Cost of Capital

Meaning of Cost of Capital

The term cost of capital refers to the minimum rate of return a firm must earn on its investments. This is
in consonance with the firm's overall objective of wealth maximization. Cost of capital is a complex,
controversial but significant concept in financial management.

Hampton, John defines the term as "the rate of return the firm requires from investment in order to
increase the value of the firm in the market place".

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

Solomon Ezra: "Cost of Capital is the minimum required rate of earnings or the cut-off rate of capital
expenditure."

The following are the basic characteristics of cost of capital:

i) Cost of capital is a rate of return; it is not a cost as such.

ii) This return, however, is calculated on the basis of actual cost of different components of
capital.
iii) A firm's cost of capital represents minimum rate of return that will result in at least
maintaining (If not increasing) the value of its equity shares.
iv) It is related to long term capital funds.
v) Cost of capital consists of three components: a) Return at Zero Risk Level. (r0) b) Premium
for Business Risk (b) c) Premium for Financial Risk (f)
A firm's cost of capital has mainly three risks :
• Return at Zero Risk Level: This refers to the expected rate of return when a project involves no risk
whether business or financial.
• Premium for Business Risk: Business risk is possibility where in the firm will not be able to operate
successfully in the market. Greater the business risk, the higher will be the cost of capital.
• Premium for Financial Risk: It refers to the risk on account of pattern of capital structure. In other
words, a firm having higher debt content in its capital structure is more risky as compared to a firm
which has comparatively low debt content.

Importance
The determination of the firm's cost of capital is important from the point of view of the following:
i) It is the basis of appraising new capital expenditure proposals. This gives the acceptance /
rejection criterion for capital expenditure projects.
ii) The finance manager must raise capital from different sources in a way that it optimizes the risk
and cost factors. The sources of funds which have less cost involve high risk. Cost of capital helps the
managers in determining the optimal capital structure.
iii) It is the basis for evaluating the financial performance of top management.
iv) It helps in formulating appropriate dividend policy.
v) It also helps the organization in developing an appropriate working capital policy.

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Advantages/significance/Scope
• It helps in evaluating the investment options, by converting the future cash flows of the
investment avenues into present value by discounting it.
• It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
• It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is
maximum, and the cost of capital is minimum.
• It can also be used to appraise the performance of specific projects by comparing the
performance against the cost of capital.

Types of Capital

Capital is a broad term that can describe anything that confers value or benefit to its owners.

Common sources of capital include:

• Personal savings
• Friends and family
• Angel investors
• Venture capitalists (VC)
• Corporations
• Federal, state, or local governments
• Private loans

1. Debt Capital-Debt capital is money that a business borrows from investors or banks, usually to use as
growth capital.
This money is typically repaid at a later date, often with interest.
Debt capital can be acquired through bank loans, personal loans, or debentures.
Debt capital differs from equity or share capital because subscribers to debt capital do not become part
owners of the business, but are merely creditors, and the suppliers of debt capital usually receive a
contractually fixed annual percentage return on their loan, and this is known as the coupon rate.
Advantages
• Immediate access to capital
• Interest payments may be tax-deductible,
• No dilution of ownership
Disadvantages
• Interest must be paid to lenders
• Payments must be made regardless of business revenue
• Debt financing can be risky for businesses with inconsistent cash flow
2. Equity Capital-The equity capital definition refers to capital that a company owns that is not tied to
debt. This type of capital often involves investor money entering the company in exchange for shares.
Equity capital is capital raised by issuing shares in the ownership of a business. In return, shareholders
are entitled to a share in the profit and a portion of the assets if the company goes out of business.
Equity financing can come from existing shareholders or new investors.

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3. Working Capital-A company's working capital is its liquid capital assets available for fulfilling daily
obligations.
Current Assets – Current Liabilities
Working capital measures a company's short-term liquidity. More specifically, it represents its ability to
cover its debts, accounts payable, and other obligations that are due within one year.

4. Trading Capital-Trading capital is a term used by brokerages and other financial institutions that place
a large number of trades daily. Trading capital is the amount of money allotted to an individual or a firm
to buy and sell various securities. Investors may attempt to add to their trading capital by employing a
variety of trade optimization methods. A big brokerage firm like Fidelity Investments will allocate
considerable trading capital to each of the professionals who trade stocks and other assets for it.

Classification of Cost of Capital There is no fixed base of classification of cost of capital. It varies
according to need, process and purpose.
It may be classified as follows:
• Explicit Cost and Implicit Cost: Explicit cost is the discount rate that equates the present value of the
funds received by the firm net of underwriting costs, with the present value of expected cash outflows.
Thus, it is `the rate of return of the cash flows of financing opportunity’. On the other hand, the implicit
cost is the rate of return associated with the best investment opportunity for the firm and its
shareholders that will be foregone if the project presently under consideration by the firm were
accepted. In the other words, explicit cost relates to rising of funds and implicit costs relate to usage of
funds.
Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows
with the present value of cash outflows.
Implicit cost also known as the opportunity cost is the cost ·, the opportunity foregone in order to take
up a particular project. For example, the implicit cost of retained earnings is the rate of return available
to shareholders by investing the funds elsewhere.
Average Cost and Marginal Cost: An average cost is the combined cost or weighted average cost of
various sources of capital. Marginal cost of capital refers to the average cost of capital of new or
additional funds required by a firm. It is the marginal cost which should be taken into consideration in
investment decisions.
Historical Cost and Future Cost: Historical costs are book costs relating to the past, while future costs
are estimated costs. Future costs are more relevant than historical costs in financial decision-making,
whereas historical costs act as guide for estimation of future costs.
Specific Costs and Composite Cost: 'Specific cost is the cost of a specific source of capital, while
composite cost is combined cost of various sources of capital. Composite cost, also known as the
weighted, average cost of capital, should be considered in capital structure and capital budgeting
decisions.
Significance
i) Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net
Present Value method for evaluating investment proposals. So, it is very useful in capital budgeting
decisions.

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ii) Capital structure decisions: An optimal capital structure is that structure at which the value of
the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal
capital structure.
iii) Evaluation of Financial Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitably is compared to the expected and actual cost of
capital of funds and if profit is greater than the cost of capital the performance may be said to be
satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other financial decisions
as dividend policy, capitalization of profits, making the rights issue, etc.

Basic Definitions
Capital—refers to the long-term funds used by a firm to finance its assets
Weighted average cost of capital, WACC—the average percentage cost, based on the proportion each
component of the total capital, of all the funds used by the firm to finance its assets. o Capital
structure—the mix of the types of capital used by the firm to finance its assets. For example, one firm’s
capital structure might consist of 40 percent debt and 60 percent common equity while another firm’s
capital structure might be 60 percent debt, 10 percent preferred equity, and 30 percent common equity.

