A down ward trend in this ratio over a period indicates tighter control whereas up ward trend reveals a slack control over cash resources. Greater cash turnover in sales indicates the effective utilisation of cash resources. if a business can turnover its cash larger number of times, it can finance greater volume of sales with relatively lesser cash resources. This will increase the profitability of a concern. Moreover, such a business would not require proportionate increase in cash resources with the increase in sales volume.
The proportion of marketable securities in current assets indicates the firm’s prudence to invest temporary surplus in such short term investments to augment its over all profitability. Firms in India do not normally purchase marketable securities for the purpose of investing idle cash for short durations for two reasons: (i) Most of the firms consider it to be a speculative activity not meant for manufacture and (ii) investment in securities has same element of risk on account of fluctuation in their prices.
Illustration : 2
The following information is available in respect of a firm;
(d) On an average accounts receivable are collected after 80 days; inventories have an average of 100 days and accounts payable are paid approximately 60 days after they arise.
(e) The firm spends a total of Rs.1,81,20,000 annually at a constant rate.
(f) It can earn 8% on investments.
Calculate: (i) the firm’s cash cycle and cash turnover assuming 360 days in a year; (ii) minimum amounts of cash to be maintained to meet payments as they become due; (iii) saving by reducing the average age of inventories to 70 days.
Solution
(i) Cash cycle : 80 days + 100 – 60 = 120 days
Cash Turnover = 360 divided by 120 days = 3 times
(ii) Minimum operating cash =
= Rs.1,81,20,000 + 3 = Rs.60,40,000
(iii) Savings by reducing the average age of inventory to 70 days
New Cash Cycle = 120 days – 10 = 110 days
New Cash Turnover = = 3.2727 times
New Minimum operating cash =
= Rs.55,36,713
Reduction in investments = (Rs.60,40,000 – Rs.55,36,713)
= Rs.5,03,287
Savings = 8% on Rs.5,03,287 = Rs.40,263.


Illustration : 3
A firm uses a continuous billing system that results in an average daily receipt of Rs. 40,000,00. It is contemplating the institution of concentration banking, instead of the current system of centralised billing and collection. It is estimated that such a system would reduce the collection period of accounts receivable Rs.2 days.
Concentration banking would cost Rs.75,000 annually and 8% can be earned by the firm on its investments. It is also found that a lock-box system could reduce its overall collection time by four days and could cost annually Rs. 1,20,000.
1. How much cash would be released with the concentration banking system?
2. How much money can be saved due to reduction in the collection period by 2 days? Should the firm institute the concentration banking system?
3. How much cash would be freed by lock-box system?
4. How much can be saved with lock-box?
5. Between concentration banking and lock-box system which is better?
Solution
(1) Cash released by the concentration banking system
= Rs.40,00,000 x 2 days = Rs.80,00,000
(2) Savings = 8% x Rs.80,00,0000 = Rs.6,40,000. The firm should institute the concentration banking system. it costs only Rs.75,000 = 5,65,000.
(3) Cash released by the lock- box system = Rs.40,00,000 x 4 days – Rs.1,60,00,000.
(4) Savings in lock-box system: 8% on Rs.1,60,00,000. = Rs.13,80,000.
(5) Lock-box system is better. Its net savings Rs.11,60,000 (Rs.12,80,000 Rs.1,20,000) are higher than that of concentration banking.
Net savings = 12,80,000 – 1,20,000 = Rs.11,60,000
Difference net savings = 11,60,000 – 5,65,000=5,95,000
Additional savings Rs.5,95,000 if lock box system is introduced. Hence it is better to go for lock box system.
SUMMARY
Cash means and includes actual cash (in hand and at bank). Cash the blood stream in the human body, gives viability and strength to a business enterprises. The steady and healthy circulation of cash throughout the entire business operation is the basis of business solvency. This chapter provides the learner an idea about the nature of cash & issues in cash management. The motives for holding cash is explained the factors which influences the level of cash balance to be held is discussed. It also examines the strength and weakness of cash surplus / deficit. Techniques expediting collection is also dealt with in this chapter.

REVIEW QUESTIONS
9. Explain the nature of cash and state the scope and objectives of cash management.
10. Since cash does not earn can we still call it a working asset? Why? What are the principal motives for holding cash? How do they relate to cash as a working asset.
11. Enumerate the factors that influence the size of cash holdings of company. Discuss the inventory approach to cash management.
12. Discuss the methods accelerating cash inflows and decelerating cash inflows of a company.
13. Describe how a lock-box arrangement may be used to accelerate cash flow What costs are involved with the use of a lock-box?
14. Discuss the management problems involved in planning and control of cash Explain the main tools of cash planning and control.
15. What is a firm’s cash cycle’? How are the each cycle and cash turnover of a firm related? What should a firm’s objectives with respect to its cash cycle and cash turnover be?
16. Explain the following:
a. Compensating balance
b. Deposit float
c. Lock-box system
d. Cash forecast
e. Cash Budget
f. Cash ratios
g. Cash reports
h. Cash flow statement
i. Payment float
j. Cash losses
PRACTICAL PROBLEMS
2. Kay & sons manufacture summer garments. Sales are highest in the month of May. Prepare a cash budget for Kay &sons for the period January to June. The balance sheet as on the opening day of the accounting year is given:

Liabilities Amount (Rs.’000) Assets Amount (Rs.’000)
Current Liab. 3000 Cash 84480
Other liab. 10800 Debtors 42000
Capital 317280 Inventory 123000
Fixed assets 81600
Total 331080 Total 331080

The following additional information is given:

Sales Estimates
(RS.’000) (RS.’000)
Dec. 60000 April 228000
Jan. 84000 May 288000
Feb. 156000 June 108000
March 132000 July 108000


a) Sales for the month of Dec. were Rs.60,000,000.
b) Credit sales are 70% of the total sales for each month
c) Debtors are allowed a credit period of one month.
d) Gross profit margin on sales is expected to be 25%.
e) Payments for the purchases are made one month in advance.
f) A minimum inventory of Rs.60,000,000 at cost is always maintained. The co. purchase sufficient inventory each month to take care of sales of the subsequent month.
g) A 16% interest on loans ia payable in the next month of every quarter on the outstanding balance. Borrowing is possible each month in the multiples of Rs.1,000,000.
h) Other monthly expenses are:
Salary Rs.9,600,000
Rent Rs.2,400,000
Depreciation Rs.720,000
Other 1% of sales.

Prepare a cash budget for Kay & sons.


suggested readings
1. Bhabatosh Banerjee : Cash Management
Calcultta, The World Press (P) Ltd.
2. Khan, M.Y. and Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M. : Financial Management,
New Delhi, Vikas Publishing House
4. Van Horne, James C. : Financial Management and Policy,
New Delhi, Prentice Hall of India.


 
LESSON 9 RECEIVABLES MANAGEMENT
LESSON OUTLINE
• Objectives of Credit Management
• Decision Areas in Credit Management
• Credit Control Department
• Credit Policy-Credit Standard-Credit Scoring-Credit Terms
• Collection Policy-Credit Insurance-Factoring of Receivables
• Evaluation of Credit Management
• Illustrative Examples
INTRODUCTION
The whole spectrum of a business cannot entirely based on cash transactions. The sale (purchase) of goods or services is an essential part of the modern competitive economic system. In fact credit sales and therefore, receivables are treated as marketing tool to boost the sale of goods/services. The credit sales are generally made on open account and the expansion of the business depends on the expansion of credit available which in turn depends on credit worthiness of the firm.
Credit allowed i.e., deferred terms of payment to a purchaser (customer) helps him (i) to produce goods by buying input materials for which spot payment is not required, (ii) to have greater volume of sales through credit terms of payment and (iii) to deploy productive resources more economically. Greater volume of sales necessitate greater volume of production resulting in lower unit cost may lead to the possibility of lowering the selling price. Granting of credit involves use of financial resources i.e., a firm should be able to sell his goods on credit. At the same time the seller must be in a position to pay his creditors in time for the purchase of goods and services.
Objectives of Credit Management
The main objective of credit management can be enumerated as follows:
(a) Increase the volume of credit sales to the optimum level in relation to the credit period.
(b) To what extent the debtors volume to be in relation to the overall financial soundness of the firm.
(c) To have business volume to optimal level so that the point of overtrading and under-trading will not occur.
(d) Balancing of liquidity versus profitability in the context of trade off between credit volume of sales and the time span for realisation from credit customers.
(e) Control over cost of investment in sundry debtors and the cost of collection.
(f) At what level the price fixation to be done taking into account the cash discount, trade discount etc.
(g) To decide the price factor and the credit factor in relation to the competitors business.
(h) To take into account the external factors such as mercantile business conventions, effect of inflation, seasonal factors, government regulations and general economic condition.
(i) The proper lines of communication and co-ordination between finance, production, sales, marketing and credit control department.
Crucial Decision Areas in Credit Management
The credit management involves a study on (i) costs associated with the extension of credit and accounts receivables, (ii) credit policies involving credit standard, credit terms, collection policies, credit insurance, (iii) determination of size of receivables, and (iv) forecasting of receivables.
Costs Associated with the extension of Credit
The major categories of costs associated with the extension of credit and accounts receivables are (i) capital cost, (ii) administration cost, (ii) credit policies involving credit standard, credit terms, collection policies, credit insurance, (iii) determination of size of receivables, and (iv) forecasting of receivables.
(i) Capital Cost: The increased level of accounts receivable is an investment in current assets and it involves the tying up of capital. There is a time-lag between the sale of goods to and payments by, the customers. Meanwhile, the firm has to pay employees and suppliers of raw materials there-by implying that the firm should arrange for additional funds to meet its own obligations. While aviating for payment from its customers. The cost on the use of additional capital to support credit sales which alternatively could be profitably employed elsewhere, is therefore, a part of the cost of extending credit or receivables.
(ii) Administrative Cost: The maintenance of receivables calls for the use of an administrative machinery in different ways. A firm may have to create and maintain a credit department with staff, accounting records, and even to conduct investigations to find out the credit worthiness or otherwise of its customers. Administrative expenses are therefore incurred on the maintenance of receivables.
(iii) Collection Cost: An effective maintenance of receivables depend ultimately upon the effective collection of receivables. The cost of collection includes the expenses regarding engaging collection agencies or bill collectors, sending collection letters, cost of discounting bills of exchanges, collection of bills of exchange and other bank charges. A number of collection letters and reminders usually follow, which eventually increases the cost of collection.
(iv) Delinquency Cost: The cost which arises out of the failure of the customers to meet their obligations when payment on credit sales become due after the expiry of the period at credit is called delinquency cost. The important components of this cost are (i) blocking up of funds for an extended period, (ii) cost associated with steps that have to be initiated to collect the over dues e.g. legal charges.
(v) Default Risk i.e., bankruptcy: This refers to the cost of writing off bad debts in the event of debtors being adjudged as insolvent.
Credit Control Department
Where the firm is a sizable one, it is desirable that a person, called Credit Manager, be placed in charge of Credit Control Department. The Credit Controller or Manager should try to keep the bad debts down to the minimum and he may advocate the restriction of the sales to customers who would pay quickly. However, the Sales Department may be inclined to increase the sales by all possible means, and may not be careful in selecting credit customers by keeping in mind the question of recoverability of dues. These two interests conflict each other, though on the whole, both are beneficial to the organisation. It may be theoretically proper to segregate the functions of Credit Control Department and the Sales Department or even the Accounts Department. Usually most firms keep the task of credit control in the same department as is in charge of the Sales Ledger. This method provides an advantage of showing the limit of the credit and the actual amount outstanding in one single record, viz, the Sales Ledger Card.
Functions of a Credit Manager: The following are the financial details of a credit manager :
1. Maintaining credit card;
2. Involvement in credit decision;
3. Reporting credit position;
4. Institution of credit procedures;
5. Involvement in customers’ complaints;
6. Review of credit control system and procedures;
7. Attending or initiating legal formalities or actions;
8. Decision on bad debts / doubtful debts;
9. Training the credit department personnel;
10. Liaison with other departments.
Administration of Credit Control: The following are the important aspects involved in administrated of credit control.
1. The sales invoice should indicate the due date of payment.
2. The customers ledger should be recorded with the following among others, namely, the credit period allowed and the credit in terms of value.
3. Customer must signify his acceptance of credit terms in writing.
4. Close follow up of realization.
5. Month-end statement of account to be sent for customer’s confirmation.
6. Personal call by salesman and / or personnel from credit control department for collection of dues.
7. Credit assessment and review to be made to reassess the credit worthiness of the customers. A fresh decision on credit terms will depend on such an exercise.
8. There may be the necessary that persons to be entrusted fro credit control should have adequate knowledge of administering credit control.
CREDIT POLICY
The term “Credit Policy” refers to those decision variables that influence the amount of trade credit i.e., the investment in receivables. A firm’s credit policy provides the guidelines for determining whether to extend credit, to customer (and to the customers as a whole) and how much credit to extend and to how long the credit period is to be allowed / fixed. The credit policy includes (i) credit standards, (ii) credit period, (iii) credit terms, (iv) collection policy of the firm, and (v) provision of credit insurance.
Credit Standard
The credit manager has the responsibility for administering policy. However because of the pervasive importance of credit, the credit itself is established by the executive committee, which normally consists of the President / Director in charge of finance production and marketing. The ‘easy’ credit policy involves (a) extending credit to a more risky class of customers, (b) extending the allowable payment period (c) raising the cash discount allowed for prompt payments, and (d) reducing the ‘pressure’ of the collection procedure on overdue accounts. The new terms will be 3/15 and 45 instead of the current 2/10, net 30. These changes are expected to increase sales, but they will also increase the losses on bad debts and the investment in account receivables. The ‘tough’ credit policy involves (i) tightening credit standards, (ii) reducing credit terms to 1/10, net 20 and (iii) increasing the collection of efforts or overdue accounts. It will result not only in lower sales but also in lower bad debt losses and a smaller investment in account receivable.
The credit standard followed by a firm has an impact on sales and receivable. The sales and receivable are likely to be high, if the credit standard of the firm are relatively loose. In contrast, if the firm has relatively tight credit standards, the sales and receivable levels are expected to be relatively low. Relaxing credit standard involves two costs: (i) additional establishment expenses i.e., enlarged credit departmetn and the clerical expenses involved in maintaining additional accounts are servicing the added volume of receivables and (ii) bad debt losses which increase with increased sales and a slower average collection period. If new customers are attracts by the relaxed credit standards, collecting from these customers is likely to be slow than collecting from existing customers. In addition, a more liberal expansion of credit may cause certain existing customers to be less conscientious in paying their bills on time. Those who decide credit policy must consider this possibility.
The extent to which credit standards can be realised should depend upon the matching between the profits arising due to increased sales and costs to be incurred on the increased sales. Determining the optimal credit standards involves equating the marginal costs of credit to the marginal profits on the increased sales. Marginal costs include bad debt losses, investigation and collection costs and higher costs tied-up to accounts receivables if the customers delay payment longer than the usual period.
Since credit costs and credit quality are closely related, it is important to be able to judge the quality of an account. A good credit manager can make reasonably accurate judgments of the probability of default by different classes of customers. To evaluate credit risk, credit managers consider the five C’s of credit-character, capacity, capital, conditions and collateral.
Character is a customer’s own desire to pay off debts. This factor is of considerable importance, because every credit transaction implies a promise to pay. Experienced credit managers frequently insist that the moral factor is the most important issue in a credit evaluation.
Capacity is a subjective judgment of customer’s ability to pay debts as reflected in the cash flows of the individuals or firm. It is also gauged by their past records, supplemented by physical observation of customer’s plants or stores, and their business methods.
Capital refers to the financial strength of the customer, which depends primarily on the customer’s net worth relative to outstanding debt obligations.
Conditions refer to the impact of general economic trends or to special developments in certain areas of the economy that may affect customer’s ability to meet their obligations.
Collateral is any asset that customers may offer as a pledge to secure credit. Collateral, thus, serves as a cushion or shock absorber if one or several of the first four C’s are insufficient to give reasonable assurance of repayment on maturity.
Information on these items is obtained from the firm’s previous experience with customers, supplemented by a well developed system of information gathering groups. The credit worthiness of a customer can be assessed by any one of the following:
a. Past records about the business.
b. Opinions of salesman who have acquired information by interviewing the customer.
c. Valuation by professionals on the customers business assets.
d. Analysis of the financial statement of business.
Credit information can be gathered by employing the following indirect methods:
Bazar Reports or Trade Reference : Reports about the credit applicant can be obtained from the various markets particularly from businessmen carrying on the same trade.
Bank Reference or Reports from banks : Information about all customer can be obtained from different banks with which the customer deal. Most commercial banks maintain credit department of their own to perform credit investigation for their customers.
Other Sources : Credit information on business firms, especially the large ones, might be available from credit rating agencies, trade journals, newspapers, magazines, trade directories, public records such as tax returns/statements, municipal records, etc.
Credit-Scoring Systems
Many firms have used sophisticated statistical techniques in conducting their credit analysis. Multiple discriminant analysis employs a series of variables to categories people or object into two or more distinct groups. A credit-scoring system utilizes multiple discriminate analysis to categorise potential credit customers into two groups : good credit risk and bad credit risk. An important advantage of a credit-scoring system is that all of the variabels are considered simultaneously, rather than individually as in the traditional analysis of five Cs. The plastic credit cards used by millions of citizens are the result of credit-scoring systems. In addition to widespread usage in consumer credit, credit-scoring systems are increasingly used in commercial credit.
Suppose that a large retail firm had historical information on 200 customers who paid promptly and 200 customers who did not. Using data from those 400 credit applications, multiple discriminate analysis were made to determine the particular set of credit variables that best distinguishes the prompt group from the non-prompt group. The following profile of eight variables were identified:
Age (0.4) Annual income (0.6)
Martial Status (20.0) Residence (4.6)
Occupation (4.3) Home ownership (1.2)
Time on last job (0.9) Telephone (15.0)

Multiple discriminate analysis also determine the numerical weightings which each of the variables should be given in calculating a total weighted credit score for each credit applicant. The relative weights of the right variables are shown in parentheses. The discriminate procedure also provides information of management on how credit-score levels are related to likely payment patters by customers. Suppose the following guidelines were developed.
Credit score Action
Less than 60 Deny credit
60 to 80 Investigate further
Greater than 80 Grant credit

Notice that for credit scores between 60 and 80, the guidelines call for additional credit investigation.
The model of Credit-Scoring System given below shows how the credit score would be calculated for a hypothetical applicant. The middle column includes the particular values for the applicant. When combined with the relative weights, a total credit score of 104.1 is obtained. Since this easily exceeds the critical level of 80, the customers would be granted credit without further analysis.
One advantage of credit scoring, already mentioned, is that several variables are considered collectively. This captures interrelationships between variables that may be overlooked in a traditional credit analysis. Another advantage is that credit-scoring systems can be used to routinely accept or reject credit applications for which the final decision is relatively clear. This frees time for credit analyst to focus in greater detail on marginal applications. In so doing, credit scoring does not substitute for sound human judgement, but rather serves to direct that judgement to more difficult credit decisions. A disadvantage of credit scoring is that expenses are incurred by the firm in developing a workable system. Care must be taken in constructing samples of good and bad customers. Managerial judgment is needed in selecting the best profile of credit variables. Management must also experiment with the resulting guidelines to ensure that the costs of wrong decisions are minimized.


