CA INTER

FINANCIAL
MANAGEMENT
CONCEPT DECODER
ONE BOOK. EVERY CONCEPT. EXAM READY!

r t i
r t i ,
e g d o
u e !

Covers 100% ICAI Concepts

(With innovative Doubt Busters)

A A S H A A
 INDEX

1 TIME VALUE OF MONEY 01

2 COST OF CAPITAL 04

3 LEVERAGES 16

4 CAPITAL STRUCTURE 25

5 INVESTMENT DECISIONS 39

6 DIVIDEND DECISIONS 64

7 RATIO ANALYSIS 78

8 WORKING CAPITAL MANAGEMENT 101

9 SCOPE & OBJECTIVE OF FM 147

10 TYPES OF FINANCING 160

 CHAPTER 1: TIME VALUE OF MONEY
1. Introduction

✓ The Time Value of Money (TVM) is a fundamental financial concept stating that money
available at the present time is worth more than and the same amount in the future.
✓ Understanding TVM is essential for making informed financial decisions related to
investments, loans, and any situation where money is received or paid over a period of time.
✓ It allows us to compare cash flows occurring at different points in time and make informed
choices about where to put our money.
✓ Understanding TVM is crucial for sound financial decision-making and hence it is a core
principle in finance.

2. TVM Techniques

Broadly there are two TVM techniques – Future Value Technique & Present Value Technique

TVM Techniques

Future Value Present Value

(Compounding Technique) (Discounting Technique)

Future Value is the cash value of an

investment at some time in the future. Present value is today’s value of
It is tomorrow’s value of today’s tomorrow’s money discounted at
money compounded at the rate of the interest rate.
interest.

FV = PV (1 + r)n FV
PV =
1+r n

3. PV Of Multiple Cash Flows for Finite Period

In finance "Cash Flows for a Finite Period" refers to a series of cash inflows or outflows that
occur over a specific limited timeframe. This is in contrast to cash flows that are expected to
continue indefinitely (like a perpetuity). Finite Cashflows can be broadly classified into two:

Cash Flows for a Finite Period

Multiple Unequal CFs Multiple Equal CFs

Page |136
 A. Multiple Unequal CFs
The formula to calculate the Present Value of Multiple Unequal Cashflows for a finite period is as
follows:
CF 1 CF 2 CF 3 CF 4 CF n
PV= + + + +…+
(1 + r)1 (1 + r) 2 (1 + r)3 (1 + r) 4 (1 + r)n
B. Multiple Equal CFs
The formula to calculate the Present Value of Multiple Equal Cashflows for a finite period is as
follows:
CF CF CF CF CF
PV = + + + +…+
(1 + r) 1 (1 + r) 2 (1 + r)3 (1 + r) 4 (1 + r)n
PV = Annual CF x PVAF (r%, ny)

4. PV Of Multiple Cash Flows for Infinite Period (Perpetuity)

Cash flows for perpetuity refers to a stream of cashflows that are expected to continue forever,
without any end date. Infinite Cashflows can be broadly classified into two:

Cash Flows for a Infinite Period (Perpetuity)

Equal CFs upto Perpetuity Growing CFs upto Perpetuity

A. Equal CFs upto Perpetuity

The formula to calculate the Present Value of Equal Cashflows for an infinite period (Perpetuity)
is as follows:
Annual CF
PV=
Discount Rate

B. Growing CFs upto Perpetuity

The formula to calculate the Present Value of Growing Cashflows for an infinite period (Perpetuity)
is as follows:
CF1
PV=
(Discount Rate - Growth Rate)

5. Timing of Cashflows

✓ Cashflows can arise either at the beginning or at the end of each year. This concept is called
‘Timing of Cashflows’ and plays a very crucial role while computing the Present Value.
✓ Based on their timing, Cashflows can be broadly classified into two:

Page |237
 Timing of Cashflows

Deferred Annuity (CF in arrears) Annuity Due (CF in advance)

Cashflows arise at the end of Cashflows arise at the beginning of

each year each year

Note: In the absence of information, always assume Deferred Annuity

A. Deferred Annuity (Multiple Equal CFs)
The formula to calculate the Present Value of Multiple Equal Cashflows for a finite period under
Deferred Annuity is as follows: (SAME AS CONCEPT 3B)
PV = Annual CF x PVAF (r%, ny)
B. Annuity Due (Multiple Equal CFs)
The formula to calculate the Present Value of Multiple Equal Cashflows for a finite period under
Deferred Annuity is as follows:
PV = Annual CF x [1 + PVAF (r%, n - 1y)]

6. Internal Rate of Return (IRR)

IRR is the discount rate at which the Net Present Value is Zero. In simpler terms, it is the rate
of return at which the present value of cash inflows equals the present value of cash outflows.
Steps to calculate IRR
Step 1: Discount cash flows using these two discounting rates (Trial & Error).
Adjust Discount Rate:
If NPV > 0: Increase the discount rate.
If NPV < 0: Decrease the discount rate.

Step 2: Use following Interpolation Formula:

NPVL
IRR = L + x (H - L)
NPVL - NPVH
Where,
L – Lower Rate
H – Higher Rate
NPVL – NPV at Lower Rate
NPVH – NPV at Higher Rate

Page |338
 CHAPTER 2: COST OF CAPITAL

1. Introduction

✓ Cost of capital is the return expected by the providers of capital (i.e., shareholders, lenders
and the debt-holders) to the business as a compensation for their contribution to the total
capital and is expressed in rate (%).
✓ When an entity (corporate or others) procured finances from any source, it has to pay some
additional amount of money besides the principal amount.
✓ This additional money paid is said to be the cost of using the capital and it is called the cost
of capital.
✓ Cost of capital is also known as ‘cut-off’ rate’, ‘hurdle rate’, ‘minimum rate of return’ etc. It is
used as a benchmark for taking Capital Budgeting Decisions.
✓ In short, this is nothing but the discount rate we studied in TVM chapter used to
discount/compound the cash flow or stream of cash flows.
✓ In this chapter, we will use the following terms for Discount Rate from each source of
finance:
Equity Ke (Cost of Equity)
Debenture Kd (Cost of Debt)
Preference Kp (Cost of Preference)
Retained Earnings Kr (Cost of Retained Earnings)
Overall Cost of Capital Ko (WACC - Weighted Average Cost of Capital)

2. Important Terms/Concepts used in Cost of Capital

The following are a few terms/concepts which will be used throughout this chapter.
A. Different Types of Issue Price
Securities of a company may be issued at:
✓ At Par (e.g., ₹100)
✓ At Discount (e.g., ₹ 90)
✓ At Premium (e.g., ₹ 110)
B. Different Types of Redemption Value
Securities of a company may be redeemed at:
✓ At Par (e.g., ₹100)
✓ At Discount (e.g., ₹ 90)
✓ At Premium (e.g., ₹ 110)
Note: In the absence of information, always assume redemption is at Par.

Page |436
 C. Flotation Cost/Issue Cost
✓ Flotation costs are those associated with the issue of NEW securities (E.g., Brokerage,
Commission, Underwriter Commission, etc.)
✓ These costs apply only to new issues and not to existing securities.
✓ In case the flotation cost is given in the question, the issue price must be taken after deducting
the flotation cost to arrive at NET PROCEEDS. (Since it is an outflow, it is being reduced.)
Doubt Busters:
If the flotation cost is say 1%, it can either be applied as a % on Issue Price or on Face Value in
the absence of information. Students are expected to write a note regarding the approach
followed in the solution.
D. Concept of Tax Savings on Interest
✓ The payment of interest to the debenture holders are allowed as expenses for the purpose of
tax and hence can save the tax liability of the company. Saving in the tax liability is also known
as tax shield.
✓ Example: Co A & B are similar in all aspects except that Co A raised an amount from Debentures
whereas the same amount was raised from Preference Shares by Co B.
Particulars Co A Co B
EBIT 100 100
Less: Interest (30) -
EBT 70 100
Tax @ 30% (21) (30)
EAT 49 70
Less: Pref Div - (30)
Net Earnings to Equity SH 49 40
✓ It can be clearly seen from the above example that despite having the same EBIT, the Net
Earnings is more for Co A as compared to Co B since interest is a tax-deductible expense
whereas Dividend is not a tax-deductible.

3. Cost of Debentures (Kd)

Based on redemption (repayment of principal) on maturity the debts can be categorized into
two

Cost of Long Term Debentures

Cost of Irredeemable Debentures Cost of Redeemable Debentures

Page |537
 A. Cost of Irredeemable Debentures
The debentures which are not redeemed by the issuer of the debentures is known as irredeemable
debentures. Cost of Irredeemable Debentures is calculated as follows:
I
Kd = (1 - t)
NP
Where,
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or Current market price
t = Tax rate
B. Cost of Redeemable Debentures
Cost of Redeemable Debentures can be calculated using two approaches:
i. YTM Method (PV/IRR Method)
ii. Approximation Method (Shortcut/Formula Method)
i. YTM Method (PV/IRR Method)
✓ In this Method, Kd is calculated by discounting the relevant cash flows using IRR concept.
✓ Here, YTM is the annual return (cost) of an investment (funding) from the current date till
maturity date.
✓ The relevant cash flows are as follows:
Year Cash flows
0 Net proceeds in case of new issue/ Current market price in case of
existing debt (NP or P0)
1 to n Interest net of tax [I(1 - t)]
n Redemption value (RV)
✓ Steps to calculate relevant cash flows:
Step-1: Identify the cash flows.
Step-2: Calculate NPVs of CFs as identified above using two discount rates (guessing).
Step-3: Calculate IRR.
ii. Approximation Method (Shortcut/Formula Method)
✓ Cost of Redeemable Debentures under Approximation Method is calculated as follows:
(RV - NP)
I(1 - t) +n
Kd =
RV + NP
( )
2
(The above formula to calculate Kd is used where only interest on debt is tax deductible.)
✓ Sometime, debts are issued at discount and/ or redeemed at a premium. If discount on issue
and/ or premium on redemption are tax deductible, the following formula can be used to
calculate the cost of debt:

Page |638
 (RV - NP)
I+ n
Kd = (1 - t)
(RV + NP)
2
✓ Where,
I = Interest payment
NP = Net proceeds or Current market price
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Remaining life of debentures
Doubt Busters:
1. In the absence of any specific information, students may use any of the two Methods (YTM
or Approximation) to calculate Kd.
2. The Approximation Method gives only the approximate value of Kd whereas YTM Method gives
the accurate value of Kd.
3. Under Approximation Method, in the absence of any specific information, students may use
any of the two formulae to calculate the Kd with logical assumption.
4. ‘Net proceeds’ means Issue Price less floatation cost.
5. If Issue Price is not given, then students can assume it to be equal to Current Market price.
If Current Market price is also not given, then assume it to be equal to Face Value.
6. If Floatation Costs are not given, then simply assume it to be equal to zero.
Other Issues in Kd
1. Amortization of Debenture/Bond
✓ A Debenture/bond may be amortized every year i.e., principal is repaid every year rather
than at maturity.
✓ In such a situation, the principal will go down with annual payments and interest will be
computed on the outstanding amount. The cash flows of the bonds will be uneven.
✓ The formula for determining the value of a bond or debenture that is amortized every year
is as follows:
CF 1 CF 2 CF 3 CF 4 CF n
✓ VB = + + + +…+
1 2 3
(1 + kd ) (1 + kd ) (1 + kd ) (1 + kd )4 (1 + kd )n
n
CFt
✓ VB = ∑ t
t=1 (1 + kd )
2. Cost of Convertible Debentures
✓ The holders of the convertible debentures have the option to either get the debentures
redeemed into the cash or get specified numbers of company’s shares in lieu of cash.
✓ The calculation of cost of convertible debentures are very much similar to that of
redeemable debentures.

Page |7 39
 ✓ While determining the redemption value of the debentures, it is assumed that all the
debenture holders will choose the option which has the higher value and accordingly, it will
be considered to calculate the cost of debentures.
✓ Redemption Value is taken as HIGHER of the following:
• Cash Value of Debenture (or)
• Value of Equity Shares
3. Zero Coupon Bond (Deep Discount Bonds)
✓ These Bonds are generally issued at deep discounts and are redeemed at Par
✓ There will not be any coupon payments during the life of the Bond.
✓ Kd for Zero Coupon Bond is calculated using YTM approach
RV
✓ Bo =
(1 + kd )n
4. Treatment of Short-Term Debt
✓ Short term debt is a part of current liability and not a part of capital employed
✓ Hence, while calculating WACC (Ko) we should not consider short term debt eg: creditors
5. Cost of Long-Term Bank Loan
✓ All the calculations as same as normal Kd computation (Redeemable Debentures)
✓ Kd = Int Rate (1 - t)
✓ No concept of Premium/Discount

4. Cost of Preference Share Capital (Kp)

✓ The preference shareholders are paid dividend at a specified rate on face value of preference
shares.
✓ The payment of dividend to the preference shareholders are not charged as expenses but
treated as an appropriation of after-tax profit.
✓ Hence, dividend paid to preference shareholders does not reduce the tax liability of the
company.
✓ Like the debentures, Preference share capital can also be categorized as redeemable and
irredeemable.

Cost of Preference Share Capital

Cost of Irredeemable of Cost of Redeemable of

Preference Share Capital Preference Share Capital

Page |840
 A. Cost of Irredeemable of Preference Share Capital
The of Preference Shares which are not redeemed by the issuer is known as irredeemable of
Preference Shares. Cost of Irredeemable of Preference Share Capital is calculated as follows:
PD
Kp =
P0
Where,
PD = Annual preference dividend
P0 = Net proceeds from issue of preference shares
B. Cost of Redeemable Preference Share Capital
Cost of Redeemable Preference Share Capital can be calculated using two approaches:
i. YTM Method (PV/IRR Method)
ii. Approximation Method (Shortcut/Formula Method)
i. YTM Method (PV/IRR Method)
✓ In this Method, Kp is calculated by discounting the relevant cash flows using IRR concept.
✓ Here, YTM is the annual return (cost) of an investment (funding) from the current date till
maturity date.
✓ The relevant cash flows are as follows:
Year Cash flows
0 Net proceeds in case of new issue/ Current market price in case of
existing Preference Shares (NP or P0)
1 to n Preference Dividend (PD)
n Redemption value (RV)
✓ Steps to calculate relevant cash flows:
Step-1: Identify the cash flows.
Step-2: Calculate NPVs of CFs as identified above using two discount rates (guessing).
Step-3: Calculate IRR.
ii. Approximation Method (Shortcut/Formula Method)
✓ Cost of Redeemable Preference Share Capital under Approximation Method is calculated as
follows:
(RV - NP)
PD + n
Kp =
(RV + NP)
2
✓ Where,
PD = Annual preference dividend
RV = Redemption value of preference shares
NP = Net proceeds from issue of preference shares
n = Remaining life of preference shares

Page |941
Doubt Busters:
1. In the absence of any specific information, students may use any of the two Methods (YTM
or Approximation) to calculate Kp.
2. The Approximation Method gives only the approximate value of Kp whereas YTM Method gives
the accurate value of Kp.
3. ‘Net proceeds’ means Issue Price less floatation cost.
4. If Issue Price is not given, then students can assume it to be equal to Current Market price.
If Current Market price is also not given, then assume it to be equal to Face Value.
5. If Floatation Costs are not given, then simply assume it to be equal to zero.

5. Cost of Equity Share Capital (Ke)

✓ Just like any other source of finance, Cost of Equity (Ke) is the expectation of equity
shareholders.
✓ Ke computation is quite complex since there is no fixed contractual payment for equity
shareholders. Moreover, there is no concept of redemption for equity shares.
✓ Hence, there is not a single method to calculate cost of equity but different methods which
are as follows:
✓

Dividend Price Approach

Earning Price Approach

Cost of Equity Share Capital Growth Approach

Realized Yield Approach

Capital Asset Pricing Model (CAPM)

✓ Which method to follow?

▪ If dividend is expected to be constant, then Dividend Price Approach should be used.
▪ If EPS is expected to be constant, then Earning Price Approach should be used.
▪ If Dividend and Earning are expected to grow at a constant rate, then Growth Approach
(Gordon’s model) should be used.
▪ If it is difficult to forecast future, then Realised Yield Approach should be used, which
looks into past.
When the cost of equity or expectation of investors is dependent on risk i.e., Higher the risk,
higher the expectations and vice versa, then Capital Asset Pricing Model (CAPM) should be used,
which is based on risk.

Page10
| 42
 A. Dividend Price Approach
✓ This is also known as Dividend Valuation Model. This model makes an assumption that the
dividend per share is expected to remain constant forever.
✓ Here, cost of equity capital is computed as follows:
D
Cost of Equity (Ke) =
P0
Where,
Ke = Cost of equity
D = Expected dividend (also written as D1)
P0 = Market price of equity (ex- dividend)
B. Earnings Price Approach
✓ This approach assumes that the earnings per share will remain constant forever.
✓ The Earning Price Approach is similar to the dividend price approach; only it seeks to nullify
the effect of changes in the dividend policy.
✓ Here, cost of equity capital is computed as follows:
E
Cost of Equity (Ke) =
P
Where,
E = Current earnings per share
P = Market price per share
C. Growth Approach or Gordon’s Model
✓ As per this approach, the rate of dividend growth remains constant. Where, earnings, dividends
and equity share price all grow at the same rate, the cost of equity capital may be computed
as follows:
D1
Cost of Equity (Ke) = +g
P0
Where,
D1 = [D0 (1 + g)] i.e. next expected dividend
P0 = Current Market price per share
g = Constant Growth Rate of Dividend

✓ In case of newly issued equity shares where floatation cost is incurred, the cost of equity
share with an estimation of constant dividend growth is calculated as below:
D1
Cost of Equity (Ke) = +g
P0 -F
Where, F = Flotation cost per share
Doubt Busters:
1. Confusion regarding D1 and D0.
▪ If the words ‘Dividend Expected’ is given, consider it as D1.

Page 11
| 43
 ▪ If the words ‘Dividend Paid’ is given, consider it as D0.
▪ If the question is silent, you can assume the given figure either as D1 or D0 upon writing a
note.

2. Estimation of Growth Rate

Generally, two methods are used to determine the growth rate, as discussed below:
i. Average Method
n D
0
g = √ -1
Dn

Where,
D0 = Current dividend,
Dn = Dividend in n years ago

ii. Gordon’s Growth Model

g=bxr
Where,
b = Earnings Retention Ratio
r = Rate of Return on Funds invested
D. Realized Yield Approach
✓ According to this approach, the average rate of return realized in the past few years is
historically regarded as ‘expected return’ in the future.
✓ It computes cost of equity based on the past records of dividends actually realised by the
equity shareholders.
✓ This is based on the principle that Cost to the Co. is equal to Investors’ Return.
✓ This method is computed from the Investor’s perspective and is normally followed when shares
are sold by equity investors after a few years in the secondary market.
✓ Here, Ke is calculated by discounting the relevant cash flows using IRR concept
E. Capital Asset Pricing Model (CAPM) Approach
✓ CAPM model describes the risk-return trade-off for securities.
✓ The idea behind CAPM is that the investors need to be compensated in two ways –
(i) Time value of money and (ii) Risk.
✓ This method says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus risk premium
✓ Thus, the cost of equity capital can be calculated under this approach as:
Cost of Equity (Ke) = Rf + ß (Rm - Rf)
Where,
Ke = Cost of equity capital

Page 12
| 44
 Rf = Risk free rate of return
ß = Beta coefficient
Rm = Rate of return on market portfolio
(Rm – Rf) = Market risk premium

6. Cost of Retained Earnings (Kr)

✓ Retained Earnings belongs to the Equity Shareholders and hence is very much a part of Equity.
✓ Like other sources of fund, retained earnings also involves cost. It is the opportunity cost of
dividends foregone by shareholders.
✓ Therefore, Kr is often used interchangeably with the Ke, as Kr is nothing but the expected
return of the shareholders from the investment in shares of the company.
✓ The formulas used for calculation of cost of retained earnings are same as formulas used for
calculation of cost equity and hence: Kr = Ke
✓ It should be noted that the concept of Floatation cost is not used for the calculation of cost
of retained earnings.
Doubt Busters:
1. For calculation of Ke:
P0 = Net Proceeds realized which is Issue Price less floatation cost.
2. For calculation of Kr:
P0 = Current Market Price (CMP). If CMP is not available, then Issue Price can be taken.
3. However, ICAI has used Current Market Price & Issue Price interchangeably in their solutions
for calculating Kr. In this case, students are suggested to write a note regarding the approach
followed in their answers.
4. When Personal Income Tax & Personal Brokerage of the Investor are given,
Kr = Ke (1 - tp) (1 - tb)
Where,
tp = Personal Income Tax
tb = Personal Brokerage

7. Weighted Average Cost of Capital (WACC)

✓ A company usually does not procure entire fund from a single source, rather it makes a mix of
various sources of finance.
✓ Hence, cost of total capital will be equal to weighted average of cost of individual sources of
finance.
✓ WACC is also known as the overall cost of capital which includes the cost of different sources
of capital and depends on the capital structure of a company.

Page 13
| 45
✓ WACC is preferred because the proportions of various sources of funds in the capital
structure are different.
✓ To be representative, therefore, cost of capital should take into account the relative
proportions of different sources of finance.
✓ WACC represents the minimum rate of return at which a company produces value for its
investors.
✓ The steps to calculate WACC is as follows:
Step 1: Calculate the total capital from all the sources of capital.
(Long-term debt capital + Pref. Share Capital + Equity Share Capital +
Retained Earnings)
Step 2: Calculate the proportion (or %) of each source of capital to the total capital.
Step 3: Multiply the proportion as calculated in Step 2 above with the respective
cost of capital.
Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the
WACC.
(Ke + Kd + Kp + Kr as calculated in Step 3 above)

Doubt Busters:
1. For calculation of WACC, there is a choice of weights between the Book Value (BV) and Market
Value (MV).
2. While Book value weight is operationally easy and convenient, Market value weight is more
correct and represents a firm’s true capital structure

8. Marginal Cost of Capital (MCC)

✓ The marginal cost of capital may be defined as the cost of raising an additional rupee of capital
and is referred to as the cost incurred in raising new funds.
✓ Marginal cost of capital is derived, when the average cost of capital is calculated using the
marginal weights which represent the proportion of funds the firm intends to employ.
✓ To calculate the marginal cost of capital, the intended financing proportion should be applied
as weights to marginal component costs.
✓ Calculation of MCC is very similar to that of WACC but for the fact that all the calculations
here are done only on the new funds raised.

Page14
| 46
 Core Theory Topics

A. Significance Of Cost Of Capital

The cost of capital is crucial for making informed financial decisions. It helps in:
1. Evaluating Investment Options: By discounting future cash flows with the appropriate cost of
capital, managers can assess the present value of investment opportunities. Different options
may have distinct costs of capital, so it’s essential to use the relevant rate for each.
2. Financing Decisions: When selecting between financing options, managers compare their costs
to choose the more cost-effective one, considering financial risk and control as well.
3. Designing Credit Policy: The cost of providing credit is weighed against the benefits of
extending credit to customers, using the cost of capital to evaluate the present value of both
costs and benefits.
B. RISK CLASSIFICATION UNDER CAPM APPROACH
The risk to which a security is exposed, can be classified into two groups:
i. Unsystematic Risk: This is also called company specific risk as the risk is related with the
company’s performance. This type of risk can be reduced or eliminated by diversification of
the securities portfolio. This is also known as diversifiable risk.
ii. Systematic Risk: It is the macro-economic or market specific risk under which a company
operates. This type of risk cannot be eliminated by the diversification hence, it is non-
diversifiable. The examples are inflation, Government policy, interest rate etc.

As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable

risk is the risk which cannot be eliminated; therefore, a business should be concerned as per CAPM
method, solely with non-diversifiable risk.

The non-diversifiable risks are assessed in terms of beta coefficient (b or β) through fitting
regression equation between return of a security and the return on a market portfolio.
C. THE SHORTCOMINGS CAPM APPROACH
a. Estimation of beta with historical data is unrealistic; and
b. Market imperfections may lead investors to unsystematic risk.
ER CAPM APPROACH

Page | 47
 CHAPTER 3: LEVERAGES

1. Introduction

✓ The term leverage represents influence or power.

✓ In financial analysis, leverage represents the influence of one financial variable over some
other related financial variable (Magnifying Effect)
✓ These financial variables may be costs, output, sales revenue, Earnings Before Interest and
Tax (EBIT), Earning Per Share (EPS) etc.
✓ Objective of financial management is to maximize wealth. Here, wealth means market value.
✓ Value is directly related to performance of company and inversely related to expectation of
investors.
✓ In turn, expectation of investor is dependent on risk of the company. Therefore, to maximize
value, company should try to manage its risk.
✓ This risk may be business risk, financial risk or both as defined below:
▪ Business Risk: It refers to the risk associated with the firm's operations. It is the
uncertainty about the future operating income (EBIT) i.e., how well can the operating
income be predicted?
▪ Financial Risk: It refers to the additional risk placed on the firm's shareholders because
of use of debt i.e., the additional risk, a shareholder bears when a company uses debt in
addition to equity financing. Companies that issue more debt instruments would have
higher financial risk than companies financed mostly or entirely by equity.
✓ In this chapter we will discuss factors that influence business and financial risks.

2. Important Terms/Concepts used in Leverages

The following are a few terms/concepts which will be used throughout this chapter.
A. Types of Fixed Cost
Fixed Costs can be classified as follows:

Fixed Cost

Fixed Operating Cost Fixed Financial Cost

Eg: Interest on Debt;

Eg: Salary; Factory Rent etc.
Preference Divided

Note: If the question is silent, assume it as Fixed Operating Cost.

Page 16
| 36
 B. Marginal Costing Terminologies
✓ Variable Costs – Costs that vary with Sales
✓ Contribution = Sales (-) Variable Cost
Contribution
✓ Profit Volume Ratio (PVR) = × 100
Sales
✓ Break-Even Point (BEP) – A point of volume where the EBIT is equal to zero i.e total operating
cost is equal to total sales revenue.
Fixed Cost
BEP (in units) =
Contribution per unit
✓ Margin of Safety (MOS) – It refers to the sales level beyond the breakeven point
MOS = Actual Sales (-) Break Even Sales
C. Some Ratios used in Numerical Problems in this chapter
The following are some ratios used in the numerical problems in this chapter along with leverage
calculations. These are ideally a part of Ratio Analysis Chapter.
EFE
i. EPS =
No. of Equity shares
EFE
ii. ROE (Return on Equity) =
Equity shareholders fund
Where Equity shareholders fund = Equity shares capital (+) Reserves and surplus
MPS Market Price per share
iii. Price Earnings Ratio (PE Ratio) = =
EPS Earnings Per Share
EPS
iv. Earnings Price Ratio (Earning yield Ratio) =
MPS
Note: It is the Inverse of PE Ratio
Sales
v. Total asset turnover ratio =
Total assets
vi. Return on Capital Employed (ROCE) [Return on Investment (RoI)]
EBIT EBIT (1-T)
= (or)
Capital Employed Capital Employed
Where: Capital Employed = Equity + Retained Earnings + PSC + Debentures + LTL
vii. Coverage Ratios
EBIT
a) Interest Coverage Ratio =
Interest
EAT
b) Preference Dividend Coverage Ratio =
PD
EFE
c) Equity Dividend Coverage Ratio =
ED
EBIT
viii. Operating Profit Ratio = x 100
Sales

Page 17
| 37
 3. Types of Leverages

There are three commonly used measures of leverage in financial analysis.

Types of Leverages

Operating Leverage Financial Leverage Combined Leverage

It is the relationship
It is the relationship It is the relationship
between Sales and
between EBIT and EPS between Sales and EPS
EBIT

Indicates Business risk Indicates Financial Risk Indicates Total Risk

Chart Showing Degree of Operating Leverage, Financial Leverage and Combined leverage
Profitability Statement

Sales xxx

Less: Variable Cost (xxx) Degree of

Contribution xxx Operating
Leverage
Less: Fixed Cost (xxx)

Operating Profit/EBIT xxx

Less: Interest (xxx)

Degree of
Earnings Before Tax (EBT) xxx com bined
Leverage
Less: Tax (xxx)
Degree of
Earnings After Tax (EAT) xxx
Financial
Less: Pref. Dividend (xxx) Leverage

Net Earnings available to Equity Shareholders (EFE) xxx

No. Equity Shares (N) xxx

Earnings per Share (EPS) [EFE ÷ N] xxx

Page 18
| 38
 4. Operating Leverage

A. Meaning of Operating Leverage

✓ Operating Leverage (OL) measures the relationship between Sales and EBIT.
✓ It measures the tendency of operating income (EBIT) to change disproportionately with change
in sale volume. This disproportionate change is caused by operating fixed cost, which does not
change with change in sales volume.
✓ In other words, Operating Leverage maybe defined as the employment of an asset with a fixed
cost so that enough revenue can be generated to cover all the fixed and variable costs.
✓ The use of assets for which a company pays a fixed cost is called operating leverage.
✓ Operating leverage is a function of three factors:
o Amount of fixed cost,
o Variable contribution margin, and
o Volume of sales.
B. Operating Leverage Formulas
Operating Leverage can be calculated using the following formulas
✓ Formula - 1:
Percentage Change in EBIT
Degree of Operating Leverage (DOL) =
Percentage Change in Sales
✓ Formula - 2:
Contribution
Degree of Operating Leverage (DOL)=
EBIT
✓ Formula - 3:
1
Degree of Operating Leverage (DOL)=
Margin of Safety (%)
Note: "Degree of Operating Leverage (DOL)" and “Operating Leverage (OL)" are identical
words and can be used interchangeably.
C. Relationship between Break-Even Point, Fixed Cost and Operating Leverage
The relationship between Operating leverage, break-even point and fixed cost is as

under:

Operating Leverage Fixed cost Break-Even point

1. Firm with High OL 1. High fixed cost 1. Higher Break-even point

2. Firm with Low OL 2. Lower fixed cost 2. Lower Break-even point

D. Relationship between Margin of Safety (MOS) and Operating Leverage

✓ MOS refers to the sales level beyond the breakeven point
✓ Higher MOS indicates lower business risk indicating higher profit and vice versa.
✓ MOS is inversely related to OL.

Page 19
| 39
 If MOS Business Risk DOL (1/MOS)

Rises Falls Falls

Falls Rises Rises

E. Analysis & Interpretation of Operating Leverage

S. No. Situation Result

1 When No Fixed Cost No Operating Leverage (OL = 1)

2. When EBIT = 0 (Sales At BEP) OL is Undefined (OL = ∞)

3. When EBIT > 0 (Sales more than BEP) OL is Positive

4. When EBIT < 0 (Sales less than BEP) OL is Negative

Note: DOL can never be between zero and one. It can be zero or less or it can be one or more.

5. Financial Leverage

A. Meaning of Financial Leverage

✓ Financial Leverage (FL) measures the relationship between EBIT and EPS.
✓ FL maybe defined as ‘the use of funds with a fixed cost in order to increase earnings per
share’. In other words, it is the use of company funds on which it pays a limited return
✓ In short, FL is caused by Fixed Financial Cost (Interest & Preference Dividend).
✓ Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing
the return to common stockholders. This concept is also known as ‘Trading on Equity’
B. Financial Leverage Formulas
Financial Leverage can be calculated using the following formulas
✓ Formula - 1: General Formula
Percentage Change in EPS
Degree of Financial Leverage (DFL)=
Percentage Change in EBIT
✓ Formula - 2: When the co. has issued Preference Shares,
EBIT
Degree of Financial Leverage (DFL)=
PD
EBIT-Int-
(1-tax)
✓ Formula - 3: When the co. has not issued Preference Shares,
EBIT
Degree of Financial Leverage (DFL)=
EBT
Note: "Degree of Financial Leverage (DFL)" and “Financial Leverage (FL)" are identical words
and can be used interchangeably.
Doubt Busters:
1. Sometimes, ICAI uses Formula – 3 even when Preference Shares are issued. Therefore, when
Preference Shares are issued, students can either follow Formula - 2 or Formula – 3.

Page 20
| 40
2. Logically speaking, Formula – 2 is only correct when Preference Shares are issued.
C. Analysis & Interpretation of Financial Leverage
S. No. Situation Result

1 When there is No Fixed Financial Cost No Financial Leverage (FL = 1)

2. When EBIT level is equal to Fixed Financial Cost FL is Undefined (FL = ∞)

3. When EBIT level is more than Fixed Financial FL is Positive

Cost

4. When EBIT level is less than Fixed Financial Cost FL is Negative

D. Financial Leverage as ‘Trading on Equity’

✓ Financial leverage indicates the use of funds with fixed cost like long term debts and
preference share capital along with equity share capital which is known as trading on equity.
✓ The basic aim of financial leverage is to increase the earnings available to equity shareholders
using fixed cost fund.
✓ A firm is known to have a positive/favourable leverage when its earnings are more than the
cost of debt.
✓ If earnings are equal to or less than cost of debt, it will be a negative/unfavourable leverage.
✓ When the quantity of fixed cost fund is relatively high in comparison to equity capital it is said
that the firm is ‘’trading on equity”.