Cost of Equity: Cost of equity capital is the rate at which investors discount the expected dividends of
the firm to determine its share value. Theoretically, the cost of equity capital is described as the
"Minimum rate of return that a firm must earn on the equity financed portion of an investment project
in order to leave unchanged the market price of the shares".
Cost of equity can be calculated from the following approach: • Dividend price (D/P) approach. •
Dividend price plus growth (D/P + g) approach. • Earning price (E/P) approach. • Realized yield approach.

Cost of Debt: Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be
issued at par, at premium or at discount and also it may be perpetual or redeemable.

Cost of Preference Share Capital: Cost of preference share capital is the annual preference share
dividend by the net proceeds from the sale of preference share. There are two types of preference
shares irredeemable and redeemable.

Cost of Retained Earnings: Retained earnings are one of the sources of finance for investment proposal.
It is dissimilar from other sources like debt, equity and preference shares. Cost of retained earnings is
the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by
the cost of equity capital.

Weighted average cost of capital- It is also known as weighted average cost of capital and composite
cost of capital. Weighted average cost of capital is the expected average future cost of funds over the
long run found by weighting the cost of each specific type of capital by its proportion in the firm's capital
structure. Weighted average cost of capital (WACC) represents a company's average after-tax cost of
capital from all sources, including common stock, preferred stock, bonds, and other forms of debt.
The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.

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 (b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.

Assignment of Weights- The weights to specific funds may be assigned based on the following:
(i) Book Values: Book value weights are based on the values found on the balance sheet. The
weight applicable to a given source of fund is simply the book value of the source of fund
divided by the book value of total funds.
(ii) Market Value Weights: Under this method, assigned weights to a particular component of
capital structure is equal to the market value of the component of capital divided by the
market value of all components of capital and capital employed by the firm.

FACTORS AFFECTING WACC

(A) Controllable Factors: Controllable factors are those factors that are within the control of the firm.
They are:
(i) Capital Structure Policy: As we have assumed that a firm has a given target capital structure where
we assigned weights based on that target capital structure to calculate WACC. However, a firm can
change its capital structure or proportions of components of capital that affect its WACC. For example, a
firm decides to use more debt and less equity, which will lead to reduction of WACC. At the same time,
increasing proportion of debt in capital structure increases the risk of both debt and equity holder,
because it increases fixed financial (commitment) charges.
(ii) Dividend Policy: The required capital may be raised by equity or debt or by combination of both the
sources. Equity capital can be raised by issue of new equity shares or through retained earnings.
Sometimes companies may prefer to raise equity capital by retention of earnings, because it involves no
flotation costs. Firms may feel that retained earnings are less costly when compared to issue of new
equity. But it is different it is more costly, since the retained earnings is the income that is not paid as
dividends. Hence, investors expect more return so it affects cost of capital.
(iii) Investment Policy: While estimating initial cost of capital, generally, we use the starting point for the
required rates of return on the firm’s existing stock and bonds. Therefore, we implicitly assume that new
capital will be invested in assets of the same type and with the same degree of risk. But it is not correct
as no firm invests in assets similar to what they currently operate, when a firm changes its investment
policy.
(B) Uncontrollable Factors: The factors that is not possible to be controlled by the firm that mostly
affects the cost of capital. This type of factors is known as external factors.
(i) Tax Rates: Tax rates that are beyond the control of a firm, have an important effect on the overall
cost of capital. Computation of debt involves consideration of tax. In addition to lowering capital gains
tax rate relative to the rate on ordinary income makes stocks more attractive and that reduces cost of
equity and it would lower the overall cost of capital.
(ii) Level of Interest Rates: Cost of debt is interest rate. If interest rates increases, automatically cost of
debt also increases. On the other hand, if interest rates are low, then the cost of debt is less. The
reduced cost of debt reduces WACC and this will encourage an additional investment.
(iii) Market Risk Premium: Market risk premium is determined by the risk in investing proposed stock
and the investor’s aversion to risk. Market risk is out of control risk, i.e., firms have no control on this
factor.
Specific Cost

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“Specific cost“usually refers to the individual component costs associated with each source of capital
used by a company.
1. Cost of Debt: The cost associated with obtaining funds through debt.
It is typically the interest rate paid on debt
Companies may raise debt capital through issue of debentures or raise loans from financial institutions
or accept deposits from the public. All these resources involve a specific rate of interest. The interest
paid on these sources of funds is a charge on the profit and loss account of the company. In other
words, interest payments made by the firm on debt issue qualify tax deduction in determining net
taxable income. Computation of cost of debenture or debt is relatively easy, because the interest rate
that is payable on debt is fixed by the agreement between the firm and the creditors. Computation of
cost of debenture or debt capital depends on their nature. The debt/debentures can be perpetual or
irredeemable and redeemable, cost of debt capital is equal to the interest paid on that debt, but from
company point of view it will be less than the interest payable when the debt is issued at par since the
interest is tax deductible. Hence, computation of debt is always after tax cost.
(a) Cost of Irredeemable Debt -Perpetual debt provides permanent funds to the firm, because the
funds will remain in the firm till liquidation. Cost of perpetual debt is the rate of return that
lender expects (i.e., fixed interest rate). The coupon rate or the market yield on debt can be said
to represent an approximation of cost of debt. Bonds/debentures can be issued at: (i) par/face
value, (ii) discount and (iii) premium.
(b) Cost of Redeemable Debt -Redeemable debentures are those having a maturity period or
repayable after a certain given period of time. In other words, these type of debentures are
under legal obligation to repay the principal amount to its holders either at a certain agreed
intervals during the duration of loan or a lump sum amount at the end of maturity period. These
type of debentures are issued by many companies when they require capital for temporary
needs.
2. Cost of Equity -Firms may obtain equity capital in two ways:
(a) Retention of earnings, and
(b) Issue of (additional) equity shares to the public.
The cost of equity or the return required by the equity shareholders is the same in both the
cases, since in both cases; shareholders are providing funds to the firm to finance firm’s
investment proposals. Retention of earnings involves an opportunity cost. Shareholders could
receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings
or issue of additional equity shares, the cost of equity is the same. But issue of additional equity
shares to the public involves a flotation cost whereas there is no flotation cost for retained
earnings. Hence, issue of additional equity shares to the public for raising equity finance involves
a bigger cost when compared to the retained earnings.
I. Cost of Retained Earnings (Kre)- Retained earnings is one of the internal sources of funds to
raise equity funds. Retained earnings are those part of (amount) net earnings which is
retained by the firm for investing in capital budgeting proposals instead of paying them
as dividends to shareholders. Corporate executives and some analysts too normally
consider that the retained earnings are cost free, because there is no legal binding for
the firm to pay dividends to equity shareholders. But it is not so. They involve
opportunity cost. The opportunity cost of retained earnings is the rate of return the