Model of Credit-scoring System
Variable Measurement Value Weight Weighted value
Age In years as reported 36 0.4 14.4
Marital status Coded 1 (yes) or 0 (no) 1 20.0 20.0
Occupation Coded 1 to 5 for different processions 4 4.3 17.2
Time on last job In years as reported 6 0.9 5.4
Annual income In thousand of rupees and reported 22.5 0.6 13.5
Residence Coded 1 to 5 for different postal zones 3 4.6 13.8
Home ownership Number of years owned as reported 4 1.2 4.8
Telephone Coded 1 (yes) or 0 (no) 1 15.0 15.0
Total Credit score 104.1

Credit Terms
The stipulations under which the firm sells on credit to its customers are called credit terms. Credit terms have four components – the cash discount, the cash discount period, the credit period and the credit limit. Changes in each of these components affect the firm’s sales, profits, average collection period and bad debt expenses. Each trade has its customary terms of credit which frequently dictate the nature of credit terms to be offered by a firm. New firms normally offer liberal credit terms so as to attract customers. Sometime, even an established firm may offer still more favourable terms in order to retain old customers and to attract new ones.
Cash Discount : Many firms offer to grant cash discounts to their customers in order to induce them to any their bills early. The cash discount terms indicate the rate of discount and the period for which discount has been offered. If a customer does not avail this offer, he is expected to make full payment by the net date. For example, credit terms expressed as ‘2/10, net 30”. This implies that a 2 per cent discount will be granted if the payment is made by the tenth day or even before; if the offer is not availed, the full payment has to be made by the 30th day. When a firm initiates or increases the rate of cash discount, the following changes and effects on profits can be expected :

Item Direction of change Increase / Decrease Effect on Profit Positive / Negative
(i) Sales Volume
(ii) Average collection period
(iii) Bad Debtor expenses
(iv) Profit per unit Increase
Decrease
Decrease
Decrease Positive
Positive
Positive
Negative

Advantages of Cash Discount : The seller gives this discounts because (i) he receivables his sale proceeds quickly (promptly) and can use it to buy more goods without having to borrow from his bank, (ii) he saves time and expenses in the collection of bills. This leads to less clerical work, less postage, less stationery etc. Usually, delay leads to default or payment once delayed means payment denied. Hence remember the old saying, a rupee saved is a rupee earned; (iii) he has less trouble over bad debts; and (iv) he avoids litigation or unnecessary legal expenses.
Credit Period : The time duration for which credit is extended to the customers is referred to as credit period. It is generally stated in terms of net date. Normally, the credit period of the firm is governed by the industry norms, but firms can extend credit for longer duration to stimulate sales. Changes in the credit period also affect’s the firm’s profitability. Increasing the credit period should increase the sales both the average collection period and bad debt expenses are likely to increase as well. Thus the net effect on profit may be negative. If the firm’s bad debts build up, it may tighten up its credit policy as against the industry norms.
Cash Discount Period : In addition to the size of the cash discount offered, the length of the discount period also may affect the average collection period and profit. When the cash discount period is increased there is a positive effect on profits because many customers who did not take the cash discount in the past, may now be tempted to avail it, thereby reducing teh average collection period. However, there is also a negative effect on profit when discount period is extended because people who already were taking the cash discount will be able to still take it and pay later, thereby lengthening the average collection period. For all practical purposes, the discount period is variable within only a narrow range. The minimum period for mailing invoice and receipt of chequest6 is about ten days. To increase it significantly beyond ten days defeats its purpose. In reality, them the discount period is not an important decision variables.
Credit Limit : The firm has not only to determine the duration of credit but also the amount of credit. The decision on the magnitude of credit will depend on the amount of contemplated sales and customer’s financial strength. In case of the customer who is a frequent buyer of the firm’s goods, a line of credit can be established. For example, if a customer normally buys goods of Rs.25,000 per month on the average, for him the line of credit can be fixed at this level. The credit line must be reviewed periodically in order to know the development in the account. If the tendencies of slow paying are found, the credit line can be revised downward. At times, a customers may ask for the amount of credit in excess of his credit line. The firm may grant excess credit to him, if the product has a high margin or if the additional sales help to use the unutilized capacity of the firm.
Collection Policy
Collection policy refers to the procedures the firm follows to obtain payment of past-due accounts. Prompt collection of accounts tends to reduce investment required to carry receivables and the costs associated with it. A firm with long over-due accounts will be exposed to greater amount of risk of non-payment. It is also possible that customers who have not cleared the payment long due may be hesitant to place order on the firm for further supplies causing loss of some sale to the firm.
The overall collection policy of the firm is determined by the combination of the collection procedures it undertake. These procedures include such things as reminder letters sent, phone calls, personal calls and legal action. Monthly statements should be sent to the customers of overdue accounts. Some of the customers may not pay until they are reminded. It should be ensured that statement of accounts are sent promptly at the end of each month.
The most important variable of credit policy is the amount expended on collection of accounts. Other things remaining same, the greater the amount spent on collection efforts, the lower the percentage of bad debt losses and the shorter is the average collection period and vice-versa.
Some of the common impediments in debts collection visible in many companies are (i) inadequate invoicing producers, (ii) incomplete documents,(iii) non-compliance with the terms of despatch, (iv) absence of debtors information such as list of outstanding, age, schedule, etc. Some of the effective steps in debt collection drive are :
1. Organizing and maintaining an efficient credit (collection) department.
2. Setting credit standards and terms and defining clearly the collection policies and procedures.
3. Preparing periodically, the customers accounts by age, sales regions, territories, etc., and sending them to respective sales offices staff for follow up.
4. Assigning specific responsibility for collection.
5. Offering incentives like cash discounts for prompt payments.
6. Organizing a machinery for settlement in case of disputes.
7. Reviewing the customers accounts periodically, to identify frequent default and irregular accounts in order to tighten the credit terms and avoid bad debts. It is only the effective follow-up which can produce quick liquidity and as such there is no substitute for close and systematic review of customers accounts.
Financing of Debtors : Some of the financial policies used to finance debtors and ensure efficient credit management to vogue especially in industrialized countries are, factoring of debtors, borrowing against purchasing of debtors, etc. In India, however, though borrowings against debtors, (i.e. working finance facilities against pledge of books debts) is not uncommon, factoring and purchasing of debtors are not very popular. There is need for separate agencies to undertake debt collection. For non-banking finance companies this would be a new avenue of business.
Credit Insurance
This is a method by which insurance cover is obtained for possible bad debts. There are several types of which, the following are the most important: (a) The Whole Turnover Policy : This covers the total turnover for the period of 12 months and premium of a specified percentage is payable on the turnover. The turnover relating to associate companies, Government department, nationalized industry and local authority are considered free of risk and not included, (b) The Specific Account Policy: It provides insurance cover to any account which involves a large sum of debt.
Valuation of Sundry Debtors
The basis of valuations is the amount, which it is estimated, will be realized by collection in the ordinary course of business. This will involve a reduction in the book value from the sale price figure to the estimated collectable value and this is effected by means of provisions for doubtful debts and discounts allowable. Books debts should be calssified as under: (a) according to age; (b) according to security realisability; and (c) showing separately, debts due by persons connected with the management and others.
According to age, sundry debtors should be classified into:
(1) debts outstanding for a period exceeding six months;
(2) other debts.
According to security and realisability, sundry debtors should be classified as under:
(i) debts fully secured and in respect of which the company is fully secured;
(ii) debts considered good fro which company holds no security other than the debtor’s personal security; and
(iii) debts considered doubtful or bad.
The debts due from persons connected with the management and others should be classified as under:
(i) debts due by directors or other officers of the company or any of them either severally or jointly with any other person;
(ii) debts due by firms in which any director is a partner.
(iii) debts due by private companies in which any director is a director or a member;
(iv) debts due from other companies under the same management. By way of a note in the balance sheet, the maximum amount due by directors or other officers of the company at any time during the year should be stated.
The provision in respect of bad and doubtful debts should be shown by way of deduction. Such a provision should not exceed the amount of debts stated for be considered doubtful or bad.
Factoring of Receivables
Receivables may be pledged as collateral which is called discounting of receivables or sold to a financing agency, whish is called “factoring”. Commercial banks and finance companies are the primary institutions that lend against a pledge of receivables. Factor purchase account receivable outright.
The pledging of account receivable is characterized by the fact that the lender not only has a claim against the receivables but also has recourse to the borrower (seller). If the person or the firm that bought the goods does not pay the selling firm must take the loss. In otherwords, the risk of default on the accounts receivables pledged remains with the borrowers. Also, the buyer of the goods is not ordinarily notified about the pledging of the receivables.
Factor of Factoring company is a firm that, by arrangement, purchases the trade debts of its clients and collects them on its own behalf. The factor has the right to select the debts he will service and may not be prepared to make advances against debts that he considers doubtful. Factoring is common method of financing receivables in United States but developed more recently (since 1960) in the United Kingdom.
In India, factoring of receivables has been introduced based on the recommendations of Kalyanasundaram Committee, 1986. Four factoring concerns have been permitted by the Reserve Bank of India.
Southern Zone : Can bank Factor Ltd., Sponsored by Canara Bank
Western Zone : SBI Factor & Commercial Services Ltd.,
Sponsored by State Bank of India.
Eastern Zone : All bank Factor Ltd., Sponsored by Allahabad Bank.
Northern Zone : PNB Factor Ltd.,
Sponsored by Punjab National Bank.
Functions of Factors : The factor performs three functions in carrying the normal procedure for factoring of debts (i) financing (lending) (ii) risk bearing (iii) credit checking.
Financing : The factors function is to help to provide the trade with working capital. Once the client sends a batch of invoice to the factor, he can draw a high percentage of the amount in invoices. The client may have to pay about 2% over the bank rate for a period only from the date of advance to the date of payment by the customer. This finance strictly speaking is not borrowing and will not appear in the balance sheet as such the company’s ability to raise further finance is not affected. A firm employing a factoring organisation will thus have more capital at its disposal, an important consideration in a time of credit restriction.
Risk bearing : Factors by making finance available to their clients are taking credit risk instead of providing of finance. The degree of service provided and willingness to bear risk of bad debts and other terms vary from company to company. For bearing risk and servicing the receivables, the factor receives a fee of 1 to 3 per cent of the face value of the receivables sold. The free will vary according to typical size of individual accounts, the volume of receivables sold and the quality of accounts.
Credit checking : Credit checking about the buyer’s credit worthiness and acceptability may be done either by the credit department of the seller or by the factor. Where factoring is available a small and a medium sized firm can avoid establishing a credit department. The factor maintains a credit department and makes credit check on accounts. The factor’s service might well be less costly than a department that may have excess capacity for the firm’s credit volume. At the same time, if the firm uses part of the time of a non-credit specialist to perform credit checking, lack of education, training and experience may result in excessive losses.
Procedure for Factoring Accounts Receivable : When a seller receives an order from a buyer, a credit approval slip is written and immediately sent to the factoring company for a credit check up. If the factor does not approve the sale, the seller generally refuses to execute the order. This procedure informs the seller, prior to the sale about the credit worthiness and acceptability to the factor. If the sale is approved, shipment is made and the invoice is stamped to notify the buyer to make payment directly to the factoring company. Factoring is normally a continuous process instead of the single cycle.
Kinds of Factoring : There are different kinds of factoring done by factors; (i) Notification and Non-notification factoring and (ii) Recourse and Non-resources factoring.
There are some factors who buy clients invoices by advancing heavy percentage of invoice value and the balance will be paid after the debt is collected. In this case, although the firms buy invoices the supplier is responsible for collecting the debt and to guarantee the payment. This kind of facility offered is called “non-notification factoring” whereby the customers is not notified the sale of the invoice. It should be noted that the facility offered, by which cash is advanced, is based upon the credit worthiness of the customers and the credit control procedures of the firm.
When a firm factors its receivables, it may be either with or without recourse depending upon the type of arrangement negotiated. If the factoring arrangement involves full resource, the firm will want to maintain some sort of credit department in order to limit its risk exposure. On the othershand, if the receivables are sold without recourse the factor bears both the risk of bad debt losses and of the expenses associated with the collection of accounts.
Advantages : For the seller of the goods and also the exporter factoring arrangement has a number of advantages :
1. It gives him all the advantages of a cash trade while allowing him to offer credit to his customers (either local or overseas or both).
2. It relieves him all the work involved in sales accounting and debt collecting.
3. It eliminates the uncertainty and risk of bad debts should buyers becomes insolvent.
4. Consequently, the cash flows of the firm are more predictable.
Its principal short coming is that it can be expensive. For a small firm, the savings may be quite significant. Second, the firm is using a highly liquid asset as security and such financing may be regarded as a confession of a firm’s unsound financial position.
Evaluation of Receivables Management
The possible measures of appraising performance of the credit department are as follows : (a) percentage of orders rejected to credit sales; (b) percentage of monthly collections on past dues accounts to the accounts due at the beginning of each month; and (c) percentage of bad debts to credit sales. When taken together these measures may present a picture of undesirable strictness or leniency. Thus an unusually low turnover of receivables in relation to the characteristic ratio of the industry, a negligible reduction rate, a high proportion of past due accounts would require tightening of credit standards and collection procedure. The problem would have to be analyzed on the basis of historical and horizontal standards in order to find out whether or not percentage and ratios are unusually high or low.
Turnover of Debtors (Debtor’s Velocity) Ratio: This ratio explains the relationship of net (credit) sales of a firm to its books debts indicating the rate at which cash is generated by turnover of receivables or debtors. The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivables remain uncollected i.e. ageing of receivables.
Turnover of Debtors Ratio (Number of times in a year)
=
If the annual turnover rate is say 6 times, this means that, on an average receivables are collected in 2 months, i.e., average collection period is 2 months time. Alternatively, average collection period is calculated thus:
=
Trade debtors include bills receivables along with book debts. Bills arising not from regular sales e.g., a bill receivable from the buyer of fixed assets, should be excluded. Bad and doubtful debts and their provisions are not deducted from the total debtors in order to avoid the impression that a large amount of receivables have been collected. If the break up of sales into cash and credit sales is not available, the analyst has to use the total sales for computation of the ratio. As to the calculation of daily sales, the number of working days of the firm during the year is customarily taken as 360 days rather than 365 days exact; Average collection period is analyzed with reference to the (billing) terms of sales and then, over dues are counted after the expiry of credit period allowed.
Creditor’s (Creditors’ Velocity) Ratio: This ratio shows the velocity of the debt discharged by matching annual credit purchases to the outstanding payables (both trade creditors and bills payables) at the accounting date.
Creditors or payables Ratio (Number of times in a year)
=
Smaller the payable ratio, greater the credit period enjoyed and consequently larger the benefit reaped from credit suppliers.
Average Payment Period (Number of days in a year)
=
Ageing of Accounts Receivables : Ageing of Accounts is yet another method of analyzing the liquidity of receivables. This involves classifying the amount due in each account according to the period that it is outstanding or categorizing the receivables at a point of time according to the proportions billed in previous months. For instance, such a classification as on 31 December of any year may reveal that 60% of the amounts outstanding are not more than a month old, 20% may be more than a month but less than 2 months old, 12% may be outstanding for more than 60 days (2 moths) but less than 90 days (3 months) and 8% of the amount may be more than 3 months old. If the terms of sale require payment within 30 days, the information as regards ageing of accounts shows that 40% of the amount of receivables are overdue, 20% are upto one month overdue 12% up to 2 months overdue and 8% are more than 2 months overdue. Evidently, the accounts with outstanding dues which are long overdue need to be investigated and written off, if they are uncollectable. With the information on ageing of accounts, the analyst can get an accurate picture of the investment in receivables and changes in the basic composition of the investment over time.
Ageing Schedule
Outstanding Period (day) Outstanding Debtors (Rs.) Percentage of total debtors
1 to 30
31 to 60
61 to 90
Over 91 2,40,000
80,000
48,000
32,000 60%
20%
12%
8%
4,00,000 100%

The Ageing Schedule breaks down debtors according to length of time for which they have been outstanding and gives a detailed idea of the quality of debtors. The average collection period measures the quality of debtors in an aggregative way while ageing schedule very clearly spots out the slow paying debtors.
I

llustration : 1
A firm sells goods of Rs.10,000 on ‘2/10, Net 30 days basis’. The customer has two options (i) either to avail of cash-discount by making payment on or before 10th day; or (ii) to keep the credit open and pay full amount by the 30th day.
Assuming that bank finance is available on 18 per cent per annum suggest which option would be more beneficial to the customer to exercise.
Solution
In cases, the first option is exercised, the customer saves Rs.200 and has to pay only Rs.9,800.
If the customer does not avail of the facility of 2% cash-discount and pays Rs.10,000 on the 30th day, then it would imply that he is paying interest of Rs.200 on Rs.9,800 (10,000-200) for getting the facility of keeping Rs.9,800 for a duration of 20 days. This by implication would mean that Rs.200 is the interest on Rs.9,800 for 20 days. On this basis the interest for 12 months can be calculated as follows :
Interest for 12 months =
Annual Rate of interest =
As the rate of bank credit is only 18%, there is no point in exercising the second option (not availing of the facility of 2% discount) and paying 36.74% interest.
Therefore the customer must make the payment by the 10th day and take advantage of 2% cash discount. In case cash is not readily available then resorting to borrowing from bank (@ 18%) and making the payment by the 10th day (to get a discount Rs.200) will be beneficial to the customer.
Illustration : 2
A firm is considering pushing up its sales by extending credit facilities to the following categories of customers:
(a) Customers with a 10% risk of non-payment, and
(b) Customers with a 30% risk of non-payment.
The incremental sales expected in case of category (a) are Rs.40,000 while in case of categoring (b) they are Rs.50,000. The cost of production and selling costs are 60% of sales while the collection costs amount to 5% of sales in case of category (a) and 10% of sales in case of category (b) you are required to advise the firm about extending credit facilities to each of the above categories of customers.
Solution
(a) Estending Credit Facilities with 10% Risk of Non-payment
Rs.
Incremental sales
Less : Loss in collection (10%) 40,000
4,000
36,000
Net sales realized
Less : Production and selling costs (60% of sales)
Collection Costs (5%)
24,000
2,000

26,000
10,000

Thus, the firm can have extra income of Rs.10,000 by accepting the 10% risk group. It may, therefore, lower is credit standard in favour of this category of customers.
(b) Extending Credit Facilities with 30% Risk of Non-payment
Rs.
Sales by accepting 30% risk group
Less : Loss on collection (30%) 50,000
15,000
Net sales realized 35,000
Less : Production and selling costs (60% of sales) 30,000
Collection costs (10%) 5,000 35,000
Incremental Income Nil

Thus, the firm does not stand to gain or lose on account of extending credit to customers with 30% risk on non-payment. The firm should not, therefore, extend credit to such customers unless it is beneficial for the firm in the long-term because of having a wider market for its products.
Illustration : 3
The following are the details regarding the operations of a firm during a period of 12 months.
Sales Rs.12,00,000
Selling Price per unit Rs.10
Variable cost price per unit Rs.7
Total cost per unit Rs.9
Credit period allowed to customers One month
The firm is considering a proposal for a more liberal extension of credit which will result in increasing the average collection period from one month to two months. This relaxation is expected to increase the sales by 25% from its existing level.
You are required to advise the firm regarding adoption to the new credit policy, presuming that the firm’s required return on investment is 25%.
Solution
Computation of New Sales
Present sales
Additional sales 1,20,000 units x Rs.10
30,000 units x Rs.10 Rs.12,00,000
Rs. 3,00,000
Rs.15,00,000

Computation of New Total Cost
Present cost of sales
Cost of additional sales 1,20,000 x 9
30,000 x 7* 10,80,000
2,10,000
12,900,000

*Only variable costs to be considered.
New Average cost per unit =
=
Average Investment in Receivables under new sales pattern
Total annual sales 1,50,000 units
Cost of sales (1,50,000 x 8.6) 12,000
Average collection period 2 moths
Amount invested in receivables =
Additional investment in receivables = New investment - Existing investment
= Rs.2,15,000 – 90,000* = Rs.1,25,000

Profitability on additional sales
= Additional units sold x Contribution per unit
= 30,000 x Rs.3 = Rs.90,000
Return additional investment in receivables.
=
The required return on investment is only 25% where the actual return on additional investment in receivables comes to 72%. The proposal should, therefore, be accepted.
Illustration : 4
XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two proposed policies. Currently, the firm has annual credit sales of Rs.50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs.1,50,000. The firm is required to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the selling price. Given the following information which is the better option?
Present Policy Policy option I Policy option II
Annual credit sales Rs.50,00,000 Rs.60,00,000 Rs.67,50,000
Accounts receivable turnover ration 4 times 3 times 2.4 times
Bad debts losses Rs.1,50,000 Rs.3,00,000 Rs.4,50,000
Solution
XYZ Corporation Evaluation of Credit Policies
Present Policy Policy Option I Policy Option II
Annual Credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover 4 times 3 times 2.4 times
Average collection period 3 months 4 months 5 months
Average level of accounts receivables
12,50,000
20,00,000
28,12,500
Marginal increase in investment in receivables less profit margin (i.e. 70% of increase in receivables)

:

5,25,000

5,68,750
Marginal increase in sales : 10,00,000 7,50,000
Profit on marginal increase in sales (30%) : 3,00,000 2,25,000
Marginal increase in bad debts losses :
1,50,000
1,50,000
Profit on marginal increase (sales less marginal bad debts lossess) : 1,50,000 75,000
Required return on marginal investment at 25% : 1,31,250 1,42,188
Surplus (loss) after required rate of return 18,750 (67,188)

The above analysis shows that the Policy Option I gives a surplus of Rs.18750 whereas Policy Option II shows a deficit of Rs.67,188 on the basis of 25% return. Thus, Policy Option I is better.
Notes
1.
2.
Illustration : 5
A firm has annual sales of Rs.15,00,000. It grants 2 months credit to its customers with no cash discount facility. It intends to offer a discount of “2/10, net 60”. It is expected that this will reduce the average collection period to one month and 50% of the customers (in value) will take advantage of this benefit. The selling price is Rs.10 per unit, while the average cost per units comes to Rs.8.60. You are required to advise the firm regarding this new scheme presuming the required return on investment is 25% and one month is of 30 days.
Solution
Rs.
Annual credit sales 15,00,000
Cash discount allowed (15,00,000 x
15,000
Present investment in receivables (15,00,000 x
2,15,000
Expected investment receivables (15,00,000 x 1/12 x 8.6 / 10) 1,07,500
Decrease in investment in receivables 1,07,500
Savings in capital costs (1,07,500 x 25/100) 26,875
Net savings (Rs.26,875 – Rs.15,000) 11,875

Since the new creditors terms will result in a net savings of Rs.11,875, hence the firm may adopt them.
SUMMARY
The whole spectrum of a business can not entirely based on cash transaction. The sale of goods or services is an essential part of the modern competitive economic system. In fact credit sales and therefore receivable are treated as marketing fools to boost the sale of goods / services. The credit sales are generally made on open account and the expansion of the business depends on the expansion of credit available which in turn depends on credit worthiness of the firm. Their chapter lays the objective of credit (Receivable) management; identifies the decision areas in credit management. The cost associated with receivables management has been discussed. Credit policy, credit standard and credit terms and collection policy all has been evaluated and explained in the chapter.
REVIEW QUESTIONS
1. Explain the objectives of receivables management.
2. What are the determinants on the size of investment in receivables?
3. What system of control would you suggest to keep the investment in receivables within reasonable limits?
4. What benefits and cost are associated with the extension of credit? How should they be combined to obtain an appropriate credit policy?
5. What are a firm’s credit standards? On what basis are they normally established?
6. What is meant by a firm a credit terms? What do they determine?
7. What are collection policies? How can they be evaluated?
8. Explain briefly : (i) Credit insurance (ii) Factoring (iii) Ageing of Receivables (iv) Delinquent debts (v) Credit scoring.
9. A company manufactures several products which are marked all over India through wholesalers. How would the company decide the credit control policy it should adopt?
10. What factors should be taken in to account in deciding upon the credit limits to be allowed to a new customers who is likely to have substantial transaction with the seller?