E. Financial Leverage as a ‘Double edged Sword’

✓ When the cost of ‘fixed cost fund’ is less than the return on investment, FL will help to increase
return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts
etc.
✓ However, when cost of debt will be more than the return it will affect return of equity and
EPS unfavourably and as a result firm can be under financial distress.
✓ Therefore, financial leverage is also known as “double edged sword”.
✓ Effect on EPS and ROE:
▪ When, ROI > Interest – Favourable – Advantage
▪ When, ROI < Interest – Unfavourable – Disadvantage

Page 21
| 41
 ▪ When, ROI = Interest – Neutral – Neither advantage nor disadvantage
✓ This concept can be summarised as follows:

Financial Leverage

ROI > Kd = Positive / ROI > Kd = Negative /

Advantage Disadvantage

Example: Example:
ROI = 25% Kd = 15% ROI = 10% Kd = 15%

10% 5%
Surplus received to equity
shareholder i.e. EPS 

Note: DFL can never be between zero and one. It can be zero or less or it can be one or more.

6. Combined Leverage

A. Meaning of Combined Leverage

✓ Combined Leverage (CL) measures the relationship between Sales and EPS.
✓ It indicates the effect the changes in sales will have on EPS.
✓ Combined leverage measures total risk. It depends on combination of operating and financial
risk.
✓ Therefore, CL is caused by both Fixed Operating & Fixed Financial Cost.
B. Combined Leverage Formulas
Combined Leverage can be calculated using the following formulas
✓ Formula - 1:
Degree of Combined Leverage (DCL) = DOL x DFL
✓ Formula - 2:
Percentage Change in EPS
Degree of Combined Leverage (DCL) =
Percentage Change in Sales
✓ Formula - 3: When the co. has issued Preference Shares,
Contribution
Degree of Combined Leverage (DCL) =
PD
EBIT-Int-
(1-tax)
✓ Formula - 4: When the co. has not issued Preference Shares,
Contribution
Degree of Combined Leverage (DCL) =
EBT

Page 22
| 42
 Note: "Degree of Combined Leverage (DCL)" and “Combined Leverage (CL)" are identical words
and can be used interchangeably.
Doubt Busters:
1. Sometimes, ICAI uses Formula – 4 even when Preference Shares are issued. Therefore, when
Preference Shares are issued, students can either follow Formula - 3 or Formula – 4.
2. Logically speaking, Formula – 3 is only correct when Preference Shares are issued.
C. Analysis & Interpretation of Combined Leverage
Combine leverage measures total risk. It depends on combination of operating and financial risk.

DOL DFL Comments

Low Low Lower total risk.

Cannot take advantage of trading on equity.

High High Higher total risk. Very risky combination.

High Low Moderate total risk. Not a good combination.

Lower EBIT due to higher DOL and lower advantage of trading on equity due

to low DFL.

Low High Moderate total risk. Best combination.

Higher financial risk is balanced by lower total business risk.

Doubt Busters:
1. All the three leverages (OL, FL & CL) can be in positive or negative
2. Depreciation is treated as Fixed Operating Cost.
3. In case of reverse working problems when both OL & FL are given, alterative solutions are
possible depending on how students approach the question.

7. OL vs FL vs CL

DOL DFL DCL

Shows level of business risk. Shows level of financial risk. Shows level of total or

combined risk.

It is dependent upon fixed It is dependent upon interest It is dependent upon fixed

cost. and preference dividend cost, interest & preference

dividend.

Measures % change in EBIT Measures % change in EPS Measures % change in EPS

which results from a 1% which results from a 1% which results from a 1%

change in Sales. change in EBIT. change in Sales.

Page 23
| 43
For example, if DOL is 3 and For example, if DFL is 2 and For example, if DCL is 6 and

there is 8% increase in output there is 5% increase in EBIT there is a 8% increase in sales

then EBIT will increase by then EPS will increase by 10% then EPS will increase by 48%

24% & if there is a 8% and if there is a 5% decrease and if there is a 8% decrease

decrease in output then EBIT in EBIT then EPS will in sales then EPS will decrease

will decrease by 24%. decrease by 10%. by 48%.

There is a unique DOL for There is a unique DFL for There is a unique DCL for

each level of output. each level of EBIT. each level of sales.

It is undefined at Operating It is undefined at Financial It is undefined at Financial

B.E.P. B.E.P. B.E.P.

Page 24
| 44
 CHAPTER 4: CAPITAL STRUCTURE DECISIONS

Introduction

✓ Capital structure refers to the combination of capitals from different sources of finance.
✓ The capital of a company consists of Equity Share Holders' Fund, Preference Share Capital
and Long-Term External Debts.
✓ The source and quantum of capital is decided keeping in mind the following factors:
▪ Control: Capital structure should be designed in such a manner that existing
shareholders continue to hold majority stake.
▪ Risk: Capital structure should be designed in such a manner that financial risk of a
company does not increase beyond tolerable limit.
▪ Cost: Overall cost of capital remains minimum.
✓ Practically, it is difficult to achieve all of the above three goals together, hence, a finance
manager has to make a balance among these three objectives.
✓ However, the objective of a company is to maximise the value of the company and it is prime
objective while deciding the optimal capital structure. Capital Structure decision refers to
deciding the forms of financing (which sources to be tapped); their actual requirements
(amount to be funded) and their relative proportions (mix) in total capitalization.

In this context, this chapter can be broadly classified into four parts

Capital Structure Decisions

EBIT-EPS Indifference Point Break Even Points Capital

EBIT-EPS-MPS
Structure
Analysis
Theories

Faculty’s Note:
The above classification of this chapter is crafted from the faculty’s own perspective and
creative approach to enhance the understanding and to simplify the complex concepts covered
and hence the sequence may be different from ICAI Study Material.

Page 25
| 36
 Part A: EBIT-EPS Indifference Point

A. Meaning
✓ It is the level of EBIT at which EPS under two different financial plans are the same.
B. Formula
✓ The indifference point can be calculated algebraically in the following manner:
(EBIT-I1 )(1-t)- PD1 (EBIT-I2 )(1-t)- PD2
=
E1 E2
Where,
EBIT = Indifference point
E1 = Number of Equity shares in Alternative 1
E2 = Number of Equity shares in Alternative 2
I1 = Interest charges in Alternative 1
I2 = Interest charges in Alternative 2
PD1 = Preference Dividend in Alternative 1
PD2 = Preference Dividend in Alternative 2
t = Tax-rate
C. Decision Rule
Which Plan to Choose?
✓ If Expected EBIT < Indifference Point EBIT, select the Plan with Lower Fixed Financial Cost.
✓ If Expected EBIT > Indifference Point EBIT, select the Plan with Higher Fixed Financial Cost.
✓ If Expected EBIT = Indifference Point EBIT, then select Any Plan.
D. Cases When Indifference Point Cannot Be Calculated
When the No of Equity Shares under both alternatives equal AND
1. The Fixed Financial Cost of one Alternative is always more than the other alternative.
(Reason: EPS of one alternative is always greater than EPS of the other alternative)
2. When the fixed financial cost of both the alternatives is equal.
(Reason: EPS under both the alternatives will always be the same)
E. Graphical Presentation of Indifference Point

Page 26
| 37
 Part B: Break-Even Points (BEP)

A. Introduction
✓ Break Even Points indicates a ‘No Profit, No Loss’ situation.
✓ There are three types of Break-Even Points

Break-Even Points

Operating BEP Financial BEP Overall BEP

B. Operating BEP
✓ Operating BEP is the Sales level at which EBIT is Zero.
FC
✓ Operating BEP (Units) =
Contribution per unit
FC
✓ Operating BEP (value) =
P/V Ratio
C. Financial BEP
✓ It is the EBIT level at which EPS is Zero.
Preference Dividend
✓ Financial BEP = Interest +
( 1 - Tax Rate)
D. Overall BEP
✓ It is the Sales level at which EPS is Zero.
Preference Dividend
Operating Fixed Cost + Interest +
(1 - t)
✓ Overall BEP (Units) =
Contribution per unit
Preference Dividend
Operating Fixed Cost + Interest +
(1 - t)
✓ Overall BEP (Value) =
Contribution per unit

Page 27
| 38
 Part C: EBIT-EPS-MPS Analysis

✓ In this segment, we will try to find the best source (mix) of funding the business.
✓ Various sources from where money can be raised are as follows:
(i) Equity share capital
(ii) Retained earningss
(iii) Preference share capital
(iv) Debentures
(v) Long Term Loans
✓ The basic objective of financial management is to design an appropriate capital structure which
can provide the highest wealth, i.e., highest MPS, which in turn depends on EPS.
✓ This will be done using metrics such as EPS, MPS, ROE etc. which needs to be worked out on a
case-to-case basis (in all numerical problems) as there is no Fixed Thumb Rule.
✓ The following points need to be kept in mind
▪ EPS varies with different financing mixes due to the level of debt financing.
▪ Leverage affects EPS because of fixed financial charges like interest on debt and
preference dividends.
▪ If Return on Assets > Cost of Financing, increasing fixed charge financing
(debt/preference shares) raises EPS (Favourable Financial Leverage or Trading on Equity).
▪ If Return on Assets < Cost of Financing, increasing debt/preference shares reduces EPS.
▪ Debt vs. Preference Shares:
Debt Financing is generally preferred because:
o Interest rates on debt are usually lower than fixed dividends on preference shares.
o Interest on debt is tax-deductible, reducing the real cost compared to preference
share capital.
▪ Analysing capital structure and leverage impact on EPS and MPS helps in selecting the
optimal debt level.
▪ EBIT-EPS Analysis is a crucial tool for financial managers to effectively plan and design
the firm's capital structure.
Doubt Busters:
1. EBIT (Operating Profit) will not change depending on the Capital Structure.
2. MPS = EPS x PE Ratio
3. EPS = Earnings Available to Equity SH / No. of Equity Shares

Page 28
| 39
 Part D: Capital Structure Theories

A. Segment Background
✓ In this segment, we will study the relationship between the cost of capital, capital structure,
and the value of the firm.
✓ We will also be learning the four popular Capital Structure Theories (Perspectives) which
are:
1. Net Income (NI) approach
2. Net Operating Income (NOI) approach
3. Traditional approach
4. Modigliani-Miller (MM) approach [with & without Tax]

Net Income (NI) Approach

Capital
Structure
Traditional Approach
Relevance
Theory
Modigliani and Miller (MM)
Capital
Structure Approach- 1963: With tax
Theories
Net Operating Income (NOI)
Capital
Structure Approach

Irrelevance Modigliani and Miller (MM)

Theory
Approach -1958: Without tax

B. General Assumptions in Capital Structure Theories

✓ There is no Preference Share Capital
✓ There are only two sources of funds used by a firm i.e., Debt and Equity
✓ Taxes are not considered (except MM Approach with Tax)
✓ The dividend payout ratio is 100% (DPS = EPS)
✓ Business risk is constant over time.
✓ The firm has perpetual life.
✓ Kd will always be less than Ke (Kd < Ke)
✓ The firm’s total financing remains constant. The degree of leverage can be changed by selling
debt to purchase shares or selling shares to retire debt.

Page 29
| 40
 C. General Formulas in Capital Structure Theories
1. Value of the Firm (Overall Co) is equal to Value of Equity + Value of Debt
VF = V E + VD
EPS EFE
2. VE (Per share) = ; VE (in total) =
Ke Ke
Total Interest
3. Value of Debt =
Kd
EBIT
4. Value of firm =
Ko
5. KO = KdWd × KeWe

Doubt Busters:
1. Generally, Ke > Kd
2. Lower the KO higher the VF & vice versa
D. Net Income Approach (NI)
✓ This approach was given by David Durand in the year 1952.
✓ According to this approach, capital structure decisions are relevant.
✓ This theory suggests that the value of the firm can be increased by reducing KO,
✓ KO can be decreased through a higher proportion of debt.
✓ Other Points in NI Approach:
▪ Ke > Kd
▪ Ke and Kd (Remain constant)
✓ Graphical Presentation:

E. Net Operating Income Approach (NOI)

✓ The NOI Approach was also proposed by David Durand in 1952.
✓ As per this approach, capital structure decisions are irrelevant.
✓ This approach is exactly the opposite of the NI approach.
✓ As per this approach, the VF and KO remain constant.
✓ VF cannot be increased or decreased by changing the debt component.
✓ Other Points in NOI Approach:
▪ Ke > Kd
▪ Kd will remain constant

Page 30
| 41
 ▪ KO will remain constant

✓ Graphical Presentation:

Doubt Busters:
1. In NOI Approach, KO remains constant because the Low-Cost advantage of Debt is exactly
offset by increase in Ke
2. NI vs NOI (With increase in debt):
Kd Ke KO VF
NI Constant Constant Decrease Increase
NOI Constant Increase Constant Constant

F. Traditional Approach
✓ According to this approach, capital structure decisions are relevant.
✓ Through proper mix of debt and equity, risk can be reduced and VF can be increased.
✓ This approach can be studied under three phases.
Phase 1:
▪ Ke and Kd remain constant.
▪ Ke > Kd
▪ KO will decrease with an increase in debt.
Phase 2:
▪ Ke will increase.
▪ Kd remains constant.
▪ Ke > Kd.
▪ KO will remain constant.
Phase 3:
▪ Ke will increase.
▪ Kd will increase.
▪ Ke > Kd.
▪ KO will increase
✓ Optimum capital structure occurs at the point where value of the firm is highest and the cost
of capital is the lowest.
✓ Main Highlight of Traditional Approach

Page 31
| 42
 ▪ The firm should strive to reach the optimal capital structure and its total valuation through
a judicious use of both the debt and equity in capital structure.
▪ At the optimal capital structure, the overall cost of capital will be minimum and the value
of the firm will be maximum.
✓ Graphical Presentation:

G. Modigliani-Miller (MM) Approach

✓ The NOI approach is definitional or conceptual and lacks behavioural significance. It does not
provide operational justification for irrelevance of capital structure.
✓ However, Modigliani-Miller (MM) approach provides behavioural justification for constant
overall cost of capital and therefore, total value of the firm.
✓ There are two types under Modigliani-Miller (MM) approach:

MM Approach -1958: without tax

Modigliani-Miller (MM) Approach

MM Approach- 1963: with tax

I. MM Approach without Tax

✓ This approach was given by Modigliani-Miller in 1958.
✓ This approach is similar to NOI approach.
✓ Capital structure decisions are irrelevant.
✓ VF and KO will always remain constant and are not affected by increase/decrease in debt (Wd).
✓ MM approach presents THREE PROPOSITIONS in their analysis:
PROPOSITION – 1:
EBIT (NOI)
▪ VF =
KO
▪ The total value of firm and KO remains constant.
▪ Therefore, Value of levered firm = Value of unlevered firm.

Page 32
| 43
 PROPOSITION – 2:
Debt
Ke = KO (+) (KO – Kd ) ×
Equity

PROPOSITION – 3:
The capital structure does not affect the overall cost of capital (K0); the cost of capital is
affected only by business risk and not by financial risk.
✓ Graphical Presentation:

II. MM Approach with Tax

✓ In 1963, MM model was amended by incorporating tax, they recognized that the value of the
firm will increase, or cost of capital will decrease where corporate taxes exist.
✓ If tax rate is given, then the Value of Levered firm > Value of Unlevered firm.
✓ This is due to tax advantage on interest payment.
✓ Formulas:
▪ Value of Levered Firm (VL) = VUL + (D × T)
Where,
VUL = Value of Unlevered Firm
D = Debt
T = Tax Rate
Debt
▪ Cost of equity in a levered company (Keg) = Keu + (Keu – Kd)
Debt + Equity
Where,

Keg = Cost of equity in a levered company

Keu = Cost of equity in an unlevered company

Kd = Cost of debt

Page 33
| 44
 ▪ WACC in a levered company (Kog) = Keu (1 – tL)
Where,

Kog = WACC of a levered company

Keu = Cost of equity in an unlevered company

t = Tax rate
Debt
L=
Debt + Equity

H. Arbitrage Process
✓ Arbitrage refers to buying asset or security at lower price in one market and selling it at a
higher price in another market.
✓ As a result, equilibrium is attained in different markets.
✓ This is illustrated by taking two identical firms of which one has debt in the capital
structure while the other does not.
✓ Investors of the firm whose value is higher will sell their shares and instead buy the shares
of the firm whose value is lower.
✓ They will be able to earn the same return at lower outlay with the same perceived risk or
lower risk. They would, therefore, be better off.
✓ Detailed explanation on Arbitrage will be covered in our classroom discussion.

Page 34
| 45
 Core Theory Topics

A. Trade-off Theory
✓ Concept:
▪ Balances the costs and benefits of debt and equity financing to determine an optimal
capital structure.
✓ Key Elements:
▪ Tax Benefits of Debt: Interest payments are tax-deductible, reducing the overall cost
of debt.
▪ Costs of Financial Distress: Includes bankruptcy costs and non-bankruptcy costs (e.g.,
employee turnover, strained supplier relations, and conflicts among stakeholders).
✓ Optimal Capital Structure:
▪ Achieved when the marginal benefit of debt (mainly tax savings) equals the marginal cost
of financial distress and agency costs.
▪ As debt increases, the marginal benefit declines, and the marginal cost rises.
✓ Principle:
▪ Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an
optimal capital structure which is given by the trade-off theory.
▪ According to Modigliani and Miller, the attractiveness of debt decreases with the
personal tax on the interest income.
▪ A firm experiences financial distress when the firm is unable to cope with the debt
holders' obligations. If the firm continues to fail in making payments to the debt holders,
the firm can even be insolvent.

B. Pecking Order Theory

✓ Pecking order theory suggests that managers may use various sources for raising of fund in
the following order:
1. Managers first choice is to use internal finance.
2. In absence of internal finance, they can use secured debt, unsecured debt, hybrid debt
etc.
3. Managers may issue new equity shares as a last option.
✓ This theory is based on Asymmetric information, which refers to a situation in which
different parties have different information.
✓ In a firm, managers will have better information than investors. This theory states that
firms prefer to issue debt when they are positive about future earnings. Equity is issued
when they are doubtful and internal finance is insufficient.

Page 35
| 46
 ✓ The pecking order theory argues that the capital structure decision is affected by
manager’s choice of a source of capital that gives higher priority to sources that reveal the
least amount of information.
✓ Myers has given the name ‘PECKING ORDER’ theory as here is no well-defined debt-equity
target and there are two kind of equity internal and external.
✓ Now Debt is cheaper than both internal and external equity because of interest. Further
internal equity is less than external equity particularly because of no transaction/issue cost,
no tax etc.

C. Factors affecting capital structure

1. Financial leverage or The use of long-term fixed interest bearing debt and
Trading on Equity: preference share capital along with equity share capital is
called financial leverage or trading on equity.
2. Growth and stability of The capital structure of a firm is highly influenced by the
sales: growth and stability of its sales. If the sales of a firm are
expected to remain fairly stable, it can raise a higher level of
debt.
3. Cost Principle: According to this principle, an ideal pattern or capital structure
is one that minimizes cost of capital structure and maximizes
earnings per share (EPS). For e.g. Debt capital is cheaper than
equity capital from the point of its cost and interest being
deductible for income tax purpose, whereas no such deduction
is allowed for dividends.
4. Risk Principle: According to this principle, reliance is placed more on common
equity for financing capital requirements than excessive use of
debt.
5. Control Principle: While designing a capital structure, the finance manager may
also keep in mind that existing management control and
ownership remains undisturbed.
6. Flexibility Principle: By flexibility, it means that the management chooses such a
combination of sources of financing which it finds easier to
adjust according to changes in need of funds in future too..
7. Financial leverage or The use of long-term fixed interest bearing debt and
Trading on Equity: preference share capital along with equity share capital is
called financial leverage or trading on equity.
8. Growth and stability of The capital structure of a firm is highly influenced by the
sales: growth and stability of its sales. If the sales of a firm are

Page 36
| 47
 expected to remain fairly stable, it can raise a higher level of
debt.

D. Over-Capitalization
Over-Capitalization Occurs when a firm has excess capital or assets worth less than its issued
share capital, and earnings are insufficient to pay dividends and interest.
Causes of Over- 1. Raising more money through share or debenture issuance than the
Capitalization company can use profitably.
2. Borrowing at high rates than the company's earning rate.
3. Overpaying for fictitious assets like goodwill.
4. Incorrect depreciation provision and over-distribution of dividends.
5. Wrong estimation of earnings and capitalization.
Consequences of 1. Lower dividend and interest payments.
Over-Capitalization 2. Decline in share price.
3. Window dressing of financial statements.
4. Possible reorganization or even liquidation.
Remedies for Over- 1. Reorganization of the company.
Capitalization 2. Buyback of shares.
3. Reduction in debenture holders' and creditors' claims.
4. Reducing share value to free up funds for asset replacement

E. Under-Capitalization
Under- Occurs when a company's actual capitalization is lower than the proper
Capitalization capitalization required based on its earning capacity. Often seen in
companies with insufficient capital but large secret reserves due to
unrecorded appreciation of fixed assets.
Consequences of 1. Higher dividend rate compared to similar companies.
Under- 2. Higher share price due to higher earnings.
Capitalization 3. Real value of shares being greater than their book value.
Effects of Under- 1. Encourages acute competition as high profits attract new businesses.
Capitalization 2. High dividend rate may lead to higher wage demands from workers’
unions.
3. Consumers may feel exploited.
4. Management may manipulate share values.
5. May invite more government control, regulation, and higher taxes.

Page 37
| 48
Remedies for 1. Share split to reduce dividend per share, but EPS remains the same.
Under- 2. Issue of bonus shares to lower both dividends per share and average
Capitalization earnings rate.
3. Increase par value of shares in exchange for existing shares.

F. Over-Capitalization vis-à-vis Under-Capitalization

Conclusion Both over-capitalization and under-capitalization are problematic, but over-
capitalization is more dangerous to the company, shareholders, and society.
Handling Under- Under-capitalization is easier to manage compared to over-capitalization.
Capitalization It’s more about adjusting the capital structure rather than an economic
problem.
Danger Level Under-capitalization is less dangerous than over-capitalization, but both
situations are undesirable. Every company should aim for proper
capitalization.

Page 38
| 49
 CHAPTER 5: INVESTMENT DECISIONS
1. Introduction
✓ Investment decision is concerned with optimum utilization of fund to maximize the wealth
of the organization and in turn the wealth of its shareholders.
✓ As we have seen in the Cost of Capital chapter, each rupee of capital raised by an entity
bears some cost, commonly known as cost of capital.
✓ It is necessary that each rupee raised is to be invested in a very prudent manner which
requires a proper planning for capital, and it is done through a proper budgeting.
✓ In simple terms, Capital Budgeting involves:
▪ Identification of investment projects that are strategic to business’ overall
objectives;
▪ Estimating and evaluating post-tax incremental cash flows for each of the investment
proposals; and
▪ Selection of an investment proposal that maximizes the return to the investors.

2. Types Of Capital Investment Decisions

✓ There are many ways to classify the capital budgeting decision.
✓ Generally capital investment decisions are classified in two ways.
▪ On the basis of Firm’s Existence
▪ On the basis of Decision Situation

Replacement And Modernisation

Decisions

On the basis
of firm's Expansion Decisions
existence

Diversification Decisions
Types of capital
investment Decisions
Mutually Exclusive Decisions

On the basis
Accept-reject Decisions
of Situations

Contingent Decisions

Page 39
| 36
 3. Steps of Capital Budgeting Procedure
The following are the steps involved in Capital Budgeting Procedure
1. Estimation of Cash flows over the entire life for each of the projects under
consideration.
2. Evaluate each of the alternative, using different decision criteria.
3. Determining the minimum required rate of return (i.e., WACC) to be used as discount rate
(Already covered in Cost of Capital Chapter)

Accordingly, this chapter is divided into two sections:

Capital Budgeting

Capital Budgeting
Estimation of Cash Flows
Techniques

Page 40
| 37
 Part A: Estimation of Cash Flows

4. Estimation of Project Cash Flows

✓ Capital Budgeting analysis considers only incremental cash flows from an investment likely
to result due to acceptance of any project.
✓ Therefore, one of the most important tasks in capital budgeting is estimating future cash
flows for a project.
✓ Before we analyse how cash flow is computed in capital budgeting decision, following items
needs consideration:

A. Depreciation
✓ Depreciation is a non-cash item and itself does not affect the cash flow.
✓ However, we must consider tax shield or benefit from depreciation in our analysis.
✓ Since this benefit reduces cash outflow for taxes, it is considered as cash inflow.
Example -1
X Ltd. manufactures electronic motors fitted in desert coolers. It has an annual turnover of
₹ 30 crore and cash expenses to generate this much of sale is ₹ 25 crore. Suppose applicable
tax rate is 30% and depreciation is ₹ 1.50 crore p.a.
The table below is showing Tax shield due to depreciation under two scenarios i.e., with and
without depreciation:
No Depreciation is Charged Depreciation is Charged
(₹ Crore) (₹ Crore)

Total Sales 30.00 30.00

Less: Cost of Goods Sold (25.00) (25.00)
5.00 5.00
Less: Depreciation - (1.50)
Profit before tax 5.00 3.50
Less: Tax @ 30% (1.50) (1.05)
Profit after Tax 3.50 2.45
Add: Depreciation* - 1.50
Cash Flow 3.50 3.95
o Being non- cash expenditure depreciation has been added back while calculating the
cash flow.
o As we can see in the above table that due to depreciation under the second scenario, a
tax saving of ₹ 0.45 crore (₹ 1.50 – ₹ 1.05) was made.
o This is called tax shield. The tax shield is considered while estimating cash flows.

Page 41
| 38
 B. Opportunity Cost
✓ Opportunity cost is foregoing of a benefit due to choosing an alternative investment
option.
✓ This opportunity cost can occur both at the time of initial outlay and during the tenure of
project.
✓ Opportunity costs are considered for estimation of Cash Flows.
C. Sunk Cost
✓ Sunk cost is an outlay of cash that has already been incurred in the past and cannot be
reversed in present.
✓ Therefore, these costs do not have any impact on decision making, hence should be
excluded from capital budgeting analysis.
D. Working Capital
✓ While evaluating the projects, initial working capital requirement should be treated as
cash outflow and at the end of the project its release should be treated as cash inflow.
✓ It is important to note that no depreciation is provided on working capital though it might
be possible that at the time of its release its value might have been reduced.
✓ Further there may be also a possibility that additional working capital may be required
during the life of the project.
✓ In such cases the additional working capital required is treated as cash outflow at that
period of time.
✓ Similarly, any reduction in working capital shall be treated as cash inflow.
✓ It may be noted that, if nothing has been specifically mentioned for the release of working
capital it is assumed that full amount has been realized at the end of the project.
✓ However, adjustment on account of increase or decrease in working capital needs to be
incorporated.
E. Additional Capital Investment
✓ It is not necessary that capital investment shall be required in the beginning of the
project.
✓ It can also be required during the continuance of the project.
✓ In such cases, it shall be treated as cash outflows at that period of time.
F. Block of Assets and Depreciation
✓ Tax shield/benefit from depreciation is considered while calculating cash flows from the
project which is calculated as per the provisions of Income Tax Act of the country.
✓ The treatment of deprecation is based on the concept of “Block of Assets”, which means
a group of assets falling within a particular class of assets.

Page 42
| 39
✓ The treatment of tax depends on the fact whether block of asset consist of one asset or
several assets.
Example- 2
Suppose A Ltd. acquired new machinery for ₹1,00,000, depreciable at 20% as per written
down value (WDV) method. The machine has an expected life of 5 years with salvage value
of ₹10,000. The treatment of depreciation/ short term capital loss in the 5th year in two
cases shall be as follows:
Depreciation for initial 4 years shall be common and WDV at the beginning of the 5th year
shall be computed as follows:
₹

Purchase Price of Machinery 1,00,000

Less: Depreciation @ 20% for year 1 20,000
WDV at the end of year 1 80,000
Less: Depreciation @ 20% for year 2 16,000
WDV at the end of year 2 64,000
Less: Depreciation @ 20% for year 3 12,800
WDV at the end of year 3 51,200
Less: Depreciation @ 20% for year 4 10,240
WDV at the end of year 4 40,960

Case 1 - There is no other asset in the Block: When there is only one asset in the block and
block shall cease to exist at the end of 5th year, then no deprecation shall be charged in 5th year
and tax benefit/loss on short term capital loss/ gain shall be calculated as follows:
₹

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 10,000
Short Term Capital Loss (STCL) 30,960
Tax Benefit on STCL @ 30% 9,288

Case 2 - More than one asset exists in the Block: When more than one asset exists in the
block, then deprecation shall be charged in the terminal year (5th year) in which asset is sold.
The WDV on which depreciation be charged shall be calculated by deducting sale value from
the WDV in the beginning of that year. Tax benefit on depreciation shall be calculated as
follows:

Page 43
| 40
 ₹

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 10,000
WDV 30,960
Depreciation @ 20% 6,192
Tax Benefit on Depreciation @ 30% 1,858

Now suppose if in above two cases, sale value of machine is ₹50,000, then no depreciation
shall be provided in Case 2 because the WDV at the beginning of 5th year is only ₹40,960
i.e., less than sale value of ₹50,000 and tax loss on STCG in Case 1 shall be computed as
follows:

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 50,000
Short Term Capital Gain (STCG) 9,040
Tax outflow on STCG @ 30% 2,712

G. Exclusion of Financing Costs Principle

✓ When cash flows relating to long-term funds are being defined, financing costs of long-
term funds (interest on long-term debt and equity dividend) should be excluded from the
analysis.
✓ The interest and dividend payments are reflected in the weighted average cost of capital.
✓ Hence, if interest on long-term debt and dividend on equity capital are deducted in
defining the cash flows, the cost of long- term funds will be counted twice.
✓ The exclusion of financing costs principle means that:
▪ The interest on long-term debt is ignored while computing profits and taxes.
▪ The expected dividends are deemed irrelevant in cash flow analysis.
H. Post-tax Principle
✓ Tax payments like other payments must be properly deducted in deriving the cash flows.
✓ That is, cash flows must be defined in post-tax terms.
✓ The discounting rate and the cash flows, both must be post-tax only.

Page 44
| 41
 Statement showing the calculation of Cash Inflow After Tax (CFAT)
Particulars (₹) (₹)

Sales value xxx

Less: Variable Cost xxx
Contribution xxx
Less: Fixed Cost
(a) Fixed Cash Cost (excluding Interest) xxx
(b) Depreciation xxx xxx
Earning Before Tax (EBT) xxx
Less: Tax xxx
Earning After Tax (EAT) xxx
Add: Depreciation xxx
Cash Inflow After Tax (CFAT) xxx

Doubt Busters:
1. In Replacement Decision Sums, when the seller of a new machine accepts the old
machine as an exchange, the following should be the treatment:
▪ If the co is following SLM for IT purpose - Do not reduce the Sale Value of Old
Machine from the Cost (since no block of asset concept)
▪ If the co is following WDV for IT purpose - Reduce the Sale Value of Old Machine
from the cost (since block of asset concept is present)
2. Interest being a Financing cost along with its tax shield should be ignore for calculating
CFAT.

Page 45
| 42
 Part B: Capital Budgeting Techniques

5. Introduction to Capital Budgeting Techniques

✓ In order to maximize the return to the shareholders of a company, it is important that
the best or most profitable investment projects are selected.
✓ Results of making a bad long-term investment decision can be devastating in both financial
and strategic terms.
✓ Proper care is required for investment project selection and evaluation.
✓ There are number of techniques available for the appraisal of investment proposals and
can be classified as presented below:

Capital Budgeting Techniques

Traditional or Non-Discounting Time adjusted or Discounted Cash Flows

Accounting Net Internal

Discounted Modified
Payback Rate of Present Profitability Rate of
Payback Internal
Period Return Value Index (PI) Return
Period Rate of
(ARR) (NPV) (IRR) Return
(MIRR)

6. Traditional or Non-Discounting Techniques

✓ These techniques of capital Budgeting does not discount the future cash flows.
✓ There are two such traditional techniques namely Payback Period and Accounting Rate of
Return.

A. Payback Period
✓ Time required to recover the initial cash-outflow is called pay-back period.
✓ The payback period of an investment is the length of time required for the cumulative
total net cash flows from the investment to equal the total initial cash outlays.
✓ At that point in time (payback period), the investor has recovered all the money invested
in the project.
✓ Steps in Payback period technique:
▪ The first step in calculating the payback period is determining the total initial capital
investment (cash outflow).
▪ The second step is calculating/estimating the annual expected after-tax cash flows
over the useful life of the project.

