Financial Management

DBA 1654 FINANCIAL MANAGEMENT

1

NOTES

Anna University Chennai

UNIT I

FOUNDATIONS OF FINANCE

Lesson 1

Financial Management : An Overview

1. Introduction

2. Learning objectives

3. Section title

3.1 Meaning

3.2 Definition

3.3 Objectives of financial management

3.3.1 Profit Maximization Vs Wealth Maximization

3.3.2 Advantages of Wealth Maximization

3.3.3 Criticisms of Wealth Maximization

3.4 Dimensions of Financial Management

3.5 Scope and Functions of Financial Management

3.6 Role and Functions of the Finance Managers

3.7 Financial Management and Economics

3.8 Financial Management and Accounting

3.9 Evolution of Financial Management

3.10 Functional Areas of Financial Management

3.11 Financial Decisions

Have You Understood?


3

NOTES


of a certain plan.Financial plans aim at an effective utilization of funds. The term ‘Financial

management’ connotes that the fund flow is directed according to some plan. Financial

management connotes responsibility for obtaining and effectively utilizing funds necessary

for the efficient operation of an enterprise. The finance function centres round the

management of funds raising and using them effectively. But the dimensions of financial

management are much broader than mere procurement of funds. Planning is one of the

most important activities of the financial manager. It makes it possible for the financial

manager to obtain funds at the best time in relation to their cost and the conditions

under which they can be obtained and their effective use by the business firm.

Financial management is dynamic, in the making of day- to-day financial decisions

in a business of any size. The old concept of finance as treasurership has broadened to

include the new, meaningful concept of controllership. While the treasurer keeps track

of the money, the controller’s duties extend to planning analysis and the improvement of

every phase of the company’s operations, which are measured with a financial yardstick.

Financial management is important because it has an impact on all the activities

of a firm. Its primary responsibility is to discharge the finance function successfully. It

touches all the other business functions. All business decisions have financial implications,

and a single decision may financially affect different departments of an organization.

Financial management, however, should not be taken to be a profit-extracting

device. No doubt finances have to be so planned as to contribute the profit-making

activities. Financial management implies a more comprehensive concept than the simple

objective of profit making or efficiency. Its broader mission is to maximize the value of

the firm so that the interests of different sections of the community remain protected. It

should be noted, therefore, that financial management does not mean management of a

business organization with a view to maximizing profits.

Financial management applies to every organization, irrespective of its size,

nature of ownership and control - whether it is a manufacturing or service organization.

It applies to any activity of an organization which has financial implications. To say that

it applies to private profit-making organizations alone is to narrow the scope of the

subject. Moreover, financial management does not handle merely routine day-to-day

matters. It has to handle more complex problems such as mergers, reorganizations and

the like. It plays two distinct roles. Firstly, it safeguards interests of the corporation,

which is a separate legal entity. Secondly, this separate legal entity has no meaning

unless the interests of owners and other sections of the community, which are directly

concerned with the corporation, are properly protected.

Financial management is thus an integrated and composite subject. It welds

together much of the material that is found in Accounting, Economics, Mathematics,

Systems analysis and Behavioral Sciences, and uses other disciplines as its tool. For a

long time, finance has been considered as a rather sterile function concerned with a


5

NOTES


have to be taken into consideration. The availability of funds depend upon the kind of

commercial strategies adopted by a firm during a particular period of time. Various

different theories of financial management provides an analytical framework for an

evaluation of courses of action.

Maximization of profits is often considered to be a goal or an alternative goal of

a firm. However, this is somewhat narrow in concept than the goal of maximizing the

value of the firm because of the following reasons:

(a) The maximization of profits, as reflected in the earnings per share, is not an

adequate goal in the first place because it does not take into consideration time value of

money.

(b) The concept of maximization of earnings per share does not include the risk

of streams of alternative earnings. A project may have an earning steam that will attain

the goal of maximum earnings per share; but when compared with the risk involved in it,

it may be totally unacceptable to a stockholder, who is generally hostile to risk-bearing

activities.

(c) This concept of maximization of earnings per share does not take into account

the impact of dividend policy upon market price or value of the firm. Theoretically, a

firm would never pay a dividend if the objective is to maximize earnings per share.

Rather, it would reinvest all its earnings so as to generate greater earnings in the future.

Financial management techniques, are applicable to decisions of individuals,

nonprofit organizations and of business firms. Also, it is applicable to different situations

in different organizations.

Financial managers are interested in providing answers to the following questions:

1. Given a firm’s market position, the market demand for its products, its

productive capacity and investment opportunities, what specific assets should

it purchase? This Indirectly emphasizes the approach to capital budgeting.

2. Given a firm’s market position and investment opportunities, what is the total

volume of funds that it should commit? This indirectly emphasizes the composition

of a firm’s assets.

3. Given a firm’s market position and investment opportunities, how should it

acquire the funds which are necessary for the implementation of its investment

decisions? This underscores the approach to capital financing.

3.3.1 PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION

Although in general profit maximization is the prime goal of financial

management,there are arguments against the same.The following table presents points

in favour as well as against profit maximization.


7

NOTES


Increase in Profits: A firm should increase its revenues in order to maximize its value.

For this purpose, the volume of sales or any other activitie should be stepped up. It is a

normal practice for a firm to formulate and implement all possible plans of expansion

and take every opportunity to maximize its profits. In theory, profits are maximized

when a firm is in equilibrium. At this stage, the average cost is minimum and the marginal

cost and marginal revenue are equal. A word of caution, however, should be sounded

here. An increase in sales will not necessarily result in a rise in profits unless there is a

market for increased supply of goods and unless overhead costs are properly controlled.

Reduction in Cost: Capital and equity funds are factor inputs in production. A firm

has to make every effort to reduce cost of capital and launch economy drive in all its

operations.

Sources of Funds: A firm has to make a judicious choice of funds so that they maximize

its value. The sources of funds are not risk-free. A firm will have to assess risks involved

in each source of funds. While issuing equity stock, it will have to increase ownership

funds into the corporation. While issuing debentures and preferred stock, it will have to

accept fixed and recurring obligauons. The advantages of leverage, too, will have to be

weighed properly.

Minimum Risks: Different types of risks confront a firm. “No risk, no gain” - is a

common adage. However, in the world of business uncertainties, a corporate manager

will have to calculate business risks, financial risks or any other risk that may work to

the disadvantage of the firm before embarking on any particular course of action. While

keeping the goal of maximization of the value of the firm, the management will have to

consider the interest of pure or equity stockholders as the central focus of financial

policies.

Long-run Value: The goal of financial management should be to maximize long run

value of the firm. It may be worthwhile for a firm to maximize profits by pricing its

products high, or by pushing an inferior quality into the market, or by ignoring interests

of employees, or, to be precise, by resorting to cheap and “get-rich- quick” methods.

Such tactics, however, are bound to affect the prospects of a firm rather adversely

over a period of time. For permanent progress and sound reputation, it will have to

adopt an approach which is consistent with the goals of financial management in the

long-run.


9

NOTES


employment under favourable working conditions. However, a good financial

management alone cannot guarantee that a business will succeed. But it is a necessary

condition for business success, though not the only one. It may, however, be described

as a pre-requisite of a successful business. In other words, there are various other

factors which may support or frustrate financial management by supportive or non-

supportive policies.

Wealth maximization is as important objective as profit maximization. The

operating objective for Financial Management is to maximize wealth or the net present

worth of a firm. Wealth maximization is an objective which has to be achieved by those

who supply loan capital, employees, society and management. The objective finds its

place in these segments of the corporate sector, although the immediate objectives of

Financial Management may be to maintain liquidity and improve profitability.

The wealth of owners of a firm is maximized by raising the price of the common

stock. This is achieved when the management of a firm operates efficiently and makes

optimal decisions in areas of capital investments, financing, dividends and current assets

management. If this is done, the aggregate value of the common stock will be maximized.

3.4 DIMENSIONS OF FINANCIAL MANAGEMENT

The different dimensions of financial management are dealt below:

Anticipating Financial Needs: The financial manager has to forecast expected events

in business and note their financial implications. Financial Manager anticipates financial

needs by consulting an array of documents such as the cash budget, the pro-forma

income statement, the pro-forma balance sheet, the statement of the sources and uses

of funds, etc. Financial needs can be anticipated by forecasting expected funds in a

business and their financial implications.

Acquiring Financial Resources: This implies knowing when, where and how to obtain

the funds which a business needs. Funds should be acquired well before the need for

them is actually felt. The financial manager should know how to tap the different sources

of funds. He may require short-term and long-term funds.

The terms and conditions of the different financial sources may vary significantlyat

a given point of time. Much will also depend upon the size and strength of the borrowing

firm. The financial image of a corporation has to be improved in appropriate financial

circles which are primarily responsible for supplying finance.

Allocating Funds in Business: Allocating funds in a business means investing them in

the best plans of assets. Assets are balanced by weighing their profitability against their

liquidity. Profitability refers to the earning of profits and liquidity means closeness to

money. The financial manager should steer a prudent course between over-financing


11

NOTES


Financial Management plays two significant roles:

v To participate in the process of putting funds to work within the business and

to control their productivity; and

v To identify the need for funds and select sources from which they may be

obtained.

The functions of financial management may be classified on the basis of liquidity,

profitability and management.

(1) Liquidity: Liquidity is ascertained on the basis of three important considerations:

(a) Forecasting cash flows, that is, matching the inflows against cash outflows;

(b) Raising funds, that is, financial management will have to ascertain the sources

from which funds may be raised and the time when these funds are needed;

(c) Managing the flow of internal funds, that is, keeping its accounts, with a

number of banks to ensure a high degree of liquidity with minimum external borrowing.

(2) Profitability: While ascertaining rofitability, the following factors are taken into

account:

(a) Cost Control: Expenditure in the different operational areas of an enterprise

can be analysed with the help of an appropriate cost accounting system to enable the

financial manager to bring costs under control.

(b) Pricing: Pricing is of great significance in the company’s marketing effort,

image and sales level. The formulation of pricing policies should lead to profitability,

keeping, of course, the image of the organization intact.

(c) Forecasting Future Profits: Expected profits are determined and evaluated. Profit

levels have to be forecasted from time to time in order to strengthen the organization.

(d) Measuring Cost of Capital: Each source of funds has a different cost of capital

which must be measured because cost of capital is linked with profitability of an enterprise.

(3) Management: The financial manager will have to keep assets intact, for assets are

resources which enable a firm to conduct its business. Asset management has assumed

an important role in financial management. It is also necessary for the financial manager

to ensure that sufficient funds are available for smooth conduct of the business. In this

connection, it may be pointed out that management of funds has both liquidity and

profitability aspects. Financial management is concerned with the many responsibilities

which are thrust on it by a business enterprise. Although a business failure may not

always be the result of financial failures, financial failures do positively lead to business

failures. The responsibility of financial management is enhanced because of this peculiar

situation.

Financial management may be divided into two broad areas of responsibilities,

which are not by any means independent of each other. Each, however, may be regarded


13

NOTES


International cash management deals with more mechanical areas of cash collection,

holding and disbursement. International cash management involves longer distances,

exchange controls different currency units and multiple financial institutions.

A variety of instruments exist for effecting international transfer of funds. There

may be payment instructions in written or documentary form incorporating some form

of credit. The standard method of transferring funds internationally is by mail payment

order, which is a lengthy process. Cable transfers reduce remittance time appreciably.

Other international modes of payment include bank drafts, cheques and trade bills.

Sight and time drafts, acceptances and letters of credit are termed as documentary

credits.

The international liquidity management is regulated by exchange control and

other barriers which usually prohibit the flow of funds in desired directions. Funds held

by individual subsidiaries in different countries cannot be considered fungible and there

is little or no chance of international pooling of funds. Even intra-country liquidity

management may be affected by weak capital markets which offer few investment

media or banking systems which delay transfers. This area is also affected by

impediments in banking and mail systems.

3.6 Role and Functions of the Financial Manager

The financial manager performs important activities in connection with each of

the general functions of the management. He groups activities in such a way that areas

of responsibility and accountability are cleared defined. The profit centre is a technique

by which activities are decentralised for the development of strategic control points.

The determination of the nature and extent of staffing is aided by financial budget

programme. Direction is based, to a considerable extent, on instruments of financial

reporting. Planning involves heavy reliance on financial tools and analysis. Control requires

the use of the techniques of financial ratios and standards. Briefly, an informed and

enlightened use of financial information is necessary for the purpose of co-ordinating

the activities of an enterprise. Every business, irrespective of its size, should, therefore,

have a financial manager who has to take key decisions on the allocation and use of

money by various departments. Specifically the financial manager should anticipate

financial needs; acquire financial resources; and allocate funds to various departments

of the business. If the financial manager handles each of these tasks well, his firm is on

the road to good financial health. The financial manager’s concern is to:

v Determine the total amount of funds to be employed by a firm;

v Allocate these funds efficiently to various assets;

v Obtain the best mix of financing in relation to the overall evaluation of the firm.

Since the financial manager is an integral part of the top management, he should

so shape his decisions and recommendations as to contribute to the overall progress of


15

NOTES


investment is quite profitable, he is forced to sacrifice this option, if the investment is

going to lock up funds for an unreasonable period; the longer the period, the greater is

the risk. Most financial managers are, therefore, tempted to compromise between

profitability and liquidity, and select projects which are reasonably profitable and, at the

same time, sound from the liquidity point of view.

3.7 Financial Manage and Economics

Knowledge of economics is necessary for the understanding of financial

environment and the decision theories which underline contemporary financial

management. Macro-economics gives an insight into the policies of the government

and private institutions through which money flows, credit flows and general economic

activity are controlled.

In recent years, a significant change has taken place in the study of financial

management, as it has in all other aspects of business and public administration. A

considerable progress has been made in the development of theoretical structures for

the solution of business problems. The model-building approach to financial management

has been developed from two separate branches of study - economics and operations

research, aided by computer science. The link between economics and financial

management is close. A study of financial management is likely to be barren if it is

divorced from the study of economics. Financial management has, in fact, evolved over

the years as an autonomous branch of economics.

3.8 Financial Management and Accounting

It is of greater managerial interest to think of financial management as something

of which accounting is a part, which is concerned mainly with the raising of funds, in the

most economic and suitable manner; using the funds as profitably as possible (for a

given risk level); planning future operations and controlling current performance and

future developments through financial accounting, cost accounting, budgeting, statistics

and other means.