PRACTICAL PROBLEMS
1. The Chidambaram & Co. Limited has currently annual credit sales of Rs.7,80,000. Its average age of accounts receivables is 60 days. It is contemplating a change in its credit policy that is expected to increase sales to Rs.10,00,000 and increase the average age of accounts receivables to 72 days.
The firm’s sale price is Rs.25 per unit, the variable cost per unit is Rs.12 and the average cost per unit at Rs.7,80,000, sales volume is Rs.17. Assume 360 days in a year.
i. What is the average accounts receivable with both the present and the proposed plans?
ii. What is the average cost per unit with the proposed plan?
iii. Calculate the marginal investment receivable resulting from the proposed change.
iv. What is the cost of marginal investment if the assumed rate of return is 15%
[Ans.: (i) Rs.1,28,000 (ii) Rs.16 per unit (iii) Rs.37,330 and (iv) Rs.5,600]
2. A firm has credit sales amounting to Rs.32,00,000. The sale price per unit is Rs.40, the variable cost is Rs.25 per unit while the average cost per unit is Rs.32. The average age of accounts receivable of the firm is 72 days.
The firm is considering to tighten the credit standards. It will result in a fall in the sales volume to Rs.28,00,000 and the average age of accounts receivable to 45 days.
Assume 20% rate of return. Is the proposal under consideration feasible?
[Ans.: The firm should not adopt more strict credit collection policy as it will decrease profits by Rs.1,05,350]
3. The Ramasamy & co. Limited is examining the question of relaxing its credit policy. It sells at present 20,000 units at a price of Rs.100 per unit, the variable cost per unit is Rs.88 and average cost per unit at the current sales volume is Rs.92. All the sale are on credit, the average collection period being 36 days.
A relaxed policy is expected to increase sales by 10% and the average age of receivables to 60 days. Assuming 15% return, should the firm relax its credit policy?
[Ans.: The firm should relax its credit policy as it increases profit by Rs.1,200].
SUGGESTED READINGS
1. Chandra, Prasanna : Fundamental of Financial Management
New Delhi, Tata McGraw Hill Co.
2. Hampton, J.J. : Financial Decision Making.
New Delhi, Prentice Hall of India.
3. Khan, M.Y. and Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.
4. Pandey, I.M. : Financial Management
New Delhi, Vikas Publishing House.

 
LESSON 10 INVENTORY MANAGEMENT
LESSON OUTLINE
• Motives for Holding Inventories
• Objectives for Inventory Management
• Costs for Inventory Policies and Decisions
• Inventory Control Techniques - EOQ – Stock levels – ABC Analysis etc,
• Inventory Valuation – LIFO – FIFO – HIFO – NIFO etc.
Motives for Holding Inventories: Generally three motives are involved in holding inventories.
(i) The transaction motive which emphasises the need to maintain inventories to facilitate smooth production and sales operations (called transaction inventory).
(ii) The precautionary motive which necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply force (called precautionary inventory).
(iii) The speculative motive which influences the decision to increase or reduce inventory levels to take advantage of price fluctuations (called speculative inventory).
Objectives of Inventory Management: Broadly, the objectives of inventory management can also be classified into operative objectives and financial objectives. Supply of all types of materials, avoidance of wastage like theft, pilferage, leakage, spoilage etc., promotion of manufacturing efficiency and prompt execution of their orders to ensure better service to customers. The financial objectives of inventory management include effecting economy in purchasing through economic order quantity and taking advantage of favourable markets, maintaining optimum level of investment in inventories, etc.,
Management information on stocks is required by the production department so that they can schedule workloads, shift-work and machine usage. Information on finished goods is required by the marketing department so that they can estimate whether customers’ requirements can be met or not.
Cost for Inventory policies and Decisions
There are four cost factors involved in general inventory policies:
(i) Acquisition or Ordering Cost: The cost associated with the placement of a purchase order i.e. expenses of the firm in acquiring or processing inventory. The cost associated with ordering consists of (a) Salaries of the staff in administration and purchase department, (b) Rent for the space used by the purchase department, (c) The postage, telegram and telephone hills. (d) The stationery and other consumable required by the purchasing depts., (e) Entertainment charges on vendors, (f) Travelling expenses, (g) Lawyers and court fees due to legal matters arising out of purchase, etc.
All these costs usually come to 15 to 20% as ordering cost. The expenditure on ordering of material is direct proportional to the number of orders placed.
(ii) Material Cost: It is the cost of materials itself.
(iii) Carrying or Holding Cost: It is the cost associated with keeping the materials in stock. The following costs are incurred in keeping materials in store, and the longer the materials are stored, the greater these costs become: (a) Capital costs i.e. the loss of return that could be obtained if the capital tied up in stock was employed elsewhere, (b) Space costs such as rent, heating, lighting etc., (c) equipment costs like bins, racks, etc., (d) personal costs involved in storing, stock taking security etc, (e) insurance costs i.e. protection against fire, theft, etc., (f) property taxes, (g) cost of handling the material, (h) stationery and other consumables used by the stores, (i) cost of wastage and material losses in the store, (j) obsolescence and deterioration costs. The higher the stock levels, the longer the time materials in stock, and so the greater is the risk, and therefore ultimate cost of obsolescence, (k) depreciation and repair cost for the stores facilities and handling equipment.
(iv) Overstock and understock costs: Carrying inventory which results where there is stock left on hand after the demand for the item has terminated. This cost is called the overstock cost. Understock cost refers to the cost of running out of goods or cost associated with shortages i.e., lost sales or profits.
S.No. Inventory with cost Inventory without cost
(i)
(ii)

(iii)
(iv)
(v)
(vi) Return on Investment
Storage cost

Handling cost
Handling equipment
Obsolescence
Spoilage and shelf life Stock out costs
Lost sale. Loss of future sale
(Demand x Future Profitability)
Loss of customers/goodwill
Down time cost
Idle, labour Idle production
Capacity and other cost

INVENTORY CONTROL TECHNIQUES
In most manufacturing concerns inventories are controlled through the following techniques:
(i) Economic Order Quantity,
(ii) Determination of stock Levels,
(iii) Inventory Turnover Ratio,
(iv) Input-output Ratio Analysis,
(v) A B C Analysis,
(vi) Perpetual inventory or Continuous stock taking,
(vii) Value Analysis,
Economic Order Quantity (E.O.Q.)
The Economic Order Quantity (E.O.Q.) is the optimum or the most favourable quantity which should be ordered for purchase each time when the purchases are to be made. The Economic Order Quantity is one where the cost of carrying is equal to, or almost equal to the cost of not carrying. The E.O.Q. is also known as Reorder Quantity or Standard Order Quantity and it depends upon two factors viz, cost of carrying and cost of ordering and receiving per order. The cost of carrying or holding costs can be estimated by the management on the basis of sales of past years but costs of not carrying enough are only estimated.
The formula of E.O.Q. is =
Where, I = interest payment including variable cost of storage per unit per year.
C = Consumption of materials concerned in units.
O = Cost of ordering and receiving per order,
Assumptions
(i) Inventory is consumed at a constant rate,
(ii) Cost do not vary over the period of time,
(iii) Lead time is known and constant,
(iv) Ordering cost, carrying cost and unit price are constant,
(v) Holding or carrying costs are proportional to the value of stocks held,
(vi) Ordering cost varies proportionately with price.
For example, a unit of material ‘x’ costs Rs.50 and the annual consumption is 2,00,000 units. The cost of placing an order and receiving the material is Rs.200 and the interest including variable cost of storage per unit per year is 10% per annum.
Economic Order Quantity =
=
The E.O.Q. approach can be extended to production runs to determine the optimum size manufacture. Two factors deciding the economic production size are set-up costs and carrying costs. Set-up cost is roughly equivalent to the ordering cost per order. It includes (a) engineering cost of setting up the production lines or machine, (b) paper-work cost of processing the work order and authorising production and (c) ordering cost to provide raw-materials for the batch or order. The set-up cost will reduce with bulk production runs, but the carrying costs will increase as large stocks of manufactured inventories will be held. Thus, the economic production-lot size is one where the total of set-up cost and carrying cost is minimum.
Illustration : 1
A manufacturer buys certain equipment from supplier at Rs.30 per unit. Total annual needs are 800 units. The following further date are available:
Annual return on investment 10%
Rent, insurance, taxes per unit per year Re.1.
Cost of placing an order Rs.100
Determine the economic order quantity.
Solution
Cost of carrying inventory per unit.
= 30 x 10% + 1 = Rs.4
E.O.Q. =
Determination of Stock Levels
The demand and supply method of stock control technique determines different stock levels viz; Maximum level, Minimum level, Reorder level, Average level, Danger level, etc.
Maximum Stock Level represents the quantity of inventory above which should not be allowed to be kept. This quantity is fixed keeping in view the disadvantages of over stocking. The disadvantages of over stocking are: (i) working capital is blocked up unnecessarily in stores and interest may have to be paid thereon (ii) more storage space is required so more rent, insurance charges and other costs of carrying inventory have to be incurred; (iii) there is risk of deterioration in quality depreciation in quantity due to evaporation, rusting etc, and risks of obsolescence besides the risk of loss due to breakage, theft, excessive consumption also, and (iv) possibility of financial loss on account of subsequent fall in prices.
The following are the factors helpful in deciding the limits of inventory to be stored: (a) amount of capital available and required for purchases, (b) storage facilities and storage costs (c) rate of consumption of the material, (d) possibilities of price fluctuations, (e) seasonal nature of supply of materials, (f) possibility of loss due to five, evaporation, moisture, deterioration in quality, etc, (g) insurance costs (h) possibility of change in fashion and habit which will outdate the products manufactured from that material, (i) restrictions imposed by government or local authority or Trade association in regard to materials in which there are interest risks e.g. fire explosion or as to imports or procurement, (j) economic order quantity, and (k) Lead Time.
Lead Time: From the time the requisition for an item is raised; it may take several weeks or month is before the supplies are received, inspected, and taken in stock. This time is called as “Lead time” or “Precurement Time” and involves the time for the completion of all or some of the following activities: (i) Raising of a purchase requisition, (ii) Inquiries, tenders, quotations, (iii) Receiving quotations, tenders, their scrutiny and approval, (iv) Placement of order on a supplier/ suppliers, (v) Suppliers time to make the goods ready (may have to be manufactured or supplied ex-stock), (vi) Transportation and clearing, (vii) Receipt of materials at the company, (viii) Inspection and verification of the materials, (ix) Taking into stock, and (x) Issuing items and carrying them to the place of work.
This lead time required to procure any item can be divided into two parts namely internal lead time (also known as Administrative Lead Time) required for organizational formalities to completed and external lead time (also known as Delivery Lead Time) as shown below:
Total Lead Time
Internal Lead Time + External Lead Time + Internal Lead Time
(Requisition order) (Placement of order (Taking unit stock)
and Receipt of goods)
It is a common belief that external lead time should be controlled and reduced but it has been found in actual practice that internal lead time constitute a considerable part of total lead time and offers ample scope for reduction. The management must make a determined and deliberate effort to reduce lead time by selectively delegating powers, better paper work procedures, and fixing targets individually for all activities. Obviously, in order to receive supplies before the stock reaches zero level, it is necessary to order the materials much in advance i.e., when the stock available is sufficient to last during the lead time.
Minimum Stock Level represents the quantity below which stock should not be allowed to fall. This is known as safety or buffer stock. The main purpose of this level is to ensure that production is not held up due to shortage of any material. This level is fixed after considering : (i) average rate of consumption of materials, and (ii) lead time.
Reorder Level (or Order level) is the point at which if stock of the material in store reaches the store – keeper should initiate the purchase requisition for fresh supplies of the materials. This level is fixed between maximum and minimum stock levels in such a way that the difference of quantity of the materials between the reorder level and the minimum level will be sufficient to meet the requirement of production up to the time the fresh supply to the material is received.
Danger Level means a point at which issues of the material are stopped and issues are made only under specific instructions. This level is generally fixed below the minimum stock level. When stock of materials reaches the danger level the purchase officer should take special arrangements to get the materials at any cost.
Just-in-time Inventory Control : The just-in-time inventory control system, originally developed by Taiichi Okno of Japan, simply implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components “just-in-time” to meet its assembly requirements. This may be contrasted with the traditional inventory management system which calls for maintaining a healthy level of safety stock to provide a reasonable protection against uncertainties of consumption and supply-the traditional system may be referred to as a “just-in-case” system.
The just-in-time inventory system, while conceptually very appealing, is difficult to implement because it involves a significance change in the total production and management system. It requires inter alia (i) a strong and dependable relationship with suppliers who are geographically not very remote from the manufacturing facility, (ii) a reliable transportation system, and (iii) an easy physical access in the form of enough doors and conveniently located docks and storage areas to dovetail incoming supplies to the needs of assembly line.
Formulae for Determination of Stock Levels
(i) Maximum Level = Reorder level + Reorder Quantity – (Minimum consumption x Minimum Reorder period)
(ii) Reorder Level = Maximum consumption x Maximum Reorder period
(iii) Minimum Level = Reorder level – (Normal consumption x Normal reorder period)
(iv) Average stock level = Minimum level + ½ of Reorder Quantity
(or)
= ½ (Minimum stock + Maximum stock)
(v) Danger Level = Maximum delivery time x Maximum rate of consumption
(or)
= Minimum rate of consumption x Emergency delivery time.
Illustration : 2
From the following information calculate the Maximum stock level, Minimum stock level, Reordering level, Average stock level and Danger level.
a. Normal consumption 300 units per day.
b. Maximum consumption 420 units per day
c. Minimum consumption 240 units per day
d. Reorder quantity 3,600 units
e. Reorder period 10 to 15 days
f. Normal reorder period 12 days
g. Time required to emergency purchase 4 days
Solution
Reordering level = Maximum consumption x Maximum reorder period
= 420 x 15 = 6.300 units
Minimum stock level = Reordering level – (Normal consumption x Normal reorder period)
= 6,300 – (300 x 12) = 2,700 units
Maximum stock level = Reordering level + Reorder quantity – (Minimum consumption x Minimum reorder period)
= 6,300 + 3,600 – (240 x 10)
= 9,900 – 2,400 = 7,500 units
Average stock level = ½ (Minimum stock level + Maximum stock level)
= ½ (2,700 + 7,500) = 5,100 units
Danger level = Minimum consumption per day x Time required for emergency purchase .
= 240 x 4 = 960 units.
Control through ABC Analysis – Selective Control
Different types of analysis each having its own specific advantages and purposes, help in bringing a practical solution to the control of inventory. The most important of all such analysis is ABC analysis. The others are:
F.S.N. - (Fast, Slow, Non-moving items) Analysis.
GOLF - (Government controlled, Ordinary available, Locally available and Foreign items) Analysis.
H.M.L. - (High, Medium, Low cost) Analysis.
S.D.E. - (Scarce, Difficult, Easily Available) Analysis.
SOS - (Seasonal and Off seasonal) Analysis.
V.E.D. - (Vital, Essential, Desirable) Analysis.
An effective inventory control system should classify inventories according to values so that the most valuable items may be paid greater and due attention regarding their safety and care, as compared to others. Hence, it is desirable to classify the production and supply items, both purchased and manufactured, depending upon their importance and subject each class of group of items to control commensurate with importance. This is the principle of control by importance and exception (C.I.E.) or selective control as applied to inventories and the technique of grouping is termed as A.B.C. analysis or classification which it said to be “Always Better Control”. As the items are classified in the importance of their relative value, this approaches is also known as Proportional (parts) Value Analysis (PVA) or Annual Usage Value (AUV) analysis.
The general procedure for implementing the ABC technique is as follows:
1. Classify the items of inventories.
2. Determine the expected use in units over a given period of time.
3. Determine the total cost of each item by multiplying the expected units by its unit price;
4. Rank the items in accordance with total cost, giving first rank to the item with highest total cost and so on;
5. Calculate percentage (ratio) of number of units of each item to total units of all and the percentage of total cost of each item to total cost of all items
6. Combine items on the basis of their relative value to form three categories – A, B and C e.g., classify the inventory as A, B or C based on the top 20%, the next 30% and the last 50% valuation respectively.
7. Decide cut-off points and method of control.
8. Tag the inventory with A,B.C classification and record these classifications in the item inventory master record.
Illustration : 3
The following information is known about a group of items. Classify the materials in A, B, C, Classification.
Model Number Annual consumption in pieces Unit price in Rs.
501
502
503
504
505
506
507
508
509
510 30,000
2,90,000
3,000
1,10,000
4,000
2,20,000
15,000
80,000
60,000
8,000 10
15
10
5
5
10
5
5
15
10

Solution:
Model Number Annual Consumption in pieces Unit Price
Rs. Annual consumption value Rs. Rank (According to value)
501
502
503
504
505
506

507
508
509
510 30,000
2,90,000
3,000
1,10,000
4,000
2,20,000

15,000
80,000
60,000
8,000 10
15
10
5
5
10

5
5
15
10 3,00,000
42,00,000
30,000
5,50,000
20,000
22,00,000

75,000
4,00,000
9,00,000
80,000 6
1
9
4
10
2

8
5
3
7
Total 8,10,000 87,55,000



Model No. & items Annual consumption value Rs. % Rank
A Category 502
506 10%
10% 42,00,000
22,00,000 48% 25% 1
2
Total 20% 64,00,000 73%
B Category 509
504
508 10%
10%
10% 9,00,000
5,50,000
4,00,000 10%
6%
5% 3
4
5
Total 30% 18,50,000 21%
C Category 501 10% 3,00,000 31/2
1% 6
510
507
503 10%
10%
10% 80,000
75,000
30,000 1%
¼
¼ 7
8
9
505 10% 20,000 10
Total 50% 5,05,000 6%
Grand Total 100% 87,55,000 100%
Control Through Perpetual Inventory System
The Institute of Costs and Management Accountants, England defines the perpetual inventory system as “a system of records maintained by the controlling department, which reflects the physical movement so stocks and their current balance”. Thus, this is a method of ascertaining balance after every receipt and issue of materials through stock records, to facilitate regular checking and to avoid closing down for stock-taking. In order to ensure accuracy of perpetual inventory record, it is desirable to check the physical stocks by a programme of continuous stock-taking. Any discrepency noted between physical stocks and the stock records can be investigated and rectified, then and there.
INVENTORY VALUATION
Materials are issued to different job or work orders from the stores. These jobs or work order are charged with the value of materials issued to them. Following are the important methods of valuing material issues :
A. Based on Cost Price
i. The first in First Out (FIFO) Method.
ii. The Last in First Out (LIFO) Method.
iii. The Highest in First Out (HIFO) Method.
iv. The Next in First Out (NIFO) Method.
v. The Base Stock Method
vi. The Specific (or Actual) Fixed Price Method.
vii. The Inflated Price Method.
viii. Fixed Cost Method.
ix. Average Cost Method.
a. Simple average price method.
b. Periodic simple average price method.
c. Weighted average price method.
d. Periodic weighted average price method.
e. Moving simple average price method.
f. Moving weighted average price method.
B. Based on Market Price Method
(i) Realisable Value Method
(ii) Replacement Value Method
C. Based on Standard Price Method
(i) Current Standard Price
(ii) Basic Standard Price
Methods Based on Actual Cost
(i) First In First Out (FIFO) Method : This method operates under the assumption that the materials which are received first are issued first and, therefore, the flow of cost of materials should also be in the same order. Issues are priced at the same basis until the first batch received is used up, after which the price of the next batch received becomes the issue price. Upon this batch being fully used, the price, of the still next batch is used for pricing and so on. In other words, the materials issued are priced at the oldest cost price listed in the storese ledger account and consequently the materials in hand are valued at the price of the latest purchases.
Example