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 shareholder forgoes by not putting his/her funds elsewhere, because the management
has retained the funds.
II. Cost of Equity-The cost of equity capital (Ke ) may be defined as the minimum rate of return
that a firm must earn on the equity financed portions of an investment project in order
to leave unchanged the market price of the shares. The cost of equity is not the out-of-
pocket cost of using equity capital as the equity shareholders are not paid dividend at a
fixed rate every year.
Approaches to Calculate Cost of Equity
1. Dividends Capitalization Approach-According to this approach, the cost of equity
capital is calculated on the basis of the required rate of return in terms of the future
dividends to be paid on the shares. Accordingly, Ke is defined as the discount rate
that equates the present value of all expected future dividends per share, with the
net proceeds of the sale (or the current market price) of a share.
Dividend Capitalization approach, suffers from the following limitations:
• It does not consider future earnings.
• It ignores the earnings on retained earnings.
• It ignores the fact that market price rise may be due to retained earnings and not
on account of high dividends.
• It does not take into account the capital gains.
2. Earnings Capitalization Approach- According to this approach, cost of equity (Ke ) is
the discount rate that equates the present value of expected future earnings per
share with the net proceeds (or current market price) of a share. The advocates of
this approach establish a relationship between earnings and market price of share.
Computation of retained earnings cost separately leads to double the company’s
cost of capital. This approach is employed under the following conditions. They are:
(a) Constant earnings per share over the future period (b) There should be either
100 per cent retention ratio or 100 per cent dividend payout ratio and (c) Company
satisfies the requirements with equity shares and does not employ debt
3. Dividend Capitalization plus Growth Rate Approach -Computation of cost of equity
capital based on a fixed dividend rate may not be appropriate, because the future
dividend may grow. The growth in dividends may be constant perpetually or may
vary over a period of time. It is the best method over dividend capitalization
approach, since it considers the growth in dividends. Generally, investors invest in
equity shares on the basis of the expected future dividends rather than on current
dividends. They expect increase in future dividend. Growth in dividends will have
positive impact on share prices.
4. Bond Yield Plus Risk Premium (BYRP) Approach -According to this approach, the
rate of return required by the equity shareholder of a company is equal to Ke = Yield
on long-term Bonds + Risk Premium The logic of this approach is very simple, equity
investors bear a higher risk than bond investors, hence their required rate of return
should include a premium for their higher risk. In other words, bondholder and
equity shareholder both are providing funds to the company, but the company
assures a fixed rate of interest to the bondholders and not equity shareholders,
hence, there is risk involved due to uncertainty of expected dividends.

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 iii. COST OF PREFERENCE SHARES- Preference share is one of the types of shares issued by the
companies to raise funds from the public. Preference share is the share that has two
preferential rights over equity shares: (i) preference in payment of dividend, from
distributable profits, and (ii) preference in the payment of capital at the time of liquidation
of the company. The cost of preference share capital is a function of the dividend expected
by the investors. Generally, preference share capital is issued with an intention (a fixed rate)
to pay dividends. In case if dividends are not paid, it will affect the firm’s fund raising
capacity.

Unit 2-Capital Structure Theories

Capital Structure means a combination of all long-term sources of finance. It includes Equity Share
Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other such long-term
sources of finance. A company has to decide the proportion in which it should have its own finance and
outsider’s finance particularly debt finance.
Factors affecting Capital Structure
• Control- Determination of capital structure also operates in the company’s willingness to maintain
control. The issue of equity shares involves the risk of losing control.
• Size of Company-Small companies may have to rely on the founder’s money but as they grow they will
be eligible for long-term financing because larger companies are considered less risky by investors.
• Nature of Business -If your business is a monopoly you can go for debentures because your sales can
give you adequate profits to pay your debts easily or pay dividends.
• The Regularity of Earnings-A firm with large and stable incomes may incur more debt in its capital
structure, unlike the one that is unstable.
• Capital Structure of Other Companies: Capital structure is influenced by the industry to which a
company is related. All companies related to a given industry produce almost similar products, their
costs of production are similar, they depend on identical technology, they have similar profitability, and
hence the pattern of their capital structure is almost similar.
• Conditions of the Money Markets–Capital markets are always changing. You don’t want to issues
company shares during a bear market; you do it when there is a bull run.
• Government policy– This is important to consider. A change in lending policy may increase your cost
of borrowing.
• Cost of Floating– The cost of floating equity is much higher than that of floating debt. This may
influence the finance manager to take debt financing the cheaper option.
• Debt -Equity Ratio– As stated debt is a liability whose interest has to be paid irrespective of earnings.
Equity, on the other hand, is shareholders money and payment depends on profits being paid. High debt
in the capital structure is risky and may be a problem in adverse times. However, debt is cheaper than
issuing shares. Debt interest has some tax deductions that is not the case for dividends paid to equity
holders.

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Optimal Capital Structure
The optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and
maximize the value of the firm.

Features of a Good Capital Structure

• Profitability-it should ensure most profits are earned. It should offer the least cost of financing with
maximum returns
• Solvency-the structure should not lead the company to a point it risks being insolvent. Too much debt
threatens a company’s solvency so any debt taken should be manageable
• Flexibility-should things change the capital structure should be one that can be easily maneuvered to
meet new market demands
• Control– the structure should not give away control of the company. So, caution should be taken not
to give too much away that owners lose their controlling stake.

Capital structure theory

The capital structure theory is the approach to determine the value proportion of the capital share to
the overall cost of capital for a company to thrive.
Capital structure theories are divided into two categories: theories of relevance and theories of
irrelevance.

1. Relevance Theory of Capital Structure:-Relevance to Firm Value: According to this theory,

capital structure decisions can impact a firm's value. In other words, the choice between debt
and equity financing can influence a company's worth. –
**Tax Shield**: The theory argues that interest payments on debt provide a tax shield, reducing
a firm's tax liability and increasing its value. This is especially relevant in a high-tax environment.
**Financial Distress Costs**: It acknowledges that excessive debt can lead to financial distress
costs, including bankruptcy, which can harm a company's value.
2. Irrelevance Theory of Capital Structure:
The irrelevance theory, as proposed by Modigliani and Miller, asserts that, under certain
conditions, capital structure decisions are irrelevant to a firm's value. The irrelevance

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 proposition theorem states that taking on debt does not affect a company's value as long as it
does not encounter distressed loan costs or income taxes.
Specifically, they proposed two key propositions: -
Proposition I: In a world without taxes or bankruptcy costs, the value of a firm is independent of
its capital structure.
Proposition II: In a world with taxes, the value of a leveraged firm is higher than that of an
unleveraged firm because of the interest tax shield.
1. Net Income approach- According to this approach, the market value of equity shares is based on
the earning available for equity shareholders after the payment of interest on debt if it is
included in the Capital Structure. The earning of the firm after the payment of all other expenses
except interest on debt is called Net Operating Income (NOI) and the earning available for equity
shareholders after the payment of interest is called as “Net Income (NI). Therefore, Net Income
= Net Operating Income (NOI) - Interest on debt (I). According to this approach, as the debt
increases, overall or weighted average cost of capital decreases and vice versa. Therefore
increase in debt results in the increase in the value of the firm and consequently increases the
value of the equity shares of the company.
Net Income approach is based on the following assumptions:
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity i.e. the capitalization rate of debt is less than
the rate of equity capitalization. This prompts the firm to borrow.
(iii) The debt capitalization rate and the equity capitalization rate remain constant.
(iv) The proportion of the debt does not affect the risk perception of the investors. Investors
are only concerned with their desired return.
(v) The cost of debt remains constant at any level of debt.