Effective planning and direction depends on adequate accounting information

available to a management on the financial condition of an enterprise. This includes:

• Decisions which affect external, legal and financial relationships of funds;

decisions on methods of financing, fixed and working capital in general

• Financial structure, credit policy, payment of dividends, creation of reserves

• Decisions which are mainly internal and refer to the deployment of funds on

different projects

• Quasi-financial decisions which arise from marketing; personnel, production or

any other discipline and other problems which have financial aspects

• Decisions for which accounting records and reports are widely used.


17

NOTES


The central issue of financial policies is a wise use of funds and the central

process involved is a rational matching of advantages of potential uses against the caution

of advantages of potential uses against the caution of alternative potential sources so as

to achieve broad financial goals which an enterprise sets for itself. The new or modern

approach is an analytical way of looking at the financial problems of a firm. Financial

problems are a vital and an integral part of overall management. In this connection, Ezra

Solomon observes: If the scope of financial management is re-defined to cover decisions

about both the use and the acquisition of funds, it is clear that the principal content of

the subject should be concerned with how financial management should make judgements

about whether an enterprise should hold, reduce, or increase its investments in all forms

of assets that require company funds.

With the advent of industrial combination the financial manager of corporation

was confronted with the complexities of budgeting and financial operations. The size

and composition of the capital structure was of particular importance. The major concern

of financial management was survival. Its attitude to long-term trade was hostile. It

looked upon dividend as a residual payment. The discipline of financial management

was conditioned by changes in the socio-economic and legal environment. Its emphasis

shifted from profitability analysis to cash flow generation; and it developed an interest in

internal management procedures and control. In the circumstances, cost, budget

forecasting, aging of accounts receivable and monetary management assured considerable

importance.

With technological progress, financial management was almost forced to improve

its methodology. Such things as cost of capital, optimal capital structure, effects of

capital structure upon cost of capital and market value of a firm were incorporated in

the subject. Moreover, financial management laid emphasis on international business

and finance, and showed a serious concern for the effects of multi-nationals upon price

level movements. The concern for liquidity and profit margins was indeed tremendous

throughout the several phases of financial management. Modern financial management,

however, is basically concerned with optimal matching of uses and sources of corporate

funds that lead to the maximisation of a firm’s market value.

3.10 Functional Areas of Financial Management

It would indeed be an extremely difficult task to delineate functions of modern

financial management. The subject management has been stretched to such a limit that

a finance manager today has to be conversant with a large variety of subjects, while the

traditional finance manager concerned him with such macroeconomic areas of finance

as long-term financing, short-term financing, study of financial institutions, capital market

(more particularly, the stock exchange), promotion, planning of corporations, underwriting

of securities, and so on. A lot of literature on the subject of Financial Management

seems to be devoted to these and similar matters. These areas, to be precise, belong to

corporation finance. Modern Financial Management should hence forward concentrate


19

NOTES


terms and conditions on which they offer credit. To be precise, the financial manager

must definitely know what he is doing.

Financial Analysis: It is the evaluation and interpretation of a firm’s financial position

and operations, and involves the comparison and interpretation of accounting data. The

financial manager has to interpret different statements. He has to use a large number of

ratios to analyse the financial status and activities of his firm. He is required to measure

its liquidity, determine its profitability and assets and overall performance in financial

terms. This is often a challenging task, because he must understand the importance of

each one of these aspects to the firm and he should be crystal clear in his mind about the

purposes for which liquidity, profitability and performance are to be measured.

Optimal Capital Structure: The financial manager has to establish an optimum capital

structure and ensure the maximum rate of return on investment. The ratio between

equity and other liabilities carrying fixed charges has to be defined. In the process, he

has to consider the operating and financial leverages of his firm. The operating leverage

exists because of operating expenses, while financial leverage exists because of the

amount of debt involved in a firm’s capital structure. The financial manager should have

adequate knowledge of different empirical studies on the optimum capital structure and

find out whether, and to what extent, he can apply their findings to the advantage of the

firm.

Cost-Volume-Profit Analysis: This is popularly known as the ‘CVP relationship’.

For this purpose, fixed costs, variable costs and semi-variable costs have to be analysed.

Fixed costs are more or less constant for varying sales volumes. Variable costs vary

according to sales volume. Semi-variable costs are either fixed or variable in the short

run. The finance manager has to ensure that the income for the firm will cover its vari-

able costs, for there is no point in being in business, if this is not accomplished. More-

over, a firm will have to generate an adequate income to cover its fixed costs as well.

The finance manager has to find out the break- even-point (i.e), the point at which total

costs are matched by total sales or total revenue. He has to try to shift the activity of the

firm as far as possible from the break-ever point to ensure company’s survival against

seasonal fluctuations.

Profit Planning and Control: Profit planning and control have assumed great impor-

tance in the financial activities of modern business. Economists have long before con-

sidered the importance of profit maximization in influencing business decisions. Profit

planning ensures attainment of stability and growth. In view of the fact that earnings are

the most important measure of corporate performance, the profit test is constantly used

to gauge success of a firm’s activities.

Profit planning is an important responsibility of the finance manager. Profit is the

surplus which accrues to a firm after its total expenses are deducted from its total

revenue. It is necessary to determine profits properly, for they measure the economic


21

NOTES


keep down cost of capital and maximize the rate of return on investment. The

organizational and manpower analysis ensures that a firm will have the requisite manpower

to run the project. In this connection, it should be remembered that a project is exposed

to different types of uncertainties and risks. It is, therefore, necessary for a firm to

gauge the sensitivity of the project to the world of uncertainties and risks and its capacity

to withstand them. It would be unjustifiable to accept even the most profitable project

if it is likely to be the riskiest.

Capital Budgeting: Capital budgeting decisions are most crucial; for they have long-

term implications. They relate to judicious allocation of capital. Current funds have to

be invested in long-term activities in anticipation of an expected flow of future benefits

spread over a long period of time. Capital budgeting forecasts returns on proposed

long-term investments and compares profitability of different investments and their cost

of capital. It results in capital expenditure investments. The various proposal assets

ranked on the basis of such criteria as urgency, liquidity, profitability and risk sensitivity.

The financial analyser should be thoroughly familiar with such financial techniques as

pay back, internal rate of return, discounted cash flow and net present value among

others because risk increases when investment is stretched over a long period of time.

The financial analyst should be able to blend risk with returns so as to get current

evaluation of potential investments.

Working Capital Management: Working capital is rightly an adjunct of fixed capital

investment. It is a financial lubricant which keeps business operations going. It is the

life-blood of a firm. Cash, accounts receivable and inventory are the important compo-

nents of working capital, which is rotating in its nature. Cash is the central reservoir of

a firm that ensures liquidity. Accounts receivables and inventory form the principal of

production and sales; they also represent liquid funds in the ultimate analysis. The finan-

cial manager should weigh the advantage of customer trade credit, such as increase in

volume of sales, against limitations of costs and risks involved therein. He should match

inventory trends with level of sales. The uncertainties of inventory planning should be

dealt within a rational manner. There are several costs and risks which are related to

inventory management. The risks are there when inventory is inadequate or in excess of

requirements. The former may hold up production, while the latter would result in an

unjustified locking up of funds and increase the cost of capital. Inventory management

entails decisions about the timing and size of purchases purely on a cost basis. The

financial manager should determine the economic order quantities after considering the

relationships of different cost elements involved in purchases. Firms cannot avoid mak-

ing investments in inventory because production and deliveries involve time lags and

discontinuities. Moreover, the demand for sales may vary substantially. In the circum-

stances, safety levels of stocks should be maintained. Inventory management thus in-

cludes purchase management and material management as well as financial manage-

ment. Its close association with financial management primarily arises out of the fact

that it is a simple cash asset.

Dividend Policies: Dividend policies constitute a crucial area of minancial management.


23

NOTES


An analysis of financial data with the help of scientific tools and techniques to

improve performance of an undertaking (and to achieve better operating results and

better quality of products) is essential n0wdays a day. It is necessary to take a fresh

look at finance management in most Indian industries. The management of capital in

Indian industries is generally anchored to traditional legacies and practices. This is true

for both private and public sectors.

The modern tools of management, including capital management, performance

budgeting, cost control, organizational development and R & D, have not yet become

popular with the captains of our industry. There is an absence of data on the marginal

efficiency of capital, input-output analysis, technical co-efficient, etc., which render

current evaluation of issues somewhat difficult. The preponderance of proprietary, part-

nership and private companies has made industrial units something like closed shops.

The management of these sectors is rested in family complexes about which there is no

adequate information. Moreover, social obligations, growth potents, technical feasibil-

ity of financial planning and flow, and physical productivity - these need a better re-

orientation and gearing up of capital management practices. The vagaries of govern-

ment policy on dividend payments and tax rates and limits on share capital floatation

have resulted in a low and uncertain supply of funds to the equity market. As a conse-

quence, business houses are forced to look for their borrowings elsewhere as the only

reliable method of finance, even when the cost of these borrowing is relatively high. The

present behaviour of financial management is a result of government policy, in an uncer-

tain capital market.

3.11 Financial Decisions

Financial decisions are the decisions relating to financial matters of a corporate

entity. Financial requirement, Investment, Financing and Dividend Decisions are the

most important areas of financial management, which facilitate a business firm to achieve

wealth maximisation. Financial decisions have been considered as the means to achieve

long-term objective of the corporates.

Funds Requirement Decision: Financial requirement decision is one of the most

important decisions of finance manager. This decision is considered with estimation of

the total funds required by a business unit. The total amount of capital and revenue


25

NOTES


Lesson 2

Time Value of Money

1.Introduction

2.Learning Objective

3.Section Title

3.1 Reasons for Time Value of Money

3.2 Future Value of a Single Cash flow

3.3 Future Value of an Annuity

3.4 Present Value of a Single Cash flow

3.5 Present Value of an Annuity

3.6 Finding the Interest Rate

3.7 Present Value of Perpetuity


1.INTRODUCTION

A project is an activity that involves investing a sum of money now in anticipa-

tion of benefits spread over a period of time in the future. How do we determine whether

the project is financially viable or not? Our immediate response to this question will be

to sum up the benefits accruing over the future period and compare the total value of

the benefits with the initial investment. If the aggregate value of the benefits exceeds the

initial investment, we will consider the project to the financially viable. While this ap-

proach prima facia appears to be satisfactory, we must be aware of an important as-

sumption that underlies our approach. We have assumed that irrespective of the time

when money is invested or received, the value of money remains the same. We know

intuitively that this assumption is incorrect because money has time value. How do we

define this value of money and build it into the cash flow of a project? The answer to

this question forms the subject matter of this lesson.


27

NOTES


First year Principal at the beginning 1000

Interest for the year 100

(Rs. 1,000 x 0.10)

Principal at the end

Second year Principal at the beginning 1100

Interest for the year 1100

(Rs. 1,100 x 0.10) 110

Principal at the end 1210

Third year Principal at the beginning 1210

Interest for the year

(Rs. 1,210 x 0.10) 121

Principal at the end 1331

Formula

The general formula for the future value of a single cash flow is:

FVn = PV (I + k)

n

FVn= future value n years hence

PV= cash flow today (present value)

k = interest rate per year

n = number of years for which compounding is done. The growth of future

value is shown in the following Table:1

Table: 1 Future Value of a Single Cash Flow

Equation (1) is a basic equation in compounding analysis. The factor (1 + k)n is

referred to as the compounding factor or the future value interest factor (FVIFk,n

). It is

very tedious to calculate (1 + k)’. To reduce the tedium, published tables are available

showing the value of (1 + k) n for various combinations of k and n. Table 2 shows some

typical values of (I + k) n.

Table: 2 Value of FVIFk,n

for Various combinations of k and n


29

NOTES


rule of thumb is the rule of 69. According to this rule of thumb, the doubling period is

equal to:

0.35 + teInterestRa

69

As an illustration of this rule of thumb, the doubling period is calculated for two

interest rates, 10 percent and 15 percent.

Table 3

Interest Rate Doubling Period

10 percent 0.35 + 10

69 = 725 years

15 percent 0.35 + 15

69= 4.95 years

Finding the Growth Rate

To calculate the compound rate of growth of some series, say the sales series

or the profit series, over a period of time, we may employ the future value interest

factor table. The process may be demonstrated with the help of the following sales data

for Alpha Limited.

Table 4

Years 1981 1982 1983 1984 1985 1987

Sales (Rs. in million) 50 57 68 79 86 99

What has been the compound rate of growth in the sales of Alpha for theperiod 1981-87, a six-year period? This question may be answered in two steps:

Step 1: Find the ratio of sales of 1987 to 1981. This is simply: 99/50 = 1.98.

Step 2: Consult the FVIFk, n

table and look at the row for 6 years, till you finda value which is closest to 1.98 and then read the interest rate corresponding to thatvalue.

In this case, the value closest to 1.98 is 1.974 and the interest rate correspond-

ing to is 12 per cent. Hence, the compound rate of growth is 12 per cent.

Shorter Compounding Period

So far, we assumed that compounding is done annually. Now, we consider the

case where compounding is done more frequently. Suppose, you depoit Rs. 1,000

with a finance company which advertises that it pays 12 per cent interest semi-annu-


31

NOTES


We have seen above that Rs. 1,000 grows to Rs. 1,123.6 at the end of a year

if the nominal rate of interest is 12 per cent and compounding is done semi-annually.

This means that Rs. 1,000 grows at the rate of 12.36 per cent per annum. The figure of

12.36 per cent is called the effective rate of interest—the rate of interest under annual

compounding which produces the same result as that produced by an interest rate of

12 per cent under semi-annual compounding.

The general relationship between the effective rate of interest and the nominal

rate of interest is as follows:

r=(1+m

k ) m-1

Where r = effective rate of interest

k = nominal rate of interest

m = frequency of compounding per year

Example a bank offers 8 per cent nominal rate of interest with quarterly com-

pounding. What is the effective rate of interest?

The effective rate of interest is:

(1 +4

08.0) 4_1 = 0.0824 = 8.24 per cent

Table 5 gives the relationship between the nominal and effective rates of inter-

est for different compounding periods. In general, the effect of increasing the frequency

of compounding is not as dramatic as some would believe it to be—the additional gains

dwindle as the frequency of compounding increases.

Table: 5 Nominal and Effective Rates of Interest

3.3 Future value of an annuity

An annuity is a series of periodic cash flows (payments or receipts) of equal

amounts. The premium payments of a life insurance policy, for example, are an annuity.

When the cash flows occur at the end of each period the annuity is called a regular

annuity or a deferred annuity. When the cash flows occur at the beginning of each


33

NOTES


The term

+ −

k

kn 1

)1( is referred to as the future value interest factor for an annuity

(FVIFA k, n

). The value of this factor for several combinations of k and a is in following

table.