Receipts Issues Rs.
2nd Jan. (first consignment)
500 kg. @ Rs.8.00 per kg.
5th Jan. (second consignment)
300 kg. @ Rs.8.20 per kg 7th Jan. 600 kg
500 kg. @ Rs.800 per kg.
100 kgs. @ Rs.8.20 per kg.
Rs.4,000
820
Total issue value : Rs.4,820

Advantages
1. This method is realistic in so far as it assumes that materials are issued to production in the order of their receipts.
2. The valuation of closing stock tends to be nearer current market prices as well as at cost.
3. Being based on cost, no un realized profits enter into the financial result.
4. The method is easy to operate if the prices do not fluctuate very frequently.
Disadvantages
1. The issue prices may not reflect current market prices and, therefore, when price increases the cost of production is unduly low.
2. The cost of consecutive similar jobs may differ simply because the prior job exhausted the supply of lower priced stock. This renders comparison between different jobs is difficult.
3. The method may involve cumbersome calculations if the prices fluctuate quite frequently.
The FIFO method is most successfully used when (a) the size and the cost of raw material units are large, (b) materials are easily identified as belonging to a particular purchased lot, and (c) not more than two or three different receipts are on a materials card at one time.
(ii) Last In First Out (LIFO) Method : This method operates on the assumption that the latest receipts of materials are issued first for production and the earlier receipts are issued last, i.e., in the reverse order to FIFO. It uses the price of the last batch received for all the issues until all units from this batch have been issued after which the price of the previous batch received becomes the issue price. usually, a new delivery is received before the first batch is fully used, in which case the new delivery price becomes the ‘last-in’ price and is used for pricing issues until either the batch is exhausted or a new delivery is received.
Example : Assuming the same figures which were taken in FIFO method, the issue of 600 Kgs, the value is shown below:
300 kgs. @ Rs.8.20 per kg. = Rs.2,460
300 kgs. @ Rs.8.00 per kg. = Rs.2,400
600 kgs. Total value = Rs.4,850

Advantages
1. The method keeps the value of issues close to the current market prices.
2. No unrealized profit or loss is usually made by using this method.
3. In periods of raising prices, the high prices of the most recent purchases are charged to operations, thus reducing profit figure and resulting in a tax saving.
Disadvantages
1. The value of the closing stock may be quite different from the current market value and hence may not be acceptable for income tax purposes.
2. Comparison among similar jobs is very difficult because different jobs may bear different charges for materials consumed.
3. This method does not conform to the physical flow of materials.
4. The number of calculation complicates the stores accounts and increases the possibility of clerical errors when rates of receipt are highly fluctuating.
Under condition of rising market prices, LIFO method is generally considered better. This is so because under LIFO method reasonably correct effect of current prices is reflected in the cost and the cost is not understand. The quotation of prices for the products also becomes more safe than FIFO.
(iii) Highest In First Out (HIFO) Method : The method is based on the assumption that stock of materials should be always valued at the lowest possible price. Materials purchased at the highest price are treated as being first issued irrespective of the date of purchase. The method is very suitable when the market is constantly fluctuating because cost of highly priced materials is recovered from the production at the earliest. But it involves too many calculations as in the case with the LIFO and FIFO methods. The method has not been adopted widely.
(iv) Next In First Out (NIFO) Method : The method attempts to value material issues at an actual price which is as near as possible to the market price. Under this method the issues are made at the next price i.e., the price of materials which has been ordered but not yet received. In other words, issues are at the latest price at which the company has been committed even though materials have not yet been physically received. This method is better than market price method under which every time when materials are issued, their market price will have to be ascertained. In case of this method materials will be issued at the price at which a new order has been placed and this price will hold good for all future issues till a next order is placed.
(v) Base Stock Method : The method is based on the contention that each enterprise maintains at all times a minimum quantity of materials in its stock. This quantity is termed as base stock. The base stock is deemed to have been created out of the firm lot purchased and therefore, it is always valued at this price and is carried forward as a fixed asset. Any quantity over and above the base stock is valued in accordance with any other appropriate method. As this method aims at matching current costs to current sales the LIFO method will be most suitable for valuing stock of materials other than the base stock. The base stock method has the advantage of charging out material as at actual cost. Its other merits or demerits will depend on the method which is used for valuing materials other than the base stock.
(vi) Specific Price Method : Where materials are purchased for a particular job, they should be charged to that particular job at their actual cost. This method can always be use where materials are purchased and set aside for a particular job until required for production. This method is best suited for job order industries which carry out individual jobs or contracts against specific orders. From the point of view of costing, the method is desirable because it ensures that the cost of materials issued is actual and that neither profit nor loss arises out of pricing. This method however, is difficult to use if purchase and issues are numerous and the materials issued cannot be identified.
(vii) Inflated Price Method : In case of certain materials wastage is unavoidable on account of their inherent nature, e.g., if a log of timer is issued to various departments in pieces of if it is kept for seasoning, there will be some loss in its quantity. In such a case the production should be charged at an inflated price so as to recover the total cost of materials over the different issues.
(viii) Average Cost Method :
(a) Simple Average Price : Simple average price is the average of the prices without any regard to quantities. The calculation of simple average price involves adding of different prices dividing by the number of different pieces. The method operates under the principle that when materials are purchased in lots and are put in store, their identity is lost and, therefore, issues should be valued at the average price of all the lots in store. Though this method is very easy to operate, but it is crude and usually produces unsatisfactory results. The value of closing stock may be quite absurd. Moreover, materials are not charged at actual cost and, therefore, a profit or loss will usually arise out of pricing.
(b) Weighted Average Price : Weighted average price is calculated by dividing the total cost of material in stock by the total quantity of material in stock. This method averages prices after weighing (i.e., multiplying) by their quantities. The average price at any time is imply the balance value divided by the balance units. Issue prices need to be computed on the receipt of new deliveries and not at the time of each issue as in the case of FIFO and LIFO. Thus as soon as a fresh lot is received, a new issue price is calculated and all issues are then taken at this price until the receipt of the next lot of materials. This method operates under the assumption that the identity of the materials, when put in stores, is lost and therefore their cost should reflect the average of the total supply.
Advantages
1. Since the receipts are much less frequent than issues, the method is not so cumbersome because the calculation of the new issue price arises only when fresh lots are purchased. All subsequent issues are then charged at this price until the next lot is received.
2. The method even out the effect of widely varying prices of different consignments comprising the stock.
3. A profit or loss may arise out of pricing.
4. Issue prices may run to a number of decimal points.
(c) Periodic Simple Average Price : This method is similar to the simple average price except that there the issue price is calculated at the end of each period (normally a month) covering the prices at which purchases were made during the period and not at the occasion of each issue of material.
(d) Periodic Weighted Average Price : The periodic weighted average price is the weighted average price of materials purchased during a period. It is calculated by dividing the total cost of materials purchased during a period by the total quantity of materials purchased during that period. A new average price is calculated at the end of each period (normally a month).
(e) Moving Simple Average Price : This price is obtained by dividing the total of the periodic simple average prices of a given number of periods, by the number of periods, the last of the period being that for which material issues are valued. The calculation of moving simple average price requires to decide upon the number of periods (months), i.e., 3, 5, 7 etc. If, for example, a 5-monthly simple average is to be calculated, the periodic simple average prices of 5 periods have to be added and total of these prices divided by 5 would give simple moving average price.
(f) Moving Weighted Average Price : This is a derivation of the weighted average method. To obtain the weighted average price, the weighted average price of a given number of periods (including and preceding the period of accounting) have to be added and divided by the number of period.
Selection of a Suitable Method of Pricing Issues : No single method can be appropriate in all circumstances. The selection of a proper method of pricing issues depends on the following factors: (a) the nature of the business and type of production, e.g., intermittent such as job or continuous such as process; (b) the method of costing used, whether the cost accounts are maintained according to the standard costing system, if so, method of issuing materials on standard cost should be used; (c) the nature of materials e.g., if materials are to be kept for some time for maturing or seasoning, an inflated price will have to be charged; (d) the frequency of purchases and issues; (e) the extent of price fluctuations; (f) The policy of the management : if the management wants that the cost accounts should represent the current position and correspond with estimates and besides that they should disclose efficiently in buying, pricing materials issues at market price may be suitable; (g) relative value of material issued and relative size of batch of material issued; (h) length of inventory turnover period and quantity of material to be handled; and (i) the necessity for maintaining uniformity within an industry.
Illustration : 4
XYZ Ltd, has purchased and issued the materials in the following order:
January 1 purchases 300 units Rs.3 per unit
4 purchases 600 “ 4 “
6 Issue 500 “ - - “
10 purchases 700 “ 4 “
15 Issue 800 “ - - “
20 purchases 300 “ 5 “
23 Issue 100 “ - - “

Ascertain the quantity of closing stock as on 31st January and state what will be its value (in each case) if issues are made under the following methods.
(a) Average cost, (b) First-in-first-out, and (c) Last-in-first-out
Solution
(a) Average Cost method
January 6 Issue 500 @ Rs.3.67
15 Issue 800 @ Rs.3.88
23 Issue 100 @ Rs.4.44
31 Balance 500 @ Rs.4.44
Value of Closing Stock Rs.2,220
(b) First-in-first out method
January 6 Issue 500 (300@ Rs.3+200 @ Rs.4)
15 Issue 800 (@ Rs.4)
23 Issue 100 (@ Rs.4)
31 Balance 500 (200@ Rs.4+300 @ Rs.5)
Value of Closing Stock Rs.2,300
(c) Last-in-first-out method
January 6 Issue 500 @ Rs.4
15 Issue 800 @ Rs.4
23 Issue 100 @ Rs.5 (Continued)
31 Balance 500 (200@ Rs.5+300 @ Rs.3)
Value of Closing Stock Rs.1,900
Illustration : 5
The following information is obtained from the records of ABC Ltd:
January 1 Opening Bank 100 units Rs.200
10 Purchases 40 units Rs.100
25 Purchases 100 units Rs.300
31 Sale 140 units Rs.700
On January 31st, the replacement cost was Rs.3.5 unit. Determine the closing stock, cost of goods sold and profit for the month using LIFO, FIFO and Replacement cost (use the format of a trading account).
Solution

Trading a/c (i) Using LIFO Method :

Date Particular Units Amount Date Particulars Units Amount
Jan 1
“ 10
“ 25
“ 31 Opening stock
Purchases
Purchase
Profit 100
40
100 200
100
300
300 Jan. 31
Jan. 31 Sales
Closing stock 140
100 700
200
240 900 240 900

Opening stock + purchase – closing stock = Cost of goods sold.
(200 + 400) - - 200 = Rs.400.
(ii) Using FIFO Method :

Date Particular Units Amount Date Particulars Units Amount
Jan 1
“ 10
“ 25
“ 31 Opening stock
Purchases
Purchase
Profit 100
40
100 200
100
300
400 Jan. 31
Jan. 31 Sales
Closing stock 140
100 700
300
240 1,000 240 1,000

Cost of goods sold = (200 + 400) – 300 = Rs.300.
(iii) Using Replacement Cost Method:

Date Particular Units Amount Date Particulars Units Amount
Jan 1
“ 10
“ 25
“ 31 Opening stock
Purchases
Purchase
Profit 100
40
100 200
100
300
425 Jan. 31
Jan. 31 Sales
Closing stock 140
100 700
325
240 1,025 240 1,025
Cost of goods sold = (200 + 400) – 325 = Rs.275.
Conclusion.
LIFO
Rs. FIFO
Rs. Replacement Cost Method
Rs.
Closing stock
Cost of goods sold
Profit 200
400
300 300
300
400 325
275
425

SUMMARY
The success of a business concern largely depends upon efficient purchasing, storage, consumption and accounting. The uncontrolled inventories are dangerous and at times it is called as graveyard of business. Hence inventory control system should be so defined as to ensure the provision of the required quality of material at the required time to meet the needs of production and sales, while keeping the investment in them at a minimum.
REVIEW QUESTIONS
1. What re the objective of inventory management?
2. What is the financial manager’s role in respect of the management of inventory?
3. What purpose does safety stock serve? What are the benefits and costs associated with safety stock?
4. What re inventory carrying charges? How are they calculation?
5. What are ordering costs? How are they calculated?
6. What are the costs of stock-outs? How should the costs of stock-out and the carrying costs be balanced to obtain the safety stock?
7. What is lead time? What are the various activities occuring during the lead time?
8. How would you determine Economic Ordering Quantity?
9. What factors do you consider in fixing the maximum and the minimum stock levels?
10. What do you understand by ABC analysis? What are its advantages? Discuss the inventory policies for A, B and C items.
11. Explain the following : (a) LIFO Method (b) FIFO Method

PRACTICAL PROBLEMS
1. 10,000 units of a component are required per year. Rs.100 is ordering cost on an average per order Rs.2 is the average stock carrying cost p.a. per unit.
[Ans.: E.O.Q. 1,000 units; 10 times : Rs.2,000]
2. Two components, A and B are used as follows:
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Reorder Quantity A : 300 units : B : 500 units
Reorder Period A : 4 to 6 weeks : B : 2 to 4 weeks
Calculate for each component (i) Reorder level, (ii) Minimum level, (iii) Maximum level, and (iv) Average Stock level
[Ans. (i) A 450 units, B 300 unit (ii) A 200 units, B 150 units
(iii) A 650 units, B 750 units (iv) A 350 units, B 400 units]
3. A manufacturing company uses Rs.50,000 materials per year. The administration cost per purchases is Rs.50, and the carrying cost is 20% of the average inventory. The Company currently has an optimum purchasing policy but has been offered a 4 per cent discount if they purchase five times per year. Should the offer be accepted. If not, what counter offer should be made.
4. The following are taken from the records of M/s Balaji & Co. Thirupathi for the year 1994. The valuation of inventory is Re.1 per k.g. or litre.
Opening stock Purchases Closing stock
Material A
Material B
Material C 700 kg
200 litres
1,000 k.g. 11,500 k.g.
11,000 litres
1,800 k.g. 200 k.g.
1,200 litres
1,200 k.g.

Calculate the material turnover ratio and express in number of days the average inventory is held.
[Ans.: Material A – 26.67 times ; 14 days. Materials B – 14.29 times; 26 days. Material C – 1.46 times; 250 days].
SUGGESTED READINGS
1. Chandra, Prasanna : Fundamental of Financial Management,
New Delhi, Tata McGraw Hill Co.
2. Gopalakrishnan, P : Inventory and Working Capital Management,
New Delhi, Macmillan India Ltd.
3. Menon, K.S. : Stores Management,
Madras, Macmillan India Ltd.

 
LESSON 11 SOURCES OF WORKING CAPITAL FINANCE
LEARNING OBJECTIVES
• Trade Credit – Customers Advances
• Commercial Bank Credit – Cash Credit / Discounting
• Commercial Papers
• Inter Company Deposits / Loans
• Public Deposit
The following is a snapshot of various sources of working capital available to a concern:
Sources of Working Capital










The long term working capital can be conveniently financed by (a) owner’s equity e.g. shares and retained earnings, (b) preferred equity, (c) lender’s equity e.g., debentures, and (d) fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc. This capital can be preferably obtained from owner’s equity as they do not carry with them any fixed charges in the form of interest or dividend and so do not throw any burden on the company.
Intermediate working capital funds are ordinary raised for a period varying from 3 to 5 years through loans which are repayable in installments, e.g., term-loans from the commercial banks or from finance corporations. Short term working capital funds can be obtained for financing day-to-day business requirements through trade credit, bank credit, discounting bills and factoring of account receivables. Factoring is a method of financing through accounts receivable under which a business firm sells its accounts to financial institution, called the factor.

Sources of short-term finance
In choosing a source of short term financing, the finance manager is concerned with the following five aspects of each financing arrangement.
(i) Cost : Generally the finance manager will seek to minimize the cost of financing, which usually can be expressed as an annual interest rate. Therefore, the financing source with the lowest interest rate will be chosen. However, there are other factors which may be important in particular situations.
(ii) Impact on credit rating : Use of some sources may affect the firm’s credit rating more than use of others. A poor credit rating limits the availability, and increases the cost of additional financing.
(iii) Reliability : Some sources are more reliable than others in that funds are more likely to be available when they are needed.
(iv) Restrictions : Some creditors are more apt to impose restrictions on the firm than others. Restrictions might include rupee limits on dividends, management salaries, and capital expenditures.
(v) Flexibility : Some sources are more flexible than others in that the firm can increase or decrease the amount of funds provided very easily.
All these factors must usually be considered before making the decision as to the sources of financing.
Trade Credit
Trade credit represents credit granted by manufacturer, wholesalers, etc., as an incident of sale. The usual duration of credit is 30 to 90 days. It is granted to the company on ‘open account’, without any security except that of the good will and financial standing of purchaser. No interest is expressly charged for this, only the price is a little higher than the cash price.
The use of trade credit depends upon the buyer’s need for it and the willingness of the supplier to extend it. The willingness of a supplier to grant credit depends upon (i) the financial resources of the supplier; (ii) his eagemess to dispose of his stock; (iii) degree of competition in the market; (iv) the credit worthiness of the firm; nature of the product; (vi) size of discount offered; (vii) the degree of risk associated with customers.
The length of the credit period depends upon : (a) Customer’s marketing period (b) nature of the product (long credit for new, seasonal goods and short credit on perishable goods and low-margin goods) and (c) customer location (long distance evidencing the amount that he owes to the seller.
Cost of Trade Credit
The trade credit as a source of financing is not without cost. The cost of trade credit is clearly determined by its terms. However, the terms of trade credit vary industry to industry and from company to company. However, regardless of the industry, the two factors that must be considered while analysing the terms and the cost of trade credit are : (i) the length of time the purchaser of goods has before the bill must be paid and (ii) the discount, if any that is offered for prompt payment. For instance, a concern purchases goods worth Rs.10,000 on terms Rs.10,000/2/10, net 30 days. it means if the payment is made within ten days the firm will be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in full. if the concern wants to use Rs.9,800 for 20 days at a cost of Rs.200 and then its actual cost works to 2.04%.
Advantages of Trade Credit
Trade credit, as a form of short term financing has the following advantages.
(i) Ready availability : There is no need to arrange financing formally.
(ii) Flexible means of financing : Trade credit is a more flexible means of financing. The firm does not have to sign a Promissory Note, pledge collateral, or adhere to a strict payment schedule on the Note.
(iii) Economic means of financing : Generally, during periods of tight money large firms obtain credit more easily than small firms do. However, trade credit as a source of financing is still more easily accessible by small firms even during the periods of tight money.
Customers Advances
Depending upon the competitive condition of the market and customs of trade, a company can meet its short-term requirements at least partly through customer/dealers advances. Such advances represent part of the price an carry no interest. The period of such credit will depend upon the time taken to deliver the goods. This type of finance is available only to those firms which can dictate terms to their customers since their products is in great demand as compared to the products of the other competitive firms.
COMMERCIAL BANK : BILL DISCOUNTING AND CASH CREDIT
Bank credit is the primary institutional source for working capital finance. Banks offer both unsecured as well as secured loans to business firms. At one time banks confined their lending policies to such loans only. Banks, now, provide a variety of business loans, tailored to the specific needs of the borrowers. Still, short term loans are an important source of business financing such as seasonal build ups in accounts receivable, and inventories. The different forms in which unsecured and secured short-term loans may be extended are discounting of bills of exchange, overdraft, cash credit, loans and advances. Banks provide credit on the basis of the security. A loan may either be secured by tangible assets or by personal security. Tangible assets may be charged as security by any one of the following modes, viz., lien, pledge, hypothecatio, mortage, charge, etc.