Criticisms of NI Approach
(i) The assumption of constant cost of debt at any level of debt is not correct. The funds providers
insist for more rate of interest above certain level of debt.
(ii) The assumption of risk perception of equity share holders is also not correct. As the debt
increases the financial risk also increases and equity share holders will expect more return on
their investment and hence the rate equity capitalization also increases with the increase in
financial leverage.
(iii) 100% dividend payout and absence of corporate tax are not practically possible.

2. Net Operating Income approach As per this approach, the market value of the firm is based on
the earning available for fund providers after paying all other expenses except interest on debt.
The profit available for funds providers or for calculating the market value of the firm is called
Net operating Income (NOI). This theory is just opposite to NI approach. NI approach is relevant
to capital structure decision. It means decision of debt equity mix does affect the WACC and
value of the firm. As per NOI approach the capital structure decision is irrelevant and the degree
of financial leverage does not affect the WACC and market value of the firm. NOI approach
evaluates the cost of capital and therefore the optimal Capital Structure on the basis of
operating leverage by means of NOI approach.

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 The NOI approach is based on following assumptions: (i) There are no corporate taxes. (ii) Cost
of debt remains constant at all level of debt. (iii) Overall cost of capital remains constant.
(iv) Value of the firm depends on expected net operating income and overall capitalization rate
or the opportunity cost of capital. (v) Net operating income of the firm is not affected by the
degree of financial leverage. (vi) The operating risk or business risk does not change with the
change in debt equity mix. (vii) WACC does not change with the change in financial leverage.

Criticisms of NOI approach The NOI approach is criticized on the following grounds: (i) The
assumption of absence of corporate tax is not correct. (ii) The cost of debt increases with the
increase in the quantum of debt. (iii) As the cost of debt increases with the increase in financial
leverage, the overall cost of capital also increases with increase in financial leverage. (iv) An
investor values differently the firm having higher level of debt in its capital structure than the
firm having less debt or no debt.
3. Traditional Theory Approach: According to this approach weighted average cost of capital
decreases only up to a certain level of financial leverage and starts increasing beyond certain
level of judicious mix of debt and equity. Hence, a firm has an optimum capital structure when
the weighted average cost of capital is minimum and the market value of the firm is maximum.
This approach has main three stages
First Stage: Increasing Value In the first stage the cost of equity (ke) either remains constant or
rises slightly with increase in debt. At this stage, the increase in cost of equity is less than the
advantage in cost due to lower cost of debt than equity. During this stage, the cost of debt (kd)
remains constant since, it is considered as a rational decision. Consequently, the overall cost of
capital (ko) decreases with increase in leverage and thus the total value of the firm (V) also
increases.
Second Stage: Optimum Value At this stage, the cost of equity increases faster than it increases
at the first stage when debt is increased. Further the benefit of low cost of debt is wiped off by
increase in cost of equity beyond certain level, hence, the firm reaches at a stage of minimum
weighted average cost of capital and maximum value of the firm at certain level of debt equity
mix where the optimum capital structure is attained.
Third Stage: Declining Value As the debt is increased beyond certain level, the increase in cost of
equity becomes greater than the advantage of low cost of debt and therefore weighted average
cost of capital increases and the market value of the firm decreases. At this stage, the value of
the firm goes on declining with every increase in debt replacing the equity. This happens
because investors perceive a higher degree of financial risk and demand a higher rate of return
on equity, which exceeds the advantage of low cost debt.
4. MODIGLIANI AND MILLER APPROACH- This approach was devised by Modigliani and Miller
during the 1950s. The fundamentals of the Modigliani and Miller Approach resemble that of the
Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy
theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a
company. Whether a firm is highly leveraged or has a lower debt component in the financing
mix has no bearing on the value of a firm. The Modigliani and Miller Approach further states
that the market value of a firm is affected by its operating income, apart from the risk involved
in the investment. The theory stated that the value of the firm is not dependent on the choice of
capital structure or financing decisions of the firm.

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 ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH • There are no taxes. • Transaction
cost for buying and selling securities, as well as the bankruptcy cost, is nil. • There is symmetry
of information. This means that an investor will have access to the same information that a
corporation would and investors will thus behave rationally. • The cost of borrowing is the same
for investors and companies. • There is no floatation cost, such as an underwriting commission,
payment to merchant bankers, advertisement expenses, etc. • there is no corporate dividend
tax
This theory had two further assumptions.

Absence of Corporate taxes: According to Modigliani-Miller’s theory, in the absence of the

corporate tax, the value of the creditworthy firm will be equal to that of the amount of equity
compromised.
Presence of corporate taxes: In the case where taxes are applied, the value of the creditworthy
firm is equal to the value of the indebted firm summed up with the product of the tax rate and
the value of debt.

Unit 3-Risk analysis in capital Budgeting

Capital Budgeting
The decision on investing in long term assets has significant impact on the future of the company, since
future is uncertain.
It is difficult to predict expected return and risk factors associated with investment
Risk and Return are the 2 important consideration of investment decision. One of the important tool
used in FM to evaluate the risk and return factor-Capital Budgeting
Capital budgeting is the process by which investors determine the value of a potential investment
project. Capital budgeting is a process of evaluating investments and huge expenses in order to obtain
the best returns on investment.
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the
best returns on investment.
Financial tool to evaluate the value of long term project

Objectives of Capital budgeting

• Selecting profitable projects

• Capital expenditure control
• Finding the right sources for funds
SIGNIFICANCE OF CAPITAL BUDGETING
• Capital budgeting is an essential tool in financial management
• Capital budgeting provides a wide scope for financial managers to evaluate different projects in
terms of their viability to be taken up for investments.
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of capital expenditure projects
• Ultimately the fate of a business is decided on how optimally the available resources are used.

Types of Capital expenditure Proposal

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 • 1.Expansion-increase output of existing product or expand retail outlets
• 2. Diversification –extension of business activities into disparate field.
• 3.Replacement and modernization
• 4.Research and development
• 5.Miscellaneous
CAPITAL BUDGETING PROCESS:
1. Determine Investment Proposal
2. Screening Investment Proposal
3. Assessment of investment proposal
4. Prioritizing investment proposal
5. Decision Making
6. Implementation
7. Review

Capital Budgeting Decision Type

Accept or Reject Decisions- Independent project
Mutually exclusive Decisions-Dependent Project
Capital Rationing Decisions-allocating resources in favor of desired proposal based on availability of
fund

Capital Budgeting methods for Ascertaining Return

Capital Budgeting Under Risk and Uncertainty

Risk is inseparable from return in the investment world.