Table 6 Value of FVIVA k, n

for various Combinations of k and n

n/k 6% 8% 10% 12% 14%

2 2.060 2.080 2.100 2.120 2.140

4 4.375 4.507 4.641. 4.779 4.921

6 6.975 7.336 7.716 8.115 8.536

8 9.897 10.636 11.46 12.299 13.232

10 13.181 14.487 15.937 17.548 19.337

12 16.869 18.977 21.384 24.133 27.270

Example: Four equal annual payments of Rs. 2,000 are made into a deposit account

that pays 8 per cent interest per year. What is the future value of this annuity at the end

of 4 years?

The future value of this annuity is:

Rs. 2,000 (FVIFA8%, 4

) = Rs. 2,000 (4.507)

= Rs. 9,014

Sinking Fund Factor

Equation (4) shows the relationship between FI’A A, Ic and a. Juggling it a bit,

we get:

A=FVAn

+ −1)1( nk

k

+ −1)1( nk

k In Eq. (5), the inverse of FVIFA ,, is called the sinking (1+ky-’fund

factor.

Equation (5) helps in aswering the question: How much should be deposited

periodically to accumulate a certain sum at the end of a given period? The periodic

deposit is simply A and it is obtained by dividing FVAn by FV1FA.

k,n


35

NOTES


Formula

The process of discounting, used for calculating the present value, is simply the

inverse of compounding. The present value formula can be readily obtained by

manipulating the compounding formula:

FVn = PV (1+kn (1)

Dividing both the sides of Eq. (4.1) by (l+k)n, we get,

PV=FVn

+ k1

1 n (6)

The factor

+ k1

1 n in Eq. (4.6) is called the discounting factor or the present value

interest factor (PV1F j. Table 7 gives the value of PVIFk,n

for several combinations of

k and n. A more detailed table of P VIF, is given in Appendix at the end of this book.

Example: Find the present value of Rs. 1,000 receivable 6 years hence if the rate of

discount is 10 per cent.

The present value is:

Rs. 1,000 x PVIF10%,6

= Rs. 1,000 (0.5645) = Rs. 564.5

Example: 1 Find the present value of Rs. 1,000 receivable 20 years hence if the dis-

count rate is 8 per cent. Since Table 7 does not have the value of PVIF we obtain the

answer as follows:

Table 7 Value of PVIF k,n

for Various Combinations of k and n


37

NOTES


Table 8 Present Value of an Uneven Cash Flow Stream

Present value of the Stream 13376

Shorter Discounting Periods

Sometimes, cash flows may have to he discounted more frequently than once a

year, semi-annually, quarterly monthly, or daily. As in the case of intra-year compound-

ing, the shorter discounting period implies that (i) the number of periods in the analysis

increases and (ii) the discount rate applicable per period decreases. The general for-

mula for calculating the present value in the case of shorter discounting period is:

Where PV = present value

FVn = cash flow after n years

m = number of times per year discounting is done

k = annual discount rate

To illustrate, consider a cash flow of Rs. 10,000 to be received at the end of

four years. The present value of this cash flow when the discount rate is 12 per cent (k

= 12 per cent) and discounting is done quarterly (m = 4) and it is determined as follows:

PV = Rs. 10,000 x PVJFk/m, mxn

= Rs. 10,000 x PVIF3%, 16

= Rs. 10,000 x 0.623 = Rs. 6,230

3.5 Present value of an annuity

Suppose, you expect to receive Rs. 1,000 annually for 3 years, each receipt

occurring at the end of the year. What is the present value of this stream of benefits if the


39

NOTES


Table 9 Value of PVIFA k, n

for Different Combinations of k and n

Example: What is the present value of a 4-year annuity of Rs. 10,000 discounted at 10

percent?

The PVIFA10%, 4

is 3.170

Hence, PVAn = Rs. 10,000 (3.170) = Rs. 31,700

Example: A 10-payment annuity of Rs. 5,000 will begin 7 years hence. (The first occurs

at the end of 7 years.) What is the value of this annuity now if the discount rate is 12 per

cent?

This problem may be solved in two steps.

Step 1 Determine the value of this annuity a year before the first payment begins,

i.e., 6 years from now. This is equal to

Rs. 5,000 (PVJFA124 = Rs. 5,000 (5.650) = Rs. 28,250.

Step 2 Compute the present value of the amount obtained in Step 1.

Rs. 28,250 (PV1F1 6) = Rs. 28,250 (0.507) = Rs. 14,323.

Capital Recovery Factor

Equation (4.9) shows the relationship between PVAn A, k, and n. Manipulating

it a bit, we get:


41

NOTES


Putting in words, it means that the present value interest factor of a perpetuity is

simply I divided by the interest rate expressed in decimal form. Hence, the present

value of perpetuity is simply equal to the constant annual payment divided by the inter-

est rate. For example, the present value of a perpetuity of Rs. 10,000 if the interest rate

is 10 per cent is equal to: Rs. 10,000/0.10 = Rs. 1,00,000. Intuitively, this is quite

convincing because an initial sum of Rs. 1,00,000 would, if invested at a rate of interest

of 10 per cent, provide a constant annual income of Rs.10,000 forever, without any

impairment of the capital value.

HAVE YOU UNDERSTOOD?

1. Why does money have time value?

2. State the general formula for the future value of a single cash flow.

3. What is the relationship between effective rate of interest and nominal rate of

interest?

4. What is an annuity?

5. State the formula for the future value of an annuity.

6. What is a sinking fund factor? Illustrate it with an example.

7. State the general formula for calculating the present value of a single cash flow.

8. What is the general formula for calculating the present value of a cash flow

series?


43

NOTES


Ø Calculation of beta

Ø Relationship between risk and return

Ø Risk and return: Implications on investment

3.SECTION TITLE

3.1 Risk and Return:Concepts

Risk and return may be defined in relation to a single investment or a portfolio

of investments. We will first look at risk and return of a single investment held in isolation

and then discuss risk and return of a portfolio of investments.

Risk

Risk refers to the dispersion of a probability distribution: How much do individual

outcomes deviate from the expected value? A simple measure of dispersion is the range

of possible outcomes, which is simply the difference between the highest and lowest

outcomes. A more sophisticated measure of risk, employed commonly in finance, is

standard deviation’.

How is standard deviation calculated? The standard deviation of a variable

(which for our purposes represents the rate of return) is calculated using the following

formula:

Where = standard deviation

pi= probability associated with the occurrence of I th rate of return

ki= I th possible rate of return

k= excepted rate of return

n= number of possible out comes possible out comes

The calculation of the standard deviation of rates of return of Bharath Food

and Oriental Shipping is shown in Table 2. Looking at the calculation of standard

deviation, we find that it has the following features:

1. The differences between the various possible values and the expected value it squared.

This means that values which are far away from the expected value have much more

effect on standard deviation than values which are close to the expected value.

2. The squared differences are multiplied by the probabilities associated with the

resspective values. This means that the smaller the probability that a particular value will

occur, the lesser its effect on standard deviation.

3. The standard deviation is obtained as the square root of the sum of squared differences

(multiplied by their probabilities). This means that the standard deviation and expected

value is measured in the same units and hence the two can be directly compared.


45

NOTES


Table 2 Return and Risk:Individual Securities and Portfolio

Year Alpha Company Beta Industries Portfolio:50%Alpha

50% Beta

1 11 15 13

2 13 9 11

3 -8 27 9.5

4 27 -3 12

5 17 12 14.5

Statistics@

Mean Return(k) 12% 12% 12%

Standard Deviation(s) 12.76% 10.81% 4.73%

@When historical return data, rather than the probability distribution of return, is

used, the formulae used for calculating the mean return and the standard deviation

are as follows:

FIGURE 3.1

Diversifiable and Non-diversifiable Risk

What happens when more and more securities are added to a portfolio? In

general, the portfolio risk decreases and approaches a limit. Empirical studies have

suggested that the bulk of the benefit from diversification, in the form of risk reduction,

can be achieved by forming a portfolio of 10-15 securities - thereafter the gains from

diversification are negligible or even nil. Figure 5.2 represents graphically the effect of

diversification on portfolio risk.


47

NOTES


Return

The return from an investment is the realisable cash flow earned by its owner

during a given period of time. Typically, it is expressed as a percentage of the beginning

of period value of the investment. To illustrate, suppose you buy a share of the equity

stock of Olympic Limited for Rs. 80 today. After a year you expect that (i) a dividend

of Rs. 2 per share will be received and (ii) the price per share will rise to Rs. 90. The

expected return, given this information, is simply:

In general, terms, the rate of return is defined as:

k = actual, expected, or required rate of return

Pt = price of the security at time

Pt-1

= price of the security at time t-1

Dt= income receivable from the security at time t

( It may be noted that the period over which the rate of return is calculated is normally

one year. However, it can be defined as any other interval, six months, one month, one

week, one day, or any other).

Probability

When you buy an equity stock you are aware that the rate of return from it is

likely to vary-and often vary widely. For example, if you buy a share of Olympic Limited

for Rs. 80 today, you may be confronted with the following possible outcomes as far as

the price after a year is concerned:

All the three outcomes may not be equally likely. The first outcome, for example,

may be more likely than the others. In more formal terms we say that the probability

associated with outcome A is greater than the probability associated with the other

outcomes.


49

NOTES


Where k = expected rate of return

pi = probability associated with the D possible outcome

ki = the possible outcome

n = number of possible outcomes.

From Eq. (2) it is clear that k is the weighted arithmetic average of possible outcomes—

each outcome is weighted by the probability associated with it. The expected rate of

return for Bharath Foods is:

kb= (0.30) (25%) + (0.50) (20%) + (0.20) (15%) = 20.5%

Similarly, the expected rate of return for Oriental Shipping is:

k0 = (0.30) (40%) + (0.5) (10%) + (0.20) (-20%) = 13.0%

= 13.0%

Returns

FIGURE 3.3

How is non-diversifiable risk measured? It is generally measured by beta, β .

Though not perfect, beta represents the most widely accepted measure of the extent to

which the return on a financial set fluctuates with the return on the market portfolio. By

definition, the beta for the market portfolio is 1. A security which has a beta of say, 1.5,

experiences greater fluctuation than the market portfolio. More precisely, if the return

on market portfolio is expected to increase by 10 per cent, the return on the security

with a beta of 1.5 is expected to increase by 15 per cent (1.5 x 10 per cent). On the

other hand, a security which has a beta of, say, 0.8 fluctuates lesser than the market

portfolio. If the return on the market portfolio is expected to rise by 10 per cent, the

return on the security with a beta of 0.8 is expected to rise by 8 per cent (0.8 x 10 per

cent). Individual security betas generally fall in the range 0.60 to 1.80 and rarely, if ever,

assume a negative value.


51

NOTES


Table 4

The beta for security j, 3, is calculated in Table 5. Given the values of (3 (0.76)

and cx, (2.12 percent) the regression relationship between the return on security j (Ic)

and the return on market portfolio (k.,) is shown graphically in Fig. 5. The graphic

presentation is commonly referred to as the characteristic line. Since security j has a

beta of 0.76 we infer that its return is less volatile than the return on the market portfolio.

If the return on the market portfolio rises/falls by 10 per cent, the return on security j

would he expected to increase/decrease by 7.6 percent (0.76 x 10%). The intercept

term for security j (a.,) is equal to 2.12 percent. It represents the expected return on

security j when the return on the market portfolio is zero.

Table 5 Calculation of Beta


53

NOTES


FIGURE 3.4 SECURITY MARKET LINE

Its required rate of return is 11 per cent. Security B is a neutral security with a

beta of 1. Its required rate of return is equal to the rate of return on the market portfolio.

Security C is an aggressive security with a beta of 1.5. Its required rate return is 17 per

cent.

(In general, if the beta of a security is less than 1 it is characterised as defensive,

if the beta of a security is equal to I it is characterised as neutral; and if the beta of a

security is more than 1 it is characterised as aggressive.)

Changes in Security Market Line

The two parameters defining the security market line are the intercept (R1) and

the slope (kM - R

1). The intercept represents the nominal rate of return on the risk-free

security. It is expected to be equal to: risk-free security real rate of return plus inflation

rate. For example, if the risk-free real rate of return is 2 per cent and the inflation rate is

8 per cent the nominal rate of return on the risk-free security is expected to be 10 per

cent. The slope represents the price per unit of risk and is a function of the risk-aversion

of investors.

If the real risk-free rate of return and/or the inflation rate change, the intercept

of the security market line changes. If the risk-aversion of investors changes the slope

of the security market line changes. Figure 3.5 below shows the change in the security

market line when the inflation rate increases and Figure 3.6 shows the change in the

security market line when the risk-aversion of investors decreases


55

NOTES


Change in the Security Market Line caused by a a decrese in Risk Aversion

The investors, after analyzing the prospects of stock A, conclude that its

earnings, dividends, and price will continue to grow at the rate of 6 per cent annum.

The previous dividend per share, D0, was Rs. 1.70. The dividend per share

expected a year hence is:

D1= Rs. 1.70 (1.06) = Rs. 1.80

The market price per share happens to be Rs. 22.

What would investors, in general, do? Investors would calculate the expected

return from stock A as follows:

Finding that the expected return is less than the required rate, investors, in

general, would like to sell the stock. However, as there would be no demand for the

stock at Rs. 22 per share, existing owners will have to lower the price to such a level

that it fetches a return of 15 per cent, its required return. That price, its equilibrium

price, is the value of P in the following equation:

Solving Eq., for P4, we find that the equilibrium price is Rs. 20,00

If the market price initially had been lower than Rs. 20.00, investors, finding its

return to be greater than its required return, seek to buy it. In this process, the price will

be pushed up to Rs. 20.00, its equilibrium price.

Changes in Equilibrium Stock Prices

Stock market prices tend to change in response to changes in the underlying

factors. To illustrate, let us assume that stock A, described above, is in equilibrium and

sells at a price of Rs. 20.00 per share. If the expectations with respect to this stock are

fulfilled, its equilibrium price a year hence will be Rs. 21.20,6 per cent higher than the

current price. However, several factors could change in the course of a year and alter

its equilibrium price. Suppose the values of underlying factors change as follows:


57

NOTES


Lesson 4

Valuation of Securities

1.Introduction


3.Section Title

3.1 Valuation Concept

3.2 Bond Valuation

3.3 Equity Valuation: Dividend Capitalization Approach

3.4 Equity Valuation: Ratio Approach

Have you understood?