Discounting and Purchase of Bills
Under the Bill Market scheme, the Reserve Bank of India envisages the progressive use of bills as an instrument of credit as against the current practice of using the widely prevalent cash credit arrangement for financing working capita. To popularise the scheme, the discount rates are fixed at lower rates than those of cash credit, the difference being about 1 to 1.5 per cent.Cash Credits
Banks in India normally make loans and advances in three forms viz., cash credits, overdrafts and loans. Cash credit is an arrangement by which a banker allows the customer to borrow money upto a certain limit (called cash credit limit) against some tangible security or on the basis of a promissory – note signed and fixes the limit annually or quarterly after taking into account several material levels, etc. The banker keeps adequate cash balances so as to meet the customer’s demand as and when demand arises. Once the cash credit arrangement is made, the customer need to take the whole advance at once but may draw out or utilize the bank credit at any time without keeping a credit balance. Further, the borrower can put back any surplus amount which he may find with him for the time being. The bank can also withdraw the credit at any time in case the financial position of the borrower goes down. Generally the borrower is charged interest on actual amount utilized by him and for the period of actual utilization only; interest is charged by the bank on daily debit balance.
Overdrafts
When a customer having a current account requires a temporary financial accommodation, he is allowed to overdraw (to draw more than his credit balance) his current account up to an agreed limit. Overdraft accounts can either be secured or unsecured, usually, security is insisted upon for an overdraft arrangement. The customer is allowed to withdraw the amount by cheques as and when he needs it and repay it by means of deposits into his account as and when it is feasible for him. Interest is charged in the daily demit balance i.e., the exact amount overdrawn by the customer and for the period of actual utilization. This is more advantageous to the customer-borrower in the sense that the interest is charged only on the amount drawn by him. But the banker is comparatively at a disadvantage because he has to keep himself in readiness with the full amount of the overdraft and he can charge interest on the amount actually drawn. An overdraft, is different from a cash credit in that the former is supposed to be for a comparatively short time whereas the latter is not so.
Loans
When an advance to a customer is made in a lump sum against security or otherwise, without liberty to him of repaying, with a view to making a subsequent withdrawal it is called a long. The entire loan amount is paid to the borrower in cash or is credited to his current account and interest is charged on the full amount of the loan from quarterly rests from the date of sanction. where the loan is repayable in instalments the interest is charged only on the reduced balance. A loan once rapid on full or in part cannot be withdrawn again by the borrower, unless the banker grants a fresh loan which will be treated as a separate transaction. In this respect a long account differs from a cash credit or an overdraft account. A banker prefers to make an advance in the form of a loan because he can charge interest on the entire amount of the loan sanctioned or disbursed and secondly, loan account involves a smaller operating cost than overdraft or cash credit because in the latter case there is continuity and magnitude of operation.
Critical Evaluation of Bank Finance
Bank credit offers the following advantages to the borrowing companies :
(1) Timely Assistance : Banks assist the borrowing companies by providing timely assistance to meet the working capital requirements. A company can usually rely upon the bank for amounts of loan upto an agreed limit sanctioned by bank in advance.
(2) Flexibility : Bank assistance is flexible to the company. The accommodation can easily be got extended and may be used when it is urgently needed. It helps the company in maintaining goodwill in the market. Also, if the mount of loan or a part of it is no more required it can be repaid and interest on it be saved.
(3) Economy : Bank assistance entails the payment of only interest and does not involve the kind of costs which are to be incurred in the issue of securities such as commission on underwriting etc. Moreover, the rate of interest is not very high. The interest is payable only for the period the loan remains unpaid. Thus it reduces the cost of borrowings.
(4) No permanent burden : The borrowings can be repaid if it is no more required. In this way, it is not a permanent burden to the concern.
(5) No interference with company management : The loan provided by the bank is simply a loan and no string is attached to it. Generally banks do not interfere with the management of the borrowing companies, till bank is assured of the repayment of loans.
(6) Secrecy : This is by far the greatest advantage of bank finance. Any information supplied to bank regarding financial position of the borrowing company is not made public in any may by the bank.
Drawback of Bank Finance
Bank accommodation and loans suffer from the following drawbacks.
(1) Burden of mortgage or hypothecation : The stock of raw material, finished or semifinished goods are to be kept in a godowns under bank control and can be used only with the permission of bank or after paying the amount of loan.
(2) Short-duration of assistance : Banks provide only short-term assistance generally for the period less than a year and its renewal or extension is quite uncertain depending upon the discretion of bank’s authorities.
(3) Cumbersome terms : Banks grant assistance generally, to the extent of 50 to 75% of the cost of security pledged or hypothecated, thus having a margin of 25% to 50%. In addition, banks press the borrowing companies to have the goods in their godowns. Minimum interest is paid on a certain specific amount whether it is drawn or not and repayment of loan is strictly enforced as per the agreement entered into between the company and the bank. Thus, the terms of borrowings are too harsh. It also increases the cost of new borrowings and of the production.
COMMERCIAL PAPERS
Commercial Papers (CPs) are short-term usance promissory notes with a fixed maturity period, issued mostly by the leading, reputed, well-established, large corporations who have a very high credit rating. If can be issued by body corporates whether financial companies or non-financial companies. Hence, it is also referred to as Corporate paper.
Features of a Commercial Paper
(i) They are unsecured and backed only by the credit standing of the issuing company.
(ii) They are negotiable by endorsement and delivery like pro-notes and hence are highly flexible instruments.
(iii) Since Commercial Papers are issued by companies with good credit-rating, they are regarded as safe and liquid instruments. In India, as per the RBI guidelines, any private or public sector company can issue Commercial Papers provided (a) its minimum tangible net worth (paid up share capital plus reserves and surplus) is equal to Rs.4 crores and it has a minimum current ratio of 1.33:1 as per the latest audited balance sheet, (b) it enjoys a working capital limit of Rs.4 crores or more, (c) it is listed on one or more of the stock exchanges, and (d) it obtains every 6 months an excellent credit rating (P1 or A1) from a rating agency approved by RBI like CRISIL, ICRA, CARE, etc.
(iv) Commercial Papers are normally issued at a discount and are in large denominations.
(v) Issues of Commercial Papers may be made through banks, merchant banks, dealers, brokers, open market, or through direct placement through lenders or investors.
(vi) Commercial Papers normally have a buy-back facility; the issuers or dealers can buy back Commercial Papers if needed.
(vii) The maturity period of Commercial Papers may vary from 3 to 6 months.
(viii) The minimum denomination of a Commercial Paper is to be Rs.5 lakhs and the maximum amount of Commercial Paper finance that a company can raise is limited to 20% of the maximum permissible bank finance.
(ix) No prior approval of RBI is needed to make Commercial Paper issues and underwriting of the issue is not mandatory.
(x) The minimum size of a commercial paper issue is Rs.25 lakhs.
Commercial Papers are mostly used to finance current transaction of a company and to meet its seasonal needs for funds. They are rarely used to finance the fixed assets or the permanent portion of working capital. The rise and popularity of Commercial Papers in other countries like USA, UK, France, Canada and Australia, has been a matter of spontaneous response by the large companies to the limitations and difficulties they experienced in obtaining funds from banks.
INTRA-CORPORATE DEPOSITS
A deposit made by one company with another, normally for a period up to six months, is referred to as an inter-corporate deposit. Such deposits are of three types:
Call Deposits : In theory, a call deposit is withdrawable by the lender on giving a day’s notice. In practice, however, the lender has to wait for at least three days. The interest rate on such deposits maybe around 14 per cent per annum.
Three months Deposits : More popular in practice, these deposits are taken by borrowers to tide over a short-term cash inadequacy that may be caused by one or more of the following factors: disruption in productin, excessive imports of raw material, tax payment, delay in collection, dividend payment, and unplanned capital expenditure. The interest rate on such deposits is around 16 per cent annum.
Six-months Deposits : Normally, lending companies do not extend deposits beyond this time-frame. Such deposits, usually made with first-class borrowers, carry an interest rate of around 18 per cent per annum.
Growth of Inter-Corporate Deposit Market : Traditionally, some prosperous companies in the fold of big business houses such as Birlas and Goenkas carried substantial liquid funds meant primarily to exploit investment opportunities in the form of corporate acquisitions and takeovers. Until such opportunities arose, the liquid funds were deposited with other companies with an understanding that they would be withdraw at short notice. From the early seventies (more particularly from 1973), the inter-corporate deposit market grew significantly in the wake of the following development:
(i) Substantial excise duty provisions made by the companies ever since the Bombay High Court made a ruling that excise duty was not payable on post-manufacturing expenses.
(ii) Curbs on working capital financing imposed by the Reserve Bank of India after the first oil shock of 1973.
(iii) Imposition of restrictions on acceptance of public deposits (this was perhaps caused largely by the failure of W.G. Forge and Company Limited).
(iv) Burgeoning liquidity of scooter companies (little Bajaj, Honda etc.) and, of late, of car companies (like Maruti Udhyog), which have received massive booking deposits from their customers.
PUBLIC DEPOSITS
Public deposits constitute an important source of industrial finance in some of the Indian industries, particularly in sugar, cotton textile, engineering, chemicals, and electricity concerns. Although public deposts are principally a form of short-term finance, but have since long been utilized to provide long and medium term finance by cotton mills of Bombay, Ahmedabad and Sholapur and tea gardens of Bengal and Assam. The system is a legacy from the old past when the banking system had not developed adequately and the money was kept for safe custody with the mahajans. In Bombay and Ahmedabad the men who established the mill companies were either merchants or shroffs in whom the public had confidence, and hence their savings were entrusted to them. These deposits are received form (i) from public, (ii) the shareholders and (iii) the employees of the mills.
Merits :
(1) Returns : The interest has to be paid irrespective of the level of profits of a company. It has to be paid even if a company incurs loss in a particular year. This is in sharp contrast with dividend on shares, which becomes payable only if there are profits and even then only if the directors recommend such a payment.
(2) Frequent payments : Many companies offer interest payments on half-yearly, or even on monthly basis. One can expect frequent returns, instead of just once or twice in a year.
(3) Regularity : If the company’s management is honest and efficient, it is quite likely that the interest payments will be regular, and that the principal sum will be returned on the due date.
(4) No fluctuations : The principal sum is not subject to any fluctuations unlike the market prices of shares. One can be sure of the value of one’s investments.
(5) Preference over shareholders : In case the company goes into liquidation, the fixed deposit holder enjoy preference over the shareholders, for both the principal and the interest as unsecured creditors of the company.
(6) Tax deduction at source : Income tax will not be deducted at source up to an interest income of Rs.10,000 at one time, or during one year for one deposit holding (on sums exceeding Rs.10,000 tax is deducted at source at the rate of 10%). So far, so good. many brokers advertise and circulate literature enumerating the merits of fixed deposits. But all these merits are subject to a major qualification provided the company is financially sound. Now, turn to the other side of the story.
There are many risks associated with fixed deposits with companies :
(1) Lack of security : Fixed deposits are absolutely unsecured. If a company becomes insolvent there is no chance that a fixed deposit holder may get anything back. It is no consolation that the shareholders is also going to lose in such as case. The Central Government or the Reserve Bank of India does not come to the rescue of the deposit-holder. The broker who might have lured the innocent investors to invest in that company will not even, perhaps, acknowledge his letters of complaints. The investor can do one thing to write off the investment as bad debt.
(2) No protection : There are many tales of woe even when a company dopes not become insolvent. Several companies neither pay interest nor return the principal. Therefore, for very understandable reasons, they do not even reply registered letters. There is no statutory authority on earth to whom one, as a small investor, can go for any effective remedy. The Company Law Board or the Registrar of Companies cannot, and do not, generally, come to one’s rescue.
SUMMARY
One of the important tastes of the finance manager is to select an appropriate sources to finance the current assets. A business firm has various sources to meet its financial requirements. The current assets are supported by a combination of long term and short term sources of financing. In selecting a particular sources, the firm has to consider the merits and demerits of each sources in the context of prevailing constraints. This chapter provides an idea about the various sources, the cost of trade conduct, bank credit. It explains the significance of public deposits and inter-corporate loans deposits.

REVIEW QUESTIONS
1. What are the different sources of financing working capital requirements?
2. Explain the merits and demerits of trade credit as a source of working capital finance to industry.
3. Critically evaluate bank credit as a main source of working capital finance to industrial undertakings.
4. Write brief notes on the following:
(a) Inter Corporate Deposits
(b) Marathe Committee
(c) Commercial Paper
(d) Public Deposits
SUGGESTED READINGS
1. Kulkarni, P.V. : Corporate Finance,
Bombay, Himalaye Publishing House.
2. Srivastava, R.M. : Financial Management,
Meerut, Prakati Prakashan.


 
LESSON 12 LONG TERM SOURCES OF FINANCE
Learning Objectives:
• Various sources of long term finance
• Understanding the features of ordinary shares
• Nature and types of preference shares
• Features and types of debentures.
• Issue procedure of rights shares
• Lease financing and its advantages
• Hire purchase financing
• Comparison of lease financing with hire purchase financing
I. Introduction
Two major sources of finance available to a company for raising finance are – shares and loans. Shares include ordinary or equity shares and preference shares. Borrowed funds could be in the form of debentures and borrowings from financial institutions.

II. Ordinary shares
Ordinary shares also known as equity shares represent the ownership of the investors on the company. The owners’ capital is divided into small equal and indivisible units called as shares. A share as defined by Farewel, J. is “the interest of a shareholder in the company, measured by a sum of money, for the purpose of liability in the first place, and of interest in the second, but also consisting a series of mutual covenants entered into by all the shareholders interest”.
For the capital invested by the shareholders, they are entitled to dividends. The rate of dividends is not fixed. Being the owner’s of the business, shareholders bear the risk of ownership. They become entitled to dividends after the claims of all other parties are satisfied.
Features of equity shares:
i. Maturity: Equity share capital is permanent in nature, as they have no specified maturity date. Equity shareholders can demand refund of their funds only at the time of liquidation of the company. Even at the time of liquidation, the capital is redeemed only after the claims of all others have been satisfied.
ii. Claim on income: The equity shareholders have a residual claim on the income of the company. The rate of dividend is not fixed, which depends on the earnings left after meeting all the fixed claims on the earnings. Equity shares are also called as ‘variable income security’. Even if the company has sufficient profits after meeting all liabilities, the distribution of this surplus is the discretion of the Board of Directors of the company.
iii. Claim on assets: Equity shareholders have a residual claim on the assets of the company. In the event of liquidation, the assets of the company are utilized to first satisfy the claims of creditors and preference shareholders. Only after the claims of these parties are fully satisfied, payment is made to the equity shareholders out of the left over assets.
iv. Right to control or voting rights: The Equity shareholders exercise their right to control the company by electing a Board of Directors. The Board of Directors approves the major policies and decisions of the company while the managers appointed by the Board of Directors execute these decisions. Thus, equity shareholders have an indirect control over the company. They have the legal powers to elect the Board of Directors. In addition, if the Board of Directors fails to serve the interest of the shareholders, they can replace the directors.
a. In addition, they are required to vote on a no. of important matters like change in memorandum of association, distribution of profits. Majority of votes takes the decisions. Each equity share carries one vote. Shareholders can vote in person or in proxy.
v. Pre - emptive right: This right enables a shareholder to maintain his proportionate shareholding in the company. Sec 81 of the Companies Act, 1956 suggests that whenever the public ltd. proposes to issue new share capital, the shares must be first offered to the existing equity shareholders in the proportion as their current ownership. The shareholders, right to purchase a stated no. of shares at a specified price during a given period is termed as pre – emptive right and such an offer is termed as rights issue. These rights can be exercised at the subscription price or can be waived off or can be sold in the stock market.
vi. Limited liability: The liability of the equity shareholders’ of company, unlike a sole proprietor, is limited to the unpaid amount of their investment in shares. If the shareholder has already paid the full amount on his share then he cannot be held liable further for any losses of the company even at the time of the liquidation.

Advantages of equity shares
i. Payment of dividends on equity shares is discretionary
ii. Equity share capital can be raised without any charge against the assets of the company.
iii. It is a permanent source of capital. The company has no liability to redeem it except under the liquidation of the company.
iv. The equity capital increases the borrowing base for the company as the lenders generally lend in proportion to the company’s equity capital.
Disadvantages of equity share capital
i. Equity shares have a higher cost as the dividends are not tax deductible and as are interest payment and the cost of raising equity capital is higher as compared to debt.
ii. Equity shares are riskier from the investors’ point of view as dividend payment is optional. Thus, the investors expect higher rates of return.
iii. The issue of new shares leads to dilution in the earnings and ownership of the existing shareholders.
Right Shares
Whenever an existing company wants to issue new equity shares, the existing shareholders will be potential buyers of these shares. Generally, the Articles or Memorandum of Association of the company gives the right to existing shareholder to participate in the new equity issues of the company. This right is known as pre-emptive right and such offered shares are called Right shares or Right Issue or ‘Privileged Subscription’. The term simply indicates the fact that such shares will be first offered to the existing shareholders.
Under Section 81 of the Companies Act, 1956 where at any time after the expiry of two years from the from the allotment of shares being made for the first time after its formation, whichever is earlier, it is proposed to increase the subscribed capital of the company by allotment of further shares, then such further shares shall be offered to the persons who, at the date of the offer, are holders of the equity shares of the company, in proportion as nearly as circumstances admit, to the capital paid on those shares at that date. Thus the existing shareholders have a pre-emptive right to subscribe to the new issues made by a company. This right has at its root in the doctrine that each shareholder is entitled to participate in any further issue of capital by the company equally, so that his interest in the company is not diluted.
Right issue and Financial Policy: The issue of right shares always affects financial policy of the company as well as the market. Some of the important ways in which financial policy is affected are given below.
(i) When the right shares at low price available then share market of the existing shares might be adversely influenced.
(ii) When the right shares at low price are available then the potential investors might feel tempted to invest money thereby the finances of the business can become sound.
(iii) Financial Policy will be unfavourably influenced in case right shares are offered to existing shareholders much above their purchasing capacity.
(iv) When new shares have been added less dividend will be paid and that will adversely affect the busienss.
Whenever right shares are offered it is essential to review the market trends and earnings position of the company so as to know how the shares are being traded in the stock market. While fixing the price of the right shares, the following facts will have to be taken into consideration: (i) the price what the market can bear, (ii) state of the capital market, (iii) trends in share market, (iv) profit earning capacity of the existing shares, (v) the proposed plan of expansion, (vi) dividend policy of the company, and (vii) resource position of the enterprise, (viii) reserves position of the company, and (xi) the size of the right issue.
Advantages of Right Issue
(a) Right issue gives the existing shareholders and opportunity for the protection of their pro-rata share in the earning and surplus of the company.
(b) Existing shareholders can also maintain their proportion in the voting power as before.
(c) There is more certainty of the shares being sold to the existing shareholders. If a right issue is successful it is equal to favourable image and evaluation of the company’s good will in the minds of the existing shareholders:
(d) The flotation costs of a right issue will be comparatively lower than a public issue. The expenses to be incurred, otherwise of shares are offered to public, are avoided.
Illustration : 1
A corporation earns Rs.80 lakhs after tax and has 18 lakh shares of Rs.10 each outstanding. The market price of a share is 25 times the EPS. The corporation plans to raise Rs.180 lakhs of new equity funds through a rights offering and decides to sell the new stock to shareholders at a subscription price of Rs.60 per share. The financial position before the company offers the right shares is as given below:
Balance Sheet as on . . . . . .
Liabilities Rs. Assets Rs.
Debentures @ 10% 800
Common Stock 200 Total Assets 2,000
Retained Earnings 1,000
Total 2,000 2,000

Income Statement
Total Earnings 200
Interest on Debt 80
Income Before Taxes 160
Taxes (60%) 96
Earnings After Taxes 64
Earnings Per Share (20 laksh shares) is Rs.3.20
Market Price of Stock is Rs.80

i. How many rights will be required to purchase a share of the newly-issued stock?
ii. What is the value of each rights?
iii. What effect will the rights offering have on the price of the existing stock?
Solution
The corporation desires to raise Rs.200 lakh of new equity funds through a rights offering. For this purpose, it will have to issue 3 lakhs of new shares to existing stockholders.