In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an
investment decision.
A situation where the potential outcomes and their probabilities are known or can be estimated with
reasonable degree of confidence

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The risk associated with a project may be defined as the variability that is likely to occur in the future ret
urns from the project.
Examples-fluctuation in exchange rate or interest rate

Uncertainty
A situation where the probabilities of different outcomes are unknown or cannot be reasonably
estimated
Uncertainty is not easily quantifiable
Example-Launching a new product
Uncertainty refers to a state of not knowing or having limited information about future events or
outcomes.
It involves ambiguity, unpredictability, and the absence of clear probabilities or measures of likelihood.
Uncertainty can arise from various factors, such as incomplete data, complex environments, or
situations with multiple possible outcomes.
Unlike risk, uncertainty is not easily quantifiable or manageable through traditional risk management
techniques.

Types of risk

• A. Systematic Risk

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 • B. Unsystematic Risk

Systematic risk- Systematic risk is due to the influence of external factors on an organization. Such
factors are normally uncontrollable from an organization's point of view. It is a macro in nature as it
affects a large number of organizations operating under a similar stream or same domain. It cannot be
planned by the organization.

• Interest rate risk results from a change in the market interest rate. It mainly impacts fixed-
income securities, like bond prices and asset-backed securities. The yield on these securities is
inversely related to the interest rate. As interest rates go up, investors find it more attractive to
pull their money out of fixed-income securities.

• Market risk results from the general tendency of investors to behave as per the market. For
example, investors avoid investing in even the best-performing companies during a financial
crisis. Usually, market risk accounts for about two-thirds of total systematic risk.

• Purchasing power risk or inflation risk results from the decline in the purchasing power of
money due to inflation

2. Unsystematic Risk

Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view. It is a micro in
nature as it affects only a particular organization. It can be planned, so that necessary actions
can be taken by the organization to mitigate (reduce the effect of) the risk.

• Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale
and purchase of securities affected by business cycles, technological changes, etc.

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 • Financial risk is also known as credit risk. It arises due to change in the capital structure of the
organization

• Operational risks are the business process risks failing due to human errors. This risk will change
from industry to industry. It occurs due to breakdowns in the internal procedures, people,
policies and systems.

Sources of Risk

1. Market Risk:

Market risk, also known as systematic risk or non-diversifiable risk, is one of the most significant risks in
capital budgeting. It stems from the fact that the value of investments can fluctuate due to
macroeconomic factors that affect the entire market (CFI Team, 2020). This risk can impact capital
budgeting decisions in the following ways:

- Economic Conditions: Economic downturns, recessions, or changes in economic conditions can

affect consumer demand, project revenue, and overall business conditions. For example, a recession can
lead to reduced demand for a product or service, impacting a project's cash flows and profitability.

- Foreign Exchange Risk: If a project involves international operations or sales, currency exchange rate
fluctuations can significantly impact project returns. Unfavorable currency movements can reduce the
value of cash flows in the local currency, affecting NPV

2. Operational Risk:

Operational risk is another significant risk in capital budgeting, and it relates to the day-to-day
operations and management of a project (Segal, 2023). Several factors contribute to operational risk:

- Market Acceptance and Competition: If the project involves introducing a new product or service,
there's a risk associated with market acceptance and competition. If competitors launch similar offerings
or if the target market doesn't adopt the product as expected, revenue and profitability may suffer.

- Regulatory and Compliance Risks: Changes in regulations or non-compliance with existing ones can
lead to unexpected costs or project delays. This is especially relevant in industries like healthcare,
finance, and energy.

3. Project-Specific Risks:

These are risks that are unique to a particular project and can significantly impact its success. They
include:

- Cost Overruns: Initial budget estimates may prove to be inaccurate, leading to cost overruns. These
overruns can negatively impact the project's financial feasibility and profitability (Indeed Editorial Team,
2023).

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 - Technological Obsolescence: Rapid technological advancements can render a project's technology or
equipment obsolete before it's fully realized. For example, investing in outdated software or machinery
can lead to a project's early obsolescence.

Reason for considering risk in capital budgeting

• Protecting shareholder value

• Enhancing decision making accuracy

• Optimizing resource allocation

• Meeting stakeholders expectations

• Facilitating effective risk management

Techniques of Risk Analysis

1. Risk-adjusted discount rate is the rate used in the calculation of the present value of a risky
investment. The risk-adjusted discount rate is the total of the risk-free rate, i.e. the required return on
risk-free investments, and the market premium, i.e. the required return of the market. Financial analysts
use the risk-adjusted discount rate to discount a firm’s cash flows to their present value and determine
the risk that investor should accept for a particular investment
2. Certainty Equivalent Factor (CEF) is the ratio of assured cash flows to uncertain cash flows.
Under this approach, the cash flows expected in a project are converted into risk-less equivalent
amount. The adjustment factor used is called CEF. This varies between 0 and 1. A co-efficient of 1

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indicates that cash flows are certain. The greater the risk in cash flow, the smaller will be CEF ‘for
receipts’, and larger will be the CEF ‘for payments’. While employing this method, the decision maker
estimates the sum he must be assured of receiving, in order that he is indifferent between an assured
sum and expected value of a risky sum. Method of Computation under CE approach: Step 1: Convert
uncertain cash flows to certain cash flows by multiplying it with the CEF. Step 2: Discount the certain
cash flows at the risk free rate to arrive at NPV. Decision Rule: If the resultant NPV is positive project can
be accepted.
3. Probability Assignment The concept Of probability is one of the statistical techniques to handle
risk in capital budgeting projects. It may be described as a "measure of some one’s opinion about the
likelihood that an event will occur". If an event is certain to occur, we can say that it has 100%
probability of occurrence one. If an event is certain not to occur, we can say that its probability of
occurring is zero. Thus the probability of occur all events' lies between 0 and 1.
4. Standard Deviation and Coefficient of Variation The probability assignment approach to risk
analysis in capital budgeting does not provide decision maker, about the variability of cash flows and
therefore the risk. To overcome this 'limitation, standard deviation technique is used. Which is an
absolute measure of risk? In case of capital budgeting this measure is used to compare the variability of
possible cash flows of different projects from their: respective mean. A project having larger standard
deviation will be more risky as compared to a project having smaller standard deviation. .
The following steps are involved in calculating standard deviation:
I) Mean value of possible cash flows is computed.
2) Deviations between the mean value and the possible cash flows are found out.
3) Deviations are squared.
4) Squared deviations are multiplied by the assigned probabilities which give weighted squared
deviation.
5) The weighted squared deviations are totaled and their square root is found out. The resulting figure is
the standard deviation.
Coefficient of variation is a relative measure of risk. It is defined as the standard deviation of
probability distribution divided by its expected value.
5. Sensitivity Analysis

This method is used to assess the impact of changes in key variables or assumptions on the outcomes of
an investment projects. It is the analysis about the effect of the change in certain variable on an
outcome, to estimate the variability of the outcome, or risk associated with a pro' ct.