1. INTRODUCTION

The goal of investors and investment managers is to maximize their rate of

return, or in other words, market value of their investments. Thus, investment manage-

ment is an ongoing process that calls for continuous monitoring of information that may

affect the value of securities or rate of return of such securities. Therefore, in making

valuation judgements about securities, the analyst applies consistently a process which

will achieve a true picture of a company over a representative time span, an estimate of

current normal earning power and dividend pay-out; estimate of future profitability;

growth and reliability of such expectations and the translation of all these estimates into

valuation of the company and its securities.

2.LEARNING OBJECTIVES

On learning this lesson, you will be conversant with:

• Valuation concept

• Valuation of bonds

• The concept and calculation of YTM.

• Valuation of equity under dividend capitalization approach; and


59

NOTES


Coupon Rate and Interest A bond carries a specific interest rate which is called

the coupon rate. The interest payable to the bondholder is simply, par value of the

bond x coupon rate. For example, the annual interest payable on a bond which has a

par value of Rs. 100 and a coupon rate of 13.5 percent is Rs. 13.5 (Rs. 100 x 13.5 per

cent).

Maturity Period: Typically corporate bonds have a maturity period of 7 to 10

years, whereas government bonds have maturity periods extending up to 20-25 years.

At the time of maturity the par (face) value plus, perhaps a nominal premium, is payable

to the bondholder.

b) Basic Bond Valuation Model

As noted above. the holder of a bond receives a fixed annual interest-payment

for a certain number of years and a fixed principal repayment (equal to par value) at the

time of maturity. Hence, the value of a bond is:

Where V = value of the bond

I = annual interest payable on the bond

F = principal amount (par value) of the bond repayable at the time

of maturity

n = maturity period of the bond.

Example: A Rs. 100 par value bond, bearing a coupon rate of 12 per cent, will

mature after 8 years. The required rate of return on this bond is 14 per cent. What is the

value of this bond?

Since, the annual interest payment will be Rs. 12 for 8 years and the principal

repayment will be Rs. 100 at the end of 8 years, the value of the bond will be:

Example: A Rs. 1,000 par value bond, bearing a coupon rate of 14 per cent, will

mature after 5 years. The required rate of return on this bond is 13 per cent. What is the

value of this bond? Since, the annual interest payment will be Rs. 140 for 5 years and


61

NOTES


If the required rate of return is 12 per cent (which is lower than the coupon

rate), the bond value is:

The following theorems express the effect of the number of years to maturity on

bond values.

IIa When the required rate of return is greater than the coupon rate, the dis-

count on the bond declines as maturity approaches.

IIb When the required rate of return is less than the coupon rate, the premium

on the bond declines as maturity approaches.

IIc The longer the maturity of a bond, the greater its price change in response

to a given change in the required rate of return.

To illustrate the above theorems, let us consider a bond of Sharath Limited

which has the following features:

If the required rate of return on this bond is 15 per cent, it will have a value of:

One year from now, when the matuirty period will be 7 years, the bond will have a

value of:

Given the required rate of return of 15 per cent, the bond will increase in value with the

passage of time, until it matures, as follows:


63

NOTES


The upper curve in Fig 4.1 above represents how the bond value will behave

as a function of years to maturity.

To show that the longer the maturity of a bond, the greater is its price change in

response to a given change in the required rate of return, we may refer to Fig. 4.1

When the required return decreases from 15 per cent to 11 per cent, given a maturity

period of 7 years, the value of the bond increases from Rs. 916.8 to Rs. 1,094.6, an

increase of 19A percent. However, if the same change in the required rate of return

occurs with only 2 years to maturity, the bond value would rise from Rs. 967.4 to Rs.

1,034.7—an increase of only 7.0 per cent.

To further illustrate the theorem , consider two bonds A and B, which are alike

in all respects except their period of maturity.

What happens if the required rate of return on these two bonds rises to 14 per

cent, or falls to 10 percent? The prices of these bonds will behave as follows:

From the above data, it is clear that the percentage price change in bond B (the

bond with longer maturity) is higher compared to the percentage price change in bond

A (the bond with shorter maturity) for given changes in the required rate of return.


65

NOTES


Example: The price per bond of Zion Limited is Rs. 90. The bond has a par

value of Rs. 100, a coupon rate of 14 per cent, and a maturity period of 6 years. What

is he yield to maturity?

Using the approximate formula the yield to maturity on the bond of Zion works

out to:

e) Bond Values with Semi-annual Interest

Most of the bonds pay interest semi-annually. To value such bonds, we have to

work with a unit period of six months, and not one year. This means that the bond

valuation equation has to be modified along the following lines:

• The annual interest payment, 1, must be divided by two to obtain the semi-annual

interest payment.

• The number of years to maturity must be multiplied by two to get the number of half-

yearly periods.

• The discount rate has to be divided by two to get the discount rate applicable to half-

yearly periods.

With the above modifications, the basic bond valuation equation becomes:

The procedure for linear interpolation is as follows:

(a) Find the difference between the present values for the two rates, which in this case

is Rs. 39.9 (Rs. 808—Rs. 768.1).

(b) Find the difference between the present value corresponding to the lower rate (Rs.

808 at 13 per cent) and the target value (Rs. 800). which in this case is Rs. 8.0.

(c) Divide the outcome of (b) with the outcome of (a), which is 8.0139.9 or 0.2. Add

this fraction to the lower rate, i.e., 13 percent. This gives the YTM of 13.2 percent.


67

NOTES


P1 = price of the share expected a year hence

ks= rate of return required on the equity share.

Example: Prestige’s equity share is expected to provide a dividend of Rs. 2.00 and

fetch a price of Rs. 18.00 a year hence. What price would it sell for now if investors’

required rate of return is 12 per cent 7

The current price will be

What happens if the price of the equity share is expected to grow at a rate of g

percent annually 7 If the current price. F0, becomes P

0 (1+g) a year hence, we get:

Simplifying Eq. We get,

Example: The expected dividend per share on the equity share of Road king Limited is

Rs. 2.00. The dividend per share of Road king Limited has grown over the past five

years at the rate of 5 percent per year. This growth rate will continue in future. Further,

the market price of the equity share of Road king Limited, too, is expected to grow at

the same rate. What is a fair estimate of the intrinsic value of the equity share of Road

king Limited if the required rate is 15 percent?

Applying Eq. we get the following estimate:

Expected Rate of Return

In the preceding discussion we calculated the intrinsic value of an equity share,

given information about (i) the forecast values of dividend and share price, and (ii) the

required rate of return. Now, we look at a different question: What rate of return can

the investor expect, given the current market price and forecast values of dividend and

sham price? The expected rate of return is equal to:


69

NOTES


Now, what is the value of Pn, in Eq. Applying the dividend capitalization principle,

the value of F, would be the present value of the dividend stream beyond the nth period,

evaluated as at the end of the nth year. This means:

Substituting this value of P in Eq. (6.10) we get:

We discuss below three cases:

(i) Constant dividends, (ii) constant growth of dividends, and (iii) changing

growth rates of dividends.

Valuation with Constant Dividends

If we assume that the dividend per share remains constant year after year at a

value of 1), the Eq. becomes:

Equation on simplification, becomes


71

NOTES


where P0 =price of the equity share

D1 = dividend expected a year hence

ga = super-normal growth rate of dividend.

gn = normal growth rate of dividends.

To compute the value of P0 in Eq. (6.18), the following procedure may be

employed.

Step 1. Specify the dividend stream expected during the initial period of super-

normal growth. Find the present value of this dividend stream. Using the symbols pre-

sented earlier, this can be represented as:

Step 2. Calculate the value of the share at the end of the initial growth period,

(As per the constant growth model), and discount this value to the present. In terms

of our symbols, this discounted value is:

Step 3. Add the above two present-value components to find the value of the share,

P0. as given below:

Present value Present value of the

of the dividend value of the share at

stream during the end of the initial

the initial period

period

To illustrate the above procedure let us consider the equity share of Vertigo Limited:

D0= current dividend per share = Rs. 2.00

n = duration of the period of super-normal growth = 4 years

= growth rate during the period of super-normal growth = 20 per cent

ga= normal growth rate after the super-normal growth period is over = 5 per cent

gn = equity investors required rate of return = 12 per cent


73

NOTES


Impact of Growth on Price, Returns, and P/E Ratio

The expected growth rates of companies differ widely. Some companies are

expected to remain virtually stagnant; other companies are expected to show normal

growth; still others are expected to achieve super-normal growth rate.

Assuming a constant total required return, differing expected growth rates mean

differing stock prices, dividend yields, capital gains yields, and price-earnings ratios. To

illustrate, consider three cases:

The expected earnings per share and dividend per share of each of the three

firms are Rs. 3.00 and Rs. 2.00 respectively. Investors’ required total return from eq-

uity investments is 15 per cent.

Given the above information, we may calculate the stock price, dividend yield,

capital gains yield, and price-earnings ratio for the three cases as shown in Table 1.

Table 1 Price, Dividend yield, Capital gains yield, and Price-earnings ratio un-

der Differing growth assumptions for 15 percent return

The results in Table 1 suggest the following points:


75

NOTES


Liquidation Value

The liquidation value per share is equal to

To illustrate, assume that Pioneer Industries would realise Rs. 45 million from

the liquidation of its assets and pay Rs. 18 million to its creditors and preference share-

holders in full settlement of their claims. If the number of outstanding equity shares of

Pioneer is 1.5 million, the liquidation value per share works out to:

While the liquidation value appears more realistic than the book value, there

are two serious problems in applying it. First, it is very difficult to estimate what amounts

would be realised from the liquidation of various assets. Second, the liquidation value

does not reflect earnings capacity. Given these problems, the measure of liquidation

value seems to make sense only for firms which are ‘better dead than alive’ — such

firms are not viable and economic values cannot be established for them.

Price/Earnings Ratio

Traditionally, financial analysts have employed price-earnings ratio models more

than dividend capitalization models. According to the price-earnings ratio approach,

the intrinsic value of a share is expressed as:

Expected earnings per share x appropriate price-earnings ratio

The expected earnings per share is defined as:

While the preference dividend and the number of outstanding equity shares can

be defined in certain near terms, the expected profit after tax is rather difficult to esti-

mate. To get a reasonable handle over it the following factors, inter alia, need to be

examined: sales, gross profit margin, depreciation, interest burden, and tax rate. Some

financial analysts, instead of working with the expected earnings per share for next


77

NOTES


3. “When the required rate of return is greater than/less than the coupon rate the

discount/premium on the bond declines as maturity approaches.” Illustrate this

with a numerical example.

4. “The longer the maturity of a bond, the greater its price change in response to

a given change in the required rate of return.” Illustrate this with a numerical

example.

5. Explain and illustrate the concept of yield to maturity.

6. State the formula for valuing a bond which pays interest semi-annually and

which is redeemable.

7. What is the expected rate of return on an equity share when dividends are

expected to grow at a constant annual rate?

8. Discuss the valuation of an equity share with variable growth in dividends.

9. Discuss the impact of growth on price, dividend yield, capital gains yield, and

price- earnings ratio.

10. How relevant and useful is the book value per share as a measure of investment

value?

11. What are the limitations of the liquidation value approach?

12. What factors are relevant in establishing an appropriate price-earnings ratio for

a given share? What is the likely effect of these factors on the price-earnings

ratio?

13. What are the advantages and limitation of the price-earnings ratio approach?


79

NOTES


1. INTRODUCTION

Capital budgeting is budgeting for capital projects. The exercise involves

ascertaining and estimating cash inflows and outflows, matching the cash inflows with

outflows appropriately and evaluation of the desirability of the project,under

consideration.

2. LEARNING OBJECTIVES:

After reading this lesson, you will be conversant with:

1 The nature of investment decisions

2 Scanning and identification of investment opportunities

3 Criteria for preliminary screening

4 Preparation of cash flow projections for projects

5 Assessing the financial viability of projects using the various appraisal criteria.

3. SECTION TITLE

3.1 Capital Projects

Businesses investments in capital projects are of different nature. These capital

projects involve investment in physical assets, as opposed to financial assets like shares,

bonds or funds. Capital projects necessarily involve processing, manufacturing or service

works. These require investments with a longer time horizon. The initial investment is

heavy in fixed assets and investment in permanent working capital is also heavy. The

benefits from the projects last for few to many years.

Capital projects may be new ones, expansion of existing ones, diversification

of existing ones, renovation or rehabilitation of projects, R&D activities, or captive

service projects. An enterprise may put up a new subsidiary, increase stake in existing

subsidiary or acquire a running firm. All these are considered as capital projects.

Capital projects involve huge outlay and it will last for years. Hence, these are

riskier than investments in financial assets. Capital projects have technological dimensions

and environmental dimensions. So, careful analysis is needed. Decisions once taken

cannot be easily reversed in respect of capital projects and therefore thorough evaluation

of costs and benefits is needed.

3.2 Significance of Capital Budgeting

Every business has to commit funds in fixed assets and permanent working

capital. The type of fixed assets that a firm owns influences i) the pattern of its cost (i.e.

high or low fixed cost per unit given a certain volume of production), ii) the minimum

price the firm has to charge per unit of production iii) the break-even position of the


81

NOTES


fixtures, etc. generally, gives the installed capacity. Investment in these fixed assets is

one time. Further, a one-time investment in working capital is needed in the beginning,

which is fully salvaged at the end of the life of the project.

Against this committed returns in the form of net cash earnings are expected.

These are computed as follows. Let ‘P’ stand for price per unit, ‘V’ for variable cost

per unit, ‘Q’ for quantity produced and sold, ‘F’ stand for total fixed expenses exclusive

of depreciation, ‘0’ stand for depreciation on fixed assets, ‘I’ for interest on borrowed

capital id ‘T’ for tax rate).

Then, cash earnings = [(P-V) Q-F-D-I](1-T)+D

These cash earnings have to be estimated throughout the economic life of the

investment. That is, all the variables in the equation have to be forecasted well over a

period of years.

Now, that we have the benefits from the investment estimated, the same may

be compared with costs of the capital project and ‘netted’ to find out whether costs

exceed benefits or benefits exceed costs. This process of estimation of costs and benefits

and comparison of the same is called appraisal.

Payback period, accounting rate of return, net present value, rate of return,

decision tree technique, sensitivity analysis, simulation and capital asset pricing model

(CAPM) are certain methods of appraisal.

3.4 Requisites for Appraisal of Capital Projects

The computation of profit after tax and cash flow is relevant in evaluation of

projects. Hence, this is presented here as a prelude to the better understanding of the

whole process.

Say in fixed assets at time zero, you are investing Rs.20 lakhs. You have estimated

the following for the next 4 years.