The outstanding stock of the corporation is 18 lakh shares. There are, therefore, 19 lakh rights, as one share has one right. Hence,
i. To purchase as share of the newly issued stock
rights will be required
ii. The value of each right
= R =
=
=
iii. The stockholder has the choice of exercising his rights of selling them. If he has sufficient funds, and if he wants to buy more shares of the company’s stock, he will exercise the rights. If he does not have the money, or does not want to buy more stock, he will sell his rights. In either case, the stockholder will neither benefit nor lose by the rights offering. This can be illustrated further. Suppose, a shareholder has 12 shares. As each share has a market value of Rs.80 per share, the stockholder has a total market value of Rs.960 in the company’s stock. If the exercises his rights, he will be able to purchase two additional shares (one share for 6 rights) at Rs.60 each. His new investment will thus amount to:
Rs.960 + (60 x 2) = Rs.1,080.
How now owns 12 shares of his company’s stock which, after the rights offering have a value of:

The value of his stock is Rs.1,080, that is to say, exactly what he has invested in it. Alternatively, if he sold his 12 rights, which have a value of Rs.2.86 each as shown in (ii) above, he would receive Rs.34.32. He would not have his original 12 shares of stock, plus Rs.34.32 in cash. His original 12 shares of stock now have a market value of Rs.77.14 each - - Rs.925.68 market value (77.14 x 12 – 925.68) of his stock plus Rs.32.32 in cash is the same as the original Rs.960 market value of stock with which he began (80 x 12 = 960). From a purely mechanical or arithmetical point, the stockholder neither benefits nor gains from the sale of additional shares of stock through rights. Of course, if he forgoes to exercise or sell his rights, or if the brokerage costs of selling the rights are excessive, he may suffer a loss. But, in general, the issuing corporation would make special efforts to minimize the brokerage costs; and adequate time is given to enable to stockholder to take some action so that his losses are minimal.
Illustration : 2
A company plans to issue common stock by privileged subscription. Twenty four rights are needed to get one additional share of stock. The corporation declares the subscription price at Rs.9 against the current market price of Rs.11 per share. You are required to find out:
(a) The market value of one right when stock is selling rights;
(b) The market price of the stock when the stock goes ex-rights;
(c) The market value of a right when the stock sells ex-rights; and
(d) The value of one share of ex-rights stock, if only 5 rights are needed to get one additional share of stock.
Solution
(a) The market value of one right, when the stock is selling rights on, is calculated by the following formula :
R =
Where Me is the rights on market price of outstanding stock;
S is the subscription price of the new stock;
N is the number of rights needed to purchase one new share.
In the above example,
R =
(b) The market price of the stock trading ex-right is computed by the following formula:
Me = MO – R
Where, Me is the market value of the stock trading ex-rights;
Mo is the market value of the stock with rights on;
R is the theoretical value of right.
In the above example,
Me = 11 – 0.08
= Rs.10.92
This can also be worked out with another formula:

=
(c) The market value of 1 right, when the stock is selling ex-rights, may be calculated with the following formula:
R =
=
=
= Re.0.08
= 8 paise.
(d) The market value of one share of ex-rights stock, if it takes only 5 rights to subscribe to an additional share of stock, will be ;
Me =
Me =
=
= Rs.10.66.

An overview of Underwriting of shares
In terms of Section 69 of the Companies Act, 1956, no allotment shall be made of any share capital of a company offered to the public for subscription unless the amount stated in the prospectus as the minimum amount to be subscribed has been subscribed and the application money has been received by the company whether in cash or by a cheque or other instrument which has been paid. If the minimum subscription mentioned in the prospectus is not subscribed within 120 days from the date of opening of issue, all the application moneys are forth with liable to be refunded by the company within 128 days with interest for delay beyond 78 days from the date of closure of the issue as per Section 73 of the Companies Act, 1956. In view of the far-reaching consequences of failure to raise the “minimum subscription” there is need to ensure that this subscription is procured. Hence, there is need for an insurance against under subscription. This is obtained from reliable person who undertake to procure / subscribe in the event of the failure to evoke adequate response from the public. Such an arrangement is called “Underwriting” and the person who undertakes is called “Underwriter”.
Meaning : Underwriting is an act of undertaking or the guarantee by an underwriter of buying the shares placed before the public in the event of non-subscription of the shares by the public. For this purpose, an issuing company may enter into an agreement with an underwriter or with the number of underwriters or with an institution for underwriting the issue of shares to the public. There are four types of agreement :
(i) The underwriter may enter into an agreement with the issuing company to undertake the guarantee of buying all shares offered to the public in the event of non-subscription of the share by the public, called Firm Underwriting.
(ii) For buying a portion of total issues offered to the public in the event of non-subscription by the public, called Standby Underwriting.
(iii) The underwriter may enter into an agreement with the issuing company for buying all the shares outright from the issuing company and arrange to sell them to the public through his own organization.
(iv) After entering into an agreement with the issuing company, the underwriter may invite other underwriters or underwriting firms to join with him in such proportion as agreed by the mutually. Alternative a system a sub-underwriting may also be followed for distributing the risk. The issuing company has to mention the name of the underwriters and the number of shares underwritten by him in the prospectus as prescribed in the Companies Act, 1956.
Contingent Underwriting : It is again provided in the case of reserved categories only.
Who can underwrite ? : Underwriting is generally undertaken by : 1. Public Financial Institution, 2. Banks, 3. Investment Companies or Trusts of appropriate standing or experience.
Members of the recognized stock exchange are prohibited from entering into under writing or placing arrangements in connection with any floatation of new issues unless the permission of the stock exchange of which they are members is obtained. Such permission is granted subject to certain conditions. Members are not allowed to undertake underwriting commitments of more than 5% of the public issue. Underwriting of issues should be widely distributed amongst the members of stock exchange in such a way that no single member of the stock exchange is allowed to underwrite substantial portion of the issue. New members are permitted to share the responsibility subject to their financial position.

Preference Shares
Preference shares have a prior claim on the dividends as also on the company’s assets in case of liquidation. After paying the outsiders claims, preference share capital is returned in full and only after that equity, shareholders will be paid.
A fixed rate of dividend is paid on preference share capital. Preference shares do not have voting rights.

Features of preference shares
i. Maturity: Preference shares can be both redeemable and irredeemable. Irredeemable preference shares do not have a maturity date. Redeemable preference shares have a maturity date and need to be redeemed on or before the maturity date.
ii. Claims on income: The preference shares have a prior claim on income over equity shares. Whenever the company has distributable profits, the dividend is first paid on preference share capital at affixed rate. Only after the payment of dividends on preference shares, the company can distribute dividends to other shareholders.
iii. Claims on assets: Preference shares also have a prior claim on the assets in case of liquidation. Their claims will have to be settled first in full before making any payment to the equity shareholders.
iv. Control: Preference shares do not have any voting rights; so they do not have any controlling powers on the company. However, they gain voting rights on every kind of resolution placed before the annual general meeting if the dividend due on their shares remains unpaid.
v. Hybrid form of security: preference shares represent a hybrid form of security as it has the features of both equity and debt securities. It is similar to equity in the sense that (a) payment of dividends is not obligatory, (b) dividend is paid only out of the distributable profits and, (c) dividends are not tax deductible. On the other hand, they resemble the debt security as (a) it carries a fixed rate of dividend, (b) they usually do not have voting rights and (c) they have claims on income and assets prior to equity shares.

Advantages of Preference Shares:
i. No legal obligation to pay dividends. The company does not bear a financial burden if it does not have profits.
ii. Preference shares provide a long-term capital to the company. Even in case of redeemable preference shares, they have to be redeemed out of distributable profits or out of fresh issue of shares only.
iii. They provide a riskless leverage advantage to the company, since preference dividend is a fixed obligation. The nonpayment of dividends does force the company into solvency.
iv. Preference shares do not carry voting right and hence no dilution of powers of the equity shareholders.
v. As no assets need to be pledged against preference shares, the mortgage able assets can be conserved.
i. From the shareholders’ point of view, preference shares earn a fixed rate of return and provide preferential payment of dividends and realization out of assets in case of liquidation.
ii. Although they carry no voting rights, but preference shareholders gain voting rights in case of matters directly affecting their rights as well on all resolutions if the dividend remains unpaid.

Disadvantages
i. Preference shares are expensive source of finance compared to debt as dividends on preference shares not tax deductible and preference shareholders expect a higher rate of dividends as they are riskier as compared to debt securities.
ii. Although payment of preference shares is not mandatory but they have to be paid due to their cumulative nature. In addition, non-payment of dividends harms the goodwill of the company.

Types of preference shares
i. Cumulative preference shares and non-cumulative preference shares: Cumulative feature requires that all past unpaid preference dividends need to be paid before and equity dividends can be distributed. The dividends go on accumulating unless otherwise it is paid. The holders of non-cumulative preference shares have no claim for the arrears of dividends. On these kinds of shares, dividends are paid if there are sufficient profits.
ii. Redeemable and non-redeemable preference shares: Redeemable preference shares have a specified maturity date and on such a date, the company has a right to redeem the preference share capital. On the other hand, those shares that cannot be redeemed unless the company is liquidated are known as non-redeemable preference shares.
iii. Participating and non-participating preference shares: Participating feature entitles a preference share to participate in the surplus of profits of the company after a reasonable rate of dividends is paid on the equity shares. Whereas non-participating preference shares are not entitled to participate in the surplus profits.
iv. Convertible and non-convertible preference shares: A convertible preference share can be converted into equity shares after a specified date at a specified price at the option of the shareholder where as a non-convertible preference share cannot be converted in to equity share.

Debentures
A debenture is an acknowledgement or a promissory note of long-term debt. A fixed rate of interest is paid on the debenture. A debenture holder is a creditor of the company.

Features of debentures:
i. Maturity: Debentures are issued for a specified period. The principal amount of debentures needs to be repaid within this time otherwise the debenture holders may force winding up of the company as creditors.
ii. Interest rate: The interest rate on a debenture is fixed. This rate indicates the percentage of the par value that must be paid out in the form of interest. Payment of interest is legally binding on the company. This payment is tax deductible for a company.
iii. Control: Debentures carry no voting rights but in the event of liquidation, they have a prior claim over the assets of the company.
iv. Call feature: Debentures of a company sometimes provide for the call feature, which entitles the company to redeem its debentures at a prefixed price before the maturity date.
v. Indenture: An indenture or a debenture trust deed is a legal agreement between the company and the debenture trustees. The debenture trustees are responsible to safeguard the interests of the debenture holders by ensuring that the company fulfills all the contractual obligations.
vi. Security: Debentures may provide for a charge on the assets of the company as a security to its holders. If the company defaults, the trustees can seize the security to settle the claims of the debentures. The debentures may have either a specific charge on the assets or a floating charge on all the assets of the company.

Types of debentures
i. Convertible or non convertible debentures: A convertible debenture can be converted into fully or partly paid equity shares after a specified date at a specified price at the option of the shareholder where as a non-convertible debenture cannot be converted in to equity share. Non-convertible debentures are repayable on maturity. Convertible debentures can further be classified into fully and partly convertible debentures.
Fully convertible debentures: These are converted into equity shares after the lapse of a certain period specified at the time of issue of the debentures.
Partly convertible debentures: These are partly converted into equity shares and the balance is redeemed at time of maturity of the debentures.
ii. Redeemable and irredeemable debentures: These debentures are redeemed on the expiry of a specified period. The interest payment is done periodically but the principal amount is redeemed after a fixed period. As against these, irredeemable debentures are not redeemable during the lifetime of the company. The company becomes liable to redeem the principal amount only in case of liquidation or in the event of default by the company.
iii. Zero coupon bonds: These bonds do not carry interest but are issued at a deep discount from its eventual maturity value. The difference between the issue price and the maturity value represents the gain or interest earned by the investor.
iv. Zero interest bonds: These bonds are usually convertible debentures that yield no interest. Nevertheless, the debentures are converted into equity shares at some specified future date. This arrangement results in reduction in the financing cost as no interest is paid in the initial years and conversion normally takes place in the after the project starts bearing profits.
v. Secured premium notes: This kind of note is a transferable instrument with detachable warrant against which the holder gets equity share after a fixed period.

Advantages of debentures:
a) Advantages to the company:
i) Debentures provide long-term funds to the company.
ii) The interest on debentures is usually lower than the rate of dividend paid on the shares.
iii) The interest on debenture is a tax-deductible expense, thus the effective cost of debentures is lower as compared to the equity capital where dividend is not a tax-deductible expense.
iv) Debt financing does not result in dilution of control of the existing equity shareholders.
v) A company can trade on its equity by mixing debentures in its capital structure and thereby increase its earnings per share.
vi) Debentures provide flexibility to the capital structure as they can be redeemed whenever the company has surplus funds.
b) Advantages to the investors:
i) Debentures provide a fixed and stable source of income to the investors.
ii) It is comparatively safer investment as regular interest payment is mandatory for the company and the debentures have a floating charge on the assets of the company.
iii) Debentures are normally more liquid than the other securities and they have a fixed maturity.

Disadvantages of debentures
Disadvantages to the company:
a) The fixed interest charges and principal repayment are legal obligations of the company. These have to be paid even if there are no profits. Default in these payments, may lead to winding up of the company.
b) Charge on the assets of the company restricts the company from using these assets for other sources.
c) Debentures increase the financial risk of the firm.
d) A company with fluctuating earnings or dealing in products with high elasticity of demand cannot conveniently use this source to their benefit as it involves fixed cash outflow.
Disadvantages to the investor
a) Debentures do not carry voting rights, so the investors do not have any controlling powers.
b) The market prices of debentures are vulnerable to the changes in the interest rates.


Term loans

In addition to raising capital through equity shares, preference shares or debentures a business can also raise funds through term loans, which can directly be raised from the banks and financial institutions. In India, term loans are usually obtained for financing large capital expenditures. Term loans are obtained through banks or FIs by private placement rather than public subscription.

Features of long term loans:
i. Maturity: Term loans are normally granted for a fixed period, within which the principal amount should be repaid to the lender. In certain cases a grace period, also known as moratorium of initial 1 to 2 years is provided. During this period of grace, the business is not required to make repayment of the loan amount.
ii. Private placement: As the loans are procured directly from a bank or FI it said to be a private placement. The advantages of this kind of placement are the ease of negotiation and low cost of raising the funds.
iii. Security: A security in the form of pledging of an asset has to be provided in a term loan agreement. Normally the assets acquired using the funds are pledged as security for the loan. This is termed as primary security. The company’s current and future assets also secure the loans. This is termed as secondary or collateral security.
iv. Restrictive covenants: The lenders add certain covenants to be stringently followed by the borrower. The covenants may be regarding maintaining a minimum base of assets in terms of working capital. Alternatively, the firm may be restrained from raising additional loans without the concurrence of the lender.
v. Tax deductibility: The interest on the term loans are allowed as expense for the purpose of computation of tax liability, resulting in savings in income tax burden.
Lease Financing
Leasing is an arrangement that provides a business with the use and control over assets without buying or owning it. It is a form of renting the asset.
A lease is a contract conferring a right on one person called a tenant or lessee to possess and use the asset belonging to another person called a landlord or lessor. It is a rental agreement between landlord and tenant. The consideration for the lease is called rent or the rental. The lessee pays the rental to the lessor as regular fixed payments over a period of time at regular intervals. A lease can be for a fixed period of time (called the term of the lease) but (depending on the terms of the lease) may be terminated sooner.
The amount and timing of payment of lease rental, though generally fixed, can be tailored to the lessee’s profits or cash flows and can take the form of up- fronted lease, wherein more rentals are charged in the initial years and less in the later years of the contract and vice versa in the back – ended lease.
At the end of the lease contract, the asset reverts to the lessor who is the legal owner of the asset. Only the owner that is the lessor is entitled to claim depreciation on the leased assets.
Types of leases
i) Operating lease
ii) Financial lease
iii) Sale and lease back
Operating Lease: It is a short term cancellable lease agreements. Under this arrangement the lessor is normally responsible for maintenance and insurance. This type of lease arrangement is convenient for assets such as computers, office equipment, cars etc. Because of the short duration and the lessee’s option to cancel the lease, the risk of obsolescence is that of the lessor.
Financial Lease: This long term lease arrangement is normally non – cancellable lease contracts are known as financial lease. This arrangement is common with high cost and high technology equipment. Normally financial leases are long enough to cover the useful life of the asset. Most financial leases are direct leases wherein the lessor buys the asset identified by the lessee and signs a contract to lease it out to the lessee. In financial lease the maintenance, insurance and risk of obsolescence are generally borne by the lessee.
Sale and lease back: This is an arrangement where the user sells off an existing asset owned by him to the lessor and leases it back from him. Such arrangement provides substantial tax benefit.
Advantages of lease financing:
Advantages to the Lessee:
i. Avoidance of initial cash outlay: Leasing enables the lessee to use an asset without making heavy capital investment in buying the asset. Even the initial margin money, as requisite under the loan financing may not be required under the lease financing.
ii. Convenient source of financing: Lease arrangement does not require mortgage of assets because the ownership of asset leased remains with the lessor. Also the restrictive covenants imposed in loan financing can be avoided.
iii. Transferring the risk of obsolescence: With the rapid changes in the technologies, the business has to bear the risk of obsolescence, .if it is the owner of the asset. The lessee (user of the asset) can shift this risk upon the lessor by acquiring the asset on hire rather than buying it.
iv. Higher returns on capital employed: By acquiring the asset on lease the payments towards the lease rentals reduce the tax liability of the firm. These assets do not appear on the balance sheet. This implies higher returns on capital employed.
Advantages to the lessor:
i. Tax benefits: the lessor being the owner of then asset can avail of tax benefits accruing due to depreciation, investment allowance, etc.
ii. No gestation period: The leasing firm can start earning lease rentals right from day one as against the other businesses that have a higher gestation period.
Disadvantages of Leasing
Disadvantages to the lessee:
i. Loss of moratorium period: The lease rentals start from day one but the assets employed in the business take a long time before they generate revenue to pay it back.
ii. No modifications can be made to the asset: As the lessee is not the owner of the asset, he is not entitled to make any substantial modifications to the asset to suit his needs.
iii. Loss of certain tax benefits like depreciation, investment allowance which an owner of the asset is entitled to.
Disadvantages to the lessor:
i. The lessor has to bear the risk of obsolescence as he is the owner of the asset.
ii. Lessor does not get adequately reimbursed for the price level changes or inflation.
iii. The lessor cannot avail of certain tax benefits such as concession in sales tax, duties, etc. as he, though being the owner of the asset is not the user of the asset. This increases the cost for the lessor, thus compelling him to increase the lease rentals.
iv. It takes a long time to recover the cost of the asset. Thus, the lease rentals received in the initial years does not represent the actual realised profits

Hire Purchase financing:
In a hire purchase agreement, the seller also called the hiree sells the asset to the hirer in exchange for the payment to be made over a specified period generally in installments. The ownership of the asset passes to the hirer on the payment of all the installments. The hirer has the option to terminate the agreement any time before the transfer of ownership of the asset. The hirer is required to show the asset in his balance sheet and is entitled to claim depreciation, though he does not own the asset until full payment is made to the hiree. The payment made by the hirer can be divided into two parts – the interest and the principal amount. Thus he can also avail the tax benefit on the interest charges borne by him.
Lease versus Hire-Purchase
A leasing transaction must be distinguished from a hire-purchase transaction or that of payment by installments. In the case of payment by instalment the user actually purchases the capital equipment himself and merely makes the payment in periodic installments over a specified period, and thereby becomes the owner at the very outset. In a hire purchase transaction a sizable down payable is made, the balance payable over a specified period comprises of principal and interest, and the ownership in the property passes to the person taking the equipment at the end of the period when the last payment is made.
The main advantage of buying assets on hire purchase is that the business is able to use the earnings (employing the asset) to pay the hire purchase charges as they fall due. The asset must normally have a longer expected life than the length of the hire-purchase agreement, and the value should also be in excess of the amount outstanding on the agreement.
The main disadvantage of hire purchase financing is that interest rates are usually high (i.e. more than 15%). As this rate is applied to total amount involved (i.e. the initial balance) the effective rate charged on the balances outstanding, will tend to double the actual rate charged. Due to this grave disadvantage, this method is not always favoured. In spite of its expensiveness, this method is more particularly used by those business houses whose work necessitates their expenses and profits to be spread over a lengthy period e.g. the building construction industry.
Thus, in installment and hire-purchase transaction the user gets vested with ownership and custody of the equipment, as against a lease transaction where the user (lessee) has only the custody/usage of the equipment and ownership vests in the lessor.

REVIEW QUESTIONS
1. What are the characteristics of equity shares?
2. Critically evaluate equity shares as a source of finance both from the point of (i) the company and (ii) the investing public.
3. What do you understand by no-par shares? State the advantages claimed by such shares.
4. What are Right Shares? What is its significance for financial management?
5. What do you mean by Bonus Shares? State the guidelines for issue of such shares.
6. Explain essential characteristics of preference shares.
7. State and explain the various kinds of preference shares.
8. State the conditions to which the issue of redeemable preference share are subjected to in India,
9. Explain the merits and demerits of preference shares as a source of industrial finance both from the point of (i) the company and (ii) investing public.
10. What are the relevant factors, necessary to be kept in mind by a corporate financial controller in recommending the issue of (i) Bonus shares and (ii) Cumulative Convertible preference Shares?
11. Define the word ‘debenture’ and bring out its salient features.
12. What are the different types of debentures that may be issued by a company?
13. What are the advantages and disadvantages of debenture finance to industries?
14. What is term-financing? Explain the major sources of term-finance in India.
15. What are the special features of term-loans? Discuss the disadvantages attached with term-loan.
16. What precautions will be taken by term-lending institutions while granting term-loans?
17. Explain the meaning of the term ‘leasing’ and state the different types of leases.
18. Leasing is often called “off balance sheet” financing. Explain reasons fro agreeing or disagreeing with this characterization.
19. A sale and lease-back arrangement may be thought of as a special type of financial lease. How?
20. Is leasing an investment decision or a financing decision? How does lease financing provide for financial leverage?
21. What are the major differences between (i) financial lease and operating lease, (ii) financial lease and sale and lease back arrangement.
22. Explain the advantages and disadvantages of a lease as a source of finance.
23. Discuss the similaritites and differences, if any, between a lease and a hire purchase agreement.