Page 46
| 43
 i. Payback Period (Uniform Cash Flows)
✓ When the cash inflows are uniform over the useful life of the project, the number of
years in the payback period can be calculated using the following equation:
Total initial capital investment
Payback period =
Annual Expected After - Tax net Cash Flow
Example- 3
Suppose a project costs ₹20,00,000 and yields annually a profit of ₹3,00,000 after
depreciation @ 12½% (straight line method) but before tax at 50%.
The first step would be to calculate the cash inflow from this project. The cash inflow is
calculated as follows:
Particulars (₹)

Profit before tax 3,00,000

Less: Tax @ 50% 1,50,000
Profit after tax 1,50,000
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000
While calculating cash inflow, depreciation is added back to profit after tax since it does not
result in cash outflow.
The cash generated from a project therefore isequal to profit after tax plus depreciation. The
payback period of the project shall be:
₹20,00,000
Payback period = = 5 Years
4,00,000
ii. Payback Period (Non - Uniform Cash Flows)
✓ When the annual cash inflows are not uniform, the cumulative cash inflow from operations
must be calculated for each year.
✓ The payback period shall be corresponding period when total of cumulative cash inflows is
equal to the initial capital investment.
✓ However, if exact sum does not match, then the period in which it lies should be identified.
After that we need to compute the fraction of the year.
Example- 4
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of ₹2,00,000 and is
expected to generate cash inflows as follows:
Year Annual Cash Inflows (₹)

1 80,000
2 60,000

Page 47
| 44
 3 60,000
4 20,000

Its payback period shall be computed by using cumulative cash flows as follows:
Year Annual Cash Inflows (₹) Cumulative Cash Inflows (₹)

1 80,000 80,000
2 60,000 1,40,000
3 60,000 2,00,000
4 20,000 2,20,000
In 3rd year, cumulative cash inflows equal to initial cash outlay i.e., ₹2,00,000. Hence, payback
period is 3rd year.

Suppose if in above example, the initial outlay is ₹2,05,000, then:

Payback period shall lie between 3 to 4 years. Since up to 3 years, a sum of ₹2,00,000
shall be recovered and balance of ₹5,000 shall be recovered in the part (fraction) of 4th
year, computation is as follows:
Balance Cash outlay ₹ 5,000 1
Part of 4th year = = =
Cumulative Cash Inflow at 4
th
year ₹ 20,000 4 year

Thus, total cash outlay of ₹2,05,000 shall be recovered in 3¼ years’ time.

iii. Payback Reciprocal
✓ As the name indicates, it is the reciprocal of payback period.
✓ A major drawback of the payback period method of capital budgeting is that it does not
indicate any cut off period for the purpose of investment decision.
✓ It is, however, argued that the reciprocal of the payback would be a close approximation
of the Internal Rate of Return if the life of the project is at least twice the payback
period and the project generates equal amount of the annual cash inflows.
✓ In practice, the payback reciprocal is a helpful tool for quick estimation of rate of return
of a project provided its life is at least twice the payback period.
✓ The payback reciprocal can be calculated as follows:
Average annual cash in flow
Payback Reciprocal =
Initial investment
Example- 5
Suppose a project requires an initial investment of ₹20,000 and it would give annual cash
inflow of ₹4,000. The useful life of the project is estimated to be 10 years.
In this example, payback reciprocal = ₹ 4,000 × 100 / ₹ 20,000 = 20%

Page 48
| 45
The above payback reciprocal provides a reasonable approximation of the internal rate of
return, i.e. 20%.
B. Accounting Rate of Return or Average Rate of Return (ARR)
✓ The accounting rate of return of an investment measures the average annual net income
of the project (incremental income) as a percentage of the investment.
✓ Formula:
Average annual net income
Accounting Rate of Return (ARR) =
Investment
✓ The numerator is the average annual net income generated by the project over its useful
life.
✓ The denominator can be either the initial investment (including installation cost) or the
average investment over the useful life of the project.
✓ Average investment means the average amount of fund remained blocked during the
lifetime of the project under consideration.
Example- 6
Suppose Times Ltd. is going to invest in a project a sum of ₹3,00,000 having a life span of 3
years. Salvage value of machine is ₹90,000. The profit before depreciation for each year is
₹1,50,000.
The Profit after Tax and value of Investment in the Beginning and at the End of each year
shall be as follows:
Year Profit Depreciation Profit Value of Investment in
Before (₹) After (₹)
Depreciation Depreciation
Beginning End
(₹) (₹)
1 1,50,000 70,000 80,000 3,00,000 2,30,000
2 1,50,000 70,000 80,000 2,30,000 1,60,000
3 1,50,000 70,000 80,000 1,60,000 90,000

The ARR can be computed by following methods as follows:

Version 1: Annual Basis
Profit after Depreciation
ARR = ×100
Investment in the beginning of the year

Page 49
| 46
 Year

1 80,000
= 26.67%
3,00,000
2 80,000
= 34.78%
2,30,000
3 80,000
=50%
1,60,000
26.67%+34.78%+50.00%
Average ARR = =37.15%
3
Version 2: Total Investment Basis
Average Annual Profit
ARR= ×100
Investment in the beginning
(80,000 + 80,000 + 80,000) / 3
= × 𝟏𝟎𝟎 = 𝟐𝟔. 𝟔𝟕%
3,00,000
Version 3: Average Investment Basis
Average Annual Profit
ARR= ×100
Average Investment
Average Investment = (₹3,00,000 + ₹90,000)/2 = ₹1,95,000
Or, Average Investment = ½ (Initial Investment – Salvage Value) + Salvage Value
= ½ (₹3,00,000 – ₹90,000) + ₹90,000 = ₹1,95,000
80,000
ARR = × 100 = 41.03%
1,95,000
✓ Further, it is important to note that project may also require additional working capital
during its life in addition to initial working capital.
✓ In such situation, formula for the calculation of average investment shall be modified as
follows:
½(Initial Investment – Salvage Value) + Salvage Value + Additional Working Capital

Continuing above example, suppose a sum of ₹45,000 is required as additional working capital
during the project life, then average investment shall be:
= ½ (₹3,00,000 – ₹90,000) + ₹90,000 + ₹45,000 = ₹2,40,000 and
80,000
ARR= ×100=33.33%
2,40,000

7. Discounting Techniques
✓ Discounting techniques consider time value of money and discount the cash flows to their
Present Value and are also known as Present Value techniques.
✓ These are namely Net Present Value (NPV), Internal Rate of Return (IRR), Profitability
Index (PI), Discounted Payback Period & Modified Internal Rate of Return (MIRR)

Page 50
| 47
✓ Theoretically, the discount rate or desired / expected rate of return on an investment is
the rate of return the firm would have earned by investing the same funds in the best
available alternative investment that has the same risk.
✓ Determining the best alternative opportunity available is difficult in practical terms so
rather than using the true opportunity cost, organizations often use an alternative
measure for the desired rate of return.
✓ An organization may establish a minimum rate of return that all capital projects must
meet; this minimum could be based on an industry average or the cost of other investment
opportunities.
✓ Many organizations choose to use the overall cost of capital or Weighted Average Cost of
Capital (WACC) that an organization has incurred in raising funds or expects to incur in
raising the funds needed for an investment.

A. Net Present Value Technique (NPV)

✓ The net present value technique is a discounted cash flow method that considers the time
value of money in evaluating capital investments.
✓ The net present value method uses a specified discount rate to bring all subsequent cash
inflows after the initial investment to their present values (the time of the initial
investment is year 0).
✓ The net present value of a project is the amount, in current value of amount, the
investment earns after paying cost of capital in each period.
✓ NPV = Present Value of Net Cash Inflow - Total Net Initial Investment
C1 C2 C3 Cn
NPV= ( + + +.....+ n) - I
(1+k) (1+k) (1+k)
2 3
(1+k)

Where,
C = Cash flow of various years
k = Discount rate
N = Life of the project
I = Investment
✓ The steps for calculating net present value are:
1. Determine the net cash inflow in each year of the investment.
2. Select the desired rate of return or discounting rate or Weighted Average Cost of
Capital.
3. Find the discount factor for each year based on the desired rate of return selected.

Page 51
| 48
 4. Determine the present values of the net cash flows by multiplying the cash flows by
respective discount factors of respective period called Present Value (PV) of Cash
flows
5. Total the amounts of all PVs of Cash Flows.
✓ Decision Rule:
If NPV ≥ 0 Accept the Proposal

If NPV ≤ 0 Reject the Proposal

The NPV method can be used to select between mutually exclusive projects; the one with
the higher NPV should be selected.
B. Profitability Index/Desirability Factor/Present Value Index Method (PI)
✓ The Profitability Index (PI) is calculated as below:
Sum of discounted cash in flows
PI=
Initial cash outlay or Total discounted cash outflow (as the case may)
✓ Decision Rule:
If PI ≥ 1 Accept the Proposal

If PI ≤ 1 Reject the Proposal

In case of mutually exclusive projects, project with higher PI should be selected.
C. Internal Rate of Return Method (IRR)
✓ The internal rate of return method considers the time value of money, the initial cash
investment, and all cash flows from the investment.
✓ But unlike the net present value method, the internal rate of return method does not use
the desired rate of return but estimates the discount rate that makes the present value
of subsequent cash inflows equal to the initial investment. This discount rate is called IRR.
✓ IRR is the discount rate that equates the present value of the expected cash inflows with
the initial cash outflow.
✓ This IRR is then compared to a criterion rate of return that can be the organization’s
desired rate of return for evaluating capital investments.
✓ Steps to Compute IRR have been covered in TVM Chapter
✓ Decision Rule:
If IRR ≥ Cut-off Rate or WACC Accept the Proposal

If IRR ≤ Cut-off Rate or WACC Reject the Proposal

D. Discounted Payback Period Method

✓ This is similar to Payback period as discussed under the non-discounting method except
that the cash flows here are discounted at predetermined rate and the payback period so
calculated is called Discounted payback period.

Page 52
| 49
Example-7
For example, a ₹30,000 cash outlay for a project with annual cash inflows of ₹6,000 would
have a payback period of 5 years (₹30,000 / ₹6,000).
The problem with the Payback Period is that it ignores the time value of money. In order to
correct this, we can use discounted cash flows in calculating the payback period. Referring
back to our example, if we discount the cash inflows at 15% required rate of return, we have:
Year Cash Flow (₹) PVF@15% PV (₹) Cumulative PV (₹)

1 6,000 0.870 5,220 5,220

2 6,000 0.756 4,536 9,756
3 6,000 0.658 3,948 13,704
4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114
The cumulative total of discounted cash flows after ten years is ₹30,114. Therefore, our
discounted payback is approximately 10 years as opposed to 5 years under simple payback.
Note: It should be noted that as the required rate of return increases, the distortion
between simple payback and discounted payback grows.
E. Modified Internal Rate of Return (MIRR)
✓ There are several limitations attached with the concept of the conventional Internal Rate
of Return (IRR).
✓ The MIRR addresses some of these deficiencies e.g., it eliminates multiple IRR rates; it
addresses the reinvestment rate issue and produces results which are consistent with the
Net Present Value method.
✓ This method is also called Terminal Value method.
✓ Under this method, all cash flows, apart from the initial investment, are brought to the
terminal value using an appropriate discount rate (usually the Cost of Capital). This results
in a single stream of cash inflow in the terminal year.
✓ The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal
cash inflow as mentioned above.
✓ The discount rate which equates the present value of the terminal cash inflow to the
zeroth year outflow is called the MIRR.

Page 53
| 50
✓ The decision rule of MIRR is same as IRR i.e. you accept an investment if MIRR is larger
than required rate of return and reject if it is lower than the required rate of return.

8. Some Issues in IRR

A. IRR and Mutually Exclusive Projects

✓ Projects are called mutually exclusive, when the selection of one precludes the selection
of others
✓ E.g., in case a company owns a piece of land which can be put to use either for project S
or L, such projects are mutually exclusive to each other i.e., the selection of one project
necessarily means the rejection of the other.
✓ Mutually exclusive projects can create problem with the IRR technique as IRR is
expressed in percentage and does not take into account the scale of investment or the
quantum of money earned.
✓ Let us understand this with the help of two numerical examples.
Example - 8
Cash flows
Year 0 Year 1 IRR NPV at 10%

Project A (₹1,00,000) ₹1,50,000 50% ₹36,360

Project B (₹5,00,000) ₹6,25,000 25% ₹68,180

o Project A earns a return of 50% which is more than what Project B earns; however, the
NPV of Project B is more than of Project A.
o Acceptance of Project A means rejection of Project B since the two Projects are mutually
exclusive.
o Acceptance of Project A also implies that the total investment will be ₹4,00,000 less had
the Project B been accepted, ₹4,00,000 being the difference between the initial
investment of the two projects.
o Assuming that the funds are freely available at 10%, the total capital expenditure of the
company should ideally be equal to sum total of all outflows provided they earn more than
10% return along with the chosen mutually exclusive project.
o Selection of Project A implies rejection of an opportunity to earn an additional amount of
₹31,820 (₹68,180 - ₹36,360) for the shareholders, thus reduction in the shareholders’ wealth.
o In the above example, the larger project had lower IRR, but maximizes the shareholders’
wealth.
o It is not safe to assume that a choice can be made between mutually exclusive projects

Page 54
| 51
 using IRR in cases where the larger project also happens to have the higher IRR. Refer
next example

Example – 9
Year Project A Project B

(₹) (₹)
0 (9,00,000) (8,00,000)
1 7,00,000 62,500
2 6,00,000 6,00,000
3 4,00,000 6,00,000
4 50,000 6,00,000

In this case, Project A has the larger investment and also has a higher IRR as shown below,
Year (₹) r= PV (₹) r= PV
46% (₹) 35% (₹)

0 (9,00,000) 1.0000 (9,00,000) (8,00,000) 1.0000 (8,00,000)

1 7,00,000 0.6849 4,79,430 62,500 0.7407 46,294
2 6,00,000 0.4691 2,81,460 6,00,000 0.5487 3,29,220
3 4,00,000 0.3213 1,28,520 6,00,000 0.4064 2,43,840
4 50,000 0.2201 11,005 6,00,000 0.3011 1,80,660
415 14
IRR of Project A = 46%
IRR of Project B = 35%

However, in case the relevant discounting factor is taken as 5%, the NPV of the two projects
provides a different picture as follows:
Year Project A (₹) Project B (₹)

(₹) r= 5% PV (₹) (₹) r= 5% PV (₹)

0 (9,00,000) 1.0 (9,00,000) (8,00,000) 1.0 (8,00,000)
1 7,00,000 0.9524 6,66,680 62,500 0.9524 59,525
2 6,00,000 0.9070 5,44,200 6,00,000 0.9070 5,44,200
3 4,00,000 0.8638 3,45,520 6,00,000 0.8638 5,18,280
4 50,000 0.8227 41,135 6,00,000 0.8227 4,93,620
NPV 6,97,535 8,15,625

Page 55
| 52
o It can be seen from the above, Project B should be the one to be selected even though its
IRR is lower than that of Project A.
o This decision shall need to be taken in spite of the fact that Project A has a larger
investment coupled with a higher IRR as compared with Project B.
o This type of anomalous situation arises due to reinvestment assumptions implicit in the two
evaluation methods of NPV and IRR.
o This issue is overcome by Modified Internal Rate of Return (MIRR).
Note on Reinvestment Assumption:
✓ The NPV technique assumes that all cash flows can be reinvested at the discount rate
used for calculating the NPV.
✓ This is a logical assumption since the use of the NPV technique implies that all projects
which provide a higher return than the discounting factor are accepted.
✓ In contrast, IRR technique assumes that all cash flows are reinvested at project’s IRR.
✓ This assumption means that projects with heavy cash flows in the early years will be
favoured by the IRR method vis-à-vis projects which have larger cash flows in the later
years.
✓ This implicit reinvestment assumption means that Projects like A, with cash flows
concentrated in the earlier years of life will be preferred by the method relative to
Projects such as B.
B. Multiple IRR
✓ In cases, where project cash flows change signs or reverse during the life of a project
e.g. an initial cash outflow is followed by cash inflows and subsequently followed by a major
cash outflow, there may be more than one IRR.
✓ The following graph of discount rate versus NPV may be used as an illustration:

✓ In such situations. if the cost of capital is less than the two IRR’s, a decision can be made
easily, however otherwise the IRR decision rule may turn out to be misleading as the
project should only be invested if the cost of capital is between IRR1 and IRR2.

Page 56
| 53
✓ This issue is overcome by Modified Internal Rate of Return (MIRR).

9. Conflict between NPV & IRR

There are circumstances/scenarios under which the net present value method and the internal
rate of return methods will reach different conclusions.
Let us discuss these scenarios:

Scenario 1 – Scale or Size Disparity

✓ IRR being a relative measure and NPV an absolute measure in case of disparity in scale or
size both may give contradicting ranking.
Scenario 2 – Time Disparity in Cash Flows
✓ It might be possible that overall cash flows may be more or less same in the projects but
there may be disparity in their flows i.e., larger part of cash inflows may be occurred in
the beginning or end of the project.
✓ In such situation there may be difference in the ranking of projects as per two methods.
Scenario 3 – Disparity in life of Proposals (Unequal Lives)
✓ Conflict in ranking may also arise if we are comparing two projects (especially mutually
exclusive) having unequal lives.

10. Special Cases

A. Capital Budgeting under Capital Rationing

✓ As discussed earlier, if project has positive NPV, it should be accepted with an objective
of maximisation of wealth of shareholders.
✓ However, there may be a situation due to resource (capital) constraints (rationing) a firm
may have to select some projects among various projects, all having positive NPVs.
✓ Broadly two scenarios may influence the method of evaluation to be adopted.
▪ Projects are independent of each other and are divisible in nature: In such situation,
NPV rule should be modified and accordingly projects should be ranked on the basis of
‘NPV per rupee of Capital’ method.
▪ Projects are not divisible: In such situation, projects shall be ranked on the basis of
absolute NPV and should be mixed up to the point available resources are exhausted.
B. Projects with unequal lives
Sometimes firm may be faced with problem arises in case projects have unequal lives. In such
situations we can deal with the problem by following any of the following method:
i. Replacement Chain Method
ii. Equivalent Annualized Criterion

Page 57
| 54
 11. Summary Of Decision Criteria Of Capital Budgeting Techniques
Techniques For Independent Project For Mutually
Exclusive Projects
Non- Pay Back i. When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period should
Payback period: be selected
Accepted
ii. When Payback period ≥
Maximum Acceptable
Payback period: Rejected
Accounting i. When ARR≥ Minimum Project with the
Rate of Acceptable Rate of maximum ARR should
Return Return: Accepted be selected.
(ARR) ii. When ARR ≤ Minimum
Acceptable Rate of
Return: Rejected
Discounted Net Present i. When NPV> 0: Accepted Project with the
Value (NPV) ii. When NPV< 0: Rejected highest positive NPV
should be selected
Profitability i. When PI > 1: Accepted When Net Present
Index (PI) ii. When PI < 1: Rejected Value is same project
with Highest PI
should be selected
Internal i. When IRR >K: Accepted Project with the
Rate of ii. When IRR <K: Rejected maximum IRR should
Return (IRR) beselected

Page 58
| 55
 12. Core Theory Areas
PURPOSE OF CAPITAL BUDGETING
Reason Explanation
Substantial Capital budgeting requires significant investment for long-term objectives
Investment and survival. It involves choosing sources of finance based on the size of
the capital and timing of cash flows. A thorough study and planning is
necessary due to large investments and associated costs.
Long Capital budgeting decisions affect the future benefits and costs of the
Time firm over a long period. These decisions also influence the growth rate and
Period direction of the firm.
Irreversibility Most investment decisions are irreversible. Once made, they are difficult
to reverse due to upfront payments, contractual obligations, or
technological limitations.
Complex The decision-making process involves assessing future events, which are
Decisions hard to predict. It is challenging to estimate all the benefits and costs of
an investment decision in quantitative terms.

CAPITAL BUDGETING PROCESS

Phase Explanation
Planning The process starts with identifying investment opportunities. The
potential impact on the firm's fortunes and the management's
ability to exploit it are assessed. Poor opportunities are rejected,
and promising ones are moved to the evaluation phase.
Evaluation In this phase, proposals are assessed for investments, inflows, and
outflows. Various investment appraisal techniques like payback
method, accounting rate of return, and discounted cash flow are
used. The chosen technique should help the manager make the best
decision based on circumstances.
Selection The firm chooses the project that maximizes shareholders'
wealth, considering the returns, risks, and cost of capital for each
project.
Implementation Once a project is selected, the firm must acquire funds, purchase
necessary assets, and begin implementation of the project.

Page 59
| 56
Control The project’s progress is monitored using feedback reports,
including capital expenditure progress, performance comparisons,
and post-completion audits.
Review After project completion, or even before, the firm reviews the
project to understand its success or failure. This phase may
influence future planning and evaluation processes and generate
ideas for new proposals.

Planning Evaluation Selection Implementation Control Review

Advantages of Payback period

Advantage Explanation
Easy to The payback period is simple to calculate, making it easy for managers to use.
Compute
Easy to It provides a quick estimate of how long it will take to recoup the invested
Understand cash, making it easily understandable.
Estimate of The length of the payback period can indicate a project’s risk. Longer payback
Risk periods are riskier due to the uncertainty of long-term predictions. In
industries with high obsolescence risk or where cash is limited, shorter
payback periods are often preferred.

Advantages of Payback period

Advantage Explanation
Easy to The payback period is simple to calculate, making it easy for managers to use.
Compute
Easy to It provides a quick estimate of how long it will take to recoup the invested
Understand cash, making it easily understandable.
Estimate of The length of the payback period can indicate a project’s risk. Longer payback
Risk periods are riskier due to the uncertainty of long-term predictions. In
industries with high obsolescence risk or where cash is limited, shorter
payback periods are often preferred.

Page 60
| 57
 Limitations of Payback period
Limitation Explanation
Ignores Time The payback period ignores the time value of money. Two projects with
Value of Money the same payback period are treated as equal, even if one project
generates most of its cash inflows early, and the other generates them
later.
Ignores Total The technique only considers cash inflows up to the point when the initial
Profitability investment is fully recovered and ignores cash flows after the payback
period, failing to assess the total profitability of the investment.
Focuses on Short The payback method emphasizes short payback periods, often ignoring
Payback Periods the value of long-term projects.

Advantages of ARR
Advantage Explanation
Uses Readily The ARR method uses data that is already available from financial
Available Data reports and does not require special procedures to generate the data.
Consistency in This method aligns with the approach used to assess operating results
Evaluation and management performance, ensuring consistency in decision-making
and performance evaluation.
Considers Entire The ARR method takes into account all net incomes over the entire
Project Profitability life of the project, offering a comprehensive measure of the project’s
profitability.

Limitations of ARR
Limitation Explanation
Ignores Time Like the payback period, the ARR method ignores the time value of
Value of Money money and treats all cash flows as equal in value.
Depends on The method relies on accounting numbers, which are influenced by the
Accounting organization's choice of accounting procedures (e.g., depreciation
Procedures methods). Different procedures can lead to varying net income and book
values.
Ignores Cash ARR focuses on net income, but it ignores cash flows, which are a better
Flows measure of an investment’s actual performance.

Page 61
| 58
Excludes Working The method considers only the book value of the asset and overlooks
Capital and other necessary investments, like working capital and other outlays, that
Outlays are crucial for the project's success.

Advantages of NPV
Advantage Explanation
Considers Time Value The NPV method accounts for the time value of money, making
of Money future cash flows more accurately reflect their current value.
Considers Entire Cash The method evaluates the entire stream of cash flows, providing a
Flow Stream comprehensive view of the investment's financial impact.
Aligns with NPV shows the addition to shareholders' wealth, aligning with the
Shareholders' Wealth basic financial objectives of increasing value.
Enables Independent NPV uses discounted cash flows, allowing for comparisons of
Project Evaluation different projects in terms of current value (rupees), enabling
independent evaluation of each project.

Limitations of NPV
Limitation Explanation
Difficult Calculations NPV involves complex calculations, which may be difficult for some to
perform accurately.
Depends on Accurate The accuracy of NPV relies on forecasting cash flows and the
Forecasting discount rate, which can be challenging to estimate correctly in
practice.
Ignores Differences NPV is based on an absolute measure, so it doesn't account for
in Projects differences in initial outflows or the size of mutually exclusive
projects.

Advantages of PI
Advantage Explanation
Considers Time Value The PI method also takes into account the time value of money, making
of Money future cash flows more accurately valued.
Relative Measure of PI is a relative measure of a project's profitability, as it compares
Profitability the present value of cash inflows to the present value of cash
outflows.

Page 62
| 59
 Limitations of PI
Limitation Explanation
Fails in Capital The Profitability Index (PI) method is not effective when capital
Rationing rationing is involved, especially with indivisible projects.
Excludes Smaller After selecting a large project with a high NPV, it may exclude the
Projects possibility of taking several smaller projects that could have a higher
total NPV.
Ignores Future A project with a lower PI might generate cash flows in such a way
Opportunities that another project can be undertaken later, resulting in a higher
total NPV than a higher PI project.
Requires PI cannot be used in isolation; all alternative project options must be
Comprehensive carefully considered to ensure the best choice.
Evaluation

Page 63
| 60
 CHAPTER 6: DIVIDEND DECISIONS

1. Introduction

✓ In this chapter, we will discuss the "Dividend decision" which is one of the most important
areas of Financial Management decisions.
✓ Dividend is that part of Profit After Tax (PAT) which is distributed to the shareholders
of the company. Further, the profit earned by a company after paying taxes can be used
for:
▪ Distribution of dividend, or
▪ Retaining as surplus for future growth

Profit After Tax

Distributed Retained

Dividend Retained Earnings

✓ In this chapter, we will determine the optimum dividend paid by the company i.e., how much
dividend should be paid, and how much should be retained for investment purposes.
✓ Furthermore, there are few Dividend theories which put light on the complexities involved
in dividend decision.

Dividend Policies
(Theories)

Relevance theories Irrelevance theories

(Dividend Decisions will affect the (Dividend Decisions will not affect
market price of the company) the market price of the company)

1. Walter’s Model
2. Gordon’s Model MM Approach
3. Lintner's Model

Page64
| 36
 2. Important Concepts used in Dividend Decisions

The following are a few terms/concepts which will be used throughout this chapter.
A. Relationship Between Retained Earnings and Growth
✓ Growth (g) = b x r
Where,
g = Growth rate of the firm
b = Retention ratio
r = Rate of return on investment
B. Relationship Between Dividend Payout Ratio & Retention Ratio
(E - D)
✓ Retention Ratio (b) = × 100
E
D
✓ Dividend Payout Ratio (1-b) = × 100
E
✓ Dividend Payout Ratio + Retention Ration = 100%
Where,
E = Earnings Per Share
D = Dividend Per Share
C. Other Formulas
Market Price per Share
✓ PE Ratio =
Earnings Per Share
EFE
✓ Return on Equity (ROE) = x 100
Equity SH Funds
Equity SH Funds
✓ Book Value per Share (BVPS) =
No. of Equity Shares
✓ EPS = BVPS x ROE

3. Walter’s Model

A. Assumptions of Walter’s Model

✓ EPS and DPS remain constant.
✓ ‘r’ rate of return & ‘Ke’ cost of capital are constant.
✓ The firm has perpetual life
✓ Perfect capital markets: The firm operates in a market in which all investors
are rational and information is freely available to all.
✓ Assume no taxes
✓ No floatation or transaction cost

Page65
| 37
 B. Walter’s Formula
D r (E - D)
Po = +
Ke Ke
2

Where,
Po = Price of share today
D = Dividend per share
E = Earnings per share
Ke = Cost of equity/Expected return/Capitalization rate/Discount rate
r = Return on Investment/Return on Equity/IRR
(E - D) = Retained earnings per share
C. Optimum Dividend Payout as per Walter’s Model
✓ Under Walter’s model dividend Decisions are taken by comparing Ke (Investors
expectation) with r (Return on Investment by company) which is summarised below:
Company Condition of Correlation between Size of Optimum payout
‘r' vs ‘Ke’ Dividend and Market Price of dividend ratio
share
Growth r > Ke Negative 0%
Constant r = Ke No correlation Every payout ratio
is optimum
Decline r < Ke Positive 100%

4. Gordon’s Model

A. Assumptions of Gordon’s Model

✓ Growth rate (g = b x r) is constant
✓ Ke will remain constant
✓ Ke > g,
✓ Retention ratio (b) will remain constant
✓ ‘r’ will remain constant
✓ Firm is an all-equity firm i.e., no debt.
✓ All investment proposals of the firm are to be financed through retained earnings only.

Page66
| 38
 B. Gordon’s Formula
D1
Po = [ ]
Ke - g
Or
D0 ( 1 + g)
Po = [ ]
Ke - g
Or
E1 ( 1 - b)
Po =
Ke - br
Where,
P0 = Price per share
Do = Current year dividend
D1 = Expected Dividend per share
E1 = Earnings per share
b = Retention ratio;
(1 – b) = Payout ratio
Ke = Cost of capital
r = IRR
br = Growth rate (g)
D1 = D0(1 + g)
C. Optimum Dividend Payout as per Gordon’s Model
✓ Following is the conclusion of Dividend Decision under Gordon’s model
Company Condition of r vs Ke Optimum dividend payout ratio
Growth r > Ke 0%
Constant r = Ke There is no optimum ratio
Declining r < Ke 100%

Doubt Busters:
1. Both Walter’s Model and Gordon’s model prescribe the same Optimum Dividend Payout
Criteria.
2. Confusion regarding D1 and D0.
▪ If the words ‘Dividend Expected’ is given, consider it as D1.
▪ If the words ‘Dividend Paid’ is given, consider it as D0.
▪ If the question is silent, you can assume the given figure either as D1 or D0 upon writing
a note.

Page67
| 39
 5. Lintner’s Model

✓ Lintner’s model has two parameters:

i. The target payout ratio,
ii. The spread at which current dividends adjust to the target.
✓ Under this model, D1 i.e. Dividend to be paid is computed
✓ In this model, the current year’s dividend is dependent on current year’s earnings and last
year’s dividend and a fall in Dividend indicates a wrong signal

✓ Formula:
D₁ = Dₒ + [(EPS × Target payout) - Dₒ] × Af
Where,
D₁ = Dividend in year 1
Dₒ = Dividend in year 0 (last year dividend)
EPS = Earnings per share
Af = Adjustment factor or Speed of adjustment

6. Modigliani and Miller (MM) Approach

✓ Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961.
✓ MM approach is in support of the irrelevance of dividends i.e., firm’s dividend policy has
no effect on either the price of a firm’s stock or its cost of capital.
✓ According to MM Hypothesis
▪ Market value of equity shares of a firm depends solely on its earning power and is not
influenced by the manner in which its earnings are split between dividends and retained
earnings.
▪ Market value of equity shares is not affected by dividend size.
▪ Under MM hypothesis there is no meaningful distinction between dividend and share
repurchases. They both are ways for a company to return cash to shareholders.
A. Assumptions under MM Approach
✓ Perfect capital markets exist and investors are rational
✓ No taxes
✓ All investments should be financed through equity only
✓ No floatation or transaction cost
✓ Investors are able to forecast future prices and dividend with certainty
B. Formulas under MM Approach
✓ The value of firm will remain unchanged due to dividend decision. This can be computed
with the help of the following formula:

Page68
| 40
 (n + ∆n)P1 + E - I
Vf (or) nPo = 1
(1 + Ke )

Where:
Vf = Value of the firm in the beginning of the period
n = No. of shares at the beginning of the period
n = No. of shares issued to raise the required funds
✓ Here, market price of shares can be calculated as follows:
P1 + D1
P0 =
1 + Ke
Where,
P0 = Price in the beginning of the period
P₁ = Price at the end of the period
D₁ = Dividend at the end of the period
Ke = Cost of equity/ rate of capitalization/ discount rate

7. Dividend Discount Model (DDM)

✓ It is a financial model that values shares at the discounted value of the future dividend
payments.
✓ Under this model, the price of a share that will be traded is calculated by the PV of all
expected future dividend payment discounted by an appropriate risk- adjusted rate.
✓ The dividend discount model price is the intrinsic value of the stock i.e.
Intrinsic value = Sum of PV of Dividends + PV of Stock Sale Price
D1 D2 Dn RVn
Stock Intrinsic Value = 1
+ 2
+ ............ + n + n
(1 + Ke ) (1 + Ke ) (1 + Ke ) (1 + Ke )
✓ There can three possible situations:

Zero Growth

Dividend Discount Model Constant Growth

Variable Growth

Page69
| 41
 A. Zero Growth Rate
✓ This model assumes that dividend remains constant.
✓ In this case the stock price would be equal to:
Annual dividend
Stock's intrinsic Value =
Required rate of return
D
i.e. P0 =
Ke
Where,
D = Annual dividend
Ke = Cost of capital
P0 = Current Market price of share
B. Constant Growth Rate Model
✓ This is exactly the same as Gordon’s Model
C. Variable Growth Rate Model
✓ When more than one growth rate is applicable, this model is used
✓ Formula (Assuming growth rate becomes constant after 4 years)
D1 D2 D3 D4 D5 1
P0 = + + + +[ x ]
(1 + Ke )
1
(1 + Ke )
2
(1 + Ke )
3
(1 + Ke )
4 (Ke - g) (1 + K )4
e

8. Graham & Dodd Model:

✓ According to this model, the stock market places considerable weight on dividends than
retained earnings
✓ Formula:
E
P = m (D + )
3
Where:
P = Market Price
D = Dividend per share
E = Earnings per share
m = Multiplier

Page70
| 42
 9. Core Theory Topics

FORMS OF DIVIDEND
Form of Explanation
Dividend
Cash Dividend The most common form of dividend, paid in the form of cash, cheque,
warrant, demand draft, pay order, or through Electronic Clearing Service
(ECS). It does not include dividends in kind.
Share In a share repurchase, the company buys back its own shares using
Repurchases corporate cash. The bought-back shares can be:
a. Treasury Shares: Kept for future re-issuance.
b. Cancelled Shares: Retired from share capital. Both cash dividend and
share repurchases have the same effect on shareholder wealth,
assuming tax considerations are the same.
Stock Dividend Bonus shares are issued in lieu of a cash dividend. These shares are
(Bonus Shares) distributed to existing shareholders proportionately, retaining their
ownership percentage. The total net worth remains unaffected since
retained earnings are capitalized. Example: 10% dividend on 100 shares
means 10 extra shares.