83

NOTES


Profit after tax = PAT = PBT (1-Tax Rate). So, for the first year PAT =

13,00,000 (1-30%) = 13,00,000 (0.7) = 9,10,000. Similarly, for the other years the

profit figures can be obtained as in table 3

Table 3

Cash flow from business is equal to PAT plus depreciation. Table 3 gives cash flowfrom business.

TABLE 4

3.5 Methods used for Projects Appraisal

A. Payback Period (PBP) Method

Pay back period refers to the number of years one has to wait to setback the

capital invested in fixed assets in the beginning. For this, we have to get cash flow from

business.


85

NOTES


calculated. From the PBT for different years, average annual PBT can be calculated.

The average annual PBT = Total PBT I No. of years

Average annual PBT = 46,00,000/4

= Rs.11, 50,000

ARR = AAPBT / Investment

= 11,50,000/20,00,000 = 0.574 = 57.4%

The denominator can be an average investment, i.e., (original value plus terminal

value)/2.Here it is 10 lakhs. Then the ARR will be Rs.11, 50,000/ Rs.l0,00,000 =

1.15%

ARR can also be computed on the basis of Profit After Tax (PAT). The Average

Annual PAT / Original investment.

Average Annual PAT = Total PAT/ No. of years

= 31,00,000 / 4 = 7,75,000

So, ARR = 7,75,000 / 20,00,00 = 0.3875 = 38.75%

The denominator can be the average investment, instead of actual investment,

then ARR is = Rs.7, 75,000 / Rs. 10,00,000=0.775 or 77.5%.

Merits of ARR

i. It is simple and common sense oriented.

ii. Profits of all years are taken into account.

Demerits of ARR

i. Time value of money is not considered.

ii. Risk involved in the project is not considered.

iii. Annual average profits might be the same for different projects but accrual of

profits might differ having significant implications on risk and liquidity.

iv. The ARR has several variants and it lacks uniformity.

A minimum ARR is fixed as the benchmark rate or cut-off rate. The estimated

ARR for an investment must be equal to or more than this benchmark or cut-off rate so

that the investment or project is chosen.

C. Net Present Value (NPV) Method

Net present value is computed given the original investment, annual cash flows

(PAT + Depreciation) and required rate of return which is equal to cost of capital.


87

NOTES


with lower fluctuations risk.

D. Internal Rate of Return (IRR) Method

Internal Rate of Return (IRR) is the value of ‘k” in the equation, I + Z CF /

(l+k) t = 0. In other words, IRR is that value of “k” for which aggregated discounted

value of cash flows from the project is equal to original investment in the project. When

manually computed, “k” i.e., IRR is got through trial and error. Suppose for a particular

value of I +E CF1 I (l+k) t >0, we have to use a higher ‘k’ in our trial and if the value is

<0, a lower ‘k’ has to employed next time. Then, you can interpolate k. The value of ‘k’

thus got is the IRR.

3.6 Decision Tree Approach

Decision tree approach is a versatile tool used for decision-making under

conditions of risk. The features of this approach are: (1) it takes into account the results

of all expected outcomes, (ii) it is suitable where decisions are to be made in sequential

parts - that is, if this has happened already, what will happen next and what decision has

to follow, (iii) every possible outcome is weighed using joint probability model and

expected outcome worked out, (iv) a tree-form pictorial presentation of all possible

outcomes is presented here and hence, the term decision-tree is used. An example,

will make understanding easier.

An entrepreneur is interested in a project, say introduction of a fashion product

for which a 2 year market span is foreseen, after which the product turns fade and that

within the two years all money invested must be realised back in full. The project costs

Rs. 4,00,000 at the time of inception.

During the 1st year, three possible market outcomes are foreseen. Low

penetration, moderate penetration and high penetration are the three outcomes, whose

probability values, respectively, are 0.3, (i.e., 30% chance), 0.4 and 03 and the cash

flows after tax under the three possible outcomes are respectively estimated to be Rs.

1,60,000, Rs. 2,20,000 and Rs. 3,00,000.

The level of penetration during the 2nd year is influenced by the level of

penetration in the first year. The probability values of different penetration levels in the

2nd year, given the level of penetration in the 1st year and respective cash flows are

estimated as follows:


89

NOTES


cash flow streams can be worked out. These values, the NPV relevant to each stream

(i.e., the aggregate of the present value of the two cash flows of each stream minus

investment of Rs.4,00,000), joint probability (i.e., product of probabilities of the two

cash flows of each stream) and expected value of NPV (i.e., joint probability times

NPV of each stream) are given below in table 7.

TABLE 7

S.No PV of 1st PV of 2nd PV of both NPV of each joint Expected

year flow year flow year flows stream prob. NPV

(1) (2) (3) (4)=(2)+(3) (5)=(4)-400000 (6) (7)=(5)(6)

1 145440 50080 195520 -204480 0.06 -12269

2 145440 165200 310640 -89360 0.18 -16085

3 145440 247800 393240 -6760 0.06 -403

4 199980 214760 414740 14740 0.12 1709

5 199980 247800 447780 47780 0.16 7645

6 199980 264320 464300 64300 0.12 7716

7 272700 264320 537120 137130 0.03 4111

8 272700 330400 603100 203100 0.24 48744

9 272700 346920 619620 219620 0.03 6889

Total 1.00 47395

The expected NPV of the project is negative at Rs.12269, if low penetration

prevailed both in the 1st and 2nd years and this has a probability of 6 out of 100 or .06.

The expected NPV is negative at Rs.16085, if low penetration in 1st year and moderate

penetration in 2nd year have prevailed and the probability of this happening is 18%.

Outcome 8 shows that NPV of Rs.48, 744 with probability of 24% is possible when

high penetration in 1st year and moderate penetration in the 2nd year result. The expected

NPV of the project is the aggregate of the expected NPV of the different streams =

Rs.47395. Since, it is positive, the project may be taken up.

3.7 Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is one of the premier methods of

evaluation of capital investment proposals. CAPM gives a mechanism by which the

required rate of return for a diversified portfolio of projects can be calculated given the

risk. According to CAPM, the required rate of return comprises of two parts: first, a


91

NOTES


Simulation process gives a probability distribution to each of the truant playing

variables. Let the probability distribution for ‘T’ and ‘K’ be as follows:

Next, we construct cumulative probability and assign number ranges, separately

for T and K. Two digit random n ranges are used. We start with 00 and end with 99,

thus using 100 numbers. For the different values of the variable in question, as many

random numbers as are equal to the probability values of respective values are used.

Thus, for variable T, 20% of random numbers aggregated for its first 30% and 50% of

random number for its next value 35% and 40%.

For the first value of the unpredictable variable, we assign random numbers 00

to 19. For the second value we assign random numbers 20—69 and for the third value

random numbers 70 - 99 are assigned. Similarly, for the variable ‘K’ also random

numbers are assigned as given in table 6.

Simulation process now involves reading from random number table, random

number pairs (one for ‘T’ and another for ‘K’). The values of ‘T’ and ‘K’ corresponding

to the random numbers read are taken from the above table. Suppose the random

numbers read are: 48 and 80. Then ‘T’ is 35% and the random number 48 falls in the

random number range 20-69 corresponding to 35% and ‘K’ is 12% as the random

number 80 fails in the random number range 80-99 corresponding to 12%. Now taking

the T = 35% and K = 12%. the NPV of the project can be worked out. We know that

the project gives a PAT of Rs.9,00,000 p/a for 3 years. So, the PAT = 9,00,000 – Tax

@ 35% = Rs.9,00,000 - 3,15,000 Rs.5,85,000 pa. To this, we have to add depreciation

of Rs.6,00,000 (i.e. Rs.18,00,000 / 3 years) to get the cash flow. So, the cash flow=

5,85,000 + 6,00,000= Rs. 11,85,000 p.a.


93

NOTES


V Rs.100-Rs.250; Most Likely value is Rs.150

Q: 15000-22000; Most Likely quantity is 20,000

T: 30%-40%; Most Likely rate is 35%

Suppose, we want to study the sensitivity of NW with respect to ‘T’. then

other uncertain variables, namely, V and Q will be assigned their most likely values.

Needless to say, the variables taking constant values will take their fixed values. The

variable T’ will be taking different values within the range of its values for each such

values of T. The NPV will be worked out and sensitivity of the NPV to that factor also

be analysed. Accordingly, for our purpose: I = Rs. 18,00,000, N = 3 years, D = Rs.6,

00,000, F = Rs.15, 00,000, k = 15%. P, V and Q at their most likely values are

Rs.300, Rs. 150 and 20,000 units. ‘T’ shall take different values within its range; say

30%, 32.5%, 35%, 37.5% and 40%. For each of these 5 values of T, NPV will be

worked out and sensitivity of NW be analysed.

First let T be 30%. The annual cash flow is:

= [(P-V) Q - F - D] (J-T) + D

= [(Rs.300-Rs.150) 20000units-Rs.15, 00,000–Rs.6, 00,000](1-30%) + Rs.6, 00,000

= [Rs.30, 00,000 –Rs. 21,00,000] (0.70) +Rs. 6,00,000

= Rs.9, 00,000(0.70) +Rs. 6,00,000

= Rs. 12,30,000 pa

NPV = (Rs.12,30,000 / 1.15 +Rs.12,30,000/1.152 +Rs.12,30,000 / l.153) –

Rs.18,00,000

= Rs. 28,08,369 -Rs. 18,00,000= Rs. 10,08,369

Let T be 32.5%. The annual cash flow is:

= [(P-V) Q - F - D] (I-D) +D

= [(Rs.300-Rs.150) 20000 units-Rs. 15,00,000 –Rs.6, 00,000] (1-32.5%) + Rs.6, 00,000

= [Rs.30, 00,000 -Rs. 21,00,000] (0.675) +Rs. 6,00,000

= Rs.9, 00,000(0.675) +Rs. 6,00,000

= Rs. 12,07,500 p.a

NPV = (Rs.12,07,500/1.15 + Rs.12, 07,500/1.152 + Rs.12,07,500/1.153) –

Rs.18,00,000

= Rs.27, 56,994 – Rs.18,00,000 = Rs. 9,56,994

Let T be 35% the annual cash flow is:


95

NOTES


NPV = (11,62,500/1.15 + 11,62,500/1.152 + 1 1,62,500/1.153)— 18,00,000

= 26,54,249 - 18,00,000 = Rs. 8,54,249

= [30,00,000 - 21,00,000] (0.60) + 6,00,000

= 9,00,000 (0.60) + 6,00,000

= Rs. 11,40,000 p.a

NPV = (Rs.11, 40,000/1.15+Rs11, 40,000/1.152+Rs.11,40,000/l.153)-18,00,000

= Rs.26, 02,876 – Rs.18,00,000 = Rs. 8,02,876

You might have noted that as T rises, npv falls.

Rate of change in NPV for a given change in T.

When T rises to 32.5% (i.e. (0.325) from 30% (i.e. 0.3) NPV falls to

Rs.9,56,994 from Rs.10,08,369.

Rate of change = ./

/

TT

NPVNPV

∆

∆

61.00.0833

0.0509-

0.025/0.3

3.6951375/1008-−=== When T rises to 35% (i.e. (0.35) from 32.5% (i.e. 0.325) NPV falls to

Rs.9, 05,622 from Rs.9, 56,994.

Rate of change = ./

/

TT

NPVNPV

∆

∆

698.00.07692

0.05368-

.025/0.325

9451372/9569-−===

When T rises to 37.5% from 35% NPV falls to Rs.8,54,249 from Rs. 9,05,622

Rate of change = ./

/

TT

NPVNPV

∆

∆

794.00.0714

0.0567-

0.025/0.35

2251373/9056-−===

When T rises to 40% from 37.5% NPV falls to Rs.3,02,816 falls to Rs. 8,02,816

from Rs. 8,54,249

Rate of change = ./

/

TT

NPVNPV

∆

∆

9015.00.0667

0.0601-

50.025/0.37

4951373/8542-−===


97

NOTES


Solution

First, we have to calculate the size of investment needed. This includes, purchase

cost of new machine, cost of installation and working capital addition needed, reduced

by net sale proceeds (after capital gain tax) of old machine.

The old machine’s original cost = 000,00,14.Rs

Depreciation for the past 2 years

Rs.2, 00,000 [14,00,000 + life 7 years] 000,00,10.

000,00,4.

Rs

Rs

It is sold for 000,00,6.

000,00,16.

Rs

Rs

This gain has two components, capital gain and revenue Capital gain = Rs. Sale

value - original cost = Rs.16,00,000 - Rs.14,00,000 = Rs.2,00,000. Revenue gain

Total gain-capital gain= Rs.6,00,000 - Rs.4,00,000 = Rs.2,00,000. Tax on revenue

gain = Rs.4,00,000 x 40% = Rs.1,60,000. Tax on capital gain = 200000 x 10% =

20,000. Therefore, after adjustment, net sales proceeds of old machine = Rs. 16,00,000

- Rs.20,00,000 - Rs.1,60,000 = Rs. 14,20,000. Now, we can compute net investment

at time zero, i.e., at beginning as follows:

Cost of new machine = Rs.28,00,000

Add installation cost = Rs. 2,00,000

Cost of machine = Rs.30,00,000

Add. AddI. Working capital = Rs. 4,00,000

Rs.34,00,000

Less net sale proceeds of old machine = Rs.14,20,000

Net investment required Rs.19,80,000

Now, we have to calculate the change or increment in cash flow because of the

firm going for replacement of old machine by new one. For this purpose, what is the

cash flow from new machine and what would be the cash flow from old machine had

the firm continued with that must be computed. The difference of former over the latter

is the change in cash flow.


99

NOTES


Add: Addl. Working capital : Rs. 10,000 1,10,000

Less: Sales value of old machine

Tax shield on loss of old

Machine (book value — Market value) x

tax rate [(50000-25000) x 40%] :Rs. 10,000 35,000

—————-

Cash outflow 75,000

ii) Computation of Addl. Gross income

Addl. Production per annum =Hours of operation x Addl. Output per hour

=1000 x 15 = 15,000 units

Addl. Gross income per annum =Addl. Production p.a x unit price

= 15,000 x Rs.3 = Rs.45, 000

From 1st year to 10th year, Rs.45, 000 p.a addl. income is thus predicted.

ii) Cash Flow Computation

Details Year 1 to 9 Year 10

Rs. Rs.