SUGGESTED READINGS

1. Chandra, Prasanna : Fundamental of Financial Management
New Delhi, Tata McGraw Hill Co.
2. Kulkarni, P.V. : Corporate Finance
Bombay, Himalaya Publishing House.
3. Saravanavel, P. : Financial Management
New Delhi, Dhampat Rai & Sons.
4. Khan, M.Y. and
Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.

 
LESSON 13 DIVIDEND DECISION
LESSON OUTLINE
• Dividend Theories
• Walter’s Model
• Gordon’s Model
• M.M. Model
• M.M. Theory Criticisms
Several theories studying relationship between dividend and value of the firm have been advanced. Broadly speaking, these theories can be grouped into two categories, viz., (a) Theories relating to relevance of dividend decision in valuation of firm and (b) Theories concerning irrelevance of dividend decision. The former set of theories, with which James E. Walter, Myron Gordon, John Linter and Richardson are associated, hold that there is a direct relationship between dividend policies of the firm and the market valuation of its earnings since the investors are not neutral as to how the earnings stream is split between dividends and retention.
Irrelevance approach of dividend decision was propunded by Merton Miller and Franco Modigliani. According to these scholars, dividend decision is irrelevant and it does not in any way affect share values as investors are basically indifferent to get return in the form dividends or of capital gains.
DIVIDEND THEORIES
1. Walter’s Model
The basic emphasis of Walter’s model is maximization of wealth for the shareholders. Prof. Walter brings about the importance of the relationship between firm’s internal rate of return and its cost of capital in determining a dividend policy.
Walter’s model is based on the following assumptions
1. All investment opportunities are financed by retained profits.
2. The firm’s Internal rate of return (IRR) and its Cost of Capital (CoC) are constant.
3. All the profits are immediately either distributed as dividend or re-invested internally.
4. The firm has a very long and continuous life.
The value of earnings per share (EPS), and dividend per share (DPS) may be varied to determine the results but any given values of EPS and DPS are assumed to be constant forever for determining a given value.
The Model is as follows:

MPS =
where
MPS = Market Price Per Share
DPS = Dividend Per Share
EPS = Earnings Per Share
IRR = Internal Rate of Return
CoC = Cost of Capital
The above can be simplified as follows:
MPS =
From the above we are able to conclude that the two major factors influencing the market price of a share are (1) the dividend per share, and (2) the relationship between IRR and CoC.
One can visualize mathematically three kinds of relationship between IRR and CoC.
i.e. IRR > CoC (Growth firms)
IRR = CoC ( Normal firms)
IRR < CoC (Declining firms)
Let us take an example and find out the optimal dividend policy for the above three cases.
Assuring CoC = 15% and EPS = Rs.10.
For a growth firm, since IRR > CoC let us take IRR = 20% then if Dividend pay-out is 0
MPS =
If Dividend pay-out is Rs.5. MPS =
It is seen clarly that the optimal policy for a Growth firm is to have dividend pay-out at zero. Since if the pay-out increase the MPS decreases.
Similarly it can be established for a normal firm (IRR = CoC) that MPS is not affected by the pay-out ratio and as such there is no optimum policy.
For a declining firm (IRR < CoC) optimal policy is to have the dividend pay-out at 100%.
Criticism : Walter’s model is criticized for the following:
1. There is no external financing.
2. The IRR is constant, and
3. The cost of Capital is also constant
In practice the IRR and CoC can never be constant as they change from time to time.
II. Gordon’s Model
This model is also called Dividend Capitalization Model. Here the market value of share is equated to the present value of an infinite stream of dividends to be received by the shareholder.
The Model is as follows :
MPS =
DPS = Dividend per share K = Appropriate discount rate (cost of capital)
In the above the dividend rate is assumed to grow in future when earnings are retained. Assuming a growth percentage of ‘g’ the above model can be re-looked as follows:
MPS =
when the above is solved the equation reduces itself to
MPS =
The following are the assumption of the Gordon Mode:
1. The firm is an all equity firm.
2. No external finance is assumed. All retained earning is used for further expansion.
3. The IRR is constant and also the appropriate discount rate (k) or cost of capital is also constant.
4. Corporate taxes do not exist.
5. The earnings are continuous.
6. The proporation of retained earnings is constant and the discount rate (cost of capital) is greater then the growth rate (k > g).
The Gordon model again can be restructured from the assumptions. Since the proporation of retained earnings is always constant. Dividend will be always constant.
Dividend will be always (1 – RE%). If total earnings in a period the E then individual be (1-RE%) and earning grow at a constant IRR.
We can substitute the above assumptions and study the results of the same for various characteristics of the firm.
As seen before, MPS = in case of a normal firm since k = IRR and above can be simplified as

E1 itself a return on assets and hence the MPS will be equal to book value of assets as long as the return equals the discount rate of cost of capital. Hence, we find that MPS is a function of E1/k or Return on Assets r. A/k.
The relationship can be established as we did in Walter’s Model as followed r>k, r=k, and rIII. Miller and Modigliani (MM) Theory
While the earlier two theories viz. WALTER and GORDON model laid emphasis on the maximization of shareholder’s wealth, Miller and Modigliani (MM) asset that given the investment decision of the firm, the dividend pay-out ratio does not affect the wealth of shareholders. Their contention is that the value of firm is solely determined by the firm’s investment policy and earning power on the assets. That split off between dividend/retained earnings is irrelative and has no significance.
The critical assumption of MM are as follows:
The rate of return ‘r’ for a share which is purchased at time ‘0’ is equal to the dividend received at time 1 plus the capital gain/losses on the same converting into an equation, we got:
r =
Where,
r = Internal rate of return
D1 = Dividend at the end of period 1
P1 = Market price per share at period 1
P0 = Initial purchase price.
Reclassifying the above, we get
r. P0 = D1 + P1 – P0
r.P0 + P0 = D1 + P1
P0 (1 + r) = D1 + P1
P0 =
Since IRR (r) is equal to the cost of capital (CoC) under the assumptions, we can say,
P0 =
The above is the value for the share. If the firm has a number of shares ‘n’ we get the total value of the shares of the firm
V = nP0 =
One of the basic assumptions in both the WALTER and GORDON Model in that not external financing is envisaged. But M-M theory allows of the same. The crux of the M-M theory is that the effect of dividend payment on shareholder’s wealth is offset exactly by other means of financing. When the firm has made its investment decision, it must decide whether to retain earnings or to pay dividends and sell new shares in order to finance the investment. The decline in market price of share on account of increased shares offsets exactly the payment of dividend.
Let us see how this is brought out by M-M in their model;
nP0 =
If the firm decides to sell ‘m’ new shares at time 1 at a price P1 and total value of shares then will be nP0 + mP1. If we want to know the value at time 0 of the new share, then the value
= nP0 +
This value then is to be equated to the overall value at time1. At time 1, the number of shares will be (n + m) and the dividends paid would have been only for ‘n’ shares. The overall equation then will be as follows:

Simplifying, we get,
nP0 = [nD1 + (1 + M) P1 – nP1)]
The additional investment can be either financed by retained earnings or by new shares or by both, as per M.M’s assumptions. The amount of new shares mP1 will then be equal to (Investment – Retained earnings), or
mP1 = I1 -- (X1 -- nD1), where X1 = profits
= 11 – X1 + nD1

Substituting for mP1 in the previous equation, we get,
nP0 =
nP0 =
nP0 =
From the above, we find that the term D1 cancels out. MM assumes that the other terms XX1, Y1, (n + M) P1 and CoC are assumed to be independent of D1.
M.M. thus conclude that the current value of the firm is independent of its current dividend policy. What is gained by the shareholder in increased dividend is offset exactly by the decline in the terminal value of share, M.M. also conclude that nP0 is unaffected not only by current dividend decisions but by future dividend decisions as well. Thus the shareholders are indifferent between retention and the payment of dividend in all future periods.
M.M. also assert that the dividend irrelavance is not affected even if the firm raises external funds by issuing debet instead of shares as the real cost of debt is the same as th4 real cost of equity financing. In case of debt financing their conclusion is same with regard to leverage. Even when assumption of complete certainty is dropeed by M.M. they still conclude that dividend policy continues to be irrelevant for they attribute this to the familiar arbitrage argument. The shareholder’s wealth is unaffected by current and future dividend decisions. It depends entirely upon the expected future earnings stream of the firm.
M-M Theory Criticisms
M.M. Theory of dividend irrelevance works out well under a set of theoretical assumptions. But these are hardly valid and unrealistic in practice especially with reference to the Indian context. We find the capital markets hardly perfect. M.M. theory loses the relevance here. Internal and external financing are not equivalent and dividend policy does affect the perception of shareholders. The following are the major criticisms levelled against M.M. theory.
1. Taxes : The assumption that taxes do not exists, is only a theoretical possibility. In India every one of us are aware of the complicated tax laws. From the view point of the shareholder, capital gains is preferable than dividend income since: (i) the capital gains tax is lower than the tax on dividends and (ii) the capital gains arises only when the shares are actual sold. The value of the share goes up if the entire profits are retained than in the case of external financing, on account of the above.
2. Existence of floatation and transaction Costs : M. M’s assumption is that the wealth of shareholders does not change whether it is by internal financing or
external financing. But in practice there is always underwriting and brokerage costs when new shares are issued. Whereas there is no such costs when then profits are retained. Similarly the shareholders has to pay a brokerage fee when he decides to sell the shares.
3. The Discount rate ‘r’ and the cost of capital ‘CoC’ are assumed to be equal. In reality, both differ and investors would always like to maximise their earnings by going in for different set of portfolios.
4. M.M. Contends that dividend policy continues to be irrelevant whether the market is certain or uncertain. This his been contradicted by Gordon. He assets that uncertainty increases with time-span. This implies that risk increases as well as the discount rate. As such, shareholders will prefer immediate dividends than a future stream of dividends to avoid risk.
5. The last criticism is about the information content regarding dividends. M.M. assumed that this does not affect their contention of irrelevance. But the fact is information regarding dividends does have an impact on the share prices because they communicate information regarding the profitability of the firm. If a firm which has a stable dividends policy, deviates and changes the ratio then the shareholders and investors might believe that the management is announcing a charge in the expected future profitability of the firm. Accordingly, the price of the share might change.
Illustration 1
(a) The earnings per share of a company are Rs.8 and the rate of capitalisation applicable to the company is 10%. The company has before it an option of adopting a pay-out ratio of 25% or 50% or 75%. Using Water’s formula of dividend pay-out compute the market value of the company’s share if the productivity of retained earnings is (i) 15% (ii) 10%, and (iii) 5%.
Solution
Market value of the company’s share under different pay-out options:
(i) If productivity of retained earnings is 15% (ii) If productivity of retained earnings is 10% (iii) If productivity of retained earnings is 5%
(a) 25% Pay-out (a) 25% Pay-out (a) 25% Pay-out




=
=


= Rs.110 = Rs.80 = Rs.50
 
(b) t0% Pay – out (b) 50% Pay-out (b) 50% Pay-out




=
=
=

= Rs.100 = Rs.80 = Rs.60
(c) 75% Pay-out (c) 75% Pay-out (c) 75% Pay-out




=
=
=

= Rs.90 = Rs.80 = Rs.70

Illustration : 2
Textool Ltd. has 80,00,000 shares outstanding. The current market price of these shares is Rs.15 each. The company hopes to make net income of Rs.2,40,000 during the year ending on March 31, 1995 and it belongs to a risk-class for which the appropriate capitalisation rate has been estimated to be 20%. The company’s board is considering a dividend of Rs.2.00 per share for the current year that began on April 1, 1995. Assuming no taxes, answer questions listed below on the basis of the Modigliani-Miller dividend valuation model:
(a) What will be the price of the share at the end of March 31, 1995 (i) if the dividend is paid and (ii) if the dividend is not paid?
(b) How many new shares must the company issue if the dividend is paid and the company needs Rs.5,60,000 for an approved investment expenditure during the year?
Solution
(a) (i) If the dividend is paid
15 =
15 =
15 x 1.20 = 2 + P1¬
P1 = 18 – 2 = Rs.16 i.e. the price of the share at the end of March 31, 1995

(ii) If the dividend is not paid
15 =
15 = 1.20 = P1
P1 = 18
(b) Price of the share is Rs.16 if the dividend is paid
Hence No. of new shares to be issued:
mP1 = I – (NP – nD1)
m x 16 = 5,60,000 – (2,40,000 – (80,000 x 2))
m x 16 = 5,60,00 – 80,000
m = new shares.
SUMMARY
Several theories studying relationship between dividend & value of the firms can be broadly grouped into two categories viz., (a) Theories relating to relevance of dividend decision in valuation of firm and (b) Theories concerning irrelevance of dividend decision. This lesson recognizes the contravention as to relevance of dividends and provides an understanding about the different models of divided theories.
REVIEW QUESTIONS
1. What are the various theories of dividend policy?
2. Critically evaluate M.M. theory and what do you feel about the relevance of the theory in the Indian context?
3. Compare and contrast dividend theories for (a) growth firm (b) normal firm, and (c) declining firm
4. What are the assumptions which underly Gordon’s model of dividend effect? Does dividend policy affect the value of the firm under Gordon’s mode?
5. What is the informational content of dividend payments? How does it effect the share value?
PRACTICAL PROBLEMS
1. The earnings per share of the face value of equity Rs.100 of PQR Ltd. are Rs.20. It has an internal rate of return of 25% of EPS. Capitalisation of its risk class is 125%. If Water’s model is used:
(a) What should be the optimum pay-out ratio?
(b) What would be the market price per share if the pay-out ratio is zero?

(c) How shall the market price of the share be affected if more than zero pay-out is employed?
(d) Suppose the company has a pay-out of 25% of EPS, what would be the price per share?
(Ans: (a) zero, (b)Rs.320, (c) (i) The optimum pay-out ratio for growth firm is zero. For a normal firm one dividend policy is as good as the other. The optimum pay-out ratio for declining firm is 100%. (d) Rs280)
SUGGESTED READINGS
1. Chandra, Prasanna : Fundamentals of Financial Management,
New Delhi, Tata McGraw Hill Co.
2. Khan, M.Y. and Jain, P.K. : Financial Management,
New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M. : Financial Management,
New Delhi, Vikas Publishing House.
4. Rathnam, P.V. : Financial Advisor,
Allahabad, Kitab Mahal.
5. Saravanavel, P. : Financial Management,
New Delhi, Dhanpat Rai & Sons.


 