Advantages of Stock Dividend

Advantage Explanation
To Shareholders
No Tax on Stock No tax is payable by shareholders on stock dividend as it is
Dividend considered a capital asset under the Income Tax Act, 1961.
Increase in Future A fixed dividend per share continues after the stock dividend,
Cash Dividends which increases total cash dividend for shareholders in the future.
Improved Liquidity Bonus shares break down higher-priced shares into lower-priced
shares, giving shareholders the option to sell some of these and gain
liquidity.
To Company
Cash Conservation Stock dividends help conserve cash, which can be used for
profitable investment opportunities.
Suitable for Cash Ideal in situations where there is a cash deficiency or when lenders
Deficiency have imposed restrictions on paying cash dividends.

Page 71
| 43
 Limitations of Stock Dividend
Limitation Explanation
To ➢ No impact on wealth: Stock dividends do not increase shareholder wealth
Shareholders since they only capitalize past earnings.
➢ No extra benefit: Shareholders own the same proportion of the company
as before, just with more shares.
➢ Purely psychological effect: It creates a positive impression as a sign of
company growth but has no real financial gain.
To Company ➢ Higher administrative costs: Stock dividends are costlier to manage than
cash dividends.
➢ Disadvantage of frequent stock dividends: Regular small stock dividends
may lead to dilution of earnings over time.

Significance Of Dividend Policy

Aspect Explanation
Long-Term ➢ Equity Financing: A company can raise equity externally (new share
Financing Decision issuance) or internally (retained earnings). Retained earnings are
preferred as they avoid flotation costs.
➢ Retain or Distribute Profits?: The decision to retain earnings or pay
dividends impacts the firm’s financing options.
➢ Key Considerations:
1. Does the company have profitable investment opportunities?
2. Will the return on investment (ROI) exceed shareholders’
expected return (Ke)?
Wealth ➢ Dividend Payout vs. Market Price: The Dividend Payout Ratio (D/P)
Maximization affects the Market Price of Shares (MPS).
Decision ➢ Market Perception: Investors often prefer immediate dividends over
future capital gains due to market uncertainties.
➢ Retained Earnings & Shareholder Returns:
1. Higher Retained Earnings
Lower dividends, but potential future growth and higher earnings
per share (EPS).
2. Higher Dividends
Immediate shareholder benefit, but may limit investment
opportunities, affecting future earnings.
➢ Optimal Dividend Policy: The company should balance dividends and
retained earnings to maximize shareholder wealth, considering
investment opportunities and shareholder preferences.

Page72
| 44
 Determinants Of Dividend Decisions
Factor Explanation
Availability of If the company needs funds, it may prefer retaining earnings to save
Funds floatation costs and avoid dilution of control from issuing new equity.
Cost of Capital ➢ If financing is through debt (cheaper source), higher dividends can
be distributed.
➢ If financing requires issuing new equity, it's better to retain earnings
instead.
Capital Structure A company must maintain an optimal Debt-Equity ratio while deciding on
dividend payments.
Stock Price Generally, higher dividends increase the market price of shares, while
lower dividends may decrease it.
Investment If the company has profitable investment opportunities, it may retain
Opportunities more earnings instead of paying dividends.
Industry Trends Some industries are known for regular dividends. Companies in such
industries must pay dividends to maintain investor confidence and
market stability.
Shareholder Shareholders can be
Expectations i. Income-seeking investors (who prefer regular dividends) or
ii. Growth-oriented investors (who prefer retained earnings for
growth).
Legal Constraints As per Section 123 of the Companies Act, 2013, dividends can be
declared only from:
1. Current year's profits (after depreciation).
2. Undistributed profits from previous years (after depreciation).
3. Both current & past profits.
4. Government-provided funds (if applicable). Unrealized gains or
revaluation profits cannot be considered for dividend payments.
Taxation ➢ Before April 1, 2020: Companies paid Dividend Distribution Tax
(DDT), and dividends were tax-free for shareholders under Section
10(34).
➢ After April 1, 2020: DDT was removed, and dividends are now taxable
in the hands of investors as ‘Other Income’ at their applicable tax
rate.

Page73
| 45
 Practical Considerations in Dividend Policy
Consideration Explanation
Stable vs. Independent A company must decide whether to follow a stable dividend
Dividend Decision pattern or treat each dividend decision independently based on
financial conditions.
Financial Needs of a ➢ Retained earnings serve as a funding source for profitable
Company investments.
➢ If ROI (Return on Investment) > Required Return (Ke),
reinvesting earnings benefits shareholders.
➢ Issuing new shares involves floatation costs and potential
dilution of control.
Comparison Between Growth Companies And Mature Companies

Aspect Mature Companies Growth Companies

Dividend High payout ratios due to limited Low payout ratios as they need funds
Payout Ratio investment opportunities. for rapid expansion.
Impact on Sensitive to dividend changes Retain earnings & issue bonus shares
Share Prices investors expect stable instead of cash dividends to maintain
dividends. growth.
Earnings Retain a small portion for Gradually increase dividends as
Utilization emergency and occasional investment opportunities decline.
financial needs.
Constraints on Paying Dividends
Constraint Explanation
Legal Governed by Companies Act, 2013 (covered under "Determinants
of Dividend Decisions").
Liquidity ➢ Dividends require cash outflow.
➢ Mature companies: Have strong cash reserves and fewer
investment needs, making dividend payments easier.
➢ Growth-oriented companies: Even with high profits, they need
funds for expansion and working capital, so they are less likely
to declare dividends.
Access to Capital Market ➢ Large dividend payouts reduce cash reserves.
➢ If new shares must be issued to raise funds, existing
shareholders may face dilution of control.
➢ To avoid dilution, companies may withhold dividends and
reinvest earnings instead.

Page74
| 46
Investment ➢ If profitable investment opportunities are lacking, it is better
Opportunities to pay dividends.
➢ If needed, external funds can be raised for future investment
opportunities.

Payout Policies in Dividend Decisions

Policy Explanation
Constant ➢ Fixed dividend amount, regardless of actual earnings.
Dividend ➢ May increase or decrease over time, but generally remains stable for a
Policy considerable period.
➢ Requires a Dividend Equalization Reserve Fund to ensure dividends are paid
even in low-profit years.
➢ Treats common shareholders like preference shareholders, offering a
predictable income.
➢ Preferred by investors who depend on dividend income (e.g., retirees,
institutions).
➢ Dividends fluctuate in the short term with earnings but aim for long-term
stability.

Stable ➢ Dividend payout ratio = Fixed percentage of net earnings each year.
Dividend ➢ Example: Infosys (2011) followed a 30% payout ratio on Consolidated Profit
Policy after Tax (PAT).
➢ Warren Buffett’s View: Either large dividends or none—companies should
only pay dividends if reinvestment is not profitable.
➢ Example: If a company adopts a 40% payout ratio:
➢ Earnings per share = ₹2 → Dividend = ₹0.80 - Earnings per share = ₹1.50 →
Dividend = ₹0.60
➢ No dividend is paid in case of losses.
➢ Retained earnings adjust automatically based on earnings growth or decline.
➢ Provides a conservative approach that prevents overpayment or
underpayment.

Page75
| 47
 ➢ Used by companies that base dividends on long-term sustainable earnings
and increase dividends when earnings rise consistently.

Advantages of MM Hypothesis
a. This model is logically consistent.
b. It provides a satisfactory framework on dividend policy with the concept of Arbitrage
process.
Limitations of MM Hypothesis
a. Validity of various assumptions is questionable.
b. This model may not be valid under uncertainty.
Advantages of Walter’s Model
1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers
internal rate of return, market capitalisation rate and dividend payout ratio in the
determination of market value of shares.
Limitations of Walter’s Model
1. The formula does not consider all the factors affecting dividend policy and share prices.
Moreover, determination of market capitalisation rate is difficult.
2. Further, the formula ignores such factors as taxation, various legal and contractual
obligations, management policy and attitude towards dividend policy and so on.
Advantages of Gordon’s Model
1. The dividend discount model is a useful heuristic model that relates the present stock
price to the present value of its future cash flows.
2. This Model is easy to understand.
Limitations of Gordon’s Model
1. The dividend discount model depends on projections about company growth rate and
future capitalization rates of the remaining cash flows, which may be difficult to calculate
accurately.
2. The true intrinsic value of a stock is difficult to determine realistically
STOCK SPLITS
Meaning of Stock Split
Stock split means splitting one share into many, say, one share of ₹ 500 into 5 shares
of ₹ 100. Stock splits is a tool used by the companies to regulate the prices of shares
i.e. if a share price increases beyond a limit, it may become less tradable, for e.g.
suppose a company’s share price increases from ₹ 50 to ₹ 1000 over the years, it is
possible that it might goes out of range of many investors.

Page76
| 48
 Advantages of Stock Splits
1. It makes the share affordable to small investors.
2. Number of shares may increase the number of shareholders; hence the potential of
investment may increase.
Limitations of Stock Splits
1. Additional expenditure needs to be incurred on the process of stock split.
2. Low share price may attract speculators or short- t e r m investors, which aregenerally
not preferred by any company.
SHARE BUYBACK
Meaning of Share Buyback
Share buyback, in simple terms, means buying/repurchasing own shares by the company
resulting into decrease in share capital of the company. Thus, the shares bought back are
cancelled leading reduction in outstanding number of shares.
Share buyback is also a form of shareholders’ dividend. As the number of circulating shares
in the market fall, amount of dividend per share in the future increases.
There are two main types of buyback that can be performed by the companies. Oneis through
an open market, and another is through tender offer. While company intending to buyback
through open market, it need to go through secondary market. However, in case of tender
offer, company offers a fixed price where all the shareholders can participate or sell their
shares.

Page77
| 49
 CHAPTER 7: RATIO ANALYSIS
1. Introduction

✓ The basis for financial analysis, planning and decision making is financial statements which
mainly consist of Balance Sheet and Profit and Loss Account.
✓ The profit & loss account shows the operating activities of the concern over a period of time and
the balance sheet depicts the financial position of an organization at a particular point of time.
✓ However, the above statements do not disclose all of the necessary and relevant information.
✓ For the purpose of obtaining the material and relevant information necessary for ascertaining
the financial strengths and weaknesses of an enterprise, it is necessary to analyse the data
depicted in the financial statement.
✓ The financial manager has certain analytical tools which help in financial analysis and planning.
One of the main tools is Ratio Analysis
✓ A ratio means financial ratio or accounting ratio which is a mathematical expression of the
relationship between two accounting figures.

2. Important Terms/Concepts used in Ratio Analysis

The following are a few terms/concepts which will be used throughout this chapter.
A. Trading Account
✓ Format of Trading A/c
Sales / Revenue XXX
(-) COGS (XXX)
Gross Profit XXX
✓ Note:
COGS = Opening stock + Purchases - Closing stock + Direct Expenses.
B. Profit & Loss A/C
✓ Format of P&L A/c
Particulars Amount
(₹)
Gross Profit XXX
Less: Operating Expenses (e.g. Salary/Rent/Maintenance/AOH/POH/SOH) (XXX)
Less: Non-Operating Expenses (e.g. Interest) (XXX)
Add: Non-Operating Income (e.g. Rent / Interest Received) XXX
Net Profit before Tax XXX
Less: Tax (XXX)
Profit after Tax XXX
Less: Preference Dividend (XXX)
Earnings for Equity SHs XXX

Page 78
| 36
 Less: Equity Dividend (XXX)
Retained Earnings XXX
C. Balance Sheet
✓ Liabilities Side:
Equity Share Capital XXX
Reserves & Surplus XXX
Less: Accumulated Losses (XXX)
Less: Miscellaneous Expenses (XXX)
(a) Equity Shareholders Funds XXX
(b) Preference Share Capital XXX
(c) Net Worth/Equity/Proprietor’s/SH’s Funds XXX
(d) Debentures / Bonds / LTL XXX
(e) Current Liabilities XXX
Total Liabilities XXX
✓ Note:
Total Debt = (d) + (e)
Total Capital Employed = (c) + (d)
✓ Assets Side:
Net Fixed Asset (Including Tangible / Intangible) XXX
Add: Investments XXX
(a) Fixed Assets / Non-Current Assets XXX
(b) Current Assets XXX
Total Assets (a + b) XXX
✓ Note:
Net Fixed Assets = Fixed Assets - Accumulated Depreciation

3. Types of Ratios

The following are the different types of Ratios:

Liquidity Ratios/Short -term

solvency Ratios
Capital structure Rtios
Leverage Ratios/Long-term
solvencyRatios
Coverage Ratios
Types of
Ratios Activbity Ratios / Efficiency
Related to sales
Ratios / Performance Ratios /
Turnover Ratios
Related to overall Return on
Investment (Assets/Capital
Profitability Ratios Employed/Equity)

Required for analysis from Owner,s

point of view

Related to Market

Page 79
| 37
 4. Liquidity Ratios

✓ Liquidity or short-term solvency means ability of the business to pay its short- term liabilities.
✓ Inability to pay-off short-term liabilities affects its credibility as well as its credit rating.
✓ Continuous default on the part of the business leads to commercial bankruptcy. Eventually such
commercial bankruptcy may lead to its sickness and dissolution.
✓ Short-term lenders and creditors of a business are very much interested to know its state of
liquidity because of their financial stake.
✓ Both lack of sufficient liquidity and excess liquidity is bad for the organization.
✓ Various Liquidity Ratio are as follows:
(a) Current Ratio
(b) Quick Ratio or Acid test Ratio
(c) Cash Ratio or Absolute Liquidity Ratio
(d) Basic Defense Interval or Interval Measure Ratio
(e) Net Working Capital
A. Current Ratio
✓ A generally acceptable current ratio is 2:1. But whether or not a specific ratio is satisfactory
depends on the nature of the business and the characteristics of its current assets and
liabilities.
✓ Current Ratio is calculated as follows:
Current Assets
Current Ratio =
Current Liabilities
Where,
Current Asset = Inventories + Sundry Debtors + Cash and Bank Balances +

Receivables/ Accruals + Loans and Advances + Disposable

Investments + Any other current assets.

Current = Creditors for goods and services + Short-term Loans + Bank

Liabilities Overdraft + Cash Credit + Outstanding Expenses + Provision for

Taxation + Proposed Dividend + Unclaimed Dividend + Any other

current liabilities.

B. Quick Ratio
✓ The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of
liquidity.
✓ An acid-test of 1:1 is considered satisfactory unless the majority of "quick assets" are in
accounts receivable, and the pattern of accounts receivable collection lags behind the schedule
for paying current liabilities.

Page 80
| 38
✓ The Quick Ratio is a much more conservative measure of short-term liquidity than the Current
Ratio.
✓ It helps answer the question: "If all sales revenues should disappear, could my business meet
its current obligations with the readily convertible quick funds on hand?"
✓ Quick Ratio is calculated as follows:
Quick Assets
Quick Ratio or Acid Test Ratio =
Current Liabilities
Where,
Quick Assets = Current Assets - Inventories - Prepaid expenses
Current Liabilities = As mentioned under Current Ratio.

C. Cash Ratio/ Absolute Liquidity Ratio

✓ The cash ratio measures the absolute liquidity of the business. This ratio considers only the
absolute liquidity available with the firm.
✓ The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable
securities/ current investments. This ratio is calculated as:
Cash and Bank balances + Marketable Securities
Cash Ratio =
Current Liabilities
Or
Cash and Bank balances + Current Investments
Cash Ratio =
Current Liabilities

D. Basic Defense Interval/ Interval Measure

✓ If for some reason all the company’s revenues were to suddenly cease, the Basic Defense
Interval would help determine the number of days for which the company can cover its cash
expenses without the aid of additional financing.
✓ It is calculated as follows:
Cash and Bank balances + Net Receivables + Marketable Securities
=
Daily Operating Expenses
Or
Current Assets – Prepaid expenses – Inventories
=
Daily Operating Expenses
Where,
COGS + Selling Admin & General Exp - Depn & Non Cash Exp
Daily Operating Expenses=
No. of Days in a year
E. Net Working Capital
✓ Net working capital is more a measure of cash flow than a ratio.
✓ Bankers look at Net Working Capital over time to determine a company's ability to weather
financial crises.
✓ Loans are often tied to minimum working capital requirements.

Page 81
| 39
✓ It is calculated as follows:
Net Working Capital = Current Assets - Current Liabilities (Excl. ST bank borrowing)

5. Long-term Solvency Ratios/ Leverage Ratios

✓ The leverage ratios may be defined as those financial ratios which measure the long-term
stability and capital structure of the firm.
✓ These ratios indicate the mix of funds provided by owners and lenders and assure the
lenders of the long- term funds with regard to:
i. Periodic payment of interest during the period of the loan and
ii. Repayment of principal amount on maturity.
✓ Leverage ratios are of two types:

Capital Structure Ratios

LT Solvency Ratios/Leverage Ratios
Coverage Ratios

✓ I. Capital Structure Ratios

(a) Equity Ratio
(b) Debt Ratio
(c) Debt to Equity Ratio
(d) Debt to Total Assets Ratio
(e) Capital Gearing Ratio
(f) Proprietary Ratio
✓ II. Coverage Ratios
(a) Debt-Service Coverage Ratio (DSCR)
(b) Interest Coverage Ratio
(c) Preference Dividend Coverage Ratio
(d) Fixed Charges Coverage Ratio
I. Capital Structure Ratios
✓ These ratios provide an insight into the financing techniques used by a business and focus, as
a consequence, on the long-term solvency position.
✓ From the balance sheet, one can get only the absolute fund employed and its sources but only
capital structure ratios show the relative weight of different sources.
✓ Various capital structure ratios are discussed below.
A. Equity Ratio
✓ This ratio indicates proportion of owner's fund to total fund invested in the business.

Page 82
| 40
✓ Traditionally, it is believed that higher the proportion of owner's fund, lower is the degree of
risk for potential lenders.
✓ Equity Ratio is calculated as follows:
Shareholder's Equity
Equity Ratio =
Net Assets
✓ Where,
Shareholder's Equity = Equity Share Capital + Reserves & Surplus (excluding fictitious assets
etc).
Net Assets or Capital employed = Net Fixed Assets and Net Current Assets (CA - CL).
B. Debt Ratio
✓ This ratio is used to analyse the long-term solvency of a firm. A ratio greater than 1 would
mean greater portion of company assets are funded by debt and could be a risky scenario.
✓ Debt Ratio is calculated as follows:
Total Debt
Debt Ratio =
Net Assets
✓ Where,
Total debt or total outside liabilities includes short- and long-term borrowings from financial
institutions, debentures/bonds, deferred payment arrangements for buying capital equipment,
bank borrowings, public deposits and any other interest-bearing loan.
C. Debt to Equity Ratio
✓ A high debt to equity ratio here means less protection for creditors, a low ratio, on the other
hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb
possible losses of income and capital).
✓ This ratio indicates the proportion of debt fund in relation to equity. This ratio is very often
used for making capital structure decisions such as issue of shares and/or debentures.
✓ Lenders are also very keen to know this ratio since it shows relative weights of debt and equity.
Debt equity ratio is the indicator of firm’s financial leverage.
✓ It is calculated as follows:
Total Debt*
Debt to Equity Ratio =
Shareholder's Equity
or
Long- term Debt **
=
Shareholders' equity
✓ Note:
*Not merely long-term debt i.e., both current & non-current liabilities.
** Sometimes only long-term debt is used instead of total liabilities (i.e excluding current
liabilities)

Page 83
| 41
 D. Debt to Total Assets Ratio
✓ This ratio measures the proportion of total assets financed with debt and, therefore, the
extent of financial leverage.
✓ Higher the ratio, indicates that assets are less backed up by equity and hence higher financial
leverage. It is calculated as follows:
Total Debt
Debt to Total Assets Ratio =
Total Assets

E. Capital Gearing Ratio

✓ In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to show the
proportion of fixed interest (dividend) bearing capital to funds belonging to equity
shareholders i.e. equity funds or net worth.
✓ Again, higher ratio may indicate more risk. It is calculated as follows:
Preference Share Capital + Debentures + Other Borrowed funds
Capital Gearing Ratio =
Equity Share Capital + Reserves & Surplus - Losses

F. Proprietary Ratio
✓ It indicates the proportion of total assets financed by shareholders. Higher the ratio, less
risky scenario it shall be.
✓ It is calculated as follows:
Proprietary Fund
Proprietary Ratio =
Total Assets

II. Coverage Ratios

✓ The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios
establish the relationship between fixed claims and what is normally available out of which
these claims are to be paid.
✓ The fixed claims consist of:
o Interest on loans
o Preference dividend
o Amortisation of principal or repayment of the instalment of loans or redemption of
preference capital on maturity.
✓ The following are important coverage ratios:
A. Debt Service Coverage Ratio (DSCR)
✓ Lenders are interested in debt service coverage to judge the firm’s ability to pay off current
interest and instalments. Normally DSCR of 1.5 to 2 is satisfactory
✓ It is calculated as follows:
Earnings available for Debt Services
Debt Service Coverage Ratio =
Interest + Installments

Page 84
| 42
 Where,
Calculation of Earnings available for Debt Services =
Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other
amortizations + Interest + other adjustments like loss on sale of Fixed Asset etc.

Note:
Fund from operations (or cash from operations) before interest and taxes also can be
considered as per the requirement.
B. Interest Coverage Ratio
✓ This ratio also known as “times interest earned ratio” indicates the firm’s ability to meet
interest (and other fixed charges) obligations.
✓ It measures how many times a company can cover its current interest payment with its available
earnings.
✓ A high interest coverage ratio means that an enterprise can easily meet its interest obligations
even if earnings before interest and taxes suffer a considerable decline.
✓ A lower ratio indicates excessive use of debt or inefficient operations.
✓ This ratio is computed as:
Earnings before Interest and Taxes(EBIT)
Interest Coverage Ratio =
Interest
C. Preference Dividend Coverage Ratio
✓ This ratio measures the ability of a firm to pay dividend on preference shares which carry a
stated rate of return.
✓ This ratio indicates margin of safety available to the preference shareholders. A higher ratio
is desirable from preference shareholders point of view.
✓ This ratio is computed as:
Net Profit/Earning after taxes (EAT)
Preference Dividend Coverage Ratio =
Preference dividend
✓ Similarly, Equity Dividend coverage ratio can also be calculated as:
Earning after taxes (EAT) - Preference dividend
Equity Dividend Coverage Ratio =
Equity dividend
D. Fixed Charges Coverage Ratio
✓ This ratio shows how many times the cash flow before interest and taxes covers all fixed
financing charges.
✓ This ratio of more than 1 is considered as safe and is calculated as follows:
EBIT + Depreciation
Fixed Charges Coverage Ratio =
Interest + Repayment of Loan
Doubt Busters:
1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes),
EAT (Earnings after taxes) = PAT (Profit after taxes)

Page 85
| 43
 EBT (Earnings before taxes) = PBT (Profit before taxes)
2. Ratios shall be calculated based on requirement and availability of information and may deviate
from original formulae. If required, assumptions should be given.
3. Numerator should be taken in correspondence with the denominator and vice-versa.

6. Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios

✓ These ratios are employed to evaluate the efficiency with which the firm manages and utilises
its assets. For this reason, they are often called as 'Asset management ratios’.
✓ These ratios usually indicate the frequency of sales with respect to its assets. These assets
may be capital assets or working capital or average inventory.
✓ These ratios are usually calculated with reference to sales/cost of goods sold and are
expressed in terms of rate or times.
✓ Various Turnover Ratios are as follows:
(a) Total Assets Turnover Ratio

(b) Fixed Assets Turnover Ratio

(c) Capital Turnover Ratio/ Net Assets Turnover Ratio

(d) Current Assets Turnover Ratio

(e) Working Capital Turnover Ratio

i. Inventory/ Stock Turnover Ratio

ii. Receivables (Debtors) Turnover Ratio

iii. Payables (Creditors) Turnover Ratio

A. Total Asset Turnover Ratio

✓ This ratio measures the efficiency with which the firm uses its total assets. Higher the ratio,
better it is.
✓ A high total assets turnover ratio indicates the efficient utilization of total assets in
generation of sales.
✓ Similarly, a low asset turnover ratio indicates total assets are not efficiently used to generate
sales.
✓ This ratio is computed as:
Sales/Cost of Goods Sold
Total Asset Turnover Ratio =
Total Assets

B. Fixed Assets Turnover Ratio

✓ It measures the efficiency with which the firm uses its fixed assets.
✓ A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating
sales.

Page 86
| 44
✓ A firm whose plant and machinery are old may show a higher fixed assets turnover ratio than
the firm which has purchased them recently.
✓ This ratio is computed as:
Sales/Cost of Goods Sold
Fixed Assets Turnover Ratio =
Fixed Assets

C. Capital Turnover Ratio/ Net Asset Turnover Ratio

✓ Since Net Assets equals to capital employed it is also known as Capital Turnover Ratio.
✓ This ratio indicates the firm’s ability of generating sales/ Cost of Goods Sold per rupee of
long-term investment.
✓ The higher the ratio, the more efficient is the utilisation of owner’s and long-term creditors’
funds.
✓ This ratio is computed as:
Sales/Cost of Goods Sold
Capital Turnover Ratio =
Net Assets
D. Current Assets Turnover Ratio
✓ It measures the efficiency of using the current assets by the firm
✓ The higher the ratio, the more efficient is the utilization of current assets in generating sales.
✓ This ratio is computed as:
Sales/Cost of Goods Sold
Current Assets Turnover Ratio =
Current Assets
E. Working Capital Turnover Ratio
✓ It measures how effective a company is at generating sales for every rupee of working capital
put to use.
✓ Higher the ratio, the more efficient is the utilisation of working capital in generating sales.
✓ However, a very high working capital turnover ratio indicates that the company needs to raise
additional working capital for future needs.
✓ This ratio is computed as:
Sales/Cost of Goods Sold
Working Capital Turnover Ratio =
Working Capital
✓ Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover,
and Creditors Turnover.
i. Inventory/ Stock Turnover Ratio
✓ This ratio also known as stock turnover ratio establishes the relationship between the cost of
goods sold during the year and average inventory held during the year.
✓ This ratio indicates that how fast inventory is used or sold.
✓ A high ratio is good from the view point of liquidity and vice versa.
✓ A low ratio would indicate that inventory is not used/ sold/ lost and stays in a shelf or in the
warehouse for a long time.

Page 87
| 45
✓ It measures the efficiency with which a firm utilizes or manages its inventory. It is calculated
as follows:
Cost of Goods Sold / Sales
Inventory Turnover Ratio =
Average Inventory
Where,
Average Inventory = (Op. Stock + Cl. Stock) / 2

✓ In the case of inventory of raw material, the inventory turnover ratio is calculated using the
following formula:
Raw Material Consumed
Raw Material Inventory Turnover Ratio =
Average Raw Material Stock

ii. Receivables (Debtors) Turnover Ratio

✓ The speed with which the receivables are collected affects the liquidity position of the firm.
✓ The debtor’s turnover ratio throws light on the collection and credit policies of the firm.
✓ It measures the efficiency with which management is managing its accounts receivables.
✓ A low debtors’ turnover ratio reflects liberal credit terms granted to customers, while a high
ratio shows that collections are made rapidly.
✓ It is calculated as follows:
Credit Sales
Receivables (Debtors) Turnover Ratio =
Average Accounts Receivable

Receivables (Debtors) Velocity/Average Collection Period:

✓ Debtor's turnover ratio indicates the average collection period. However, the average
collection period can be directly calculated as follows:
Average Accounts Receivables 12 months/52 weeks/360 days
= 𝒐𝒓
Average Daily Credit Sales Receivable Turnover Ratio
Where,
Average Daily Credit Sales = Credit Sales / No. of days in year
✓ The average collection period measures the average number of days it takes to collect an
account receivable. This ratio is also referred to as the number of days of receivable and the
number of day’s sales in receivables. In determining the credit policy, debtor’s turnover and
average collection period provide a unique guidance.
iii. Payables Turnover Ratio
✓ This ratio is calculated on the same lines as receivable turnover ratio is calculated.
✓ It measures how fast a company makes payment to its creditors. It shows the velocity of
payables payment by the firm.
✓ A low creditor’s turnover ratio reflects liberal credit terms granted by suppliers, while a high
ratio shows that accounts are settled rapidly.

Page 88
| 46
✓ It is calculated as follows:
Annual Net Credit Purchases
Payables Turnover Ratio =
Average Accounts Payables

Payable Velocity/ Average payment period

✓ The average payment period can be directly calculated as follows:

Average Accounts Payable 12months/52weeks/360days

= 𝒐𝒓
Average Daily Credit Purchases Payables Turnover Ratio

✓ The firm can compare what credit period it receives from the suppliers and what it offers to
the customers. Also, it can compare the average credit period offered to the customers in the
industry to which it belongs.
Doubt Busters:
1. Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and Cost of
Sales (COS). In its absence, COGS will be equal to Cost of Sales.
2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratios eliminating
profit part.
3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital also
can be taken in denominator while calculating the above ratios. In fact, when average figures
of total assets, net assets, capital employed, shareholders’ fund etc. are available it may be
preferred to calculate ratios by using this information.
4. Ratios shall be calculated based on requirement and availability of information and may deviate
from original formulae. If required, assumptions should be given.

7. Profitability Ratios

✓ The profitability ratios measure the profitability or the operational efficiency of the firm.
✓ These ratios reflect the final results of business operations. They are some of the most closely
watched and widely quoted ratios.
✓ Management attempts to maximize these ratios to maximize the firm’s value.
✓ The results of the firm can be evaluated in terms of its earnings with reference to a given
level of assets or sales or owner’s interest etc.
✓ Therefore, the profitability ratios are broadly classified in four categories:
I. Profitability Ratios based on Sales
a. Gross Profit Ratio
b. Net Profit Ratio
c. Operating Profit Ratio

Page 89
| 47
 d. Expenses Ratio
II. Profitability Ratios related to Overall Return on Assets/ Investments
a. Return on Investments (ROI)
i. Return on Assets (ROA)
ii. Return of Capital Employed (ROCE)
iii. Return on Equity (ROE)
III. Profitability Ratios required for Analysis from Owner’s Point of View
a. Earnings per Share (EPS)
b. Dividend per Share (DPS)
c. Dividend Pay-out Ratio (DP)
IV. Profitability Ratios related to Market/ Valuation/ Investors
a. Price Earnings (P/E) Ratio
b. Dividend and Earning Yield
c. Market Value/ Book Value per Share (MV/BV)
d. Q Ratio

I. Profitability Ratios based on Sales

A. Gross Profit (G.P) Ratio/ Gross Profit Margin
✓ It measures the percentage of each sale in rupees remaining after payment for the goods sold.
✓ Gross profit margin depends on the relationship between sales price, volume and costs.
✓ A high Gross Profit Margin is a favourable sign of good management.
Gross Profit
Gross Profit Ratio = × 𝟏𝟎𝟎
Sales
B. Net Profit Ratio/ Net Profit Margin
✓ It measures the relationship between net profit and sales of the business.
✓ Net Profit ratio finds the proportion of revenue that finds its way into profits after meeting
all expenses. A high net profit ratio indicates positive returns from the business.
✓ Depending on the concept of net profit, it can be calculated as:
Net Profit or Earnings after taxes (EAT)
× 𝟏𝟎𝟎
Sales
or
Earnings before taxes (EBT)
Pre-tax Profit Ratio = × 𝟏𝟎𝟎
Sales
C. Operating Profit Ratio
✓ Operating profit ratio is also calculated to evaluate operating performance of business.
✓ Operating profit ratio measures the percentage of each sale in rupees that remains after the
payment of all costs and expenses except for interest and taxes.
✓ This ratio is followed closely by analysts because it focuses on operating results.