Addl. Gross Income 45000 45000

Add. Savings in consumable stores & repairs 2000 2000

47000 47000

Less: Addl. Materials & Labour cost 12000 12000

PBD & T 35000 35000

Addl. Depreciation ( 10000 - 5000 ) 5000 5000

PBT 30000 30000

Less Tax @ 40% 12000 12000

PAT 18000 18000

Addl. Depreciation 5000 5000

Add: Working Capital Recovery - 10000

Cash Flow 23000 33000

NPV = S CF1/(l+k) t + CF

10 / (1+ k) 10- I

t=l

Since, uniform cash flow is found throughout l to 9th years, the NPV formulate can be

slightly modified as:

NPV = [ACF S 1 / (I+k) t +CF10

X 1 (1+k) 10] - I


101

NOTES


If NPV from year to year fluctuates, there is risk. This can be measured through

standard deviation of the NPV figures. Suppose, the expected NPV of a project is

Rs.18 lakhs, and standard deviation of Rs.6 lakhs, the coefficient of variation C.V is

given by sm. Deviation divided by NPV.

C.V = Rs.6, 00,000 / Rs 18,00,000=0.33.

3.11 Risk Return Analysis for Multi Projects

When multiple projects are considered together, what is the overall risk of all

projects put together? Is it the aggregate average of standard deviation of NPV of all

projects? No, it is not. Then what? Now another variable has to be brought in to the

scene. That is the correlation coefficient between NPVs of pairs of projects. When two

projects are considered together, the variation in the combined NPV is influenced by

the extent of correlation between NPVs of the projects in question. A high correlation

results in high risk and vice versa. So, the risk of all projects put together in the form of

combined standard deviation is given by the formula:

[ ] 2/1

jiijp p σσσ ∑=

Where,

sp = combined portfolio standard deviation

Pij = correlation between NPVs of pairs of projects (i and j)

si, s

j = standard deviation of iin and jth projects, i.e., any pair of projects taken at a

time.

Illustration

Three projects have their standard deviations as follows: Rs.4000, Rs.6000

and Rs.10000. The correlation coefficients are l&2 0.6, 1&3 0.78 and 2&3: -0.5.

What is the overall standard deviation of the portfolio of projects?

sp

= [SPij s

i s

j ] ½ = [s

12+s

22+s

32+2P

12s

1s

2+2P

23s

2s

3+2P

13s

1s

3] ½

= [40002 + 60002 + 100002 + 2x0.6x4000x6000 -i- 2x0.78x6000xl0000 +

2x(-0. 5) x 10000x4000] ½

= [16000000+36000000+ 100000000+28800000+93600000-400000000] ½

= [234400000] ½ = Rs. 15,310

What is the return from these multiple projects? This is simple. It is the aggregate

NPVs. Suppose, the three projects have NPVs of Rs.16, 000, Rs.20, 000 and Rs.44,

000. The combined NPV = 16000 + 20000 + 44000 = Rs.80000.


103

NOTES


FINANCING AND DIVIDEND DECISION

Lesson 1

Financial an Operating Leverages

1 Introduction

2. Learning Objectives

3. Section Title

3.1.Leverage Calculation

3.2.Return On Investment (ROI) Leverage

3.3. Asset Leverage

3.4. Operating Leverage

3.5. Financial Leverage

3.6. Total Leverage

3.7. Fixed Charges Leverage

3.8. Combined Leverage

3.9. Managerial Analysis

3.10 Financial Analysis through Leverage


UNIT III


105

NOTES


RS

FIGURE1.1 MASTER TABLE FOR LEVERAGE

CALCULATIONS

Sales xxx

Less: Variable Cost xxx

----

Contribution xxx

Less: Fixed Cost xxx

----

Earnings Before Interest and Taxes (OP) (EBIT) xxx

Less: Interest xxx

-----

Earnings Before Tax (EBT) xxx

Less: Tax xxx

----

Earnings After Tax (EAT) xxx

Less: Preference shareholders’ dividend xxx

----

Earnings Available to Equity Shareholders xxx

----

3.2 Return on Investment Leverage

The return on investment is a very important indicator of a firm’s performance.

It is an index of operational efficiency. It should be remembered that the return on

investment is the result of asset turnover and profit margin. Asset turnover is the ratio of


107

NOTES


The change in the rate of earnings is based on the operating leverage resulting

from the fact that some costs do not move proportionally with changes in production.

This leverage operates both positively and negatively, increasing profits at a rapid rate

when sales are expanding and reducing them or causing losses when operations decline.

If all the costs were variable, the rate of profit would show fewer changes at different

operating levels. The operating leverage, then, is the process by which profits are raised

or lowered in greater proportion than the changes in the volume of production because

of the inflexibility of some costs. The higher the fixed costs, the greater the leverage and

the more frequent the changes in the rate of profit (or loss) with alternations in the

volume of activity.

Illustration

The operating leverage decreases with an increase in sales above the break-

even point. The reason is that fixed costs become relatively smaller than the revenues

and the variable costs once the break-even point is reached. The extent of the operating

leverage depends on the employment of fixed assets in the production process. The

higher the fixed costs a firm employs in the production process, the greater is its operating

leverage. This operating leverage is measured with the help of following formula:

Capital Gearing Affects

It is a company’s capacity to maintain an even distribution policy in the face of

difficult trading periods, which may occur due to Dividend policies and the building up


109

NOTES


financial leverage, the advantage is passed on to equity stockholders. On the other

hand, when the ROI is less than the interest rate, the firm loses money by its borrowings.

In other words, borrowings place it in an embarrassing position. It is not then worthwhile

for it to borrow and have an unfavourable financial leverage.

The phrase trading equity is a financial jargon which indicates the utilisation of

non-equity sources of funds in the capital structure of an enterprise. At a high debt-

equity ratio, a firm may not be able to borrow funds at a cheaper rate of interest it may

not able to borrow funds at all. This is so because creditors lose confidence in the

company which has a high debt-equity ratio. How can creditors have confidence in the

company which has only creditors and no equity stockholders? The company will,

therefore, have to strive hard to regain a reasonable debt-equity ratio so that the

expectations of the market may be satisfied. In fact, equity financing by way of a public

sale of stock offers real value of a firm. Traditionally, it has served as a spearhead for

expansion of resources and productive capacity involving risk.

Merwin Waterman states that the term trading on equity is seldom heard among

the practitioners of business finance. It is, however, a term full of an academic flavour,

and textbooks use it in discussions of the financial structures. On the ‘street’, a synonym

for this academic phraseology is financial leverage. Trading on equity is defined as the

increase in profit /return resulting from borrowing capital at a lower rate and employing

it in a business yielding a higher rate. The capital obtained from debt securities is used in

a project which produces a rate of return which is higher than its cost. This allows the

difference to be distributed to holders of equity securities. In other words, it is possible

to lever the return on investment through a tighter management.

Doing business partly on borrowed capital is known as trading on equity, which,

however, includes all forms of business with funds (or properties) obtained on contracts

calling for limited payments to those who supply funds. The expectation is that these

funds will produce a larger revenue than the limited payments call for. Thus, trading on

equity may be based upon bonds, non-participating preferred stock, and/or limited

rental leases. When a corporation earns more on its borrowed capital than the interest

it has to pay on bonds, trading on equity is profitable. But in times of poor business,

when the interest on bonds amounts to more than the company makes from the use of

these funds, trading on equity is unprofitable. For these reasons, it is said that trading on

equity magnifies profits and losses.

Most companies benefit from an objective review of their borrowings. In recent

years, borrowings have increased as a percentage of net tangible assets, either by force

of circumstances or as the result of the doctrine of gearing or leverage. Companies

have tended to borrow at different times in circumstances which often bear little

relationship to their present size and financial position.


111

NOTES


for its ROI (7 per cent) was less than its interest rate (8 per cent). The principle of

capital structure management is then simple. It is logical for a firm to borrow reasonable

amounts; If it earns higher rate than it pays for its borrowings. Similarly, when ROl is

high, the firms with a favourable financial leverage are bound to enjoy high earnings.

Advantages of Financial Leverage

1. The advantage of trading on equity is that it makes it possible for a company

to distribute higher dividends per share than it would have, if it has been financed by

stock alone.

2. The advantages and attractiveness of trading on equity for the owners of

equity capital are all too apparent. Some of these have already been explained while

discussing the requirements for trading on equity.

Limitations of Financial Leverage

1. It may cause dividends to disappear altogether and, indeed, may be

responsible for the insolvency and even bankruptcy of a corporation.

2. Companies enjoying a fairly regular income can employ borrowed funds

more safely than those with widely fluctuating incomes.

3. Beyond a certain point, additional capital cannot be employed to produce a

return in excess of the payments which must be made for its use or sufficiently in excess

thereof to justify its employment.

4. The bigger the amount of funds borrowed, the higher the interest rate the

corporation may be forced to pay in order to market its successive issues of bonds.

Such increase in interest rates, if carried far off, may offset all the advantages of trading

on equity. But such a general principle does not inevitably follow. A growing company

which is progressively increasing its net earnings through trading on equity may present

such an earning exhibit as to make it possible for further trading on equity at low or

lower rates. Moreover, money rates may fall.

3.6 Total Leverage

Operating and financial leverages are inter-dependent. At any given level of a

firm’s operations, the total extent of leverage may be measured by the following formula:

Degree of Total Leverage = Degree of Operating Leverage x Degree of Financial

Leverage or


113

NOTES


3.8 Marginal Analysis

It is clear from the above discussion that the operating leverage, the fixed charges

leverage and the combined leverage are techniques of marginal analysis.

The fixed charges leverage isolates costs and compares changes in revenues

with changes in EBIT. The fixed charges leverage isolates interest and compares changes

in EBIT with changes in EBT. Combined leverage isolates both fixed costs and interest

and compares changes in revenues with changes in EBT. It has already been stated that

operating and combined leverage uses the marginal contribution of sales. The reason is

that each additional unit of sales produces a unit of marginal contribution. Moreover,

the leverage works only when sales decrease or increase.

If, for example, the operating leverage is a drop of 50 percent in sales may

wipe off the EBIT.

Illustration

Now, if sales drops by 50 percent, the same will be reduced to Rs. 2,00,000.

It is clear that the EBIT has been wiped off.

Illustration

1. From the following Information, you are required to compute the return on

investment leverage.

Sales 1,50,000 units at Rs. 1.20 per unit.

Total Assets = Rs. 3,00,000

Earnings before interest and taxes = Rs. 30,000


115

NOTES


Solution

3. From the following Information, you are required to find out the extent of operating

leuerage in the year 1989.

EBIT (1988) Rs. 30,000

EBIT (1989) Rs. 35,000

Sales (1988) 1,50,000 units

Sales (1989) 1,80,000 units

Solution

soldqualityinchange%

EBITinChangeLeverageoperatingofExtent =

%4.83834.0%20

%67.16or==

4. A company is thinking of expansion and financing it by issuing equity stock of Rs.

50,000 shares of Rs. 100 per share or by Issuing 12% debentures of the same amount.

The tax rate is 50% and the current equity capital structure amounts to 1,00,000 sharesof Rs. 100 each. The earnings before interest and taxes are Rs. 50,00,000. You arerequired to explain the financial leverage underlying the second proposition.

Solution

To find out the financial leverage, it would be necessary to prepare a table as

below:

It is clear from the above table that when the debt is issued for Rs. 50,00,000

instead of equity stock, the earnings per share has arisen from Rs. 16.67 to Rs.22. This

explains the financial leverage which the equity stockholders enjoy when the proportion

of equity stock to the debt is increased in the capital structure.


117

NOTES


Lesson 2

Cost of Capital

1.Introduction


3.Section Title

3.1 Costs of Different Sources of Finance

3.2 Cost of Equity Capital

3.3 Cost of Retained Earnings and Cost of External Equity

3.4 Weighted Average Cost of Capital

3.5 System of Weighting


1.INTRODUCTION

Now that, we are familiar with the different sources of long-term finance, let us

find out what it costs the company to raise these various types of finance. The cost of

capital to a company is the minimum rate of return that it must earn on its investments in

order to satisfy the various categories of investors who have made investments in the

form of shares, debentures of term loans. Unless the company earns this minimum rate,

the investors will be tempted to pull out of the company, leave alone participate in any

further capital investment in that company. For example, equity investors expect a

minimum return as dividend based on their perception of the risk they are undertaking,

on the company’s past performance, or on the returns they are getting risk from shares

of other companies they have invested in.

2.LEARNING OBJECTIVE

On reading this lesson, you will be conversant with:

The meaning of cost of capital costs associated with the principal sources of

long-term finances concept of weighted average cost of capital method of calculating

specific cost of discounts sources of capital.


119

NOTES


Cost of Term Loans

The cost of the term loans will be simply equal to the interest rate multiplied by

(1- tax rate). The interest rate to be used here will be the interest rate applicable to the

new term loan. The interest is multiplied by I (1 - tax rate) as interest on term loans is

also tax deductible.

Cost of Preference Capital

The cost of a redeemable preference share (kp) is defined as:

kp =

2

nFn

FFD

+

−+

kp = cost of preference capital

D = preference dividend per share payable annually

F = redemption price

P = net amount realised per share and n = maturity period

Example

The terms of the preference share issue made by Colour-Dye-Chem are as

follows: Each preference share has a face value of Rs.100 and carries a rate of dividend

of 14 per cent payable annually. The share is redeemable after 12 years at par. If the net

amount realised per share is Rs.95, what is the cost of the preference capital?

Solution

Given that D = 14, F = 100, P = 95 and n = 12

kd

=

2

9510012

9510014

+

−+

= 0.148 or 14.8 per cent 2

3.2 Cost of Equity Capital

Measuring the rate of return required by the equity shareholders is a difficult

and complex exercise because the dividend stream receivable by the equity shareholders

is not specified by any legal contract (unlike in the case of debenture holders). Several

approaches are adopted for estimating this rate of return like the dividend forecast

approach, capital asset pricing approach, realised yield approach, earnings-price ratio


121

NOTES


Solution

The cost of equity capital (ke) will be:

ke

= gP

D

e

+1

= 08.0125

12+ = 17.6 percent

3.3 Cost of Retained Earnings and Cost of External Equity

The cost of retained earnings or internal accruals is generally taken to be the

same as the cost of equity.

i.e., kr (representing cost of retained earnings) = ke

But when for raising external equity, the company has certain floatation costs

(costs incurred during public issue, like brokerage, underwriting commission, fees to

managers of issue, legal charges, advertisement and printing expenses etc.). The formula

for ke in this will be as follows:

ke =

fP

kr

−1

1

Where f = floatation costs.