Steps

• 1. Identify key risk factors-Identify the variable which can influence the NPV.

• 2.Assess impact on project outcomes

• 3.Scenario Analysis-pessimistic-worst

• 4. Optimistic-Best Expected-most likely

Advantages
• Identifies key risk factors
• Enhance risk management

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 • Improve decision making
• Facilitates communication
Disadvantages
• Assumes independence of variables
• Limited to one variable at a time
• Static Analysis
• Subjectivity in variable selection
6. Decision tree analysis
It is an analytical technique to set forth graphically the pattern of relationship between decisions
and chance events. It is used to handle risk situations
Decision tree analysis is the process of drawing a decision tree, which is a graphic representation
of various alternative solutions that are available to solve a given problem, in order to
determine the most effective courses of action.
A decision tree is a tree-like model that acts as a decision support tool, visually displaying
decisions and their potential outcomes, consequences, and costs. From there, the “branches”
can easily be evaluated and compared in order to select the best courses of action.
• Decision Nodes: A decision node, represented on our decision tree diagram as a square,
indicates a choice that needs to be made.
• Chance Nodes: A circle represents a chance node and is used to signify uncertain
outcomes. These nodes are used when future results are not guaranteed.
• End Nodes-like the name suggest, represent the end of a diagram and illustrates a final
outcome.
• Branches: Lastly, we have branches. Branches are what connect the nodes together.
Each branch represents a potential choice and should be clearly labeled.

Steps
• 1. Identify Each of Your Options
• 2.Forecast Potential Outcomes for Each Option
• 3. Thoroughly Analyze Each Potential Result
• 4.Optimize Your Actions Accordingly

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The Benefits of Decision Tree Analysis

• Clarity: Decision trees are extremely easy to understand and follow.

• Efficiency: Building off the last point, because decision trees present information in such a
straightforward way, they can be quickly analyzed and used to make crucial decisions.

• Adaptability: Decision trees can be easily adapted to accommodate new ideas and/or
opportunities.

• Compatibility: The decision tree analysis technique can be used in tandem with other project
management methodologies, allowing you complete flexibility as you manage your projects.

Management of Current Assets

• A current asset is an asset that a company holds and can be easily sold or consumed and further
lead to the conversion of liquid cash.

• The meaning of current assets can be explained as an asset that is expected to last only for a
year or less is considered as current assets

• Current Assets is an account listed on a balance sheet that shows the value of the assets owned
by a company that can be converted to cash through liquidation, use, or sales within one year.

• Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable
securities, pre-paid liabilities, and other liquid assets.

• Cash and Cash Equivalents-By definition, assets in the Current Assets account are cash or can be
quickly converted to cash.

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• Cash equivalents are certificates of deposit, money market funds, short-term government
bonds, and treasury bills.

Accounts Receivable

• Accounts Receivable—the value of all money due to a company for goods or services delivered
or used but not yet paid for by customers—is entered in Current Assets as long as the accounts
can be expected to be paid within a year

Prepaid expenses

• Prepaid expenses—which represent advance payments made by a company for goods and
services to be received in the future—are considered current assets.

• Although they cannot be converted into cash, they are payments already made. These payments
free up capital for other uses.

• Prepaid expenses might include payments to insurance companies or contractors

Inventory

Inventory—which represents raw materials, components, and finished products—is included in

the Current Assets account.

Short-Term Investments-

Marketable securities, certificate of deposit

Significance of current asset

• Liquidity support

• Operational continuity

• Meeting short term liabilities

• Emergency preparedness

• Efficient Inventory management

• Facilitating investment in marketable securities

Cash management

It means efficient collection and disbursement of cash and any temporary investment of cash.

It’s nothing but Maintaining optimum level of cash.

Cash management is concerned with the managing of:

• cash flows into and out of the firm,

• cash flows within the firm, and

• cash balances held by the firm at a point of time by financing deficit or investing surplus cash

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 FOUR ASPECTS OF CASH MANAGEMENT

• Cash planning (Cash budget)

• Managing the cash flows (accelerate inflows, decelerate outflows)

• Optimum cash level

• Investing surplus cash (bank deposits, marketable securities, inter-corporate lending)

MOTIVES FOR HOLDING CASH

1. The Transaction Motive: It requires a firm to hold cash to conduct its business in normal
course. The firm needs cash primarily to make payments for purchases, wages & salaries, other
operating expenses, taxes, dividends, etc. For transaction purpose a firm may invest its cash in
marketable securities, i.e., it will purchase those securities whose maturity equals with
anticipated payments in future. The transaction motive refers to holding cash to meet
anticipated payments whose timings is not properly matched with cash receipts.

2. The Precautionary Motive: It is the need to hold cash to meet contingencies in future. It
provides a buffer to meet some unexpected emergency. The precautionary amount of cash
depends upon the predictability of cash flows, i.e., if the CFs can be predicted with accuracy, less
cash will be maintained for an emergency. The precautionary balance may be kept in cash &
marketable security.

3. The Speculative Motive: It relates to the holding of cash for investing in profit-making
opportunities as & when they arise, i.e., when the security price changes. The firm will hold cash
when it is expected that interest rates will rise & security prices will fall. Securities can be
purchased when the interest rate is expected to fall; the firm will benefited by the subsequent
fall in interest rates & increase in security prices.

4. Preparation for future expenditure

5. Avoidance of transaction cost- transaction cost associated with buying and selling of asset

Following purposes /objectives of cash management

• Fulfill Working Capital Requirement: The organization needs to maintain ample liquid cash to
meet its routine expenses which is possible only through effective cash management.

• Planning Capital Expenditure: It helps in planning the capital expenditure and determining the
ratio of debt and equity to acquire finance for this purpose.

• Handling Unorganized Costs: There are times when the company encounters unexpected
circumstances like the breakdown of machinery. These are unforeseen expenses to cope up
with; cash surplus is a lifesaver in such conditions.

• Initiates Investment: The other aim of cash management is to invest the idle funds in the
right opportunity and the correct proportion.

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 • Better Utilization of Funds: It ensures the optimum utilization of the available funds by
creating a proper balance between the cash in hand and investment.

• Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a profit out
of the money available.

Management of Account Receivables

Account receivables refer to the outstanding invoices or money which is yet to be paid by your
customers. Until it is paid, such invoices or money is accounted as accounts receivables. It is also
known as bills receivables.