Page 90
| 48
✓ Operating profit is often referred to as earnings before interest and taxes or EBIT.
✓ It can be calculated as:
Operating Profit or EBIT
Operating Profit Ratio = × 𝟏𝟎𝟎
Sales
Where,
Operating Profit = Sales – Cost of Goods Sold (COGS) – Operating Expenses

D. Expenses Ratio
✓ Based on different concepts of expenses it can be expresses in different variants as below:
COGS
i. Cost of Goods Sold (COGS) Ratio = ×100
Sales

Admin OHS+Selling OHS

ii. Operating Expenses Ratio = ×100
Sales

COGS + Operating expenses

iii. Operating Ratio = × 𝟏𝟎𝟎
Sales

Financial expenses *
iv. Financial Expenses Ratio = × 𝟏𝟎𝟎
Sales

*It excludes taxes, loss due to theft, goods destroyed by fire etc.

Note: Administration Expenses Ratio and Selling & Distribution Expenses Ratio can also be
calculated in similar ways.
II. Profitability Ratios related to Overall Return on Assets/ Investments

Return on Investment (ROI)

Return on Assets Return on Capital Return on Equity

(ROA) Employed (ROCE) (ROE)

Return on Total Assets Return on Net Assets

(ROTA) (RONA)

A. Return on Investment (ROI)

✓ ROI is the percentage of return on funds invested in the business by its owners.
✓ In short, this ratio tells the owner whether or not all the effort put into the business has been
worthwhile.

Page 91
| 49
✓ It compares earnings/ returns/ profit with the investment in the company. The ROI is
calculated as follows:
Return/Profit/Earnings
Return on Investment = × 𝟏𝟎𝟎
Investment

✓ The concept of investment varies and accordingly there are three broad categories of ROI i.e.
i. Return on Assets (ROA),
ii. Return on Capital Employed (ROCE) and
iii. Return on Equity (ROE).
i. Return on Assets (ROA)
✓ The profitability ratio is measured in terms of relationship between net profits and assets
employed to earn that profit.
✓ This ratio measures the profitability of the firm in terms of assets employed in the firm.
✓ Based on various concepts of net profit (return) and assets, the ROA may be measured as
follows:
Return
ROA = 𝐱 𝟏𝟎𝟎
Average Assets

Note - 1: Return could be “EBIT” or “EBIT(1-t)” or “EAT” or “EAT + Interest”

Note - 2: Average Assets could be "Average Total Assets” or "Average Tangible Assets" or
“Average Fixed Assets”. If Average figures are not available, Total figures can also be used.

ii. Return on Capital Employed (ROCE)

✓ It is another variation of ROI. ROCE should always be higher than the rate at which the
company borrows.
✓ The ROCE is calculated as follows:
Earnings before interest and taxes(EBIT)
ROCE (Pre-tax) = × 𝟏𝟎𝟎
Capital Employed

EBIT(1- t)
ROCE (Post-tax) = × 𝟏𝟎𝟎
Capital Employed

Sometimes, it is also calculated as:

Net Profit after taxes (EAT) + Interest
= × 𝟏𝟎𝟎
Capital Employed
Doubt Busters:
✓ Intangible assets (assets which have no physical existence like goodwill, patents and trade-
marks) should be included in the capital employed.

Page 92
| 50
✓ But no fictitious asset (such as deferred expenses) should be included within capital employed.
✓ If information is available, then average capital employed shall be taken.
iii. Return on Equity (ROE)
✓ Return on Equity measures the profitability of equity funds invested in the firm.
✓ This ratio reveals how profitably of the owners’ funds have been utilised by the firm.
✓ It also measures the percentage return generated to equity shareholders. This ratio is
computed as:
Net Profit after taxes - Preference dividend (if any)
ROE = × 𝟏𝟎𝟎
Net Worth/ Equity Shareholders'Funds

III. Profitability Ratios Required for Analysis from Owner’s Point of View
A. Earnings per Share (EPS)
✓ The profitability of a firm from the point of view of ordinary shareholders can be measured
in terms of earnings per share basis.
✓ It is calculated as follows:
Net profit available to equity shareholders
Earnings per Share (EPS) =
Number of equity shares outstanding

B. Dividend per Share (DPS)

✓ Earnings per share as stated above reflects the profitability of a firm per share; it does not
reflect how much profit is paid as dividend and how much is retained by the business.
✓ Dividend per share ratio indicates the amount of profit distributed to equity shareholders per
share.
✓ It is calculated as:
Total Dividend paid to equity shareholders
Dividend per Share (DPS) =
Number of equity shares outstanding

C. Dividend Pay-out Ratio (DP)

✓ This ratio measures the dividend paid in relation to net earnings.
✓ It is determined to see to how much extent earnings per share have been retained by the
management for the business. It is computed as:
Dividend per equity share (DPS)
Dividend pay-out Ratio =
Earning per Share (EPS)

IV. Profitability Ratios related to market/valuation/ Investors

✓ These ratios consider the market value of the company’s shares in calculation.
✓ Frequently, share prices data are punched with the accounting data to generate new set of
information.

Page 93
| 51
✓ These are (a) Price- Earnings Ratio, (b) Dividend Yield, (c) Market Value/ Book Value per share,
(d) Q Ratio.
A. Price- Earnings Ratio (P/E Ratio)
✓ The price earnings ratio indicates the expectation of equity investors about the earnings of
the firm.
✓ It indicates the payback period to the investors or prospective investors.
✓ A higher P/E ratio could either mean that a company’s stock is over-valued or the investors are
expecting high growth rates in future.
✓ It is calculated as follows:
Market Price per Share (MPS)
Price-Earnings per Share (P/E Ratio) =
Earning per Share (EPS)

B. Dividend and Earning Yield

✓ This ratio indicates return on investment; this may be on average investment or closing
investment.
✓ Dividend (%) indicates return on paid up value of shares. But yield (%) is the indicator of true
return in which share capital is taken at its market value.
✓ It is calculated as follows:
Dividend per Share (DPS)
= × 𝟏𝟎𝟎
Market Price per Share (MPS)

✓ Similarly, "Earnings Yield” or “Earnings Price Ratio" can be calculated as follows:

Earnings per Share (EPS)
Earnings Yield* or EP Ratio = × 𝟏𝟎𝟎
Market Price per Share (MPS)

C. Market Value/ Book Value per Share (MV/BV)

✓ It provides evaluation of how investors view the company’s past and future performance.
✓ This ratio indicates market response of the shareholders’ investment. Undoubtedly, higher the
ratio, better is the shareholders’ position in terms of return and capital gains.
✓ It is calculated as follows:
MPS
Market Value/ Book Value per Share (MV/BV) =
BVPS
Where,
MPS can be either Average Market Price or Closing Market Price
BVPS = Net worth ÷ No. of equity shares

Page 94
| 52
 D. ‘Q’ Ratio
✓ This ratio represents the relationship between market valuation and intrinsic value.
✓ Equilibrium is when Q Ratio = 1 because when it is less than 1, it could mean that the stock is
undervalued and when it is more than 1, it could mean that stock is overvalued.
✓ It is calculated as follows:
Market Value of a Company
Q Ratio=
Assets’ Replacement Cost
Doubt Busters:
1. In absence of preference dividend PAT can be taken as earnings available to equity
shareholders.
2. If information is available then average capital employed shall be taken while calculating
ROCE.
3. Ratios shall be calculated based on requirement and availability of information and may deviate
from original formulae. If required, assumptions should be given.
4. Numerator should be taken in correspondence with the denominator and vice-versa.
5. We should keep in mind that investment may be Total Assets or Net Assets. Further, funds
employed in net assets are also known as capital employed which is nothing but Net worth plus
Debt, where Net worth is equity shareholders’ fund. Similarly, the concept of returns/
earnings/ profits may vary as per the requirement and availability of information.

8. Return on Equity using the Du Pont Model

✓ A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the
DuPont system of financial analysis in 1919. That system is used around the world today and
serves as the basis of components that make up return on equity.
✓ There are various components in the calculation of return on equity using the traditional DuPont
model viz. the net profit margin, asset turnover, and the equity multiplier.
✓ By examining each input individually, the sources of a company's return on equity can be
discovered and compared to its competitors.
✓ The components are as follows:
1. Profitability/Net Profit Margin:
The net profit margin is simply the after-tax profit a company generates for each rupee
of revenue and is calculated as follows:
Net Income
Profitability/ Net Profit margin =
Sales
2. Asset Turnover:
The asset turnover ratio is a measure of how effectively a company converts its assets
into sales. It is calculated as follows:
Sales
Asset Turnover =
Assets

Page 95
| 53
 3. Equity Multiplier:
The equity multiplier, a measure of financial leverage, allows the investor to see what
portion of the return on equity is the result of debt. The equity multiplier is calculated
as follows:
Assets
Equity Multiplier =
Shareholders' Equity
✓ Calculation of Return on Equity using the DuPont model:
To calculate the return on equity using the DuPont model, simply multiply the three components
(Net Profit Margin x Asset Turnover x Equity Multiplier)

Net Income Sales Assets

ROE= x x
Sales Assets Shareholders' Equity
Extra Knowledge:
Students may note that now a company is also required to disclose the following ratios in the notes
to accounts while preparing Financial Statements:
a. Current Ratio,
b. Debt-Equity Ratio,
c. Debt Service Coverage Ratio,
d. Return on Equity Ratio,
e. Inventory turnover ratio,
f. Trade Receivables turnover ratio,
g. Trade payables turnover ratio,
h. Net capital turnover ratio,
i. Net profit ratio,
j. Return on Capital employed,
k. Return on investment.

Page 96
| 54
 9. Core Theory Topics

USERS AND OBJECTIVE OF FINANCIAL ANALYSIS - A BIRD'S EYE VIEW

Financial Statement analysis is useful to various shareholders to obtain the derived information
about the firm.
S.No. Users Objectives Ratios Used
1. Shareholders Interested in profitability and Profitability Ratios (e.g.,
growth of the organization. EPS, DPS, P/E, Dividend
Payout Ratio)
2. Investors Interested in the overall Profitability Ratios, Capital
financial health and future Structure Ratios, Solvency
perspective of the organization. Ratios, Turnover Ratios
3. Lenders Concerned about the safety of Coverage Ratios, Solvency
the money they lend to the Ratios, Turnover Ratios,
organization. Profitability Ratios
4. Creditors Interested in the liability Liquidity Ratios, Short-term
position, particularly for short- Solvency Ratios
term obligations.
5. Employees Interested in the overall Liquidity Ratios, Long-term
financial health of the Solvency Ratios, Profitability
organization, comparing it with Ratios, Return on
competitors. Investment
6. Regulator / Analyzes financial statements
Government for taxation and other payments Profitability Ratios
to the government.
7. Managers Interested in various financial
ratios for decision-making.
a. Production Focus on input-output data, Input-output Ratio, Raw
Managers production quantities, etc. Material Consumption Ratio
b. Sales Managers Focus on sales figures, both past Turnover Ratios (e.g.,
and future projections. Receivable Turnover Ratio),
Expense Ratios
c. Financial Interested in ratios to predict Profitability Ratios (e.g.,
Managers financial requirements. Return on Investment),
Turnover Ratios, Capital

Page 97
| 55
 Structure Ratios
d. CEO/General Concerned with the overall All Ratios
Manager perspective of the company,
including sales, finance,
inventory, HR, production.
8. Different Industry-specific analysis by
Industries financial managers.
a. Telecom Call Ratios, Revenue and
Expenses per Customer
b. Bank Loan to Deposit Ratios,
Operating Expenses and
Compare company ratios with Income Ratios
c. Hotel industry norms. Room Occupancy Ratio, Bed
Occupancy Ratios
d. Transport Passenger-Kilometre,
Operating Cost per
Passenger-Kilometre

APPLICATION OF RATIO ANALYSIS IN FINANCIAL DECISION MAKING

Aspect Explanation

Liquidity Position Liquidity ratios help assess if a firm can meet its short-term obligations.
Important for credit analysis by banks and short-term lenders.
Long-term Evaluates a firm’s long-term financial health using leverage (capital structure)

Solvency and profitability ratios. Indicates the firm’s ability to offer returns and
manage debt.
Operating Activity ratios measure how efficiently assets are managed and utilized. A

Efficiency firm’s solvency depends on its ability to generate sales revenue from its assets.

Overall Management is concerned with the firm’s ability to meet obligations, offer

Profitability returns to owners, and utilize assets effectively. Ratios are considered
collectively for this view.
Inter-firm Comparing a firm's ratios with industry averages or competitors helps identify

Comparison strengths and weaknesses. This comparison guides remedial measures and
future forecasting.
Financial Ratios Ratios help in budgeting by estimating future activities based on past data.

Page 98
| 56
for Budgeting They also help compare actual performance with budgeted figures and
highlight areas for adjustments.

LIMITATIONS OF FINANCIAL RATIOS

Limitation Explanation

Diversified Product Firms with multiple divisions in different industries may have aggregate

Lines data that doesn’t allow for meaningful inter-firm comparisons.

Distortion due to Historical cost values may not reflect true values due to inflation,

Inflation affecting the accuracy of financial data and ratios.

Seasonal Factors Seasonal variations in sales or inventory levels can distort ratios (e.g.,
inventory ratios during peak seasons). Monthly averages can help, but
they may not be available.
Window Dressing Year-end adjustments (like changes to the current ratio or debt-equity
ratio) can artificially alter ratios and may not reflect the true financial
situation.
Differences in Differences in accounting methods and periods can make it difficult to

Accounting Policies compare financial ratios across different firms.

Lack of Standard Industry averages may not be a suitable benchmark, as they may be too

Ratios high or low for certain firms based on their position.

Difficulty in Judging Low ratios may seem bad, but a high ratio could indicate inefficient use

Ratio Quality of resources (e.g., current ratio). Context matters.

Inter-dependence of Ratios are inter-related, meaning viewing one in isolation may mislead.

Ratios Multivariate analysis is required to understand the complete picture.

Financial Ratios are Ratios offer insights, but the final interpretation requires expert

Clues, Not Conclusions analysis; there’s no single standard for interpreting them.

Page 99
| 57
 FINANCIAL ANALYSIS

Type of Analysis Explanation

Horizontal This analysis compares financial statements from different years to assess
Analysis changes. It can be based on ratios derived from financial information over
the same period.
Vertical Analysis This analysis focuses on the financial statement of a single year. It is useful
for inter-firm comparisons. Items in the Profit and Loss account are shown
as a percentage of gross sales, and items in the Balance Sheet are expressed
as a percentage of total assets.

Page100
| 58
 CHAPTER 8: WORKING CAPITAL MANAGEMENT

1. Chapter Overview

✓ In this chapter, we will understand the meaning, need and importance of Working Capital
along with the components and methods of estimating it for a smooth functioning of an entity.
✓ In this context, this chapter is divided into six parts:

Part - 1: Introduction to WC Mgt (WC Cycle)

Part - 2: Treasury & Cash Management

Part - 3: Management of Inventory

Working Capital Management
Part - 4: Management of Receivables

Part - 5: Management of Payables

Part - 6: Financing of Working Capital

2. Important Terms/Concepts used in WC Management

Before we enter into this chapter, one needs to understand the format of Cost Sheet which is
ideally covered in P4: Cost & Management Accounting.

Cost Sheet Format for Working Capital Calculations:

Opening stock of RM xxx
(+) Purchase of RM xxx
(-) Closing stock of RM (xxx)
RM consumed xxx
(+) Direct wages xxx
(+) Direct expenses xxx
Prime cost xxx
(+) Production Overheads xxx
Gross Works Cost xxx
(+) Opening WIP xxx
(-) Closing WIP (xxx)
Works cost / Factory cost / Cost of Production (COP) xxx
(+) Opening FG xxx

Page 101
| 36
 (-) Closing FG (xxx)
Cost Of Goods Sold (COGS) xxx
(+) Administration Overheads (AOH) xxx
(+) Selling & Distribution Overheads (SOH) xxx
Cost of Sales (COS) xxx
(+) Profit xxx
Sales xxx

Doubt Busters:
AOH may be alternatively treated as product cost (Refer classroom discussion)

Page102
| 37
 PART - 1: INTRODUCTION TO WORKING CAPITAL MANAGEMENT

1. Meaning & Concept of Working Capital

✓ In accounting terms, working capital is defined as the difference between current assets and
current liabilities.
✓ If we break down the components of working capital, we will find working capital as follows:
Working Capital = Current Assets – Current Liabilities
A. Current Assets
✓ An asset is classified as current when:
i. It is expected to be realised or intends to be sold or consumed in normal operating cycle
of the entity or within twelve months after the reporting period whichever is longer; and
ii. The asset is held primarily for the purpose of trading in the ordinary course of business.
✓ For the purpose of working capital management, current assets of an entity can be grouped
into the following categories:
a. Inventory (raw material, work in process and finished goods)
b. Receivables (trade receivables and bills receivables)
c. Cash or cash equivalents (including short-term marketable securities)
d. Prepaid expenses
✓ Other current assets may also include short term loans or advances, any other accrued revenue
etc.
B. Current Liabilities
✓ A liability is classified as current when:
i. It is expected to be settled in normal operating cycle of the entity or within twelve months
after the reporting period whichever is longer; and
ii. It is settled either by the use of current assets or by creation of new current liability.
✓ For the purpose of working capital management, current liabilities of an entity can be grouped
into the following categories:
a. Payable (trade payables and bills payables)
b. Outstanding payments (wages & salary, overheads & other expenses etc.)
✓ Other current liabilities may also include short term borrowings, current portion of long-term
debts, short term provisions that are payable within twelve months such as provision for taxes
etc.

C. Working Capital Management

✓ Working Capital Management is concerned with:
a. Maintaining adequate working capital (managing the level of individual current assets and
the current liabilities) and

Page103
| 38
 b. Financing of the working capital.
✓ For the point (a) above, a Finance Manager needs to plan and compute the working capital
requirement for its business. And once the requirement has been computed he needs to ensure
that it is financed properly. This whole exercise is known as Working Capital Management.
✓ Working Capital Management is a process which is designed to ensure that an organization
operates efficiently by monitoring & utilizing its current assets and current liabilities to the
best effect.
✓ The primary objective is to enable a company maintaining sufficient cash flows in order to meet
its day-to-day operating expenses and its short-term obligations.
✓ The concept of working capital can also be explained through two angles.

Fluctuating
On the basis of Time
Permanent
Working capital
Net
On the basis of
Value
Gross

✓ Gross Working Capital refers to the firm’s investment in Current Assets

✓ Net Working Capital refers to the difference between Current Assets & Current Liabilities
✓ Permanent Working Capital is the minimum level of investment in Current Assets that is carried
by the entity at all times to carry its day-to-day activities and remains invested in the business
throughout.
✓ Fluctuating or Temporary Working Capital refers to that part of total working capital which is
required by an entity in addition to the permanent working capital.
D. Optimum Working Capital
✓ If a company’s current assets do not exceed its current liabilities, then it may run into trouble
with creditors that want their money quickly. Not being able to meet its short-term obligations,
company shall eventually lose its reputation and not many vendors would like to do business
with them.
✓ Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it)
has traditionally been considered the best indicator of the working capital situation.
✓ It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm
has an optimum amount of working capital.
✓ A higher ratio may indicate inefficient use of funds and a lower ratio would mean liquidity
issues as mentioned above.

Page104
| 39
✓ This is supplemented by Quick Ratio or Acid Test Ratio (Quick assets/Current liabilities) which
should be at least 1 (one) which would imply that there is a comfortable liquidity position if
liquid current assets are equal to current liabilities (where quick assets / liquid current assets
refer to current assets less inventory & prepaid expenses).
✓ However, it should be remembered that optimum working capital can be determined only with
reference to the particular circumstances of a specific situation.
✓ Thus, in a company where the inventories are easily saleable and the sundry debtors are as
good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound or where
the nature of finished goods are perishable in nature like a restaurant, then also the
organization cannot afford to hold large amount of working capital.
✓ On the other hand, an organization dealing in products which take a longer production time,
may need a higher amount of working capital.
✓ In nutshell, a firm should have adequate working capital to run its business operations. Both
excessive as well as inadequate working capital positions are dangerous.
E. Scope of Working Capital Management
✓ The scope of working capital management can be grouped into two broad areas:
(i) Liquidity and Profitability (ii) Investment and Financing Decision.

Scope of Working Capital Management

Liquidity and Investment and

Profitability Financing

✓ For uninterrupted and smooth functioning of the day-to-day business of an entity, it is

important to maintain liquidity of funds evenly.
✓ As we have already learnt in previous chapters that each rupee of capital bears some cost.
So, while maintaining liquidity the cost aspect needs to be borne in mind.
✓ Also, a higher working capital may be intended to increase the revenue & hence profitability,
but at the same time unnecessary tying up of funds in idle assets not only reduces the
liquidity but also reduces the opportunity to earn better return from a productive asset.
✓ Hence, a trade-off is required between the liquidity and profitability which increases the
profitability without disturbing the day-to-day functioning. This requires 3Es i.e., economy in
financing, efficiency in utilization and effectiveness in achieving the intended objectives.
✓ The trade-off between the components of working capital can be summarized as follows:

Page105
| 40
 Component of Advantages of higher Trade-off (between Advantages of lower
Working side (Profitability) Profitability and side (Liquidity)
Capital Liquidity)
Inventory Fewer stock-outs Use techniques like Lower inventory
increase the EOQ, JIT etc. to carry requires less capital but
profitability. optimum level of endangered stock-out
inventory. and loss of goodwill.
Receivables Higher Credit period Evaluate the credit Cash sales provide
attract customers and policy; use the services liquidity but fails to
increase revenue (but of debt management boost sales and revenue
can result in more bad (factoring) agencies. (due to lower credit
debts) period)
Pre-payment Reduces uncertainty Cost-benefit analysis Improves or maintains
of expenses and profitable in required liquidity.
inflationary
environment.
Cash and Cash Payables are honoured Cash budgets and other Cash can be invested in
equivalents in time, improves the cash management some other investment
goodwill and helpful in techniques can be used avenues
getting future
discounts.
Payables and Capital can be used in Evaluate the credit Payables are honoured
Expenses some other investment policy and related cost. in time, improves the
avenues goodwill and helpful in
getting future
discounts.
F. Investment and Financing of Working Capital
✓ Working capital policy is a function of two decisions, first is investment in working capital and
the second is financing of the investment.
✓ Investment in working capital is concerned with the level of investment in the current assets.
It gives the answer of ‘How much’ fund to be tied in to achieve the organisation objectives
(i.e., Effectiveness of fund).
✓ The level of investment in working capital depends on the various factors such as Nature of
Industry, Types of products, Sector of operation (Manufacturing/Trading/Service), Volume
of sales, credit policy etc.)

Page106
| 41
✓ Financing decision is concerned with the arrangement of funds to finance the working capital.
It gives the answer ‘Where from’ fund to be sourced at lowest cost as possible (i.e. Economy).
Financing decision, we will discuss this in last unit of this chapter.

2. Approaches Of Working Capital Investment

✓ Based on the organisational policy and risk-return trade off, working capital investment
decisions are categorised into three approaches i.e., aggressive, conservative and moderate.

Approaches of Working Capital

Investment

Aggressive Moderate Conservative

✓ Aggressive:
o Here investment in working capital is kept at minimal investment in current assets which
means the entity does hold lower level of inventory, follow strict credit policy, keeps less
cash balance etc.
o The advantage of this approach is that lower level of fund is tied in the working capital
which results in lower financial costs but the flip side could be risk of stock-outs & that
the organisation could not grow which leads to lower utilisation of fixed assets and long-
term debts.
o In the long run firm may stay behind the competitors. This approach would better suit a
highly integrated organisation with efficient processes.
✓ Conservative:
o In this approach, organisation choose to invest high capital in current assets.
o Organisations use to keep inventory level higher, follows liberal credit policies, and cash
balance as high as to meet any current liabilities immediately.
o The advantages of this approach are higher sales volume, increased demand due to liberal
credit policy and increase goodwill among the suppliers due to payment in short time.
o The disadvantages are increased cost of capital, inventory obsolescence, higher risk of bad
debts, shortage of liquidity in long run due to longer operating cycles.
✓ Moderate:
o This approach is in between the above two approaches. Under this approach a balance
between the risk and return is maintained to gain more by using the funds in very efficient
manner.

Page107
| 42
✓ Graph:

✓ A conservative policy implies greater liquidity and lower risk whereas an aggressive policy
indicates higher risk and poor liquidity.
✓ Moderate current assets policy will fall in the middle of conservative and aggressive policies
which most of the firms follow to strike an appropriate balance as per the requirements of
their trade or industry.
✓ Also, an organization may follow a different policy at different times as may be needed
depending on determinants of working capital as discussed earlier.

3. Current Assets to Fixed Assets Ratio

✓ The finance manager is required to determine the optimum level of current assets so that the
shareholders’ value is maximized.
✓ A firm needs both fixed and current assets to support a particular level of output.
✓ The level of the current assets can be measured by creating a relationship between current
assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed
assets ratio.
✓ Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates
a conservative current assets policy and a lower current assets/fixed assets ratio means an
aggressive current assets policy assuming all other factors to be constant.

4. Estimating Working Capital Needs

✓ Operating cycle is one of the most reliable methods of Computation of Working Capital.
✓ However, other methods like ratio of sales and ratio of fixed investment may also be used to
determine the Working Capital requirements. These methods are briefly explained as follows:
i. Current Assets Holding Period: To estimate working capital needs based on the average
holding period of current assets and relating them to costs based on the company’s
experience in the previous year. This method is essentially based on the Operating Cycle
Concept.

Page108
| 43
 ii. Ratio of Sales: To estimate working capital needs as a ratio of sales on the assumption that
current assets change with changes in sales.
iii. Ratio of Fixed Investments: To estimate Working Capital requirements as a percentage of
fixed investments.
✓ A number of factors will, however, be impacting the choice of method of estimating Working
Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and
variability in sales price would generally be considered.
✓ The production cycle and credit and collection policies of the firm will have an impact on
Working Capital requirements. Therefore, they should be given due weightage in projecting
Working Capital requirements.
✓ We will now discuss the most reliable method - Operating Cycle Method
A. Operating Or Working Capital Cycle
✓ A useful tool for managing working capital is the operating cycle.
✓ The operating cycle analyses the accounts receivable, inventory and accounts payable cycles in
terms of number of days.
✓ For example:
o Accounts receivables are analyzed by the average number of days it takes to collect an
account.
o Inventory is analyzed by the average number of days it takes to turn over the sale of a
product (from the point it comes in the store to the point it is converted to cash or an
account receivable).
o Accounts payables are analyzed by the average number of days it takes to pay a supplier
invoice.
✓ Working Capital cycle indicates the length of time between a company’s paying for materials,
entering into stock and receiving the cash from sales of finished goods.

Cash

Raw Material
Receivables Labour
Overhead

Stock WIP

✓ It can be determined by adding the number of days required for each stage in the cycle.
✓ For example, a company holds raw materials on an average for 60 days, it gets credit from the
supplier for 15 days, production process needs 15 days, finished goods are held for 30 days
and 30 days credit is extended to debtors.

Page109
| 44
✓ The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total working capital
cycle.
✓ Most businesses cannot finance the operating cycle (accounts receivable days + inventory days)
with accounts payable financing alone. Consequently, working capital financing is needed.
✓ This shortfall is typically covered by the net profits generated internally or by externally
borrowed funds or by a combination of the two.
✓ Each component of working capital (namely inventory, receivables and payables) has two
dimensions Time and Money. When it comes to managing working capital then time is money.
If you……………… Then ………………….

Collect receivables (debtors) faster You release cash from the cycle

Collect receivables (debtors) slower Your receivables soak up cash.

Get better credit (in terms of duration or amount) You increase your cash resources.

from suppliers.

Shift inventory (stocks) faster You free up cash.

Move inventory (stocks) slower You consume more cash.

✓ The determination of operating capital cycle helps in the forecasting, controlling and
management of working capital. The length of operating cycle is the indicator of performance
of management. The net operating cycle represents the time interval for which the firm has
to negotiate for Working Capital from its lenders. It enables to determine accurately the
amount of working capital needed for the continuous operation of business activities.
✓ The duration of working capital cycle may vary depending on the nature of the business.
✓ In the form of an equation, the operating cycle process can be expressed as follows:
Operating Cycle = R + W + F + D – C
Where,
R = Raw material storage period
W = Work-in-progress inventory* holding period
F = Finished goods storage period
D = Receivables (Debtors) collection period
C = Credit period allowed by suppliers (Creditors)
* work in progress inventory may also be termed as works cost.
✓ Also,
Number of Operating Cycles in a Year = 360 or 365 ÷ Operating Cycle
✓ Wherein, more the number of operating cycles better it is for the organization as it indicates
shorter operating cycle.

Page110
| 45
 B. Various components of Operating Cycle
✓ The various components of Operating Cycle may be calculated as shown below:
1. Raw Material Storage Period Average stock of raw material
=
Average Costof Raw Material Consumption perday

2. Work-in-Progress inventory AverageWork -in-progress inventory

=
Average Costof Production perday
holding period

3. Finished Goods storage period Average stock of finished goods

=
Average Costof Goods Sold perday
4. Receivables (Debtors) collection Average Receivables
=
Average Credit Sales perday
period

5. Credit period allowed by suppliers Average Payables

=
Average Credit Purchases perday
(Creditors)

5. Estimation of Different Components of Current Assets and Current Liabilities

✓ The various constituents of current assets and current liabilities have a direct bearing on the
computation of working capital and the operating cycle.
✓ The holding period of various constituents of Current Assets and Current Liabilities cycle may
either contract or expand the net operating cycle period.

A. Estimation of Current Assets

✓ The estimates of various components of gross working capital or current assets may be made
as follows:
i. Raw Materials Inventory: The funds to be invested in raw materials inventory may be
estimated on the basis of production budget, the estimated cost per unit and average holding
period of raw material inventory by using the following formula:
Estimated Production (units)
× Estimated cost per unit x Average raw material storage period
12months /365days *

ii. Work-in-Progress Inventory: The funds to be invested in work-in-progress can be estimated

by the following formula:
Estimated Production (units)
× Estimated WIP cost per unit x Average WIP holding period
12months /365days *

iii. Finished Goods: The funds to be invested in finished goods inventory can be estimated with
the help of following formula:
Estimated Production (units)
× Estimated COP per unit x Average finished goods storage period
12months /365days *

Page 111
| 46
 iv. Receivables (Debtors): Funds to be invested in trade receivables (debtors) may be estimated
with the help of following formula:
Estimated Credit sales (units)
× Estimated COS (Excl. Dep.) p.u x Average receivable collection period
12months /365days *

Note that only cash cost is considered for debtors and finished goods elements (as the
sales to debtors include cost & profit whereas the funds required for working capital
purposes doesn’t need to include profit). Further, non-cash expense like depreciation is also
excluded.

v. Cash and Cash equivalents: Minimum desired Cash and Bank balance to be maintained by the
firm has to be added in the current assets for the computation of working capital.

B. Estimation of Current Liabilities

✓ Current liabilities are deducted from the current assets to get working capital. Hence, the
amount of working capital is lowered to the extent of current liabilities (other than bank
credit) arising in the normal course of business.
✓ The important current liabilities like trade payables, wages and overheads can be estimated as
follows:
i. Trade Payables: Trade payable can be estimated on the basis of material purchase budget
and the credit purchase by using following formula:
Estimated credit purchase
× Credit period allowed by suppliers
12months /365days *

ii. Direct Wages: It is estimated with the help of direct wages budget by using following
formula:
Estimated labour hours × wages rate perhour
× Average time lag in payment of wages
12months /365days *

iii. Overheads (other than depreciation and amortization): It may be estimated with the help of
following formula:
Estimated Overheads
× Average time lag in payment of overheads
12months /360days *
*Number of days in a year may be taken as 365 or 360 days.

Page 112
| 47
 C. Estimation of Working Capital Requirements
Amount Amount Amount

(₹) (₹) (₹)

I. Current Assets:

Inventories:

-Raw Materials ---

-Work-in-process ---

-Finished goods --- ---

Receivables:

-Trade debtors ---

-Bills --- ---

Prepaid Expenses ---

Minimum Cash Balance ---

Gross Working Capital --- ---

II. Current Liabilities:

Trade Payables ---

Bills Payables ---

Wages Payables ---

Payables for overheads --- ---

III. Excess of Current Assets over Current ---

Liabilities [I – II]

IV. Safety Margin ---

V. Net Working Capital [III + IV] ---

D. Working Capital Requirement Estimation based on Cash Cost

✓ We have already seen that working capital is the difference between current assets and
current liabilities. To estimate requirements of working capital, we have to forecast the
amount required for each item of current assets and current liabilities.
✓ In practice another approach may also be useful in estimating working capital requirements.
✓ This approach is based on the fact that in the case of current assets, like sundry debtors and
finished goods, etc., the exact amount of funds blocked is less than the amount of such current
assets.