LESSON 14 DIVIDEND POLICY
LEARNING OBJECTIVES
• Dividend Policy – Determinants of Dividend Policy
• Kinds of Dividend Policies
• Forms of Dividend – Stock Dividend and Stock Split
• Companies Act and Payment of Dividend
After obtaining the necessary amount of capital, the next important function is to invest and utilize the procured capital in such a way that the investors may get an adequate return on their investments and the capital too may remain intact. The procured capital is usually invested in the further procurement of men, machines and materials and the ultimate result of this investment is either profit or loss, which in turn depends upon the earning capacity of the company. The more the earning capacity of the company, the higher would be the profit.
DIVIDEND POLICY
Dividend policy, as intimately related to retained earnings, refers to the policy concerning quantum of profits to be distributed as dividend. This is probably the most important single area of decision making for the finance manager. Action taken by the management in this area affects growth rate of the firm. An erroneous dividend policy may land the firm in financial predicament and capital structure of the firm may turn out unbalanced. Progress of the firm may be hamstrung owing to death of resources which may result in fall in earnings per share. Stock market is very likely to react to this development and share prices may tend to sag leading to decline in the total value of the firm.
If strict dividend policy was formulated to retain larger share of earnings, plentitude of resources would be available to the firm for its growth and modernization purposes. This will give rise to business earnings. In view of the improved earnings position and financial health of the enterprise, the value of shares will increase and a capital gain will result. Thus, share holders earn capital gain in lieu of dividend income the former in the long-run while the latter in the short-run. The reverse holds true if liberal dividend policy is followed to pay out higher dividends to shareholder. Consequently, the stockholder’s dividend earnings will increase but the possibility of earning capital gains is reduced. Investors desirous of immediate income will value shares with high dividend greatly. The stock market may, therefore, respond to this development and value of shares may zoom.
Owning to varying notions and attitudes of shareholder due to difference in respect of age, tax bracket, security income, habits, preferences and responsibilities while some are primarily concerned with the short-run returns, others think in terms of long-range return and still others seek a portfolio which balances their expectations over time. The above analysis lead us to conclude that dividend decision materially affects the stock holders’ wealth and so also the valuation of the firm. However, financial scholars have not been unanimous on this issue.
Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial consideration. It is difficult to determine a general dividend policy which can be followed by different firms at different times because the dividend decision has to be taken considering the special circumstances of an individual case. The following are the important factors which determine the dividend policy of a firm.
1. Legal Restrictions : Legal provisions relating to dividends as laid down in sections 93, 205, 205 A, 206 and 207 of the Companies Act, 1956 require that dividend can be paid only out of current profits or past profits after providing for depreciation or out of the money provided by Government for the payment of dividends in pursuance of a guarantee given by the Government. The Companies Act, further, provides that dividends cannot be paid out of capital, because it will amount to reduction of capital, adversely affecting the security of its creditors.
2. Magnitude and Trend of Earnings : The amount and trend of earning is an important aspect of dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid only out of present or past year’s profits, earnings of a company fix the upper limits on dividends. The dividends should generally, be paid out of current year’s earnings only, as the retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the company’s earnings should also be kept in consideration while making the dividend decision.
3. Desire and Type of Shareholders : Although, legally, the discretion as to whether to declare dividend or not has been left with the Board of Directors, the directors should give due importance to the desires of share holders in the declaration of dividends as they are the representatives of the company. Desires of shareholder for dividends depend upon their economic status. Investors, such as retired persons, widows and other economically weaker persons view dividends as a source of funds to meet their day to day living expenses. To benefit such investors, the companies should pay regular dividends. On the other hand, wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such an investor may be interested in lower current dividends and high capital gains. It is difficult to reconcile these conflicting interest of the different types of shareholders, but a company should adopt its dividend policy after taking into consideration the interests of its various groups of share holders.
4. Nature of Industry : Nature of industry, to which the company is engaged, also considerably affects the dividend policy. Certain industries have a comparatively steady and stable demand irrespective of the prevailing economic conditions. For instance, people used to liquor continue to drink both in boom as well as recession. Such firms expect regular earnings and hence, can follow a consistent dividend policy. On the other hand, if the earnings are uncertain, as in the case of luxury goods, conservative policy should be followed. Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession period. Thus, industries with steady demand of their products can follow a highest dividend payout ratio while cyclical industries should follow a lower payout ratio.
5. Age of the Company : The age of the company also influences the dividend decisions of a company. A newly established concern has to limit payment of dividend and retain a substantial part of earnings for financing its future growth and development, while older companies which have established sufficient reserves can afford to pay liberal dividends.
6. Future Financial Requirements : It is not only the desires of the shareholders but also future financial requirements of the company that have to be taken into consideration while making a dividend decision. The management of a concern has to reconcile the conflicting interests of shareholders and those of the company’s financial needs. If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its financial position. But when profitable investment opportunities do not exist then the company may not be justified in retaining substantial part of its current earnings. Thus, a concern having few internal investment opportunities should follow high payout ratio as compared to one having more profitable investment opportunities.
7. Government’s Economic Policy : The dividend policy of a firm has also to be adjusted to the economic policy of the Government as was the case when the Temporary Restriction on Payment of Dividend Ordinance was in force. In 1974 and 1975, companies were allowed to pay dividends not more than 33.33 per cent of their profits or 12 per cent on the paid-up value of the shares, whichever was lower.
8. Taxation Policy : The taxation policy of the Government also affects the dividend decision of a firm. A high or low rate of business taxation affects the net earnings of a company (after tax) and therebey its dividend policy. similarly, a firm’s dividend policy may be dictated by the income-tax status of its shareholders. If the dividend income of shareholders is heavily taxed being in high income bracket, the shareholders may fore go cash dividend and prefer bonus shares and capital gains.
9. Inflation : Inflation acts as a constraint in the payment of dividends. Profits as arrived from the profit and loss account on the basis of historical cost has a tendency to be overstated in times of rise in prices due to over-valuation of stock-in-trade and writing off depreciation on fixed assets at lower rates. As a result, when prices rise, funds generated by depreciation would not be adequate to replace fixed assets, and hence to maintain the same assets and capital intact, substantial part of the current earnings would be retained. Otherwise, due to imaginary and inflated book profits in the days of rising prices would amount to payment of dividends much more than warranted by the real profits, out of the equity capital resulting in erosion of capital.
10. Control Objectives : When a company pays high dividends out of its earnings, it may result in the dilution of both control and earnings for the existing share holders. As in case of a high dividend pay-out ratio, the retained earnings are insignificant and the company will have to issue new shares to raise funds to finance its future requirements. The control of the existing share holders will be diluted if they cannot buy the additional shares issued by the company. Similarly, issue of new shares shall cause increase in the number of equity shares and ultimately cause lower earnings per share and their price in the market. Thus, under these circumstances to maintain control of the existing shareholders, it may be desirable to declare lower dividends and retain earnings to finance the firm’s future requirements.
11. Requirements of Institutional Investors : Dividend policy of a company can be affected by the requirements of institutional investors such as financial institutions, banks, insurance corporations, etc. These investors, usually, favour a policy of regular payment of cash dividends and stipulate their own terms with regard to payment of dividend beyond certain percentage on equity shares.
12. Stability of Dividend : Stability of dividends is another important guiding principle in the formulation of a dividend policy. Stability of dividend simply refers to the payment of dividend regularly and shareholders, generally, prefer payment of such regular dividend. Some companies follow a policy of constant dividend per share while others follow a policy of constant payout ratio and while there are some other who follow a policy of constant low dividend per share plus an extra dividend in the years of high profits. A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years or those who have build up sufficient reserves to pay dividends in the years of low profits. The policy of constant payout ratio, i.e., paying a fixed percentage of net earnings every year may be supported by a firm because it is related to the firm’s ability to pay dividends. The policy of constant low dividend per share plus some extra dividend in year so high profits is suitable to the firms having fluctuating earnings from year to year.
13. Liquid Resources : The dividend policy of a firm is a also influenced by the availability of liquid resources. Although, a firm may have sufficient available profits to declare dividends, yet it may not be desirable to pay dividends if does not have sufficient liquid resources. Hence, the liquidity position of a company is an important consideration in paying dividends.
Kinds of Dividend Policies
There exists a wide variety of dividend policies that may be followed by a company. The selection of particular dividend policy is decided by the management after considering several factors. The possible policies are:
(a) Policy of no immediate dividends.
(b) A stable dividend policy.
(c) Policy of regular and extra dividends.
(d) Policy of regular bonus shares.
(e) Policy of regular dividends plus bonus shares, and
(f) Policy of irregular dividends.
(a) Policy of no Immediate Dividends : Payment of dividends is desirable from the company’s and shareholder’s point of view, but it is not compulsory. The Board of Directors may decide to pay no dividend, even though the earnings are substantial and available for the purpose. A company following this policy may justify it under the following conditions:
(1) The company is new and growing.
(2) The needed capital cannot be raised expect at very high cost and earnings, therefore, must be ploughed back in the business.
(3) The shareholders are willing to wait for a return on their investment and in the meantime are content to have their holdings appreciate in value (capital gains).
The no dividend policy must be used with great caution as it may cause dissatisfaction to shareholders because of non-payment of current dividends. After a period of no dividend while the surplus is increasing, it may be a good policy to issue bonus shares (stock dividend) so that the net worth of the company is not affected.
(b) Stable Dividend Policy : A stable dividend policy is one that maintains regularity in paying some dividend regularly event though the amount of dividend may fluctuate from year to year and may not be related with earnings. More precisely, stability of dividends refers to the amount paid out regularly. Stability of dividends can take three distinct forms :
i. Constant dividend per share , i.e., paying a fixed amount per share as dividend every year irrespective of the fluctuations in the earnings.
ii. Constant percentage of net earnings, i.e., paying a fixed percentage of net earnings every year (with this policy) the amount of dividend will fluctuate on direct to proportion of earnings), and
iii. Small constant dividend per share plus extra dividend. Generally, when we refer to a stable dividend policy, we refer to the first from of paying constant dividend per share. A stable dividend policy, therefore, does not mean an inflexible policy, but one involves that payment for a fair rate of returns taking into consideration the gradual growth of the business and the gradual evolution of external values.
Merits of Stable Dividend Policy : (1) Stable dividend policy brings various benefits to the company and shareholders. It helps in long-term financing. If a company anticipates having to raise additional funds some time in the future it must keep in mind that today’s operations will be parts of the record that investors would like to examine critically in deciding whether to buy the company’s securities. A stable dividend policy, in that event, would make financing easier.
(2) It improves the company’s credit and enhances the market value of securities.
(3) It creates shareholder’s confidence in the management and reduces investor’s uncertainty. Dividends have informational value of company can make statements about its expected earnings growth to inform share holders in order to create a favourable impression on them.
(4) The benefits outlined above would bring a great relief to the management in formulating long-term planning for the company.
From what has been said above, one should not get an erroneous impression that the stable dividend policy is without any drawback. The greatest danger associated with a stable dividend policy is that once it is adopted by the firm, it cannot be changed easily. It is, therefore, prudent that the dividend rate is fixed at a lower level so that it can be maintained even in years with reduced profits.
(c) Policy of Regular and Extra Dividends : This policy carries out the intention of regular (stable) dividend rate, and at the same time allows shareholders to share in additional earnings through extra dividends. It is not an unusual practices for companies to pay extra year-end dividends if the results of business operations indicate their justifiability. In order to avoid any possible mis-understanding, it is always advisable to clearly indicate to shareholders the amount of regular and extra dividends. In future if extra dividend is not paid, then the shareholders would not get disillusined with the company. Large companies, usually, number their dividends and label them as regular or extra.
(d) Policy of Regular Stock Dividends : A stock dividend policy refers to the distribution of share in lieu of (or in addition to) cash dividend (known as bonus share in India) to the existing shareholders. Such a policy result in increasing constantly the number of outstanding share so of the company. The policy to pay regular stock dividends is justified when : (i) there are earnings available with the company but the need is to retain cash in the business, and (ii) companies have modernization and extension programmes and the need is to finance them immediately.
The policy of regular stock dividends is not generally advisable. The policy can apply only temporarily, however, the constant cutting up of the corporate ownership into a large number of shares may prove harmful in periods of reduced earnings. Also, the value of shares may fall below a desirable range from the stand-point of later financing. Those shareholders who have a strong preference for cash dividends would feel totally disillusioned with the company.
(e) Policy of Regular Dividends and Stock Dividends : The company using this dividend policy pays the regular (stable) dividend in cash and the extra dividend in stock. This dividend policy is adopted when a company (i) wants to continue its records of regular cash payments, (ii) has reinvested earnings that it want to capitalize, and (iii) wants to give shareholders share in the additional earnings but cannot afford to use up its cash.
(f) Policy of Irregular Dividends
This policy is based upon an attitude that shareholders are entitled to much dividends as earnings and the financial condition of the company warrant. The corporation management, under this dividend policy, may declare dividends is entirely appropriate for a company that has highly unstable earnings. If this dividend policy is adopted by a company with stable earnings, it will have disastrous consequences for the company and shareholders.
Forms of Dividends
1. Annual or regular Cash Dividend : It is the dividend being paid annually by the company. It is also known as final dividend. When annual accounts of the company have been finalized and audited, the directors recommend the rate of dividend which can be distributed on the capital of the company. When approved by the shareholders of the annual general meeting, it is paid within 42 days from the date of declaration by the company. It is generally paid in cash and as a percentage of the paid-up capital, e.g. 10% or 15% of the face value of the share. Though in some cases dividend per share can also be distributed.
2. Interim Dividend : When companies have heavy earnings during a year and directors wish to pay them to the shareholders but at same time, they do not wish shareholders to regard the amount as a precedent for later years, they can distributed inter in dividend. So, it is an extra dividend paid during the year. Such dividends are immediately paid after the recommendation of the board of directors, being no need of approval of shareholders. Interim dividends are also cash dividend.
3. Scrip Dividends : Scrip dividends are used when earnings justify a dividend, but the company’s cash position is temporarily weak. So, shareholders are issued transferable promissory notes, which may or may not be interest bearing.
4. Bond Dividends : In rare instance dividends are paid in Bonds or Notes that have a long enough term to fall beyond the current liability group. Expect that the date of payment is postponed, the effect is the same as that of paying dividends in scrip. The shareholders becomes a secured creditor if the bond has a lien on assets.
5. Property Dividends : Property dividends involve a payment with assets other than cash. Such a distribution may be made whenever these are assets that the no longer necessary in the operation of the business. the investment held by the company also can be distributed by the company in the form of property dividends.
But, however, it is important to note that any cash dividends and stock dividends (i.e., bonus shares) are permissible in India. Other types of dividends are not allowed. The Indian Companies Act, 1956 governs the declaration and payment of dividends.
6. Stock Dividends : It is a form of dividend in which the surplus of company is transferred to capital account and shareholders are given the dividend in the form of shares rather than cash. Such shares are called bonus shares. This dividend is declared to only Equity Shareholders and it may take two forms: (i) making the partly paid equity shares fully paid up without asking for cash from the shareholders, or (ii) issuing and allotting shares to existing equity shareholders in a definite proportion out of reserves and surplus.
Thus, the shareholders receive stock or share certificate for the dividend. This process is also known as ‘capitalization of profits’. This stock dividend does not alter the cash position of the company. It serves to commit the retained earnings to the business as a part of its fixed capitalization.
Objectives of Stock Dividend : Stock dividends may be issued to serve one or more of the following objective :
(1) Conservation of Cash : By issuing the bonus shares a company gives profit of its prospective to the shareholders without parting with the cash. Hence, distribution of dividend in kind conserves the cash in the cash.
(2) Lowering the rate of Dividend : Stock dividend is a remedy for under capitalization too. Under-capitalized enterprise having a high rate of earnings on the capital employed lowers down the rate of dividend by increasing their capitalization. The increase in the number of shares is intended to reduce the rate of dividend per share.
(3) Transferring the formal ownership of surplus and reserves to the shareholders: The existence of huge accumulated profits and other reserves may provide a great temptation for the corporate management to indulge in speculative activities and to manipulate in the market value of share. But once these reserves are capitalized by issuing bonus shares, the scope for the above activities is reduced.
(4) Widening the Share Market : A company desiring wider ownership of its shares may issue bonus shares. Some of the old shareholders will sell their new shares. Moreover, the probable reduced value of the share prices their ownership within the buying range of a greater number of investors.
(5) Financing the Expansion Programmes : The expansion and modernisation programme of a company can easily be financed by utilizing the corporate savings through the issue of bonus shares. Bonus shares becomes the permanent part of the capital structure of a company.
(6) Enhanced Prestige : Bonus shares tend to increase the credit-standing of the issuing company. It borrowing capacity goes high in the eyes of lending institutions. It can arrange loans at a reasonable cost.
(7) True Presentations of Earning Capacity: If the revenues are not capitalised a false idea about the rate of profits is created because shares capital is left unchanged while products continue to accumulate.
(8) Tax advantage: Bonus shares are also issued at times to reap the benefit of a higher rate of deduction allowed on paid up capital than on the reserves under the payment of the Bonus Act, 1965.
Advantages of Stock Dividend
(1) Maintenance of Liquidity Position: By issuing bonus shares a company can maintain its liquidity position because in this case cash dividends are not paid to the shareholders but bonus shares are issued by the company.
(2) Satisfaction of Shareholders: By the issue of Bonus shares the number of equity shareholders in the company increases and they gain by the increased confidence of investors in the soundness of the corporation. Hence, shareholders can be satisfied by issuing bonus shares.
(3) Remedy for Under-Capitalisation: In under-capitalised enterprises the rate of dividend is high. But by issuing bonus share the rate of dividend per share can be reduced and a company can be saved from the evil effects of under-capitalisation.
(4) Economical Issue of Securities: The issue of bonus shares is the most economical issue of securities. Because other types of securities cannot be issued at this minimum cost.
(5) Other benefits like conservation of control, internal financing, etc, are available to the company.
(6) Tax Saving: Bonus shares are issued to take the benefit of a higher rate of deduction allowed on paid up capital than on the reserves under the Payment of the Bonus Act, 1965.
(7) Increase in Their Equity : By issuing bonus shares the equity of the shareholders is increased in the company. For example A is the owner of 20 equity shares of Rs.100 each. Now the company issues four bonus shares to him i.e., one bonus share for every 5 shares held. In the beginning, his equity was Rs.2000 in the company but now his equity increased upto Rs.2,400 in the company.
(8) Marketability of Shares is Increased: When a company issue bonus shares, some of the old shareholders sell their new shares to the other persons. Hence, by issuing bonus shares the marketability of shares is increased.
(9) Increase in Income: In the long-run the income of the shareholders is also increased. But it will be possible only when company is able to maintain the same rate of dividend as before on the increased capital also.
Disadvantage of Bonus Shares Issue
(1) It leads to an increase in the capitalisation of the corporation which cannot be justified until and unless there is a proportionate increase in the earning capacity of the company.
(2) It throws more liability in respect of future dividend on the company.
(3) It excludes the possibility of new investors coming in the contact with the company.
(4) The market value of existing shares goes down.
(5) Some shareholders do not like bonus shares. They prefer only cash dividends. Such investors may be disappointed. It lowers the market value of the existing shares too.
Stock Split-ups
A corporation may issue stock split-ups to its shareholders. A stock split-up merely increases the number of shares of the outstanding stock. There is no change in the total stated value of the stock or in the surplus. it has no effect on shareholders equity. Its effect is solely to repackage the evidence of ownership in small units. Stock split-ups are issued with the following objectives:
(a) To increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and obtaining an orderly distribution of shares;
(b) to conceal the distribution of large profits by reducing the rate per share;
(c) To provide a broader and more stable market for the stock;
(d) To prepare for corporate mergers;
(e) To please shareholders, since stock split-ups are viewed as bullish by the market and stockholders take split-ups as on indicator of the financial success of a corporation;
(f) To facilitate manipulation by insiders;
(g) To precede new financing.
Comparison of Stock Dividend and Stock Split

Stock Dividend Stock Split
1. The par value of the stock is unchanged The par value of the stock is reduced.
2. A part of reserves is capitalized There is no capitalization of reserves

In a nutshell a stock split is similar to a bonus issue from the economic point of view, though there are some differences from the accounting point of view.
COMPANIES ACT AND PAYMENT OF DIVIDEND
Provisions of Companies Act relating to Declaration and Payment of Dividend : In fact, the declaration and payment of dividend is an internal matter of the company and is governed by its Articles. The power regarding appropriation of profits is given to the Board of Directors. The Directors are to follow Table A or the provisions of Articles and the provisions of the Companies Act 1956 in this regard. The following are the rules regarding declaration and payment of dividend.
(1) Dividend on Paid up Capital: A company may, if so authorised by its Articles, pay dividend on the paid up value of shares (section 93 of the Companies Act).
(2) Provisions of Articles of Association: Rules 85 to 94 of Table A provide that: (i) a company may declare dividend in its general meeting provided it does not exceed the amount recommended by the board of directors, (ii) the board of directors may from time to time pay to the members such interim dividends, as appears to it to be justified by the profits of the company, (iii) notice of dividend should be given to those who are entitled to receive it, (iv) the directors may transfer any amount they think proper to the reserve fund which may be utilised for any contingencies, and (v) when a dividend has been declared, it becomes a liability of the company to the shareholders from the date of its declaration but no interest can be claimed on it.
(3) Dividends only out of Profit: Dividends can only be declared or paid out of (i) the current profits of the company, (ii) the past accumulated profits and (iii) money provided by the Central or State Government for the payment of dividends in pursuance of a guarantee given by the government. No dividend can be paid out of capital (Sec.205 (i). Director who is responsibly for payment of dividend out of capital, shall be personally liable to make good such amount to the company.
(b) Companies are not entitled to any dividend unless present or arrears of depreciation have been provided for out of the profits and an amount of 10% of profits has been transferred to reserve. However, Central government may allow any company to declare or pay dividends out of profits before providing for any depreciation.
(c) Capital Profits may also be utilised for the declaration of dividend provided (i) there is nothing in the Articles prohibiting the distribution of dividend out of capital profits; (ii) they have been realised in cash; and (iii) they remain as profits after revaluation of all assets and liabilities.
(d) Dividend cannot be paid out of accumulated profits unless current losses are made good.
4. Payment of Dividend only in Cash : (Sec. 205 (iii)). Dividends are to be paid in cash only except (i) by capitalizing the profits by issue of fully paid bonus shares, if Articles so permit, provided all legal formalities have been satisfied in respect of issue of bonus shares, and (ii) by paying up any unpaid amount on partly paid up shares.
5. Payment of Dividend to Specified person (Sec. 206) : Dividend shall be paid only to those whose names appear on the Register of members on the date of declaration of dividend to the holders of dividend warrant, if issued by the company.
6. Payment of Dividend within 42 days (Sec. 207). Dividend must be paid within 42 days of its declaration except in the following circumstances: (i) by operation of law of receive dividend is pending decision, (iv) where it is not due to the default of the company; and (v) if company lawfully adjusts and amounts against any debt due from the shareholder. Any director in default shall be liable to punishment of seven days of simple imprisonment or fine or both.
7. Payment of Interim Dividend : The directors of a company can pay interim dividend subject to the provisions of Articles. Interim dividend can be paid at any time between the two annual general meetings taking into full year’s accounts and after providing full year’s depreciation on fixed assets.
8. Transfer of Unpaid Dividend to a Special Bank Account (Sec. 205 (A). According to section 205 A, newly inserted by the companies (Amendment) Act 1974, where a company has declared a dividend but has not posted the dividend warrant in respect thereof within 42 days to the shareholders entitled to it, such unpaid dividends shall be tranferred to a special account to be opened by the company in the behalf in any Scheduled Bank to be called ‘Unpaid Dividend Account of. Co. Ltd.’ If the unpaid dividend are not so transferred the company shall pay an interest at 12% p.a.
9. Transfer of Unclaimed Dividend to Central Government : Any amount transferred to the unpaid dividend account remains unpaid or unclaimed for 3 years from the date of such transfer shall be transferred to the Investor Protection Fund by the company along with a statement giving full particulars in respect of the sums so transferred and the last known addresses of the persons entitled to receipt and such other particulars as may be prescribed. The company is entitled to a receipt for such transfer from the Reserve Bank of India.
If a company fails to comply the above said provisions (given in para 8 and 9 above), the company and every officer of the company who is in default shall be punishable with a fine which may extend to Rs.500 for every day during which default continues.
SUMMARY
After obtaining the necessary amount of capital, the next important function is to invest and utilize the procured capital in such a way that the investors may set an adequate return on then investments and the capital too may remain intact. Procurement of capital is comparatively an earlier task but efficient utilization of the capital and the management if earnings are delicate issues which depends upon the informal administration of firm. This lesson, provides an understanding about the scope of management of earnings. It identifies the determinants of dividend policy and ascertain different kinds of dividend policies. It distinguishes between stock dividend & stock split, Rules as to payment of dividend is also dealt with.
REVIEW QUESTIONS
1. Explain the significances of dividend decisions in financial management.
2. Outline and analyse the fundamental issues concerning corporate dividend policy.
3. Explain the various external and internal factors which influence the dividend decision of a firm.
4. What are the different types of dividends that can be paid by a company?
5. What are (i) a Constant-Pay-out Ratio Policy, (ii) a Constant Rupee Policy and (iii) a Regular-Extra dividend Policy? What are the ramifications of these policies?
6. What are the advantages and disadvantages of stock dividend to the company and to the shareholders? Explain.
7. As a firm’s financial manager, would you recommend to the board of directors that the firm adopt as policy a stable dividend payment per share or a stable pay-out ratio.
8. Write a short note on Pay-out Ratio. What is its importance in dividend decision?
9. What are Bonus Shares? Explain in brief the provision of Company Law relating to them and the guidelines issued by SEBI.
10. Describe the various provisions of Companies Act, 1956 governing the declaration and payment of dividend.
SUGGESTED READINGS
1. Chandra, Prasanna : Fundamentals of Financial Management,
New Delhi, Tata McGraw Hill Co.
2. Pandey, I.M. : Financial Management,
New Delhi, Vikas Publishing House.
3. Saravanavel, P. : Financial Management,
New Delhi, Dhanpat Rai & Sons.