For example, Gamma Asbestos Limited has got Rs.100 lakhs of retained earnings

and Rs.100 lakhs of external equity through a issue, in its capital structure. The equity

investors expect a rate of return of 18%. The cost of issuing external equity is 5%. The

cost of retained earnings and the cost of external equity can be determined as follows:

Cost of retained earnings

kr = ke i.e., 18%

Cost of external equity raised by the company

Now k0 = 1 - 0.05 = 18.95%

3.4 Weighted Average Cost of Capital

To illustrate the calculation of the weighted average cost of capital, let us consider

the following example:


123

NOTES


kd

=

2

)1(1

PFn

PFt

+

−+−

=

2

901006

90100)5.01(14

+

−+−

= 0.0912

ki

= 0.14 (1-0.5) = 0.07

Step 2. Determine the weights associated with the various sources of finance. We shall

define the symbols We, Wr, Wp, Wd and Wi to denote the weight of the various

sources of finance.

We = 25.0400

100=

Wr = 30.0400

120=

Wp = 025.0400

10=

Wd = 175.0400

70=

Wi = 25.0400

100=

Step 3. Multiply the costs of the various sources of finance with lh corresponding

weights and add these weighted costs to determine the weighted average cost of capital

(WAC). Therefore,

WAC = Wake + Wrkr ÷ Wkp + Wdkd + Wiki

= (0.25 x 0.16) + (0.30 x 0.16) + (0.025 x 0.1780) + (0.175 x 0.0912) +

(0.25 x 0.07)

= 0.1259 or 12.59 per cent.

3.5 System of Weighting

One issue to be resolved before concluding this section relates to the system of

weighting that must be adopted for determining the weighted average cost of capital.


125

NOTES


Lesson 3

Capital Structure

1. Introduction

2. Learning Objectives

3. Section Title

3.1 What is Capital Structure?

3.2 Features of an Appropriate Capital Structure

3.3 Determinants of Capital Structure


1 INTRODUCTION

Finance is an important input for any type of business and is needed for working

capital and for permanent investment. The total funds employed in a business are

obtained from various sources. A part of the funds are brought in by the owners and the

rest is borrowed from others—individuals and institutions. While some of the funds are

permanently held in business, such as share capital and reserves (owned funds), some

others are held for a long period such as long-term borrowings or debentures, and still

some other funds are in the nature of short-term borrowings.

The entire composition of these funds constitute the overall financial structure

of the firm. As such the proportion of various sources for short-term funds cannot

perhaps be rigidly laid down. The firm has to follow a flexible approach. A more definite

policy is often laid down for the composition of long-term funds, known as capital

structure. More significant aspects of the policy are the debt equity ratio and the dividend

decision. The latter affects the building up of retained earnings which is an important

component of long-term owned funds. Since, the permanent or long-term funds often

occupy a large portion of total funds and involve long-term policy decision, the term

financial structure is often used to mean the capital structure of the firm.


127

NOTES


companies within the same industry regarding capital structure are found. A number of

factors influence the capital structure decision of a company. The judgement of the

person or group of persons making the capital structure decision plays a crucial role.

Two similar companies can have different capital structures if the decision makers differ

in their judgement about the significance of various factors. These factors are highly

psychological, complex and qualitative and do not always follow the accepted theory.

Capital markets are not perfect and the decision has to be taken with imperfect knowledge

and consequent risk.

3.2 Features of An Appropriate Capital Structure

Capital structure is usually planned keeping in view the interests of the ordinary

shareholders. The ordinary shareholders are the ultimate owners of the company and

have the right to elect the directors. While developing an appropriate capital structure

for his company, a finance manager should aim at maximizing the long-term market

price of equity shares. In practice, for most companies within an industry, there will be

a range of an appropriate capital structures within which there are no great differences

in the market values of shares. A capital structure in this context can be determined

empirically. For example, a company may be in an industry that has an average debt to

total capital ratio of 60 percent. It may be empirically found that the shareholders in

general do not mind the company operating within a 15 percent range of the industry’s

average capital structure. Thus, the appropriate capital structure for the company ranges

between 45 percent to 75 percent debt to total capital ratio. The management of the

company should try to seek the capital structure near the top of this range in order to

make maximum use of favourable leverage, subject to other requirements such as

flexibility, solvency, etc.

A sound or appropriate capital structure should have the following features:

Profitability: The capital structure of the company should be most advantageous.

Within the constraints, maximum use of leverage at a minimum cost should be made.

Solvency: The use of excessive debt threatens the solvency of the company.

Debt should be used judiciously.

Flexibility: The capital structure should be flexible to meet the changing conditions. It

should be possible for a company to adapt its capital structure with minimum cost and

delay if warranted by a changed situation. It should also be possible for the company to

provide funds whenever needed to finance its profitable activities.

In other words, from the solvency point of view, we need to approach capital

structuring with due conservatism. The debt capacity of the company which depends

on its ability to generate future cash flows should not be exceeded. It should have

enough cash to pay periodic fixed charges to creditors and the principal sum on maturity.


129

NOTES


methods of financing. The EBIT-EPS analysis is one important tool in the hands of the

Finance Manager to get an insight into the firm’s capital structure management. He can

consider the possible fluctuations in EBIT and examine their impact on EPS under

different financing plans.

Illustration

Plan A No debt, all equity shares

Plan B 50% debt (10%), 30% preference shares (12%), 200/c equityshares

Plan C 80% debt (10%), 200/c equity shares

The face value of equity shares is Rs. 10. The rates in parentheses indicate the

fixed return on debt and preference shares.

The total amount of capital required to be raised is Rs. 2,00,000. The company

estimates its earnings before interest and taxes (EBIT) at Rs. 50,000 annually.

The effect of financial leverage (trading on equity) is presented in Table1. It will

be seen that Plan C is the most attractive, from shareholders’ point of view as the EPS

of Rs. 4.25 is the highest under this plan. The lowest EPS are when the company does

not use any debt or fixed return securities. You will note that the proportion of fixed

return securities under plans B and C is the same (80%). However, plan C gives a

higher EPS for the reason that dividend on preference share is not deductible for income

tax purposes while interest is a deductible charge.

Assuming that the estimates about EBIT turn out to be correct, the shareholders

would be benefited to the maximum if plan C is adopted. The shares of the company

will command a high premium in the market and would be greatly in demand. The


131

NOTES


effect of increasing the cost of equity. Thus, up to a point the overall cost of capital

decreases with debt, but beyond that point the cost of capital would start increasing

and, therefore, it would not be advantageous to employ debt further. So, there is a

combination of debt and equity which minimizes that firm’s average cost of capital and

maximizes the market value per share.

The cost of equity includes the cast of new issue of shares and the cost of

retained earnings. The cost of debt is cheaper than the cost of both these sources of

equity funds. Between the cost of new issue and retained earnings, the latter is cheap.

The cost of retained earnings is less than the cost of new issue because the company

does not have to pay personal taxes which have to be paid by shareholders on distributed

earnings, and also because, unlike new issues, no floatation costs are incurred if the

earnings are retained. As a result, between these two sources, retained earnings are

preferable.

Thus, when we consider the leverage and the cost of capital factors, it appears

reasonable that a firm should employ a large amount of debt provided its earnings do

not fluctuate very widely. In fact, debt can be used to the point where the average cost

of capital is minimum. These two factors taken together set the maximum limit to the use

of debt. However, other factors should also be evaluated to determine the appropriate

capital structure for a company.

Theoretically, a company should have such a mix of debt and equity that its

overall cost of capital is minimum. Let us understand this concept by taking an illustration.

Illustration

A company is considering a most desirable capital structure. The cost of debt

(after tax) and of equity capital at various levels of debt equity mix are estimated as

follows:

Debt as percentage of Cost of debt (%) Cost of equity (%)

total capital employed

0 10 15

20 10 15

40 12 16

50 13 18

60 14 20

Determine the optimal mix of debt and equity for the company by calculating composite

cost of capital:


133

NOTES


large amount of debt in their capital structure. It is somewhat risky to employ sources of

capital with fixed charges for companies whose cash inflows are unstable or

unpredictable.

Control

In designing the capital structure, sometimes the existing management is governed

by its desire to continue control over the company. The existing management team may

not only want to be elected to the Board of Directors but may also dispute to manage

the company without any outside interference.

The ordinary shareholders have the legal right to elect the directors of the

company. If the company issues new shares, there is a risk of loss of control. This is not

a very important consideration in case of a widely held company. The shares of such a

company are widely scattered. Most of the shareholders are not interested in taking

active part in the company’s management. They do not have the time and urge to attend

the meetings. They are simply interested in dividends and appreciation in the price of

shares. The risk of loss of control can almost be avoided by distributing shares widely

and in small lots.

Maintaining control however, could be a significant question in the case of a

closely held company. A shareholder or a group of shareholders could purchase all or

most of the new shares and thus control the company. Fear of having to share control

and thus being interfered by others often delays the decision of the closely held companies

to go public. To avoid the risk of loss of control the companies may issue preference

shares or raise debt capital.

Since, holders of debt do not have voting right, it is often suggested that a

company should use debt to avoid the loss of control. However, when a company uses

large amounts of debt, lot of restrictions are imposed on it by the debt-holders to

protect their interests. These restrictions curtail the freedom of the management to run

the business. An excessive amount of debt may also cause bankruptcy, which means a

complete loss of control.

Flexibility

Flexibility means the firm’s ability to adapt its capital structure to the needs of

the changing conditions. The capital structure of a firm is flexible if it has no difficulty in

changing its capitalization or sources of funds. Whenever needed, the company should

be able to raise funds without undue delay and cost to finance the profitable investments.

The company should also be in a position to redeem its preference capital or debt

whenever warranted by future conditions. The financial plan of the company should be

flexible enough to change the composition of the capital structure. It should keep itself

in a position to substitute one form of financing for another to economies on the use of

funds.


135

NOTES


Lesson 4

Dividend Policy

1 Introduction

2.Learning Objectives

3. Section Title

3.1 Forms of Dividend

3.2 Dividend Policy

3.3 Role of the Finance Manager

3.4 Role of the Board of Directors

3.5 Factors affecting Dividend Decision

Have you Understood?

1. INTRODUCTION

A business organization always aims at earning profits. The utilisation of profits

earned is a significant financial decision. The main issue here is whether the profits

should be used by the owner(s) or be retained and reinvested in the business itself. This

decision does not involve any problem is so far as the sole proprietory business is

concerned. In case of a partnership the agreement often provides for the basis of

distribution of profits among partners. The decision-making is somewhat complex in

the case of joint stock companies.

Since a company is an artificial person, the decision regarding utilisation of

profits rests with a group of people, namely the board of directors. As in any other type

of organization, the disposal of net earnings of a company involves either their retention

in the business or their distribution to the owners (i.e., shareholders) in the form of

dividend, or both.

The decision regarding distribution of disposable earnings to the shareholders

is a significant one. The decision may mean a higher income, lower income or no income


137

NOTES


Bonus Shares or Stock Dividends

Instead of paying dividends out of accumulated reserves, the latter may be

capitalized by issue of bonus shares to the shareholders. Thus, while the funds continue

to remain with the company, the shareholders acquire the right and this way their

marketable equity increases. They can either retain their bonus shares and thus be

entitled to increase total dividend or can sell their bonus shares and realise cash. Ordinarily,

bonus shares are not issued in lieu of dividends. They are periodically issued by

prosperous companies in addition to usual dividends. Certain guidelines, as laid down

by the government, are applicable for issue of bonus shares in India.

Property Dividends

This form of dividend is unusual. Such dividend may be in the form of inventory

or securities in lieu of cash payment. A company sometimes may hold shares of other

companies, eg., its subsidiaries which it may like to distribute among its own shareholders,

instead of paying dividend in cash. In case the company sells these shares it may have

to pay capital gains which may be subject to taxation. If these shares are transferred to

its shareholders, there is no tax liability.

3.2 Dividend Policy

The objective of corporate management usually is the maximization of the market

value of the enterprise i.e., its wealth. The market value of common stock of a company

is influenced by its policy regarding allocation of net earnings into ‘plough back’ and

‘payout’. While maximising the market value of shares, the dividend policy should be

so oriented as to satisfy the interests of the existing shareholders as well as to attract the

potential investors. Thus, the aim should be to maximize the present value of future

dividends and the appreciation in the market price of shares.

Policy Options

Dividend policy options refer to the policy options that the management

formulates in regard to earnings for distribution as dividend among shareholders. It is

not merely concerned with dividends to be paid in one year, but is concerned with the

continuous course of action to be followed over a period of several years. Dividend

decision involves dealing with several questions, such as:

Ø Whether dividend should be paid right from the initial year of operation i.e.,

regular dividends.

Ø Whether equal amount or a fixed percentage of dividend be paid every year,


139

NOTES


3.3 Role of the Finance Manager

The disposal of the earnings, retention in business or distribution among

shareholders, is an issue of fundamental importance in financial management. The Finance

Manager plays an important role in advising the management i.e., Board of Directors

regarding the decision. It is the latter whose privilege it is to take the decision. The

retention of profits in business helps the company in mobilizing funds for expansion.

Economists, however, believe that the entire earnings of a business should be paid to its

owners who should then decide where to reinvest them. That, all of them may decide to

reinvest the distributed earnings in the same company is another thing.

In case the company has more favorable reinvestment opportunities within it as

compared to those offered outside, it would be more profitable for the company to

retain earnings than to pay them out as dividends. The shareholders can later be

compensated by issue of bonus shares. Let us illustrate this point by taking an example.

Suppose the net profit after taxes of a company is Rs. 1 lakh and is totally distributed as

dividend to shareholders. The relevant figures would then appears as follows:

It is clear from the above example that if dividends are not paid, Rs. 1 lakh of

income is available to the company for reinvestment in business. In case dividends are

paid, it is likely that not more than Rs. 54,000would be available for reinvestment (in

the same or any other business), assuming that the stockholders are willing to reinvest

their entire dividend income. lf better outside investment opportunities are available to

the shareholders, depending upon the environment prevalent in the capital market, they

may not appreciate the recommendation (or action) of the Board of Directors for

retention of larger amounts in the business, as they might perceive it to their detriment.

As such they would be interested in receiving larger dividends. The dividend policy,

particularly the timing of the declaration of dividend, influences the market value of a

company’s shares. The Finance Manager, therefore, should be well-informed about

the capital market trends and the tax policies of the government, besides the rationale

behind the investment programme of the company.

3.4 Role of the Board of Directors

The Board of Directors has the power to determine whether and at what rate

dividend shall be paid to the shareholders. The payment of dividend is not obligatory.


141

NOTES


Ø Ownership considerations

Ø Firm-oriented considerations.

Ownership Considerations: Where ownership is concentrated in few people, there

are no problems in identifying ownership interests. Where, however, ownership is

decentralized on a wide spectrum the identification of their interests becomes difficult.