Page 113
| 48
✓ For example:
o If we have sundry debtors worth ₹ 1 lakh and our cost of sales is ₹ 75,000, the actual
amount of funds blocked in sundry debtors is ₹ 75,000 the cost of sundry debtors, the
rest (₹ 25,000) is profit.
o Again, some of the cost items also are non-cash costs; depreciation is a non-cash cost item.
Suppose out of ₹ 75,000, ₹ 5,000 is depreciation; then it is obvious that the actual funds
blocked in terms of sundry debtors totalling ₹ 1 lakh is only ₹ 70,000. In other words, ₹
70,000 is the amount of funds required to finance sundry debtors worth ₹ 1 lakh.
o Similarly, in the case of finished goods which are valued at cost, non-cash costs may be
excluded to work out the amount of funds blocked.
o Many experts, therefore, calculate the working capital requirements by working out the
cash costs of finished goods and sundry debtors. Under this approach, the debtors are
calculated not as a percentage of sales value but as a percentage of cash costs. Similarly,
finished goods are valued according to cash costs.
E. Effect of Double Shift Working in Working Capital Requirements
(Refer Classroom Discussion)

Page114
| 49
 PART - 2: TREASURY AND CASH MANAGEMENT

6. Treasury Management: Meaning

✓ The treasury management mainly deals with: -

i. Working capital management; and
ii. Financial risk management (It includes forex and interest rate management).
✓ The key goals of treasury management are: -
o Maximize the return on the available cash;
o Minimize interest cost on borrowings;
o Mobilise as much cash as possible for corporate ventures for maximum returns; and
o Effective dealing in forex, money and commodity markets to reduce risks arising because
of fluctuating exchange rates, interest rates and prices which can in turn affect the
profitability of the organization.

7. Functions Of Treasury Department

✓ The fundamental tasks for which treasury department of any enterprise is responsible are:
1. Cash Management: It involves efficient cash collection process and managing payment of
cash both inside the organisation and to third parties.
2. Currency Management: The treasury department manages the foreign currency risk
exposure of the company. If risks are to be minimized then forward contracts can be used
either to buy or sell currency forward.
3. Fund Management: Treasury department is responsible for planning and sourcing the
company’s short, medium and long-term cash needs. They also facilitate temporary
investment of surplus funds by mapping the time gap between funds inflow and outflow.
Treasury department will also participate in the decision on capital structure and forecast
future interest and foreign currency rates.
4. Banking: It is important that a company maintains a good relationship with its bankers.
Treasury department carry out negotiations with bankers with respect to interest rates,
foreign exchange rates etc. and act as the initial point of contact with them. Short-term
finance can come in the form of bank loans or through the sale of commercial paper in the
money market.
5. Corporate Finance: Treasury department is involved with both acquisition and divestment
activities within the group. In addition, it will often have responsibility for investor relations.

Page115
| 50
 8. Management Of Cash

✓ Management of cash is an important function of the finance manager. It is concerned with the
managing of:
o Cash flows into and out of the firm;
o Cash flows within the firm; and
o Cash balances held by the firm at a point of time by financing deficit or investing surplus
cash.
✓ The main objectives of cash management for a business are: -
o Provide adequate cash to each of its units as per requirements;
o No funds are blocked in idle cash; and
o The surplus cash (if any) should be invested in order to maximize returns for the business.
✓ A cash management scheme therefore, is a delicate balance between the twin objectives of
liquidity and costs.
✓ The following are three basic considerations in determining the amount of cash or liquidity as
have been outlined by Lord Keynes, a British Economist:
o Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt
payments.
o Speculative needs: Cash may be held in order to take advantage of profitable opportunities
that may present themselves and which may be lost for want of ready cash/settlement.
o Precautionary needs: Cash may be held to act as for providing safety against unexpected
events.

9. Cash Budget

✓ Cash Budget is the most significant device to plan for and control cash receipts and payments.
✓ On the basis of cash budget, the firm can decide to invest surplus cash in marketable securities
and earn profits.
✓ On the contrary, any shortages can also be managed by making overdraft or credit
arrangements with banks

Page 116
| 51
 A. Cash budget for short period
The following is the Format of Cash Budget for short period
Month 1 Month 2 Month 3 Month 12

Receipts:

1. Opening balance

2. Collection from debtors

3. Cash sales

4. Loans from banks

5. Share capital

6. Miscellaneous receipts

7. Other items
Total

Payments:

1. Payments to creditors

2. Wages

3. Overheads
(a)

(b)

(c)

4. Interest

5. Dividend

6. Corporate tax

7. Capital expenditure

8. Other items
Total

Closing balance

[Surplus (+)/Shortfall (-)]

B. Cash Budget for long period

✓ Long-range cash forecast often resemble the projected sources and application of funds
statement.
✓ The following procedure may be adopted to prepare long-range cash forecasts:

Page117
| 52
(i) Take the cash at bank and in the beginning of the year
Add:
a. Trading profit (before tax) expected to be earned;
b. Depreciation and other development expenses incurred to be written off;
c. Sale proceeds of assets;
d. Proceeds of fresh issue of shares or debentures; and
e. Reduction in working capital that is current assets (except cash) less current liabilities.
Deduct:
a. Dividends to be paid.
b. Cost of assets to be purchased.
c. Taxes to be paid.
d. Debentures or preference shares to be redeemed.
e. Increase in working capital that is current assets (except cash) less current liabilities

10. Determining the Optimum Cash Balance

✓ A firm should maintain optimum cash balance to cater to the day-to-day operations.
✓ It may also carry additional cash as a buffer or safety stock.
✓ The amount of cash balance will depend on the risk-return trade off. The firm should maintain
an optimum level i.e. just enough, i.e. neither too much (to avoid any opportunity cost) nor too
little cash balance (to settle day to day payments).
✓ This, however, poses a question. How to determine the optimum cash balance if cash flows are
predictable and if they are not predictable?
✓ In recent years several types of mathematical models have been developed which helps to
determine the optimum cash balance to be carried by a business organization.
✓ The purpose of all these models is to ensure that cash does not remain idle unnecessarily and
at the same time the firm is not confronted with a situation of cash shortage.
✓ All these models can be put in two categories:
1. Inventory type model
2. Stochastic models
✓ Inventory type models have been constructed to aid the finance manager to determine optimum
cash balance of his firm. William J. Baumol’s economic order quantity model applies equally to
cash management problems under conditions of certainty or where the cash flows are
predictable.
✓ However, in a situation where the EOQ Model is not applicable, stochastic model of cash
management helps in determining the optimum level of cash balance. It happens when the
demand for cash is stochastic and not known in advance.

Page 118
| 53
 A. William J. Baumol’s Economic Order Quantity Model, (1952)
✓ According to this model, optimum cash level is that level of cash where the carrying costs and
transactions costs are the minimum.
✓ The carrying costs refer to the cost of holding cash, namely, the opportunity cost or interest
foregone on marketable securities. The transaction costs refer to the cost involved in getting
the marketable securities converted into cash.
✓ The formula for determining optimum cash balance is:

2U × P
C =√
S
Where,
C = Optimum cash balance
U = Annual (or monthly) cash disbursement
P = Fixed cost per transaction.
S = Opportunity cost of one rupee p.a. (or p.m.)
✓ Diagram:

B. Miller-Orr Cash Management Model (1966)

✓ According to this model the net cash flow is completely stochastic.
✓ When changes in cash balance occur randomly the application of control theory serves a useful
purpose. The Miller-Orr model is one of such control limit models.
✓ This model is designed to determine the time and size of transfers between an investment
account and cash account. In this model control limits are set for cash balances. These limits
may consist of h as upper limit, z as the return point; and zero as the lower limit.
✓ When the cash balance reaches the upper limit, the transfer of cash equal to h – z is invested
in marketable securities account.
✓ When it touches the lower limit, a transfer from marketable securities account to cash account
is made.
✓ During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low limits no
transactions between cash and marketable securities account is made.

Page119
| 54
✓ The high and low limits of cash balance are set up on the basis of fixed cost associated with
the securities transactions, the opportunity cost of holding cash and the degree of likely
fluctuations in cash balances.
✓ These limits satisfy the demands for cash at the lowest possible total costs.
✓ The MO Model is more realistic since it allows variations in cash balance within lower and upper
limits. The finance manager can set the limits according to the firm’s liquidity requirements
i.e., maintaining minimum and maximum cash balance.
✓ The following diagram illustrates the Miller-Orr model.

Page120
| 55
 PART - 3: MANAGEMENT OF INVENTORY

✓ Inventories constitute a major element of working capital.

✓ It is, therefore, important that investment in inventory is properly controlled.
✓ The objectives of inventory management are, to a great extent, similar to the objectives of
cash management.
✓ Inventory management covers a large number of problems including fixation of minimum and
maximum levels, determining the size of inventory to be carried, deciding about the issues,
receipts and inspection procedures, determining the economic order quantity, proper storage
facilities, keeping check over obsolescence and ensuring control over movement of inventories.
✓ Inventory Management has been discussed in detail in Material Cost Chapter of Paper 4: Cost
and Management Accounting. Students are advised to refer the same.

Page 121
| 56
 PART – 4: MANAGEMENT OF RECEIVABLES

11. Meaning And Objective of Receivables Management

✓ Management of receivables refers to planning and controlling of 'debt' owed to the firm from
customer on account of credit sales. It is also known as trade credit management.
✓ The basic objective of management of receivables (debtors) is to optimise the return on
investment on these assets.
✓ When large amounts are tied up in receivables, there are chances of bad debts and there will
be cost of collection of debts.
✓ On the contrary, if the investment in receivables is low, the sales may be restricted, since the
competitors may offer more liberal terms.
✓ Therefore, management of receivables is an important issue and requires proper policies and
their implementation.

12. Aspects Of Management Of Debtors

There are basically three aspects of management of receivables:

1. Credit Policy: A balanced credit policy should be determined for effective management of
receivables. Decision of Credit standards, Credit terms and collection efforts is included in
Credit policy. The credit period is generally stated in terms of net days. For example, if the
firm’s credit terms are “net 50”. It is expected that customers will repay credit obligations
not later than 50 days.
Further, the cash discount policy of the firm specifies:
o The rate of cash discount.
o The cash discount period; and
o The net credit periods.
For example, the credit terms may be expressed as “3/15 net 60”. This means that a 3%
discount will be granted if the customer pays within 15 days; if he does not avail the offer he
must make payment within 60 days.
2. Credit Analysis: This requires the finance manager to determine as to how risky it is to
advance credit to a particular party. This involves due diligence or reputation check of the
customers with respect to their credit worthiness.
3. Control of Receivable: This requires finance manager to follow up debtors and decide about a
suitable credit collection policy. It involves both laying down of credit policies and execution
of such policies.

Page122
| 57
 Cost Of Maintaining Receivables
✓ There is always cost of maintaining receivables which comprises of following costs:
o The company requires additional funds as resources are blocked in receivables which
involves a cost in the form of interest (loan funds) or opportunity cost (own funds)
o Administrative costs which include record keeping, investigation of credit worthiness
o Collection costs.
o Defaulting costs.

13. Approaches To Evaluation Of Credit Policies

✓ There are basically two methods of evaluating the credit policies to be adopted by a Company
✓ Total Approach and Incremental Approach.
✓ The formats for the two approaches are given as under:
A. Statement showing the Evaluation of Credit Policies (based on Total Approach)

Particulars Present Proposed Proposed Proposed

Policy Policy I Policy II Policy III

₹ ₹ ₹ ₹

A. Expected Profit:

a. Credit Sales ………. …………. ……….. ……….

b. Total Cost other than Bad Debts

i. Variable Costs ……… ………… ………. ……….

ii. Fixed Costs ……… ………… ………. ……….

……… ………. ………. ……..

c. Bad Debts ……… ………… ……… ……….

d. Cash discount

e. Expected Net Profit before Tax .…….. ……….. ……… ……….

(a-b-c-d)

f. Less: Tax ……... ……….. ………. ………

g. Expected Profit after Tax ..……. ……… ……… ………

B. Opportunity Cost of Investments in ..…… ……… ………. ………

Receivables locked up in Collection

Period

Net Benefits (A – B) ……… ……… ……… ……….

Page123
| 58
Advise: The Policy……should be adopted since the net benefits under this policy are higher as

compared to other policies.

Here,

Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of units sold on credit

under Present Policy

Collection period (Days) Required Rate of Return
Opportunity Cost = Total Cost of Credit Sales × ×
365 (or 360) 100

B. Statement showing the Evaluation of Credit Policies (based on Incremental Approach)

Particulars Present Proposed Proposed Proposed

Policy Policy I Policy II Policy III

days days days days

₹ ₹ ₹ ₹

A. Incremental Expected Profit:

Credit Sales ………. …………. ……….. ……….

a. Incremental Credit Sales ………. …………. ……….. ……….

b. Less: Incremental Costs of Credit

Sales

i. Variable Costs ………. …………. ……….. ……….

ii. Fixed Costs ………. …………. ……….. ……….

c. Incremental Bad Debt Losses ………. …………. ……….. ……….

d. Incremental Cash Discount ………. …………. ……….. ……….

e. Incremental Expected Profit ………. …………. ……….. ……….

(a-b-c-d)

f. Less: Tax ………. …………. ……….. ……….

g. Incremental Expected Profit after ………. …………. ……….. ……….

Tax

………. …………. ……….. ……….

B. Required Return on Incremental

Investments:

a. Cost of Credit Sales ………. …………. ……….. ……….

Page124
| 59
 b. Collection Period (in days) ………. …………. ……….. ……….

c. Investment in Receivable ………. …………. ……….. ……….

(a × b ÷ (365 or 360) )

d. Incremental Investment in ………. …………. ……….. ……….

Receivables

e. Required Rate of Return (in %) ………. …………. ……….. ……….

f. Required Return on Incremental ………. …………. ……….. ……….

Investments (d × e)

Incremental Net Benefits (A – B) ………. …………. ……….. ……….

Advise: The Policy……. should be adopted since the net benefits under this policy are higher as

compared to other policies.

Here,

Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of units sold on credit

under Present Policy

Collection period (Days) Required Rate of Return
Opportunity Cost = Total Cost of Credit Sales × ×
365 (or 360) 100

14. Financing Receivables - Factoring

✓ Factoring is a relatively new concept in financing of accounts receivables. This refers to

outright sale of accounts receivables to a factor or a financial agency.
✓ A factor is a firm that acquires the receivables of other firms. The factoring lays down the
conditions of the sale in a factoring agreement. The factoring agency bears the risk of
collection and services the accounts for a fee.
✓ Factoring arrangement can be either on a recourse basis or on a non-recourse basis:
o Recourse: In case factor is unable to collect the amount from receivables then, factor can
turn back the same to the organization for resolution (which generally is by replacing those
receivables with new receivables)
o Non-Recourse: The factor bears the ultimate risk of loss in case of default and hence in
such cases they charge higher commission.
✓ The biggest advantages of factoring are the immediate conversion of receivables into cash and
predicted pattern of cash flows.
✓ Financing receivables with the help of factoring can help a company having liquidity without
creating a net liability on its financial condition and hence no impact on debt equity ratio.

Page125
| 60
✓ Besides, factoring is a flexible financial tool providing timely funds, efficient record keepings
and effective management of the collection process.
✓ This is not considered as a loan. There is no debt repayment and hence no compromise to
balance sheet, no long-term agreements or delays associated with other methods of raising
capital.
✓ Factoring allows the firm to use cash for the growth needs of business.

Statement showing the Evaluation of Factoring Proposal

Particulars ₹

A. Annual Savings (Benefit) on taking Factoring Service

Cost of credit administration saved ………...

Bad debts avoided …………

Interest saved due to reduction in average collection period …………

(Wherever applicable)

[Cost of Annual Credit Sales × Rate of Interest × (Present Collection

Period – New Collection Period) ÷ 360* days]

Total ………..

B. Annual Cost of Factoring to the Firm:

Factoring Commission [Annual credit Sales × % of Commission ………..

(or calculated annually)]

Interest Charged by Factor on advance (or calculated annually) ………...

[Amount available for advance or (Annual Credit Sales – Factoring

Commission – Factoring Reserve)] ×

Collection Period (days)

[ × Rate of Interest]
360 *

Total ………..

C. Net Annual Benefits/Cost of Factoring to the Firm: A-B

Page126
| 61
 Rate of Effective Cost of Factoring to the Firm
Net Annual cost of Factoring
×100 or
Amount available for advance

Net Annual cost of Factoring

× 100
Advances to be paid
Advances to be paid = (Amount available for advance – Interest

deducted by factor)

*1 Year is taken as 360 days

Advise:
1. The company should avail Factoring services if rate of effective Cost of Factoring to the
firm is less than the existing cost of borrowing or if availing services of factoring results in
to positive Net Annual Benefits.
2. The company should not avail Factoring services if the Rate of Effective Cost of Factoring
to the Firm is more than the existing cost of borrowing.

Page127
| 62
 PART – 5: MANAGEMENT OF PAYABLE

✓ There is an old age saying in business that if you can buy well then you can sell well.
✓ Management of your creditors and suppliers is just as important as the management of your
debtors.
✓ Trade creditor is a spontaneous / short term source of finance in the sense that it arises from
ordinary business transaction.
✓ But it is also important to look after your creditors - slow payment by you may create ill-feeling
and your supplies could be disrupted and also create a bad image for your company.
✓ Creditors are a vital part of effective cash management and should be managed carefully to
enhance the cash position.

15. Computation Of Cost Of Payables

✓ By using the trade credit judiciously, a firm can reduce the effect of growth or burden on
investments in Working Capital.
✓ Now question arises how to calculate the cost of not taking the discount.
✓ The following equation can be used to calculate nominal cost, on an annual basis of not taking
the discount:
d 365 days
×
100 - d t
✓ However, the above formula does not take into account the compounding effect and therefore,
the cost of credit shall be even higher. The cost of lost cash discount can be estimated by the
formula:
365
100 t
( ) -1
100 - d
Where,
d = Size of discount i.e. for 6% discount, d = 6
t = The reduction in the payment period in days, necessary to obtain the early discount or Days
Credit Outstanding – Discount Period.

Page128
| 63
 PART – 6: FINANCING OF WORKING CAPITAL

INTRODUCTION
Step Details
Step After Estimating The finance manager arranges funds to meet the working capital
Working Capital Needs requirements.
Types of Working Capital ➢ Permanent Working Capital: Always needed, regardless of sales
fluctuations. Financed by long-term sources like debt and
equity.
➢ Temporary Working Capital: Required for short periods.
Financed by short-term sources.
Categories of Working 1. Spontaneous Sources
Capital Finance 2. Negotiated Sources
Spontaneous Sources ➢ Naturally arise during business operations.
➢ Examples: Trade credit, employee credit, supplier credit.
Negotiated Sources ➢ Require formal negotiation with lenders.
➢ Examples: Commercial banks, financial institutions, general
public.
Factors for Selecting a 1. Cost: Expense of acquiring funds.
Financing Source 2. Impact on Credit Rating: Effect on company's financial
reputation.
3. Feasibility: Practicality of obtaining funds.
4. Reliability: Certainty of fund availability.
5. Restrictions: Limitations imposed by lenders.
6. Hedging Approach: Matching financing with asset maturity.

Page129
| 64
 SOURCES OF FINANCE
Spontaneous Sources of Finance
Source Description Key Advantages
Trade Credit ➢ Credit extended by sellers or service ➢ Lower cost than other
providers to the purchasing company. sources.
➢ Contributes to one-third of total short- ➢ Easily available.
term finance needs. ➢ Helps businesses manage
➢ If obtained without formalities, it is called cash flow efficiently.
"Open Account Trade Credit".
Bills Payable ➢ A written promise by the buyer to pay the ➢ Simple process.
seller at a future date or on demand. ➢ No immediate payment
➢ Used widely, especially by small and medium burden.
enterprises (SMEs). ➢ Widely used in all business
➢ The amount depends on purchase volume and sizes.
payment schedule.
Accrued ➢ Outstanding liabilities for services used but ➢ No additional cost.
Expenses not yet paid (e.g., wages, salaries, taxes). ➢ Improves liquidity.
➢ A built-in and automatic finance source. ➢ Helps manage short-term
➢ Interest-free with no explicit or implicit cash flow.
cost.
Inter-corporate Loans and Deposits
Sometimes, organizations having surplus funds invest for short-term period with other
organizations. The rate of interest will be higher than the bank rate of interest and depends on
the financial soundness of the borrower company. This source of finance reduces dependence on
bank financing.

Commercial Papers (CP)

Aspect Details
What is CP? ➢ An unsecured promissory note issued by a firm for short-term borrowing.
➢ Used by highly rated corporate borrowers to raise funds.
➢ Maturity period: 7 days to less than 1 year.
➢ Can be issued in denominations of Rs. 5 lakhs or multiples thereof.
Advantages of CP 1. Unsecured: No collateral required and no restrictive conditions.
2. Continuous Fund Source: Maturing CP can be repaid by issuing new CP. 3
3. Customizable Maturity: Firms can set the maturity period based on their
requirements.
4. Available in Tight Money Markets: CP can be issued even during tight

Page130
| 65
 money market conditions.
5. Lower Cost: Generally, lower cost than commercial bank loans.
Limitations of CP 1. Credit Rating Requirement: Only firms with high credit ratings can issue
CP.
2. No Flexibility in Redemption: CP cannot be redeemed before maturity or
extended beyond maturity.
Funds Generated from Operations
Funds generated during an accounting period increase working capital by the same amount. The
main components are profit and depreciation.

Public Deposits
Deposits from the public are a key source of finance for well-established, large companies. They
are primarily used for short and medium-term financing.

Bills Discounting
A method where a supplier draws a bill of exchange, directing the buyer to pay after a set period.
The supplier can discount the bill before maturity for immediate funds.

Bill Rediscounting Scheme

Introduced by the Reserve Bank of India (RBI) in 1970. It encourages the use of bills of exchange
for credit and helps create a bill market. Licensed banks can rediscount bills with the RBI.

Factoring
Aspect Description
Definition Factoring is a method where a firm sells its trade debts at a discount to a
financial institution (called the factor).
Parties The key parties are the client (the firm selling goods/services), the factor (the
Involved financial institution), and the debtor (the customer who owes money).
Process The factor buys the client’s trade debts (including accounts receivable) either
with or without recourse to the client. The factor also controls the credit
extended to the customers and manages the sales ledger.
Layman's A factor is an agent who collects the dues from the client's customers for a
Explanation fee.

Page 131
| 66
 Factoring vs. Bills Discounting
Aspect Factoring Bills Discounting
Definition A method where a firm sells its trade debts A method where a supplier draws a
at a discount to a financial institution (called bill of exchange, and the buyer
the factor). The factor collects dues for a agrees to pay after a set period.
fee.
Parties Client, Factor, Debtor Drawer, Drawee, Payee
Involved
Nature Management of book debts, focusing on A borrowing method from
accounts receivable. commercial banks.
Legislation No specific Act for Factoring. Negotiable Instrument Act applies
to Bills Discounting.

Working Capital Finance from Banks

Aspect Description
Major Source of Banks are the main suppliers of working capital credit for businesses in India.
Finance Recently, term lending financial institutions have also launched schemes for
working capital financing.
Key Committees The Tandon Committee and Chore Committee developed guidelines for
working capital financing, which have laid the foundation for innovation in this
area.
Assessment of RBI withdrew the Maximum Permissible Bank Finance (MPBF) method in April
Working Capital 1997. Banks can now develop their own methods, with Board approval, for
assessing working capital needs while following prudential guidelines and
exposure norms.
Banks' Discretion Banks have flexibility in their lending policies but must follow RBI's
directions related to directed credit (e.g., priority sector, export) and
prohibited credit (e.g., bridge finance).
Liberalization With the withdrawal of MPBF guidelines, the instructions related to lending
Effect discipline (appraisal, sanction, monitoring, and utilization) are no longer
mandatory. However, banks can include necessary guidelines in their policies.

Forms of Bank Credit

Form of Description
Credit
Cash Credit Continuous credit facility provided by banks. The borrower cannot exceed the

Page132
| 67
 sanctioned limit.
Bank Short-term borrowing facility for urgent funds. Banks set limits and can call the
Overdraft overdraft on short notice.
Bills A company selling goods on credit draws a bill on the buyer, which is discounted
Discounting with the bank. The bank sets the discounting bill limit.
Bills A company draws a bill of exchange on the bank, and the bank accepts it,
Acceptance committing to pay the amount on a specified future date.
Line of Credit A bank’s commitment to lend a certain amount of funds on demand, specifying a
maximum lending limit.
Letter of An arrangement where the bank guarantees payment or negotiates documents on
Credit behalf of a customer under specified terms and conditions.
Bank A bank guarantees payment to a third party (beneficiary) on behalf of its client,
Guarantees ensuring the client’s obligations are met.

Page133
| 68
 Core Theory Topics

Methods of Cash Flow Budgeting

Method Explanation
Receipts and Considers all expected receipts and payments for the budget period. Includes
Payments cash inflows and outflows from all functional budgets, including capital
Method expenditure. Adjustments and accruals are ignored. The closing cash balance is
calculated by adding anticipated cash inflow to the opening balance and
deducting cash payments. Commonly used in businesses.
Adjusted Adjusts sales revenue and costs by considering delays in receipts and payments
Income (changes in debtors and creditors). Non-cash items like depreciation are
Method removed to calculate the actual cash flow.
Adjusted Uses a budgeted balance sheet, where assets (except cash & bank) and short-
Balance Sheet term liabilities are expressed as a percentage of expected sales. Profit is also
Method estimated as a percentage of sales. This method helps forecast owner’s equity
and determine if extra finance is needed or if there will be a positive cash
balance.

Managing Cash Collection and Disbursements

Aspect Explanation
Objective The finance manager should minimize the gap between projected and actual cash
flows by ensuring efficient cash collection and disbursement.
Key Goals 1. Accelerate cash collections as much as possible.
2. Delay cash disbursements within a permissible time frame.

Accelerating Cash Collections

Type of Float Meaning
Billing Float Time taken between a sale and the issuance of an invoice to the
customer.
Mail Float Time when a cheque is in transit (e.g., via post, courier, or messenger).
Cheque Processing Time taken by the seller to record, sort, and deposit the cheque after
Float receiving it.
Banking Processing Time from the cheque deposit to the actual crediting of funds in the
Float seller’s account.

Page134
| 69
 Methods to Reduce Float & Speed Up Collections
Method Explanation
Faster Invoicing Issuing invoices quickly reduces billing float.
Reducing Mail Faster cheque collection reduces mail float.
Delays
Faster Cheque Immediate sorting & depositing of cheques reduces processing float.
Processing
Concentration Establishing multiple regional collection centers to reduce time lag in
Banking receiving payments. Funds from these centers are sent to the main bank of
the company, improving liquidity.
Lock Box System Customers send payments directly to a bank-managed post-office box. The
bank collects, processes, and deposits cheques directly, eliminating delays.
Reduces cheque processing float but comes with operational costs.

Controlling Payments
Strategy Explanation
Paying on Due Date Ensuring timely payments but not before the due date to maintain cash
flow.
Using Drafts Instead Drafts (bills of exchange) take longer to clear, giving more time to
of Cheques manage cash flow.
Playing the Float Issuing cheques strategically based on expected encashment timing, so
only the necessary cash balance is maintained in the bank.
Delaying Outstation Sending cheques via mail to increase the float period, allowing firms to
Payments use funds for a longer time.

Recent Developments in Cash Management

Electronic Fund Transfer Zero Balance Account Money Market Operations

Management of
Petty Cash Imprest Electronic
Temporary
System Cash Management System
Cash Surplus

Virtual Banking

Page135
| 70
Development Explanation
Electronic Fund With banking digitalization, banks are now computerized and networked,
Transfer (EFT) offering:
➢ Instant account updates
➢ Quick fund transfers
➢ Real-time foreign exchange rates.
Zero Balance Firms use zero balance accounts to manage cash efficiently by investing
Account (ZBA) excess funds in marketable securities and selling them when cash is
needed.
Money Market Large firms invest surplus funds in short-term deposits in banks and
Operations financial markets. Deposits can range from overnight to one year, and
interest rates fluctuate based on demand.
Petty Cash Imprest Companies set aside a fixed weekly amount for small daily expenses, based
System on past usage and future needs. This reduces cash management efforts
for minor transactions.
Managing Firms invest extra cash in:
Temporary Cash ➢ Short-term bank deposits
Surplus ➢ Short-term debt instruments
➢ Long-term flexible debt instruments
➢ Shares of top-performing (blue-chip) companies. Investment choice
depends on economic conditions, risk appetite, and return volatility.

Electronic Cash Management System (ECMS)

Aspect Explanation
Speed & Efficiency Modern cash management systems are electronically based because speed
is crucial.
Electronic Data & Data and funds are transferred electronically across various locations
Fund Transfers involved in cash collection, fund transfers, and payments.
Satellite-Linked Various elements of cash management are interlinked via satellite,
System ensuring real-time tracking and processing.
Limited Third-Party Some networked cash management systems allow restricted access to
Access regular parties, such as brokers or vendors, to track receipts and
payments.
Example - Finance A finance company accepting public deposits via sub-brokers may give
Companies them limited access to track collections and commissions.

Page136
| 71
 Benefits of Electronic-Scientific Cash Management
Benefit Explanation
Saves Time Speeds up cash management processes.
Higher Interest Earnings & Lower Optimizes fund utilization, increasing earnings and
Interest Costs reducing expenses on interest.
Reduces Paperwork & Manpower Minimizes manual work, leading to lower administrative
costs.
Greater Accounting Accuracy Automates bookkeeping, making it easier to detect
errors.
Better Control Over Funds Ensures efficient cash flow management and fund
tracking.
Supports Electronic Payments Enables secure and quick digital transactions.
Faster Fund Transfers Allows instant fund transfers between locations when
needed.
Quick Conversion of Instruments Speeds up turning cheques or financial instruments into
cash.
Funds Available Anytime, Anywhere Ensures money is accessible where and when required.
Reduces Idle Float Minimizes unused cash, improving liquidity.
No Idle Funds in the Organization Ensures all funds are effectively utilized.
Easier Inter-Bank Balancing Simplifies fund transfers between different banks.
True Centralized Cash Management Provides complete control over company-wide cash flow.
Faster Electronic Reconciliation Speeds up matching transactions and bank records.
Fewer Cheques Issued Reduces dependence on paper cheques, making payments
faster and more secure.

Virtual Banking & Payment System Reforms

Aspect Explanation
Evolution of Since the 1990s, banking has shifted towards relationship banking while
Banking customers prefer electronic banking like net banking & mobile banking.
Virtual Banking Uses technology to provide banking services without requiring physical
visits to branches. It started in the 1970s with ATMs and expanded due
to market competition & customer demand.
Role of RBI in The Reserve Bank of India (RBI) has introduced several initiatives to
Payment Reforms improve cash management and payment systems.
Key Technological ➢ Computerized settlement of clearing transactions
Developments ➢ MICR (Magnetic Ink Character Recognition) for faster cheque clearing
➢ Inter-city & high-value clearing facilities

Page137
| 72
 ➢ Electronic Clearing Service (ECS) & Electronic Funds Transfer (EFT)
UPI payment platforms
➢ Real-Time Gross Settlement (RTGS)
➢ Delivery vs. Payment (DVP) for government securities
➢ Indian Financial Network (INFINET)
Additional Payment Centralised Funds Management System (CFMS)
Systems Securities Services System (SSS)
Structured Financial Messaging System (SFMS)
Future Vision for Linking all bank branches with a domestic payments network for cross-
Payments border connectivity and enhanced cash control for banks & corporates.

Advantages of Virtual Banking

Advantage Explanation
Lower Transaction Virtual banking reduces the cost of handling transactions compared to
Costs traditional banking.
Faster Customer Enables quick responses to customer needs.
Service
Cost Efficiency Reduces branch operation costs and staff expenses, improving overall
cost efficiency.
Improved & Diverse Offers better banking services that are faster, more accurate, and
Services convenient for customers.
24/7 Accessibility Provides round-the-clock access to banking services, increasing
convenience and user satisfaction.

Management of Marketable Securities

Aspect Explanation
Purpose Manages surplus cash by investing in short-term securities, ensuring
both liquidity and returns.
Need for Marketable Working capital needs fluctuate, so excess funds can be parked in
Securities short-term investments and liquidated when needed.
Key Principles for 1. Safety: Minimum risk is preferred since liquidity is the priority.
Selection 2. Maturity: Investments should match expected cash needs; short-
term securities are less risky.
3. Marketability: Securities should be easily and quickly converted
into cash without losing value.
Types of Marketable ➢ Government Treasury Bills
Securities ➢ Bank Deposits
➢ Inter-Corporate Deposits
➢ Units of Unit Trust of India (UTI)
➢ Commercial Papers (CPs) of Corporates

Page138
| 73
 ➢ Deposits with Sister Concerns/Associate Companies
Money Market Mutual MMMFs have emerged as a popular short-term investment option for
Funds (MMMFs) managing temporary excess cash.