Receivable management

• Receivable management refers to the planning and monitoring of debt owed to the firm from a
customer account

• Receivable management or accounts receivable management is the strategic process of

ensuring customers makes timely payments. It is paramount in maintaining a healthy working
capital for businesses and preventing overdue or unpaid customer invoices.

Objective of Receivables Management

• Maximize Cash Flow: The primary goal is to minimize the lag between providing goods/services
and receiving payment. This promotes healthy cash flow, allowing your business to operate
smoothly and pay its own bills on time.

• Reduce Days Sales Outstanding (DSO): DSO measures the average time customers pay their
invoices. Lower DSO translates to faster cash inflow and improved financial stability.

• Minimize Bad Debt: Unpaid invoices become bad debt, impacting your bottom line. Effective
receivables management aims to prevent bad debt and write-offs through proactive strategies.

• Optimize Working Capital: By accelerating cash collection, you free up working capital for
investments, expansions, or covering operational expenses.

• Maintains Positive Customer Relationships: While collecting payments is critical, good

receivables management prioritizes open communication and customer understanding. This
fosters long-term positive relationships and encourages prompt payments.

Cost of maintaining receivable

• 1.Cost of capital- credit sale means blocking of financial resources

• 2.Administrative cost –tight control is required

• 3. Collection cost- sending legal notice etc.

• 4.Default cost-bad debt

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 Factors influencing size of receivables

• Level of Sales

Generally in the same industry, a firm having a large volume of sales will be having a larger level
of receivables as compared to a firm with a small volume of sales.

Sales level can also be used for forecasting change in accounts receivable

• Credit Policies-

A lenient credit policy encourages even the financially strong customers to make delays in
payments resulting in increasing the size of the accounts receivables

Lenient credit policy will result in greater defaults in payments by financially weak customers
thus resulting in increasing the size of the receivables

• 3. Terms Of Trade

Credit period: The term credit period refers to the time duration for which credit is extended to
the customers. It is generally expressed in terms of “net days”.

Cash discount: Most firms offer cash discount to their customers for encouraging them to pay
their dues before the expiry of the credit period. The terms of the cash discounts indicate the
rate of discount as well as the period for which the discount has been offered

4. Management of Receivable- It is also one of the factors which affects the size of receivable in
the firm. When the management involves systematic approaches to the receivable, the firm can
reduce the size of receivable.

BENEFITS OF RECEIVABLES
1. INCREASE IN SALES: Most of the firms sell goods on credit, either because of trade customs
or other conditions. The sales can be further increased by liberalizing the credit terms. This will
attract more customers to the firm resulting in higher sales & growth of the firm.
2. INCREASE IN PROFITS: Increase in sales help the firm in a) to easily recover the fixed
expenses & attaining the break-even level. b) Increase the operating profit of the firm
3. EXTRA PROFIT: Sometimes, the firm makes the credit sales higher than the usual cash selling
price. This brings an opportunity to the firm to make extra profit over & above the normal profit.

Inventory Management
• It is a stock of physical goods that contain economic value and held in various forms by
an organization in its custody awaiting packing, processing, transformation, sale in future.
• It includes raw materials, work-in-progress, finished goods and inventory of suppliers etc.
• Inventory, often called merchandise, refers to goods and materials that a business holds
for sale to customers in the near future.
• Inventory is the raw materials used to produce goods as well as the goods that are available for
sale.

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 Classification by inventory
• 1. Raw materials-: Raw materials are essential products from which one makes the final
product.
Flour for bakeries that produce bread
Crude oil held by refineries
• 2. Work-in-process: These are semi-finished goods made of raw materials. Such inventory items
are yet to be completed for final sales.
A half-assembled airliner or a partially completed yacht is often considered to be a work-in-
process inventory.
• 3.Finished goods: These are the finished items one sells to the customers. Finished goods are
products that go through the production process, and are completed and ready for sale.
• 4. Overhaul / MRO
Also known as Maintenance, Repair, and Operating Supplies, MRO inventory is all about the
small details.
It is inventory that is required to assemble and sell the finished product but is not built into the
product itself.
For example, gloves to handle the packaging of a product would be considered MRO. Basic
office supplies such as pens, highlighters, and paper would also be in this category
Inventory Management
• It is defined as the systematic location of storage and recording of goods. It is the control
program which allows the management of sales, purchases and payments
• It helps to create invoices, purchase orders, receiving list, and payment receipts and bar coded
labels.
Objectives of IM
The objectives of inventory management are as follows:
1. To ensure a continuous supply of materials and stock so that production should not suffer at
the time of customers demand.
2. To avoid both overstocking and under-stocking of inventory.
3. To maintain the availability of materials whenever and wherever required in enough quantity.
4. To maintain minimum working capital as required for operational and sales activities.
5. To optimize various costs indulged with inventories like purchase cost, carrying a cost, storage
cost, etc.
6. To keep material cost under control as they contribute to reducing the cost of production.
7. To eliminate duplication in ordering stocks.
8. To minimize loss through deterioration, pilferage, wastages, and damages.
9. To ensure everlasting inventory control so that materials shown in stock ledgers should be
physically lying in the warehouse.
10.To ensure the quality of goods at reasonable prices.
11.To facilitate furnishing of data for short and long-term planning with a controlled inventory.
12.To supply the required material continuously.
13.To maintain a systematic record of inventory
Classifications of inventory management:
• 1. Based on Nature of Inventory:
• Raw Materials Inventory

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• Work-in-Progress (WIP) Inventory
• Finished Goods Inventory
2. Based on Industry Type
Inventory in retail businesses where the finished goods are sold directly to consumers
Manufacturing Inventory Management: Involves handling raw materials, work-in-progress, and
finished goods in the manufacturing process
Service Industry Inventory Management-Pertains to businesses in the service sector that may
have inventory needs, such as spare parts for equipment or office supplies.
3. Based on Demand Patterns-
Seasonal Inventory Management: Involves adjusting inventory levels to meet seasonal
variations in demand.
Continuous (Perpetual) Inventory Management: Involves continuously updating inventory
records to maintain real-time accuracy.
Periodic Inventory Management: Involves conducting physical inventory counts at regular
intervals.
4. Based on Value and Importance
ABC Analysis -allows you to characterize your product according to their requirement. A few of
the product require more attention than others. In this add your product to each category as
per their requirem-ent list. Classifies items into categories (A, B, and C) based on their
importance and value. A items are high-priority and high-value, while C items are of lower
priority and value.
• Category A — This includes the product of high quality with a low frequency of sales.
• Category B — This includes the product of moderate quality with a moderate frequency of
sales.
• Category C — This includes the product of low quality with a high frequency of sales.
5. Based on Control Levels:
Centralized Inventory Management: Involves managing inventory from a central location or
headquarters.
Decentralized Inventory Management: Distributes inventory management responsibilities to
multiple locations, such as regional warehouses
6. Based on Strategies:
Just-in-Time (JIT) Inventory Management: Aims to minimize holding costs by receiving goods
only as they are needed in the production or sales process.
Bulk Shipments Management: Involves ordering large quantities of inventory to take advantage
of transportation cost efficiencies.
Cross-Docking Management: Transfers received goods directly from inbound to outbound
transportation with minimal storage time.
7. Based on Inventory Turnover:
Fast-Moving (High Turnover) Inventory Management: Focuses on items that have a high
turnover rate and require frequent replenishment.
Slow-Moving (Low Turnover) Inventory Management: Addresses items with a lower turnover
rate, often requiring special attention to prevent obsolescence

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 Inventory Control

Inventory control refers to all aspects of managing a company’s inventories: purchasing,shipping,

receiving, tracking, warehousing and storage, turnover, and reordering.