Factors Determining Credit Policy

Factor Explanation
Effect on Sales Credit policies impact sales—lenient credit terms may increase sales, while
Volume strict policies may reduce them.
Credit Terms Conditions set for credit period, interest rates, and repayment schedules
influence receivables management.
Cash Discounts Offering discounts for early payments can encourage faster cash inflows
and reduce outstanding receivables.
Customer Firms set criteria for approving credit customers, balancing risk and sales
Selection Policies growth.
Customer The paying practices of customers affect the likelihood of delayed payments
Payment Habits or defaults.
Collection Policies A strict collection process ensures timely payments, while a lenient policy
may increase bad debts.
Operational Billing, record-keeping, and adjustments impact receivables management—
Efficiency efficient processes minimize errors and costs.
Other Costs Interest costs, collection expenses, and bad debts affect the company’s
investment in receivables.
Lenient vs. - Lenient Policy: Liberal credit terms increase sales and receivables, but also
Stringent Credit bad debt risks and financing needs. - Stringent Policy: Selective credit
Policy approvals lower bad debts and costs, but may reduce sales if competitors
offer better terms.

Factors Under the Control of the Finance Manager

Responsibility Explanation
Supervising Credit Ensures efficient handling of credit approvals and collections.
Administration
Deciding Credit Policies Helps in formulating the best credit policies to balance risk and
sales growth.
Setting Credit Selection Defines eligibility conditions for approving credit to customers.
Criteria
Speeding Up Cash Implements aggressive collection policies to convert receivables
Collections into cash faster.
Balancing Costs & Profits Maintains an optimal trade-off between investment in receivables
and profitability from higher sales.

Page139
| 74
 Forfaiting
Aspect Explanation
Meaning Forfaiting (from the French word "forfait" meaning "relinquish a right") is a bill
discounting arrangement where an exporter sells trade bills (receivables) to a bank
or financial institution and relinquishes the right to collect payment from the
importer.
Key It is a "without recourse" financing, meaning the bank assumes the risk of non-
Feature payment, providing the exporter with immediate cash.
Process 1. Exporter sells goods/services to an overseas importer.
2. Importer issues a letter of credit (or other negotiable instrument) via its bank
(importer’s bank).
3. Exporter submits the letter of credit to its bank (exporter’s bank).
4. Exporter’s bank buys the letter of credit "without recourse" and pays the
exporter immediately.

Features of Forfaiting
Feature Explanation
Encourages Exporters Payment assurance motivates exporters to expand into new
markets.
Deferred Payment for Overseas buyers (importers) can import goods/services on credit.
Importers
Reduces Transaction Simplifies international trade transactions for exporters.
Costs & Complexity
Supports Business Growth Exporters can compete globally, while using working capital
efficiently to scale operations.
Competitive Financing for Importers can access forfaiting facilities from global financial
Importers institutions to finance imports at better interest rates.

Page140
| 75
 Example of Forfaiting – Exim Bank’s ‘Buyer’s Credit’
Aspect Explanation
What is Buyer’s A forfaiting arrangement by Exim Bank of India, providing credit to overseas
Credit? buyers to import goods from India.
Purpose Helps SMEs export capital goods/services on deferred payment terms, while
ensuring non-recourse finance for Indian exporters.
Benefit to Converts deferred credit contracts into cash contracts, enabling immediate
Exporters payments and reducing risk.
How it Works? Exim Bank makes advance payments to Indian exporters on behalf of the
overseas buyer.

The following is a diagrammatic illustration of Exim’s Buyer’s Credit:

Page 141
| 76
 Innovations In Receivable Management
During the recent years, a number of tools, techniques, practices and measures have been invented
to increase effectiveness in accounts receivable management.
Following are the major determinants for significant innovations in accounts receivable
management and process efficiency.
Re-engineering Receivable Process
Aspect Explanation
Re-engineering A fundamental re-think & redesign of the accounts receivable process
Definition using modern business strategies to reduce costs & improve
efficiency.
Impact on Receivables Decisions made across the organization can impact how resources are
allocated for managing receivables.
Key Aspects for Improving Receivables Management
Aspect Explanation
Centralization High-value transactions in accounts receivables & payables should be
centralized for better efficiency & faster recovery.
Alternative Payment Offering multiple payment options speeds up outstanding payments
Strategies and serves as a marketing tool to attract & retain customers.
Alternative Payment Methods
Payment Method Explanation
Direct Debit Automatic fund transfer from the buyer’s bank account, reducing
delays.
Integrated Voice Customers pay via phone, using a computer-based system & human
Response (IVR) operators. Ideal for businesses handling bulk payments.
Third-Party Collection Payments collected by external agencies, banks, or authorized firms
using cash, cheque, credit card, or electronic transfer.
Lock Box Processing An outsourced partner collects cheques & invoice data, then transmits
them to the company for faster processing.
Online Payments Funds transferred via RTGS, NEFT, UPI, or app-based platforms
(Paytm, PhonePe, etc.) for instant & seamless transactions.
Customer Orientation in Receivables Management
Aspect Explanation
Strategic Customer For important customers, businesses should use a case-study approach
Relations to understand payment behavior and develop strategies for quicker
debt settlement.

Page142
| 77
 Evaluation of Risk in Accounts Receivable Management
Aspect Explanation
Importance of Risk A key part of establishing control mechanisms to identify, assess, and
Evaluation manage risks in accounts receivables.
Risk Management Once risks are assessed, businesses can implement controls to either
Approach reduce risks to an acceptable level or eliminate them entirely.
Opportunity for Process Evaluating risks helps in removing inefficient practices and improving
Improvement the effectiveness of receivables management.
Re-thinking & Encourages a fresh look at processes, questioning how tasks are
Optimization performed, leading to greater efficiency & effectiveness.
Use of Latest Technology in Accounts Receivable Management
Aspect Explanation
Role of Technology Modern technology enhances efficiency in managing accounts
receivables through automation & system integration.
E-Commerce in Uses computers & electronic communication to facilitate trade in
Receivables goods & services between businesses.
Key Technologies in E- ➢ Electronic Data Interchange (EDI): Automates exchange of
Commerce business documents.
➢ Electronic Mail (Email): Enables faster communication.
➢ Electronic Funds Transfer (EFT): Ensures quick & secure
transactions.
➢ Electronic Catalogue Systems: Digital product listings for online
transactions (e.g., Amazon, Flipkart).
Automated Accounts Large firms automate receivable management to replace manual
Receivable Systems processes, reducing errors, costs, and delays.
Functionality of ➢ Automatically updates records: Adjusts customer balances,
Automated Systems inventory, and sales upon transaction.
➢ Tracks receivables & collections: Ensures faster processing of
payments & adjustments.
➢ Stores unlimited customer data: Enables better management of
multiple transactions.
Receivable Collection Practices
Aspect Explanation
Objective The goal is to reduce, monitor, and control accounts receivable while
maintaining customer goodwill.
Key Principle Minimize time lag between sales and collection to prevent buildup of
receivables and reduce bad debt risks.

Page143
| 78
Causes of Delay Billing & collection inefficiencies and customer delays can lead to
longer receivable cycles.

Major Receivable Collection Practices

Practice Explanation
Issue of Invoice Timely issuance of invoices ensures faster payment cycles.
Open Account or Open- Provides flexibility in payments, allowing continuous credit for
End Credit trusted customers.
Credit Terms or Time Clearly defined payment terms help in managing receivables
Limits efficiently.
Periodic Statements & Regular reminders & statements help track outstanding payments
Follow-Ups and ensure timely collection.
Payment Incentives & Encouraging early payments with discounts and charging late fees
Penalties reduces delays.
Record Keeping & Accurate tracking of accounts receivable ensures better financial
Continuous Audit control.
Export Factoring Third-party factors handle credit management, loss protection, and
collection services for exporters.
Business Process Companies outsource collection management to specialized agencies
Outsourcing (BPO) for efficiency and cost savings.

Use of Financial Tools/Techniques in Receivables Management

Tool/Technique Explanation
Credit Analysis Evaluates customer creditworthiness to minimize bad debts and set
appropriate credit terms.
Credit Rating Assigns credit scores to debtors based on financial status,
reputation, and payment history. Agencies like Dun & Bradstreet
provide ratings.
Sources for Credit ➢ Trade References
Evaluation ➢ Bank References
➢ Credit Bureau Reports
➢ Past Experience
➢ Published Financial Statements
➢ Salesman’s Reports
Credit Limit Setting After assessing creditworthiness, a credit limit is set, which may
increase with a positive payment history.
Credit Granting - Uses probability analysis to assess risks vs. benefits before granting
Decision Tree Analysis credit.

Page144
| 79
 Example: If profit probability = 0.9 and default probability = 0.1, the
expected net benefit is ₹50,000. Since it’s positive, credit should be
granted.
Receivables Control Monitoring and follow-ups ensure that standards and credit policies
are effectively implemented.
Collection Policy Ensures timely debt collection, minimizing bad debts and reducing the
average collection period.
Collection Process A balance between efficient debt collection and customer relations
Optimization should be maintained.
Key Questions in Credit ➢ When should collection start?
Collection ➢ What is the procedure for follow-ups & reminders?
➢ Should company representatives visit defaulting customers?
➢ How should doubtful accounts be handled? Legal action or
escalation matrix?

Credit Evaluation

Grant Do not Grant

Pays Does not Pay

Probability (0.9) Probability (0.1)

₹ 1,00,000 ₹ 4,00,000

Monitoring of Receivables
Aspect Explanation
Importance of Monitoring Regular tracking ensures efficient receivables management and
helps in maintaining liquidity.
Key Steps in Monitoring Various methods are used to analyze, compare, and control
Receivables receivables for better cash flow management.

Methods for Monitoring Receivables

Method Explanation
Computation of Average Age of Measures the average collection period, helping assess liquidity
Receivables and efficiency in collections.
Ageing Schedule ➢ Classifies receivables based on age for better control.
➢ Helps predict collection patterns and liquidity trends.

Page145
| 80
 ➢ Compares current receivables with past data and with
competitors.
➢ Identifies slow-paying customers and helps take corrective
action.
Comparison with Past Trends & Helps firms recognize increases or declines in sales trends by
Other Firms analyzing receivables over time.

Debt Collection Programme

Step Explanation
Monitoring Receivables Regular tracking of outstanding payments.
Intimation to Customers Reminders sent before the due date.
Follow-ups via Email & Phone Customers are contacted on the due date for payment
reminders.
Escalation & Legal Warning Customers with overdue accounts are informed of potential
legal action.
Legal Action on Overdue If payments remain unsettled, legal steps are initiated.
Accounts

Page146
| 81
 CHAPTER 9:SCOPE & OBJECTIVE OF FINANCIAL
MANAGEMENT
Introduction
We will like to explain Financial Management by giving a very simple scenario. For the purpose of
starting any new business/venture, an entrepreneur goes through the following stages of
decision making: -
Stage Description Key Focus
Stage 1 Decide which assets (premises, machinery, equipment, etc.) to buy. Assets
Stage 2 Determine total investment required for buying assets. Investment
(Total cost
of assets)
Stage 3 Determine cash needed for daily operations (raw material, Working
salaries, wages, etc.) — also called Working Capital requirement. Capital
(Funds for
daily
operations)
Stage 4 Decide sources to finance the total investment (assets + working Financing
capital). Sources could be Share Capital, Bank Loans, or (Source of
Investments from Financial Institutions. funds)

Financial Management Focus Areas

1. Financing Decision: Where to get the money from?
2. Investment Decision: Where to invest the money?
3. Dividend Decision: How much to distribute among shareholders to keep them satisfied?

Objective
The goal of financial management is to efficiently acquire and allocate funds, with the aim to
generate profit (or dividends) for the owners. This includes making decisions on investment,
financing, and dividends.

Meaning of Financial Management

➢ Financial management is the activity of planning and controlling a firm's financial resources.
It’s about acquiring, financing, and managing assets to achieve the business goal, mainly to
maximize shareholder wealth.
Planning & Control, Financial Resources, Shareholder Wealth

147
Definition 1
➢ It involves forecasting, planning, organizing, directing, and controlling the financial
activities of a business to meet its financial objectives.
➢ Forecasting, Organizing, Controlling
Definition 2 (Phillippatus)
➢ Financial management deals with managerial decisions that lead to acquiring and financing
both short-term and long-term credits for the firm.
➢ Managerial Decisions, Short-term & Long-term Credits
Two Basic Aspects of Financial Management
1. Procurement of funds
2. Effective use of funds to achieve business objectives.

Procurement of Funds
➢ Funds can be raised from different sources. In modern business, innovative financial
products are being used, like Carbon Credit Trading, to raise funds.
➢ Innovative Funding, Carbon Credit Trading

Cost of Funds
➢ Different sources of funds have varying risk, cost, and control. The goal is to keep the
cost of funds at a minimum by balancing risk and control.
➢ Risk, Cost of Funds, Control
Equity
➢ Funds raised by issuing equity shares are risky but do not require repayment, except in
liquidation. However, equity is usually expensive due to higher dividend expectations and
tax considerations.
➢ Equity Shares, Risk, Costly Funds

148
Debentures
➢ Debentures are cheaper than equity as they offer tax advantages. However, they are risky
since they require repayment and interest must be paid regardless of company profit.
➢ Debentures, Tax Advantages, Risk
Funding from Banks
➢ Commercial Banks provide funding for both short-term and long-term business needs. They
also support businesses in routine activities like deposits and payments.
➢ Banks, Short-term & Long-term Needs

International Funding
➢ With globalization, businesses can raise funds from international markets via FDI (Foreign
Direct Investment), FII (Foreign Institutional Investors), and financial instruments like
ADR’s and GDR’s.
➢ FDI, FII, Global Market
Angel Financing
➢ Angel investors provide funds for startups or expansions in exchange for equity ownership.
This source is often used by businesses that don’t qualify for bank loans or venture capital.
➢ Angel Investors, Equity Ownership, Startups
Key Considerations in Financial Management:
➢ Balancing equity and debt to create an optimal funding structure.
➢ Ensuring the cost of funds is as low as possible while managing risk and control effectively.

Effective Utilisation of Funds

Effective Utilization of Funds

➢ The finance manager is responsible for ensuring funds are not kept idle and are utilized
profitably. Funds should generate a return higher than their cost.
➢ Utilization, Profitability, Cost
Fixed Assets Utilization
➢ Funds must be invested in fixed assets (e.g., machinery, plants) to ensure optimal
production without harming the company's financial solvency. The finance manager needs
to understand capital budgeting.
➢ Fixed Assets, Capital Budgeting, Solvency

149
Working Capital Utilization
➢ The finance manager must maintain an optimum level of working capital, avoiding excessive
funds tied up in inventories, book debts, or cash.
➢ Working Capital, Liquidity, Efficiency
Key Considerations in Fund Utilization:
➢ Ensuring funds are profitable and not idle.
➢ Using capital budgeting techniques for long-term investments.
➢ Balancing working capital to avoid excess funds being tied up in current assets.

Evolution of Financial Management

The Traditional Phase

➢ Financial management was needed only for occasional events like takeovers, mergers,
expansion, or liquidation. Financial decisions focused on the needs of outsiders (e.g.,
investment bankers, lenders).
➢ Occasional Events, Outsiders, Lenders
The Transitional Phase
➢ Financial managers began focusing on day-to-day problems related to funds analysis,
planning, and control. The importance of these tasks grew during this phase.
➢ Day-to-Day Problems, Funds Analysis, Planning
The Modern Phase
➢ The scope of financial management greatly expanded. Financial analysis became critical for
decision-making. New theories were developed in areas like efficient markets, capital
budgeting, option pricing, and valuation models.
➢ Financial Analysis, Efficient Markets, Capital Budgeting, Decision Making

Finance Functions/ Finance Decision

Value of the Firm (V = f(I, F, D))

➢ The value of a firm depends on three key financial decisions: Investment (I), Financing (F),
and Dividend (D).
➢ Investment, Financing, Dividend
Long-Term Finance Functions
➢ The finance functions are divided into long-term and short-term decisions.
➢ Long-term Functions
Investment Decisions (I)
➢ These decisions involve selecting the assets in which funds will be invested (e.g., fixed
assets, current assets). Capital budgeting is used to evaluate investments. A part of long-
term funds is also used for working capital.
➢ Asset Selection, Capital Budgeting, Working Capital

150
Financing Decisions (F)
➢ These decisions focus on acquiring the optimum finance for financial objectives and
balancing equity and debt. Managers must understand cash flow vs. profit and assess risk
(e.g., currency fluctuations, debt risk). Hedging strategies are used to minimize risks.
➢ Capital Structure, Risk Management, Cash Flow
Dividend Decisions (D)
➢ These decisions determine how much of the profit will be paid as dividends to
owners/shareholders and how much will be retained for growth. Dividends impact the
company’s market value and stock price. The decision has both financial and growth
implications.
➢ Dividends, Profit Retention, Market Value
Short term Finance Decisions/ Function
Working Capital Management (WCM): Generally short term decision are reduced to
management of current asset and current liability (i.e., working capital Management)

Importance Of Financial Management

Importance of Financial Management

Financial management is crucial for the success of business operations. Without proper
financial administration, no business can achieve its full growth potential. Financial
management is about planning investments, funding investments, monitoring expenses against
budgets, and managing the gains from investments. It involves managing all financial matters
related to an organization.
Key tasks in financial management include:
• Avoiding over-investment in fixed assets.
• Balancing cash inflows with cash outflows.
• Ensuring adequate short-term working capital.
• Setting sales revenue targets to support growth.
• Increasing gross profit through proper pricing strategies.
• Controlling general and administrative expenses by finding more cost-efficient ways of
running operations.
• Engaging in tax planning to minimize taxes.

Scope Of Financial Management

Financial management is a critical part of overall management, focused on the acquisition and
use of funds by an organization. Based on Ezra Solomon's concept, the following aspects are
key in financial management:
1. Determining the size of the enterprise and its rate of growth.
2. Composition of assets within the enterprise.
3. Deciding on the mix of financing (i.e., the debt-to-equity ratio).
4. Analysis, planning, and control of the enterprise's financial affairs.

151
Role of the Financial Controller
The role of the financial controller has evolved significantly over time. Initially, it was limited
to fund procurement during major events (e.g., promotion, expansion, mergers). Today, it
involves making three key decisions: investment, financing, and dividends.

The figure (not shown) highlights the relationship between market value, financial decisions,
and the risk-return trade-off. The financial controller's role is to maximize shareholders'
wealth by balancing returns against risk. They must ensure that funds are properly monitored,
safeguarded, and effectively used.

Objectives Of Financial Management

Objectives of Financial Management

Effective financial management requires clear objectives or goals, as decisions are judged
based on these objectives. While various objectives can exist, we focus on two primary
objectives for detailed discussion:

1. Objective of financial management

2. Profit Maximization
3. Wealth/Value Maximization

Profit Maximization

Profit Maximization
Traditionally, profit maximization has been considered the primary goal of a company, meaning
that financial management should focus on decisions that maximize profits. Every alternative
is assessed based on whether it maximizes profit. However, profit maximization has limitations
and should not be the sole objective of a business. Some issues with focusing only on profit
maximization include:

152
1. Vague Definition of Profit
The term profit is unclear—it can refer to short-term or long-term profit, total profit, or
rate of profit, and its meaning varies among people.
2. Risk Ignorance
Profit maximization overlooks the risk involved. There is a direct relationship between risk
and profit—higher risk often leads to higher profits. Focusing only on profit could lead to
accepting high-risk proposals without considering the associated dangers.
3. Time Factor of Returns
Profit maximization doesn’t account for when the returns will be received. For example, a
proposal that offers high profits after 10 years (Proposal A) might be less attractive than
a proposal that offers lower profits but quicker returns (Proposal B).
4. Narrow Perspective
Profit maximization is too limited as it doesn’t consider social obligations, the welfare of
workers, consumers, or society, or ethical practices. Ignoring these factors could harm
the long-term sustainability of the company.

Wealth Maximization/ Value Creation

Wealth Maximization / Value Creation

The Wealth Maximization Model focuses on increasing shareholder wealth, which results from
a cost-benefit analysis adjusted for timing and risk (i.e., the time value of money).
Wealth = Present Value of Benefits – Present Value of Costs
• The finance manager must measure benefits in terms of cash flow rather than accounting
profit. This ensures that investment and financing decisions focus on cash flow.
The shareholder value maximization model suggests that the firm’s primary goal is to maximize
its market value, which means business decisions should aim to increase the net present value
(NPV) of the firm’s economic profits.

To achieve this, the finance manager should focus on:

• Cash flow instead of accounting profit.
• Cost-benefit analysis.
• Application of the time value of money.
How do we measure the value/wealth of a firm?
Measuring the Value/Wealth of a Firm
According to Van Horne, the value of a firm is represented by the market price of its common
stock. The stock price reflects the judgment of all market participants regarding the firm's
value. It considers several factors:
• Current and future earnings per share.
• Timing and risk of earnings.
• Dividend policy.
• Other factors influencing stock price.

153
The market price serves as a performance indicator, showing how well management is
performing on behalf of shareholders.

Why Wealth Maximization Works

Before understanding why wealth maximization is effective, it’s important to recognize other
possible goals for a business:
• Higher growth rate.
• Larger market share.
• Leadership in products/technology.
• Employee welfare.
• Customer satisfaction.
• Community support, such as education, research, and solving societal issues.

While these goals are significant, wealth maximization remains the primary goal because it is
critical to the survival and growth of the business. Without it, investors may lose confidence,
restricting the company’s growth and making it harder to achieve other goals like community
welfare.

Conflicts In Profit Versus Value Maximization Principle

Management Objectives: Profit Maximization vs. Wealth Maximization

➢ Management Decision-Making: In any company, the management is responsible for decision-
making. However, when external parties (like shareholders, lenders, etc.) are involved,
management's personal goals (such as profit maximization) may conflict with the broader
goals of these stakeholders.
➢ Stakeholder Influence: Management’s survival depends on satisfying stakeholders
(employees, creditors, customers, government). Wealth maximization aligns better with
the interests of stakeholders, as it focuses on increasing the firm's value over time,
benefiting all parties.

154
➢ Wealth Maximization as the Better Goal: While profit maximization is limited by timing
and social considerations, wealth maximization accounts for uncertainty and multi-period
scenarios, making it more suitable for long-term goals. In short-term, low-risk situations,
both goals may seem similar.

Comparison of Profit Maximization and Wealth Maximization

Goal Objective Advantages Disadvantages

Profit Large amount of profits Focuses on short-term gains
Maximization i. Easy to calculate profits i. Ignores risk or uncertainty
ii. Easy to link financial ii. Ignores timing of returns
decisions to profits iii. Requires immediate resources
Wealth Highest market value of shares i. No clear link between financial
Maximization i. Focuses on long-term gains decisions and share price
ii. Recognizes risk and ii. May cause management anxiety or
uncertainty frustration
iii. Considers timing of returns
iv. Focuses on shareholders'
return

Role Of Finance Executive

Changing Role of the Finance Executive

• Evolution of Financial Management: Modern financial management has evolved significantly
from traditional corporate finance. With globalization, liberalization, and the opening up
of markets, finance managers now have access to limitless opportunities.

• New Era for CFOs: In recent years, the role of the Chief Financial Officer (CFO) or
finance executive has transformed. Their role has expanded beyond just cost management
and controls to become integral to business strategy, transformation, and growth.
Key Responsibilities of the Modern Finance Executive:
1. Financial Analysis and Planning
➢ Determining the right amount of funds for the firm.
➢ Deciding the firm’s size and growth rate.
2. Investment Decisions
➢ Efficiently allocating funds to assets.
3. Financing and Capital Structure Decisions
➢ Raising funds under favorable terms.
➢ Determining the firm’s debt-equity structure.
4. Management of Financial Resources
➢ Ensuring effective management of working capital.

155
5. Risk Management
➢ Protecting the firm’s assets from potential risks.
Quote by Jeff Thomson, IMA President and CEO:
"Today’s CFO team is expected to add value well beyond the traditional roles of cost
management, controls, and acting as the conscience of the organization. They must collaborate,
integrate key business processes, and act as catalysts for business transformation and
trusted advisors to drive sustainable growth."

Organisation of Finance Function

Organization of the Finance Function: Changing Role of the CFO

The role of the Chief Financial Officer (CFO) has evolved drastically over time. Historically,
the CFO's role was primarily confined to accounting, reporting, and risk management. In
contrast, today's CFO is seen as a strategic business partner to the Chief Executive Officer
(CEO), playing a crucial role in business decision-making and long-term strategy.
Key Differences in the Role of the CFO: Past vs. Present
What a CFO Used to Do What a CFO Now Does
Budgeting Budgeting
Forecasting Forecasting
Accounting Managing Mergers and Acquisitions (M&As)
Treasury (cash management) Profitability Analysis (e.g., by customer or
product)
Preparing internal financial reports Pricing Analysis
Preparing quarterly/annual filings Decisions about Outsourcing
Tax Filing Overseeing IT Function
Tracking accounts payable and receivable Overseeing HR Function
Travel and entertainment expense Strategic Planning (sometimes overseeing this
management function)
Regulatory Compliance Risk Management

156
 Financial Distress And Insolvency

Financial Distress and Insolvency

Financial distress and insolvency are critical issues that can severely affect a firm's
operations and survival. These conditions arise when a company faces significant difficulties
in managing its finances and fulfilling its obligations.
Financial Distress:
• Definition: Financial distress occurs when a firm’s cash inflows are insufficient to meet its
current obligations (e.g., paying debts, wages, operating expenses).

• Causes:
➢ Price Fluctuations: Changes in product/service prices or input costs (e.g., raw materials,
labor) can strain financial health.
➢ Debt Levels: High levels of debt increase the pressure on the company due to higher
interest payments.
➢ Inadequate Cash Flow: If cash inflows are not sufficient to cover the company's short-
term and long-term liabilities, financial distress intensifies.
Insolvency:
• Definition: Insolvency is the state in which a firm cannot meet its debt obligations because
its revenue is insufficient. Insolvency typically results from prolonged financial distress.
• Consequences:
o The firm may have to sell its assets, often at lower prices than expected.
o If revenue generation doesn't improve, the company may ultimately fail to meet its
obligations, leading to insolvency.

Relationship Of Financial Manage- Ment With Related Disciplines

As an integral part of the overall management, financial management is not a totally independent
area. It draws heavily on related disciplines and areas of study namely economics, accounting,
production, marketing and quantitative methods. Even though these disciplines are inter-related,
there are key differences among them. Some of the relationships are being discussed below:
Here’s a simplified and organized version of the content in a table format:
Aspect Financial Management Accounting
Relationship Financial management relies on Accounting provides essential financial
accounting for financial decision- data for financial decision-making.
making and planning.
Treatment of Focuses on cash flow: revenues are Based on accrual principle: revenues are
Funds recognized when cash is received recognized when earned, and expenses
and expenses when cash is paid. when incurred, regardless of cash flow.

157
Purpose Ensures solvency and manages cash Collects and presents financial data,
flows to meet obligations and including past, present, and future
achieve goals. operations.
Key Focus Concerned with long-term financial Focused on reporting financial data and
planning, controlling, and decision- preparing financial statements like
making to maintain solvency. balance sheets and income statements.
Decision- Primarily responsible for financial Focused on data collection and
Making planning, controlling, and decision- presentation, not direct decision-
making. making.
Goal Helps the organization avoid Provides financial reports that inform
insolvency by ensuring healthy cash decision-making but doesn't engage in
flow and achieving financial goals. the decision-making process itself.

Financial Management And Other Related Disciplines

Discipline Role in Financial Management Impact on Day-to-Day

Decisions
Marketing Provides insights into capital Financial managers evaluate
requirements for new products, the capital needed for
promotions, etc. marketing plans and how these
affect cash flows.
Production Changes in production may require Financial managers assess and
capital expenditures. finance the required capital for
production process
improvements.
Quantitative Methods Provides analytical tools and Financial managers use these
techniques. methods to analyze complex
financial problems and make
informed decisions.
Economics Offers knowledge of external Helps financial managers
factors affecting the business understand broader economic
environment. trends and external factors
impacting business.
Accounting Primary discipline providing financial Essential for financial decision-
data through reports (balance making as it presents past
sheets, income statements, etc.). performance, future
projections, and liquidity.

158
 Agency Problem And Agency Cost

Agency Problem
A situation where managers may prioritize personal goals (e.g., salary, perks) over the
interests of shareholders (owners), leading to a conflict of interest.
Agency Cost
The additional cost borne by shareholders to monitor and control managers' behavior to ensure
they act in shareholders' best interest.
Types of Agency Costs
1. Monitoring: Costs of overseeing manager actions.
2. Bonding: Costs to ensure managers act in shareholders' interest.
3. Opportunity: Costs due to suboptimal decisions made by managers.
4. Structuring: Costs related to creating systems to limit agency problems.
Agency Problem with Debt Lenders
Debt lenders may face agency problems due to managers taking high risks. This is addressed
by imposing negative covenants (restrictions on borrowing).
Agency Problem between Managers & Shareholders
The key issue arises when managers’ personal interests are not aligned with shareholder wealth
maximization.
Ways to Address Agency Problem
1. Managerial Compensation: Linking manager pay to company profits and long-term
objectives.
2. Employee Stock Ownership Plans (ESOPs): Aligning manager and shareholder interests.
3. Monitoring: Strengthening oversight mechanisms to ensure managers act in the best
interest of shareholders.

159
 CHAPTER 10. TYPES OF FINANCING

Financial Needs And Sources Of Finance Of A Business

Financial Needs of a Business

Category Duration Purpose
i Long-term More than 5-10 Investment in plant, machinery, land, buildings, and
Financial Needs years permanent working capital.
ii Medium-term 1 to 5 years Funds for stores, critical spares, tools, dies,
Financial Needs moulds.
iii Short-term Up to 1 year Financing current assets like stock, debtors, cash
Financial Needs (Working Capital).

Basic Principle for Funding Needs

➢ Short-term needs → Funded by short-term sources
➢ Medium-term needs → Funded by medium-term sources
➢ Long-term needs → Funded by long-term sources

The funding approach varies based on business stage and risk level:
Stage Uncertainty Level Sources of Funds
Early Stage High Uncertainty Equity (Angel Investors)
High to Moderate Uncertainty Equity, Venture Capital, Debt
Growth Stage Moderate to Low Uncertainty Debt, Venture Capital, Private Equity
Stable Stage Low Uncertainty Debt

Classification Of Financial Sources

There are mainly two ways of classifying various financial sources (i) Based on basic Sources (ii)
Based on Maturity of repayment period.
Sources of Finance based on Basic Sources
Based on basic sources of finance, types of financing can be classified as below:

160
 Equity Shares
Share Capital
Preference Shares

External Sources
Debentures

Sources of Debt or Borrowed Loan from Financial

Finance Capital Institutions
Mainly
Internal Sources Others
retainedearnings

Sources of Finance based on Maturity of Payment

Sources of finance based on maturity of payment can be classified as below:

Sources of Finance

Short-term
Long-term Medium-term
1.Trade credit
1.Share capital or Equity 1.Preference shares
2.Accrued expenses and
shares 2.Debentures/Bonds
deferred income
2.Preference shares 3.Public deposits/fixed
3.Short term loans like
3.Retained earnings deposits for duration of
Working Capital
4.Debentures/Bonds of three years
Loans from
different types 4.Medium term loans
Commercial banks
5.Loans from financial from Commercial banks,
4.Avances received
institutions Financial Institutions,
from customers
6.Loans from State State Financial
5.Various short-term
Financial Corporations Corporations
provisions
7.Loans from commercial 5.Lease financing/Hire-
banks Purchase financing
8.Venture capital funding 6.External commercial
9.Asset securitisation borrowings
10.International inancing 7.Euro-issues
like Euroissues, 8.Foreign Currency bonds
Foreign currency loans

161
 Long-Term Sources Of Finance

Long-term financial needs can be met through two main sources:

➢ Share Capital (Equity & Preference Shares)
➢ Debt (Debentures, Long-Term Borrowings, Other Debt Instruments)

Equity Capital (Owner’s Capital)

A public limited company can raise funds from promoters or the public by issuing equity shares.
Feature Explanation
Permanent Capital Equity capital is a long-term source of finance.
Ownership & Risk Equity shareholders are the owners and bear the highest risk.
Dividend Shareholders receive dividends only after all other claims are
settled.
Claim on Assets In case of liquidation, equity shareholders have the last claim on
assets.
Cost of Capital The cost is highest as shareholders expect higher returns due to
risk.
Security for Loans A strong equity base helps in securing debt financing.
Types of Equity Shares New Issue, Rights Issue, Bonus Shares, Sweat Equity.

Advantages of Raising Funds Through Equity Shares

Advantage Explanation
i Permanent Equity shares are not redeemable, meaning the company has no cash
Source of outflow liability for repaying investors. Shares can be bought and sold
Finance freely in the market.
ii Enhances Issuing equity shares strengthens the company’s financial base, making
Borrowing it easier to raise additional funds through debt. This can lead to higher
Power earnings per share (EPS) and an increase in share prices.
iii No Legal Unlike debt, a company is not legally required to pay dividends. In tough
Obligation for times, dividends can be reduced or skipped without financial strain.
Dividends
iv Option to A company can issue more shares through a Rights Issue, allowing
Raise More existing shareholders to buy additional shares.
Capital

Disadvantages of Raising Funds Through Equity Shares

Disadvantage Explanation
i Higher Risk for Equity shares are riskier as dividends and capital gains are uncertain.
Investors
ii Earnings Dilution Issuing new equity shares reduces Earnings Per Share (EPS) unless
profits increase proportionally.

162
 iii Loss of Ownership New equity share issuance dilutes ownership, reducing the control
& Control of existing shareholders.

Preference Share Capital

Preference shares provide priority in dividend payments and capital repayment in case of
company liquidation.
Feature Explanation
Source of Long-Term Can be raised through a public issue of shares.
Funds
Cumulative Dividends If no dividend is paid in a loss-making year, it gets carried
forward until profits allow payment.
Higher Dividend Rate Dividend rate is usually higher than debenture or loan interest
rates.
Fixed Repayment Period Most preference shares have a stipulated repayment period.
Hybrid Financing Combines features of equity and debt – dividends are not tax-
deductible like equity, but the dividend rate is fixed like debt.
Cumulative Convertible These shares provide a fixed cumulative dividend for a set period
Preference Shares (CCPs) (e.g., 3 years) before converting into equity shares. Useful for
long-gestation projects.
Redeemable Option Can be redeemed at a pre-decided date or earlier from company
profits. This allows promoters to reinvest capital in other
ventures.

Various types of Preference shares can be as below:

S. Type of Preference Shares Salient Features
No.
1 Cumulative Arrear Dividend will accumulate.
2 Non-cumulative No right to arrear dividend.
3 Redeemable Redemption should be done.
4 Participating Can participate in the surplus which remains after
payment to equity shareholders.
5 Non-Participating Cannot participate in the surplus after payment of fixed
rate of Dividend.
6 Convertible Option of converting into equity Shares.

Advantages of Raising Funds Through Preference Shares

Advantage Explanation
No EPS Dilution Unlike equity shares, preference shares do not reduce Earnings Per Share
(EPS), preserving market confidence.
Leverage Benefit Carries a fixed dividend rate, helping with financial planning. Non-payment
does not lead to liquidation like debt.

163
 No Risk of No voting rights for preference shareholders (except when dividends are
Takeover unpaid), preventing hostile takeovers.
Fixed Dividends Preference dividends are pre-decided, meaning shareholders cannot claim
extra profits, unlike ordinary shareholders.
Redeemable Preference capital can be redeemed after a fixed period, allowing for
Option flexibility in financial structuring.

Disadvantages of Raising Funds Through Preference Shares

Disadvantage Explanation
No Tax Benefit Preference dividends are not tax-deductible, unlike interest on debt,
making them costlier than debentures.
Cumulative Dividend Unpaid preference dividends accumulate and must be paid before
Obligation ordinary shareholders.
Impact on Reputation If preference dividends are not paid, it prevents dividends to ordinary
shareholders, which can harm the company’s market reputation.

Difference between Equity Shares and Preference Shares are as follows:

S. No. Basis of Distinction Equity Share Preference Share
1 Dividend payment Equity Dividend is paid Payment of preference
after preference dividend. dividend is preferred over
equity dividend.
2 Rate of dividend Fluctuating Fixed
3 Convertibility Not convertible Convertible
4 Voting rights Equity shareholders enjoy They have very limited voting
full voting rights. rights.

Retained Earnings
Retained earnings refer to accumulated profits reinvested in the business rather than
distributed as dividends.
Feature Explanation
Source of Long-Term Generated by ploughing back profits into the business.
Funds
Belongs to These funds increase net worth and belong to ordinary shareholders.
Shareholders
No Additional Risk Retained earnings do not create debt obligations and entail minimal
risk.
No Ownership Dilution Unlike issuing new shares, control remains with existing owners.
Legal & Expansion Public companies must retain a portion of profits to meet legal
Needs requirements and growth plans.
Dividend Decision The decision to retain earnings depends on the company’s return on
Factor investment vs. cost of equity.

164
Debentures
Debentures are long-term debt instruments issued by public limited companies to raise funds.
Feature Explanation
Denominations & Interest Issued in amounts ranging from ₹100 to ₹1,000 with varying
Rates interest rates.
Debenture Trust Deed Issued based on a trust deed outlining the terms & conditions.
Long-Term Debt Used for raising long-term capital.
Instrument
Maturity Period Typically 3 to 10 years, longer for high-gestation projects.
Secured or Unsecured Debentures can be backed by assets (secured) or unsecured.
Stock Exchange Listing May or may not be listed on stock exchanges.
Tax Benefit Interest is tax-deductible, reducing the cost of capital.
Investor Advantage Interest is paid regardless of company profits, making it more
attractive than preference shares.

Types of Debentures Based on Convertibility

Type Explanation
Non-Convertible Cannot be converted into equity shares and are repaid on maturity.
Debentures (NCDs)
Fully Convertible Converted into equity shares based on pre-defined terms (price &
Debentures (FCDs) time). Offer lower interest rates due to conversion benefits.
Partly Convertible Partially converted into equity shares, while the remaining portion is
Debentures (PCDs) repaid on maturity. Provide both debt and equity benefits to
investors.

Other types of Debentures with their features are as follows:

Sl. No. Type of Debenture Salient Feature
1 Bearer Transferable like negotiable instruments
2 Registered Interest payable to registered person
3 Mortgage Secured by a charge on Asset(s)
4 Naked or simple Unsecured
5 Redeemable Repaid after a certain period
6 Non-Redeemable Not repayable

Advantages of Raising Finance Through Debentures

Advantage Explanation
Lower Cost of Interest is tax-deductible, making debentures cheaper than preference
Capital or equity capital. Investors also find debentures safer, so they accept a
lower return.
No Ownership Debenture holders do not have voting rights, ensuring no loss of control
Dilution for existing shareholders.

165
 Beneficial During Fixed interest payments lose value over time as prices rise, making it cost-
Inflation effective in inflationary periods.

Disadvantages of Debenture Financing

Disadvantage Explanation
Obligatory Payments Interest payments and principal repayment are mandatory, regardless
of company performance.
Restrictive Covenants Debenture agreements often include strict terms that may limit
company operations.
Increased Financial High debt obligations raise the financial risk of the company.
Risk
Large Cash Outflow Principal repayment at maturity requires a significant cash reserve.
at Maturity
Mandatory Credit Public and private debenture issues must be rated by agencies like
Rating CRISIL, which evaluate company performance, profitability, and risk.

Difference Between Preference Shares and Debentures

Basis of Difference Preference Shares Debentures
Ownership A special type of share A loan instrument used to
representing partial ownership. raise funds from the public.
Payment of Priority in dividend payments and Pays a fixed interest rate,
Dividend/Interest capital repayment during regardless of company
liquidation. profits.
Nature A hybrid financing method, A pure debt instrument with a
combining equity and debt features. fixed maturity period.

Bonds
Bonds are fixed-income securities issued to raise funds through public issues or private
placements.
Types of Bonds (Based on Call Option)
Type Explanation
Callable Issuer has the right to redeem the bond before maturity at a predetermined
Bonds call price (usually at a premium).
Puttable Investor has the right to sell the bond back to the company before maturity
Bonds (put option).

Various Bonds with their salient features are as follows:

Types of Foreign Bonds & Their Features
Sl. Bond Name Salient Features
No.
1 Foreign Currency ➢ Low interest rate bond.

166
 Convertible Bond ➢ Issuer benefits from low-cost foreign currency borrowing.
(FCCB) ➢ Risk: If the bond is not converted, the issuer must repay at
maturity, which may be challenging.
2 Plain Vanilla Bond ➢ Pays principal + interest.
➢ No embedded options.
➢ Can be issued as a discounted bond or coupon-bearing bond.
3 Convertible Floating ➢ Option to convert into long-term debt security.
Rate Notes (FRN) ➢ Protects investors from falling interest rates.
➢ No capital gains tax.
➢ Can be sold for profit.
4 Drop Lock Bond ➢ Floating rate note that converts to a fixed rate bond if rates
drop below a set level.
➢ The new fixed rate stays until maturity.
➢ Short option structure, unlike convertible FRN (long option
structure).
5 Variable Rate ➢ Floating rate bond with nominal maturity.
Demand Obligations ➢ Investors can sell back to the trustee at par + accrued
(VRDOs) interest.
➢ More liquid than a standard FRN.
6 Yield Curve Note ➢ Structured debt security.
(YCN) ➢ Yield rises when interest rates fall.
➢ Yield falls when interest rates rise.
➢ Used for interest rate hedging.
➢ Functions like an inverse floater.
7 Euro Bond ➢ Issued outside the country of the currency it is denominated
in.
➢ Example: A British company issues a bond in Germany,
denominated in USD.
➢ Not related to the Euro currency, "Euro-" refers to offshore
deposits.

Types of Indian Bonds & Their Features

Sl. Bond Name Salient Features
No.
1 Masala Bond ➢ Rupee-denominated bond issued outside India.
➢ Allows Indian companies to raise funds in foreign markets.
➢ Example: NTPC raised ₹2,000 crore in 2016 for capital
expenditure.
2 Municipal Bond ➢ Used to finance urban infrastructure projects.
➢ Ahmedabad Municipal Corporation was the first in Asia to issue
a municipal bond (₹100 crore) for a water supply project.

167
 3 Government or ➢ Issued by Government of India, RBI, state governments, or
Treasury Bond government departments.
➢ Considered low-risk investment instruments.
Some other bonds are included in other source of Financing (para 8)

Loans from Financial Institutions

Financial Institution: National
S. No. Name of the Financial Institution Year of Remarks
Establishment
1. Industrial Finance Corporation of India 1918 Converted into a public
(IFCI) company
2. State Financial Corporations (SFCs) 1951 -
3. Industrial Development Bank of India 1954 Converted into Bank
(IDBI)
4. National Industrial Development 1954 -
Corporation (NIDC)
5. Industrial Credit and Investment 1955 Converted into Bank
Corporation of India (ICICI) and Privatised
6. Life Insurance Corporation of India 1956 -
(LIC)
7. Unit Trust of India (UTI) 1964 -
8. Industrial Reconstruction Bank of India 1971 -
(IRBI)

Financial Institution: International Institutions

Sl. No. Name of the Financial Institution Year of
Establishment
1. The World Bank/ International Bank for Reconstruction and 1944
Development (IBRD)
2. The International Finance Corporation (IFC) 1956
3. Asian Development Bank (ADB) 1966

Loans from Commercial Banks

Commercial banks primarily provide short-term funding, but they also offer long-term financing
for industries.
Type Explanation
Long-Term Loans ➢ Provided for business expansion or new unit setup.
➢ Repayment is scheduled over a long period, based on
anticipated income.
Working Capital Term Loan ➢ Funds the minimum working capital requirement that remains
(WCTL) constant.

168
 ➢ Not affected by seasonal fluctuations.
Bridge Finance ➢ Short-term loan taken while waiting for approved long-term
loans to be disbursed.
➢ Helps companies avoid project delays.
➢ Secured against movable assets, guarantees, and promissory
notes.
➢ Higher interest rate than regular term loans.
➢ Repaid from sanctioned term loans once disbursed.

Venture Capital Financing

Meaning of Venture Capital Financing

Venture capital financing provides funds to high-risk startups led by qualified entrepreneurs
who lack experience and capital but have high growth potential.
Characteristics of Venture Capital Financing
Feature Explanation
Equity Finance Primarily involves equity investment in new companies.
Long-Term Focuses on growth-oriented small/medium firms.
Investment
Strategic Support Investors provide funds, sales strategy, business networking, and
management expertise to help the business grow.

Methods of Venture Capital Financing

Method Explanation
Equity ➢ Provides long-term funding via equity share capital.
Financing ➢ Venture capital firms hold less than 49% equity to ensure entrepreneurial
control.
Conditional ➢ Repayable as a royalty on sales once the business generates revenue.
Loan ➢ No interest is charged.
➢ Royalty rates range from 2% to 15%, depending on factors like gestation
period, cash flow, and risk.
➢ Some financiers allow firms to pay high-interest rates (above 20%)
instead of royalty once stable.
Income Note ➢ A hybrid security combining conventional and conditional loan features.
➢ Requires both interest and royalty payments but at low rates.
➢ IDBI’s Venture Capital Fund (VCF) funds 80-87.5% of project costs for
commercializing indigenous technology.
Participating ➢ Three-stage interest structure: No interest in the startup phase, low
Debenture interest up to a certain revenue level, then high interest after achieving
stability.

169
 Debt Securitisation

Debt securitisation is the process of converting illiquid assets into marketable securities, which
are then sold to investors. These securities represent ownership interest or are secured by a
pool of income-generating assets such as real estate, car loans, or equipment loans.
Example of Debt Securitisation
Step Explanation
1. Loan Issuance A finance company provides car loans to borrowers.
2. Need for More Funds To issue more loans, the company needs additional capital.
3. Role of Special Purpose Instead of selling individual loans, the company sells its existing
Vehicle (SPV) car loans to an SPV.
4. Pooling & Conversion The SPV pools the car loans and converts them into marketable
securities.
5. Issuing to Investors The securities are sold to investors, creating a liquid
investment.
6. Loan Repayments Borrowers continue making payments, but now payments go to
new investors, not the finance company.
7. Benefits ➢ The finance company raises funds and removes loans from
its Balance Sheet.
➢ Investors get a diversified fixed-income investment.
➢ Borrowers remain unaware of the securitisation process and
continue regular payments.

Lease Financing

Leasing is a contract between the owner (lessor) and the user (lessee), where the lessor
purchases the asset and leases it to the lessee for a specified rental payment. Leasing serves as
an alternative to buying an asset using own or borrowed funds and is faster to arrange than term
loans.

Types of Lease Contracts

Type Explanation
Operating Lease ➢ Lessor retains ownership, while lessee pays periodic rent for
using the asset.
➢ Lessor bears maintenance, insurance, and repair costs.
➢ Short-term lease, so the lessor may lease the asset to multiple
lessees.
➢ Normally cancelable with notice.
➢ Ideal for companies frequently updating equipment to avoid
technological obsolescence.
Financial Lease (Capital ➢ Long-term, non-cancelable lease—lessee cannot terminate the
Lease) agreement.

170
 ➢ Lease term covers most of the asset’s economic life.
➢ Lessee bears maintenance, insurance, and other costs.
➢ Functions like a loan in disguise, requiring fixed payments over
the lease period.
➢ Designed to amortize the lessor’s investment and ensure profit.

Note: The above diagram may be summarized in a short paragraph.

Comparison Between Financial Lease and Operating Lease

Basis Financial Lease Operating Lease
Ownership Risk & Lessee assumes risks and rewards Lessor retains ownership risks;
Reward of ownership; lessor remains legal lessee only gets right to use.
owner.
Obsolescence Risk Lessee bears risk of asset Lessor bears risk of obsolescence.
becoming obsolete.
Cancellability Non-cancelable—lessor must Cancelable—lessor can lease asset
recover full cost and interest. to other users.
Responsibility for Lessee handles maintenance, Lessor handles maintenance,
Maintenance repairs, and operations. repairs, and operations.
Payment Structure Full payout lease—single lease Non-payout lease—lessor releases
recovers full asset cost + interest. asset multiple times to different
users.

Other Types of Leases

Type Explanation
Sales and ➢ Owner sells an asset to a buyer, who leases it back to the seller.
Lease Back ➢ No physical exchange—only recorded in financials.
➢ Seller becomes lessee, and buyer becomes lessor.
➢ Allows the lessee to retain asset use while freeing up capital.
Leveraged ➢ Involves a third party (lender) along with lessor and lessee.
Lease ➢ Lessor borrows a part (e.g., 80%) of the asset cost from the lender.
➢ Lessee pays lease rentals directly to the lender; remaining amount goes to

171
 the lessor.
➢ Lessor claims depreciation benefits.
Sales-Aid ➢ Lessor partners with a manufacturer to lease products.
Lease ➢ Helps boost product sales for the manufacturer.
➢ Lessor earns from both the lessee and manufacturer (through commission
or credit).
Close-Ended ➢ Asset returns to the lessor at lease end.
Lease ➢ Lessor bears obsolescence risk and residual value responsibility.
Open-Ended ➢ Lessee has the option to purchase the asset at lease end.
Lease ➢ Flexibility for the lessee in asset ownership.
Leasing is a popular financing option in India as it eliminates immediate cash outflow and lease
rentals are tax-deductible. However, buying provides benefits like depreciation allowance and
interest deductions, requiring a careful cost-benefit evaluation.

Short-Term Sources Of Finance

Source Explanation
i Trade Credit ➢ Credit from suppliers as part of business transactions.
➢ Duration: 15 to 90 days.
➢ No explicit cost—automatically increases with business growth.
ii Accrued ➢ Accrued Expenses: Liabilities for services already received (e.g.,
Expenses & wages, taxes, interest).
Deferred ➢ Deferred Income: Advance payments for future goods/services,
Income improving liquidity.
iii Advances from ➢ Manufacturers & contractors take advance payments for large
Customers projects.
➢ Cost-free finance, useful for long-duration projects.
iv Commercial ➢ Unsecured promissory note, introduced by RBI in 1989.
Paper (CP) ➢ Issued by top-rated corporates & financial institutions.
➢ Denomination: ₹5 lakhs or multiples.
➢ Interest linked to 1-year Govt. bond yield.
➢ Must be rated by CRISIL, ICRA, CARE, FITCH, etc..
v Treasury Bills ➢ Issued by Govt. of India for short-term borrowing.
(T-Bills) ➢ Maturity: 14 to 364 days.
vi Certificates of ➢ Fixed-maturity savings certificates.
Deposit (CDs) ➢ Maturity: 15 days to 1 year.
vii Bank Advances ➢ Banks lend funds collected from public deposits.
➢ Used for economic development & profit generation.
➢ Loans are callable when required.

172
Some of the facilities provided by banks are:
Types of Short-Term Bank Advances
Type Explanation
a. Short-Term Loans ➢ One-time disbursement in cash or to the borrower's account.
➢ Secured against shares, govt. securities, life insurance policies,
or fixed deposit receipts.
➢ Repayment is either full or in scheduled installments.
b. Overdraft (OD) ➢ Allows withdrawal beyond current account balance within a fixed
limit.
➢ Repayable on demand, but limits are usually renewed annually.
➢ Interest is charged on daily balances.
c. Clean Overdrafts ➢ Given only to financially strong & reputed borrowers.
➢ No tangible security, banks rely on borrower’s personal
creditworthiness.
➢ Banks may require third-party guarantees as a safeguard.
➢ Typically short-term, not continued for long.
d. Cash Credits (CC) ➢ Credit limit sanctioned by a bank, allowing the borrower to
withdraw as needed.
➢ Interest is charged only on the amount used, not on the full limit.
➢ Secured against tradable goods via pledge or hypothecation.
➢ Though repayable on demand, banks usually do not recall them
unless necessary.
e. Advances Against ➢ Secured loans against goods, including agricultural commodities,
Goods raw materials, or finished products.
➢ Goods are charged to the bank by pledge or hypothecation.
➢ Reliable, liquid security with quick turnover.
f. Bills Purchased / ➢ Advances given against trade bills, which can be clean or
Discounted documentary.
➢ Banks purchase bills from approved customers and hold them as
security.
➢ The bank retains pledge rights over goods covered in the
documents.

viii Financing of Export Trade by Banks

Aspect Explanation
Importance of ➢ Exports are crucial for the economic growth of countries like India.
Export Finance ➢ Credit plays a key role in enabling exporters to efficiently execute
orders.
RBI Initiatives ➢ RBI has introduced measures to ensure timely and hassle-free export
credit flow, such as:
✓ Rationalization and liberalization of interest rates

173
 ✓ Flexibility in repayment/prepayment
✓ Special packages for large exporters and agricultural exports
✓ Gold Card Scheme
✓ Unrestricted sourcing of foreign funds for export credit
Types of ➢ Pre-shipment finance (before shipment)
Export Finance ➢ Post-shipment finance (after shipment)
Currency Used ➢ Export finance can be granted in Rupees or foreign currency.
Banking ➢ Banks can source funds from abroad without limits to grant export credit
Freedom in foreign currency.

Pre-Shipment Finance (Packing Credit)

Aspect Explanation
Definition Packing credit is a short-term advance provided by banks to exporters for
buying, manufacturing, processing, packing, and shipping goods to overseas
buyers.
Eligibility Available to exporters with a firm export order or an irrevocable letter of
credit from the overseas buyer.
Repayment The advance must be repaid within 180 days by negotiation of export bills
or receipt of export proceeds.
Required Exporters must provide letters of credit and firm sale contracts to show
Documentation the arrangement and finance amount.
Nature Short-term advance to fund pre-shipment activities.
Conditions Long-standing customers may receive packing credit based on firm
contracts without the need for letters of credit.

Types of Packing Credit

Type Explanation
a. Clean Packing Credit Advance based on a firm export order or letter of credit without
control over raw materials or finished goods. Requires a suitable
margin and ECGC cover.
b. Packing Credit Finance is provided where goods are hypothecated as security.
Against Exporters must submit stock statements regularly and provide a
Hypothecation of firm export order or letter of credit.
Goods
c. Packing Credit Export finance based on pledging finished goods with the bank. The
Against Pledge of goods remain under the bank's control and are shipped by approved
Goods clearing agents as required by the exporter.
d. E.C.G.C. Guarantee Packing credit loans for export activities (manufacturing,
processing, purchasing) can be guaranteed by Export Credit
Guarantee Corporation (ECGC).
e. Forward Exchange Exporters must enter into a forward exchange contract with the

174
 Contract bank to mitigate currency risk when export bills are in a foreign
currency.

Post-Shipment Finance
Type Explanation
a. Purchase/Discounting of Finance is provided by purchasing or discounting export bills
Documentary Export Bills (sight or usance) backed by documents like bill of lading, air
consignment notes, or parcel receipts.
b. E.C.G.C. Guarantee Post-shipment finance is eligible for E.C.G.C. guarantee,
which covers risks related to shipment and contracts.
Exporters must obtain risk policies covering both political
and commercial risks.
c. Advance Against Export Finance is offered against export bills forwarded for
Bills Sent for Collection collection. The bank evaluates the creditworthiness, nature
of goods, and standing of drawee.
d. Advance Against Duty Banks provide advances against export duty drawbacks or
Drawbacks, Cash Subsidy, cash subsidies receivable, with care taken to verify the
etc. exporter's export performance through negotiated or
collected export bills.

Other facilities extended to the exporters are as follows:

Service Description
Letters of Banks issue letters of credit for approved exporters, guaranteeing
Credit payments to their overseas or up-country suppliers.
Guarantees Banks provide guarantees for various purposes such as waiver of excise
duty, performance of contracts, bond in lieu of cash security deposit, and
advance payments.
Export Finance Banks offer finance to approved clients who are exporting on deferred
payment terms.
Trade Banks secure status reports of buyers and provide trade information on
Information commodities for their exporter customers through correspondents.
Economic Banks provide economic intelligence about different countries to help
Intelligence exporters.

Source Explanation
ix Inter Companies can borrow funds for a short period (e.g., 6 months) from
Corporate other companies with surplus liquidity. Interest rates vary depending on
Deposits the amount and time period.
x Certificate of A certificate of deposit (CD) is a document of title similar to a time
Deposit (CD) deposit receipt but with no fixed interest rate. The advantage is that
the investor can sell it in the secondary market for liquidity before

175
 maturity.
xi Public Deposits Public deposits are a key source of short-term and medium-term
financing, especially when credit squeeze occurs. Companies can accept
deposits up to 35% of their paid-up capital and reserves. These deposits
are unsecured loans for a period of 6 months to 3 years and should not
be used for acquiring fixed assets. They are mainly used for working
capital needs.

Other Sources Of Financing

Financial Assistance Description

Type
i Seed Capital IDBI's Seed Capital Assistance supports entrepreneurs with skills
Assistance but lacking financial resources. It is interest-free for 5 years, with a
1% service charge. The loan repayment depends on the company's
ability and includes an initial moratorium of up to 5 years.
ii Internal Cash Profit-making companies can use their reserves or cash profits for
Accruals capital expenditure like expansion or diversification, based on their
past performance. The funds should be used for working capital
needs.
iii Unsecured Loans Promoters provide unsecured loans to meet the required contribution.
These loans are subordinate to institutional loans, with interest rates
no higher than institutional loans. These cannot be repaid without
prior approval from financial institutions and count as part of equity.
iv Deferred Suppliers of machinery offer deferred credit, where the company
Payment doesn't pay upfront. A bank guarantee is required, and there's no
Guarantee moratorium for repayment, so it's ideal for profit-making companies.
v Capital Incentives Backward area development incentives are offered as lump sum
subsidies or tax exemptions to encourage new industrial units. These
depend on the location's degree of backwardness. The project’s
viability should not rely on these incentives.
vi Deep Discount Zero-interest bonds sold at a discount, with face value paid on
Bonds maturity. No interest is paid during the lock-in period.
vii Secured Premium These notes come with a detachable warrant and are redeemable
Notes after 4-7 years. The warrant can be converted into equity shares
within a specific time period.
viii Zero Interest Zero-interest debentures are automatically converted into equity
Fully Convertible shares after a certain period. Beneficial to companies as no interest
Debentures is paid. Investors benefit if the company’s share price increases.
ix Zero Coupon These bonds are sold at a discount with no interest paid. The
Bonds difference between the discounted price and face value represents
the interest earned by the investor.

176
x Option Bonds These bonds can be cumulative or non-cumulative, with interest
payable at maturity or periodically. Redemption premiums are offered
to attract investors.
xi Inflation Bonds Inflation-adjusted bonds offer interest that protects against
inflation. For example, if inflation is 5% and the interest rate is 11%,
the investor earns 16% in total.
xii Floating Rate These bonds have an interest rate that floats with market conditions.
Bonds They help issuers hedge against interest rate volatility and are
popular among financial institutions like IDBI and ICICI.

International Financing

Source of External Description

Financing
i Commercial Banks Domestic and foreign currency (FC) loans are provided by
commercial banks for both international and domestic operations.
Banks may also offer overdrafts.
ii Development Banks Development banks offer long-term and medium-term loans,
including FC loans. Examples include national agencies like EXIM
Bank.
iii Discounting of This short-term financing method is widely used in Europe and Asia
Trade Bills to fund both domestic and international business.
iv International Key international agencies, such as IFC, IBRD, ADB, and IMF,
Agencies provide funding for international trade and business.
v International Modern organizations, including MNCs, rely on borrowing in both
Capital Markets rupees and FC through international capital markets (e.g., London).
Systems for FC include:
➢ Euro-currency market
➢ Export credit facilities
➢ Bond issues
➢ Financial institutions
Euro-dollar deposits form the backbone of the Euro-currency
market.
vi Financial Different financial instruments used in the international market:
Instruments a. External Commercial Borrowings (ECB)
ECBs are commercial loans (e.g., bank loans, buyers' credit,
suppliers' credit) from non-resident lenders. These are available
through:
➢ Automatic route (no approval required)
➢ Approval route (approval needed).

177
b. Euro Bonds
Euro bonds are debt instruments not denominated in the
currency of the issuing country. They offer privacy and are
issued in bearer form.
c. Foreign Bonds
Foreign bonds are debt instruments issued by foreign entities.
They are exposed to default risk and exchange rate risks if
issued in a foreign currency.
d. Fully Hedged Bonds
Fully hedged bonds eliminate currency risk by using forward
markets to secure principal and interest payments.
e. Medium Term Notes (MTN)
MTNs are bonds issued in lots with different features like
coupon rates and currencies, allowing flexibility in timing and
documentation.
f. Floating Rate Notes (FRN)
FRNs have a floating interest rate based on prevailing exchange
rates. They are cheaper than foreign loans and can be issued for
up to 7 years.
g. Euro Commercial Papers (ECP)
ECPs are short-term money market instruments with a maturity
of less than a year and are typically denominated in US Dollars.
h. Foreign Currency Option (FC)
A FC option gives the right (not obligation) to buy or sell foreign
currency at a set price before a specified date, offering a hedge
against financial risks.
i. Foreign Currency Futures
FC Futures are obligations to buy or sell foreign currency at a
future date, offering a way to hedge against exchange rate
fluctuations.
j. Foreign Euro Bonds
These bonds have various regional names (e.g., Yankee Bonds in
the US, Samurai Bonds in Japan, Bulldogs in the UK), depending
on where they are issued.
k. Euro Convertible Bonds
Convertible bonds allow investors to convert them into equity
shares at a predetermined price. They may also include call
options or put options.
l. Euro Convertible Zero Bonds
These zero-interest bonds convert into equity shares at
maturity. They usually have a 5-year maturity and are treated as

178
 a deferred equity issue.
m. Euro Bonds with Equity Warrants
These bonds carry a coupon rate and are issued with detachable
warrants, which can be sold or converted into equity shares.
n. ESG-linked Bonds
ESG (Environmental, Social, and Governance) bonds prioritize
socially responsible investing. They include green bonds, social
bonds, and sustainability-linked bonds (SLBs).

Project-based Green Bonds

ESG Bonds
Social Bonds
Target-Based
Sustainability linked bonds (SLBs)

Type of Bond Description

Green Bonds Green bonds are issued by financial, non-financial, or public institutions
to finance environmentally-friendly projects. These projects aim for
positive environmental or climate impact. Example: Ghaziabad Municipal
Corporation raised ₹150 crore in 2021 through green bonds.
Social Bonds Social bonds finance projects that address social issues like human
rights, equality, and animal welfare. Example: Vaccine bonds were issued
to fund vaccination of vulnerable children in low-income countries.
Sustainability- SLBs combine features of green and social bonds. Proceeds are used for
linked Bonds general corporate purposes to meet Key Performance Indicators (KPIs),
(SLBs) not for specific projects.
Example: UltraTech Cement raised US$ 400 million through India's first
SLBs in 2021 to reduce carbon emissions over 10 years.

Topic Description
vii Euro Issues by Indian companies can raise foreign currency resources by issuing Global
Indian Depository Receipts (GDRs), American Depository Receipts (ADRs),
Companies and/or Foreign Currency Convertible Bonds (FCCBs) to foreign investors
(including NRIs). This investment is considered Foreign Direct
Investment (FDI).
a. American Depository Receipts (ADRs)
ADRs allow non-US companies to list on US exchanges. Each ADR
represents a specific number of the company's shares. ADRs enable
US investors to buy shares without investing directly in foreign stock
exchanges. Indian companies prefer GDRs over ADRs due to stringent
regulations in the US market.

179
 b. Global Depository Receipts (GDRs)
GDRs are negotiable certificates that represent a specific number of
shares of a stock traded in another country's exchange. These are
used by companies to raise capital in dollars or Euros, and are mainly
traded in European countries (particularly London).
c. ADRs/GDRs and the Indian Scenario
Indian companies like Infosys Technologies (first listed on Nasdaq in
1999) and Reliance Industries (first to issue sponsored GDR/ADR)
have started to tap overseas markets. Other companies like Wipro,
MTNL, SBI, and Tata Motors are also listed abroad.
d. Indian Depository Receipts (IDRs)
IDRs are similar to ADRs/GDRs but are issued by foreign companies
to raise funds in the Indian Capital Market. IDRs are traded in India
like any other Indian security. They allow foreign companies to access
Indian capital.

Contemporary Sources Of Funding

Source of Funding Description

i Crowd Funding Crowdfunding is raising money for a project from a large group of
people, typically via internet platforms (social media and websites). It
involves contributions in exchange for equity, loans (P2P lending), or as
donations. It helps start-ups gauge product demand before production.
The three parties involved are: fundraiser, mediator (platform), and
investor. Platforms may charge fees (processing, transaction, etc.).
ii Equity Funding Equity crowdfunding allows investors to fund an organisation in
exchange for securities (equity). The amount of ownership depends on
the investment. This type of funding is popular with startups. Examples
of platforms include StartEngine, EquityNet, SeedInvest.
iii Peer-to-Peer P2P lending matches lenders with borrowers to provide unsecured loans
(P2P) Lending online. Borrowers repay with interest. Risk of defaults exists. Investors
choose borrowers based on risk & returns. Platforms include i2iFunding,
Lend box, Fair cent, Rupee Circle.
iv Start-up Startups often turn to crowdfunding as they may find it difficult to
Funding secure bank loans. Crowdfunding provides a way to raise money from a
large group, through equity funding, P2P lending, or both.
v Donation-based In donation-based crowdfunding, people donate money for charity or a
Crowdfunding cause with no expectation of ownership or repayment. Platforms include
GoFundMe (for medical, educational needs), Ketto (medical), and Fuel A
Dream (charity projects, new ideas).

180