It is a system which ensures the provision of the required quantity of inventories of right quality
and at right time.

Inventory control policy

• An inventory control policy is a set of guidelines and procedures that an organization establishes
to manage its inventory effectively
• The policy outlines how the organization will maintain optimal stock levels, minimize carrying
costs, and meet customer demand.

Types of Inventory Control Policy

• Just-in-Time (JIT) Inventory Policy:
JIT aims to minimize inventory levels by receiving goods only as they are needed in the
production or sales process.
• Minimum Order Quantity (MOQ) Policy
MOQ policies involve ordering in fixed quantities to take advantage of volume discounts or meet
supplier minimum order requirements
• ABC Analysis Policy
ABC analysis categorizes inventory items into three groups (A, B, and C) based on their
importance and value.
• Economic Order Quantity (EOQ) Policy-
EOQ is a calculation that determines the optimal order quantity to minimize total inventory
costs, including ordering and holding costs.
• Safety Stock Policy
Safety stock policies involve maintaining a buffer of extra stock to protect against uncertainties
in demand and supply
• Bulk Shipments Policy:
Bulk shipments involve ordering large quantities of inventory to take advantage of
transportation cost efficiencies

Factors affecting IC policy

• Nature of the Product
• Demand Patterns
• Lead Time:
• Supplier Performance
• Cost of Holding Inventory
• Economic Order Quantity
• Financial Constraints
• Market Trends and Product Lifecycles
• Global Supply Chain Risks
• Risk Tolerance

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 The accounts receivable turnover ratio/Debtor Turnover Ratio

• The accounts receivable turnover ratio is an accounting measure used to quantify how
efficiently a company is in collecting receivables from its clients.
• The ratio measures the number of times that receivables are converted to cash during a certain
time period.
• A high ratio may indicate that corporate collection practices are efficient with quality
customers who pay their debts quickly.
• A low ratio could be the result of inefficient collection processes, inadequate credit policies, or
customers who are not financially viable or creditworthy.

The creditor’s turnover ratio

The accounts payable turnover ratio, also known as the payables turnover or the creditor’s
turnover ratio, is a liquidity ratio that measures the average number of times a company pays its
creditors over an accounting period. The ratio is a measure of short-term liquidity, with a higher
payable turnover ratio being more favorable.

Dividend Policy
According to the Institute of Chartered Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose." "The term dividend refers to
that portion of profit (after tax) which is distributed among the owners / shareholders of the
firm”.
Types
• Cash dividend: Companies mostly pay dividends in cash. A Company should have enough cash in
its bank account when cash dividends are declared.
If it does not have enough bank balance, arrangement should be made to borrow funds
• Scrip dividends: These are promises to make the payment of dividend at a future date: Instead
of paying the dividend now, the firm elects to pay it at some later date. The ‘scrip’ issued to
stockholders is merely a special form of promissory note or notes payable.
• Property dividends: These dividends are payable in assets of the corporation other than cash.
For example, a firm may distribute samples of its own product or shares in another company it
owns to its stockholders
• Bonus Shares: An issue of bonus share is the distribution of shares free of cost to the existing
shareholders, In India, bonus shares are issued in addition to the cash dividend and not in lieu of
cash dividend.
The bonus shares are distributed proportionately to the existing shareholder. Hence there is no
dilution of ownership.

Dividend Policy
A dividend policy is a policy a company uses to structure its dividend payout.
"Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."

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 Types
1. Regular dividend policy
Under the regular dividend policy, the company pays out dividends to its shareholders every
year. If the company makes abnormal profits (very high profits), the excess profits will not be
distributed to the shareholders but are withheld by the company as retained earnings. If the
company makes a loss, the shareholders will still be paid a dividend under the policy.
• 2. Stable dividend policy
Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For
example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid
out regardless of the amount of profits earned for the financial year.
Stable dividend payout ratio
Stable dividends per share

Importance of stable dividend policy

• Income for shareholder
• Investors confidence
• Signal of financial health
• Attracting income- seeking Investors
• Competitive advantage
• Flexibility in capital structure

• 3. Irregular dividend policy

Under the irregular dividend policy, the company is under no obligation to pay its shareholders
and the board of directors can decide what to do with the profits. If they a make an abnormal
profit in a certain year, they can decide to distribute it to the shareholders or not pay out any
dividends at all and instead keep the profits for business expansion and future projects.
• 4. No dividend policy
Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is
because any profits earned is retained and reinvested into the business for future growth.
Companies that don’t give out dividends are constantly growing and expanding, and
shareholders invest in them because the value of the company stock appreciates.
For the investor, the share price appreciation is more valuable than a dividend payout.

Determinants of Dividend policy

(i) Type of Industry:
Industries that are characterized by stability of earnings may formulate a more consistent policy
as to dividends than those having an uneven flow of income. For example, public utilities
concerns are in a much better position to adopt a relatively fixed dividend rate than the
industrial concerns.
(ii) Age of Corporation:
Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can formulate
clear cut dividend policies and may even be liberal in the distribution of dividends.
(iii) Extent of share distribution:

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A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large number of
shareholders widely scattered would face a great difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-operation of shareholders.
(iv) Need for additional Capital:
The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.
(v) Business Cycles:
During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for marketing
the securities in an otherwise depressed market.
(vi) Changes in Government Policies:
Sometimes government limits the rate of dividend declared by companies in a particular
industry or in all spheres of business activity. The Government put temporary restrictions on
payment of dividends by companies in July 1974 by making amendment in the Indian Companies
Act, 1956. The restrictions were removed in 1975.
(vii) Trends of profits:
The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend policy
can be regarded as prudent.
(viii) Taxation policy:
Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the
residual profits after tax available for shareholders and indirectly, as the distribution of
dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend
declared is tax free in the hands of shareholders.
(ix) Future Requirements:
Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the
business, to finance future- expansion of the business and to modernise or replace equipments
of the enterprise. The conflicting claims of dividends and accumulations should be equitably
settled by the management.
(x) Cash Balance:
If the working capital of the company is small liberal policy of cash dividend cannot be adopted.
Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.

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