Further, the influence of stockholders’ interests on dividend decision becomes uncertain

because: (a) the status or preferences of stockholders relating to their position, capital

gains, current income, etc. cannot be precisely ascertained; (b) a conflict in shareholders’

interests may arise. Inspite of these difficulties, efforts should be made to ascertain the

following interests of shareholders to encourage market acceptance of the stock:

• Current income requirements of stockholders

• Alternative uses of funds in the hands of stockholders -

• Tax matters affecting stockholders.

Since, various groups of shareholders may have different desires’ and objectives,

understandably, investors gravitate to those companies, which combine the mix of growth

and desired dividends. Since companies generally do not have a singular group of

shareholders, the objective of the maximization of the market value of shares requires

that the dividend policy be geared to investors in general.

Firm-oriented Considerations

Ownership interests alone may not determine the dividend policy. A firm’s

needs are also an important consideration, which include the following:

a) Contractual and legal restrictions

b) Liquidity, credit-standing and working capital

c) Needs of funds for immediate or future expansion

d) Availability of external capital

e) Risk of losing control of organization

f) Relative cost of external funds

g) Business cycles

h) Post dividend policies and stockholder relationships.

The following factors affect the shaping of a dividend policy.

Nature of Business

This is an important determinant of the dividend policy of a company. Companies

with unstable earnings adopt dividend policies which are different from those which

have steady earnings. Consumer goods industries usually suffer less from uncertainties

of income and, therefore, pay dividends with greater regularity than the capital goods


143

NOTES


decision. Widely held companies have scattered shareholders. Such companies may

take the dividend decision with a greater sense of responsibility by adopting a more

formal and scientific approach.

The tax burden on business corporations is a determining factor in formulation

of their dividend policies. The directors of a closely held company may take into

consideration the effect of dividends upon the tax position of their important shareholders.

Those in the high-income brackets may be willing to sacrifice additional income in the

form of dividends in favour of appreciation in the value of shares and capital gains.

However, when the stock is widely held, stockholders are enthusiastic about collecting

their dividends regularly, and do not attach much importance to tax considerations.

Thus, a company which is closely held by a few shareholders in the high income-

tax brackets, is likely to payout a relatively low dividend. The shareholders in such a

company are interested in taking their income in the form of capital gains rather than in

the form of dividends which arc subject to higher personal income taxes. On the other

hand, the shareholders of a large and widely held company may be interested in high

dividend payout.

Investment Opportunities

Many companies retain the earnings to facilitate planned expansion. Companies

with low credit ratings may feel that they may not be able to sell their securities for

raising necessary finance they would need for future expansion. So, they may adopt a

policy for retaining larger portion of earnings.

In the context of opportunities for expansion and growth, it is wise to adopt a

conservative dividend policy if the cost of capital involved in external financing is greater

than the cost of internally generated funds.

Similarly, if a company has lucrative opportunities for investing its funds and

can earn a rate which is higher than its cost of capital, it may adopt a conservative

dividend policy.

Desire for Financial Solvency and Liquidity

Companies may desire to build up reserves by retaining their earnings which

would enable them to weather deficit years or the down-swings of a business cycle.

They may, therefore, consider it necessary to conserve their cash resources to face

future emergencies, Cash credit limits, and working capital needs, capital expenditure

commitments, repayment of long-term debt, etc. influence the dividend decision.

Companies sometimes prune dividends when their liquidity declines.


145

NOTES


The demand for capital expenditure, money supply, etc. undergo great

oscillations during the different stages of a business cycle. As a result, dividend policies

may fluctuate from time to time.


1. What is dividend and why is dividend decision important?

2. “While formulating a dividend policy the management has to reconcile its own

needs for funds with the expectations of shareholders”. Explain the statement.

What policy goals might be considered by management in taking a decision on

dividends?

3. Discuss the role of a Finance Manager in the matter of dividend policy. What

alternatives he might consider and what factors should he take into consideration

before finalising his views on dividend policy?

4. “Dividend can be paid only out of profits”. Explain the statement. Will a company

be justified in paying dividends when it has unwritten-of accumulated losses of

the past?

5. What factors a company would in general consider before it takes a decision

on dividends?


147

NOTES


Lesson 1

Working Capital

1. INTRODUCTION

Effective Financial Management is the outcome, among other things, of proper

management of investment of funds in business. Funds can be invested for permanent

or long-term purposes such as acquisition of fixed assets, diversification and expansion

of business, renovation or modernization of plant and machinery, and research and

development.

Funds are also needed for short-tem purposes, that is, for current operations

of the business. For example, if you are managing a manufacturing unit you will have to

arrange for procurement of raw material, payment of wages to your workmen and for

meeting routine expenses. All the goods which are manufactured in a given time period

may not be sold in that period. Hence, some goods remain in stock, eg., raw material,

semi-finished (manufacturing-in-process) goods and finished marketable goods. Funds

are thus blocked in different types of inventory. Again, the whole of the stock of finished

goods may not be sold against ready cash, some of it may be sold on credit. The credit

sales also involve blocking of funds with debtors till cash is received or the bills are

cleared.

Working Capital refers to a firm’s investment in short-term assets: viz., cash,

short-term securities, amount receivables (debtors) and inventories of raw materials,

work-in-process and finished goods. It can also be regarded as that portion of the

firm’s total capital which is employed in short-term operations. It refers to all aspects of

current assets and current liabilities. In simple words, we can say that working capital is

the investment needed for carrying out day-to-day operations of the business smoothly.

The management of working capital is no less important than the management of long-

term financial investment.

2. LEARNING OBJECTIVES

The objectives of this unit are to familiarize you with the:

q Concepts and components of working capital

q Significance of and need for working capital


149

NOTES


FIGURE. 1 OPERATING CYCLE

3.3 Concepts of Working Capital

There are two types of working capital, namely Gross and Net working capital.

Gross Working Capital

According to this concept, working capital refers to the firm’s investment in

current assets. The amount of current liabilities is not deducted from the total of current

assets. This concept views Working Capital and aggregate of Current Assets as two

interchangeable terms. This concept is also referred to as ‘Current Capital’ or ‘Circulating

Capital’.

The proponents of the gross working capital concept advocate this for the following

reasons:

i) Profits are earned with the help of assets which are partly fixed and partly current.

To a certain degree, similarity can be observed in fixed and current assets so far

as both are partly financed by borrowed funds, and are expected to yield earnings

over and above the interest costs. Logic then demands that the aggregate of

current assets should be taken to mean the working capital.

ii) Management is more concerned with the total current assets as they constitute

the total funds available for operating purposes than with the sources from which

the funds come.

iii) An increase in the overall investment in the enterprise also brings about an increase

in the working capital.


151

NOTES


working capital emphasizes the qualitative aspect, the gross concept underscores the

quantitative.

3.4 Kinds of Working Capital

Ordinarily, working capital is classified into two categories:

• Fixed, Regular or Permanent Working Capital; and Variable, Fluctuating,

Seasonal, Temporary or Special Working Capital.

Fixed Working Capital

The need for current assets is associated with the operating cycle is a continuous

process. As such, the need for current assets is felt constantly. The magnitude of investment

in current assets however may not always be the same. The need for investment in

current assets may increase or decrease over a period of time according to the level of

production. Nevertheless, there is always a certain minimum level of current assets

which is essential for the firm to carry on its business irrespective of the level of operations.

This is the irreducible minimum amount necessary for maintaining the circulation of the

current assets. This minimum level of investment in current assets is permanently locked

up in business and is therefore referred to as permanent or fixed or regular working

capital. It is permanent in the same way as investment in the firm’s fixed assets is.

Fluctuating Working Capital

Depending upon the changes in production and sales, the need for working

capital, over and above the permanent working capital, will fluctuate. The need for

working capital may also vary on account of seasonal changes or abnormal or

unanticipated conditions. For example, a rise in the price level may lead to an increase

in the amount of funds invested in stock of raw materials as well as finished goods.

Additional doses of working capital may be required to face cutthroat competition in

the market or other contingencies like strikes and lockouts. Any special advertising

campaigns organized for increasing sales or other promotional activities may have to be

financed by additional working capital. The extra working capital needed to support

the changing business activities is called as fluctuating (variable, seasonal, temporary or

special) working capital.

Figures II and III give an idea about fixed and fluctuating working capital.


153

NOTES


iv) Advance payments towards expenses or purchases, and other short-term advances,

which are recoverable.

v) Temporary investment of surplus funds which could be converted into cash

whenever needed.

Apart from these, the need for funds to finance the current assets may be met

from supply of goods on credit, and deferment, on account of custom, usage or

arrangement, of payment for expenses. The remaining part of the need for working

capital may be met from short-term borrowing from financiers like banks. These items

arc collectively called current liabilities. Typical items of current liabilities are:

i) Goods purchased on credit

ii) Expenses incurred in the course of the business of the organization (eg., wages or

salaries, rent, electricity bills, interest etc.) which are not yet paid for.

iii) Temporary or short-term borrowings from banks, financial institutions or other

parties.

iv) Advances received from parties against goods to be sold or delivered, or as short-

term deposits.

v) Other current liabilities such as tax and dividends payable.

3.6 Importance of Working Capital Management

Because of its close relationship with day-to-day operations of a business, a

study of working capital and its management is of major importance to internal, as well

as external analysts. It is being increasingly realised that inadequacy or mismanagement

of working capital is the leading cause of business failures. We must not lose sight of the

fact that management of working capital is an integral part of the overall Financial

Management and, ultimately, of the overall corporate management. Working capital

management thus throws a challenge and should be a welcome opportunity for a finance

manager who is ready to play a pivotal role in his organization.

Neglect of management of working capital may result in technical insolvency

and even liquidation of a business unit. With receivables and inventories tending to

grow and with increasing demand for bank credit in the wake of strict regulation of

credit in India by the Central Bank, managers need to develop a long-term perspective

for managing working capital. Inefticient working capital management may cause either

inadequate or excessive working capital which is dangerous.

A firm may have to face the following adverse consequences from inadequate working

capital:

1 Growth may be stunted. It may become difficult for the firm to undertake profitable

projects due to non-availability of funds.


155

NOTES


public utilities have a limited need for working capital and have to invest abundantly in

fixed assets. Their working capital requirements are nominal because they have cash

sales only and they supply services, not products. Thus, the amount of funds tied up

with debtors or in stocks is either nil or very small. The working capital needs of most

of the manufacturing concerns fall between the two extreme requirements of trading

firms and public utilities.

The size of business also has an important impact on its working capital needs.

Size may be measured in terms of the scale of operations. A firm with larger scale of

operations will need more working capital than a small firm. The hazards and

contingencies inherent in a particular type of business also have an influence in deciding

the magnitude of working capital in terms of keeping liquid resources.

Manufacturing Cycle

The manufacturing cycle starts with the purchase of raw materials and is

completed with the production of finished goods. If the manufacturing cycle involves a

longer period the need for working capital will be more, because an extended

manufacturing time span means a larger tie-up of funds in inventories. Any delay at any

stage of manufacturing process will result in accumulation of work-in-process and will

enhance the requirement of working capital. You may have observed that firms making

heavy machinery or other such products, involving long manufacturing cycle, attempt to

minimise their investment in inventories (and thereby in working capital) by seeking

advance or periodic payments from customers.

Business Fluctuations

Seasonal and cyclical fluctuations in demand for a product affect the working

capital requirement considerably, especially temporary working capital requirements of

the firm. An upward swing in the economy leads to increased sales, resulting in an

increase in the firm’s investment in inventory and receivables or book debts. On the

other hand, a decline in the economy may register a fall in sales and, consequently, a fall

in the levels of stocks and book debts.

Seasonal fluctuations may also create production problems. Increase in

production level may be expensive during peak periods. A firm may follow a policy of

steady production in all seasons to utilise its resources to the fullest extent. This will

mean accumulation of inventories in off-season and their quick disposal in peak season.

Therefore, financial arrangements for seasonal working capital requirement should be

made in advance. The financial plan should be flexible enough to take care of any

seasonal fluctuations.

Production Policy

If a firm follows steady production policy, even when the demand is seasonal,

inventory will accumulate during off-season periods and there will be higher inventory

costs and risks. If the costs and risks of maintaining a constant production schedule are


157

NOTES


face a severe working capital problem in periods of rising price levels. The effects of

increasing price level may, however, be felt differently by different firms. It is possible

that some companies may not be affected by the rising prices, whereas others may be

badly hit by it.

Other Factors

There are some other factors which affect the determination of the need for

working capital. A high net profit margin contributes towards the working capital. The

net profit is a source of working capital to the extent it has been earned. The cash inflow

can be calculated by adjusting non-cash items such as depreciation. Outstanding

expenses, losses written off, etc. from the net profit.

The firm’s appropriation policy, that is, the policy to retain or distribute profit

has a bearing on working capital. Payment of dividend consumes cash resourse and

reduces the firm’s working capital to that extent. If the profits are retained in the business,

the firm’s working capital position will be strengthened.

3.8 Approaches to Managing Working Capital

Two approaches are generally followed for the management of working carpet (i)

the conventional approach and (ii) the operating cycle approach.

The Conventional Approach

This approach implies managing the individual components of working capital

(ii) the inventory, receivables, payables, etc. efficiently and economically so that there

are neither idle funds nor paucity of funds. Techniques have been evolved for the

management of each of these components. In India, more emphasis is given to the

management of debtors because they generally constitute the largest share of the

investment in working capital. On the other hand, inventory control has not yet been

practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever

rising prices.

The Operating Cycle Approach

This approach views working capital as a function of the volume of operating

expenses. Under this approach the working capital is determined by the duration of the

operating cycle and the operating expenses needed for completing the cycle. The duration

of the operating cycle is the number of days involved in the various stages, commencing

with acquisition of raw materials to the realisation of proceeds from debtors. The credit

period allowed by creditors will have to be set off in the process. The optimum level of

working capital will be the requirement of operating expenses for an operating cycle,

calculated on the basis of operating expenses required for a year.

In India, most of the organizations used to follow the conventional approach

earlier, but now the practice is shifting in favour of the operating cycle approach. The

banks - usually apply this approach while granting credit facilities to their clients.


159

NOTES


Gujarat Tricycles Limited

Statement of working capital requirements

Current Assets:

Stock of raw material, parts and components - (In thousand Rs.)

( l Month) 40

Stock of finished goods (2 Months) 500x160x2 1,60

Work -in- Process (112 Month) 5X160X11/2

40

Debtors (50% of sales)

(2 months credit)

500x1/2x160x3, 20 80

Less current liabilities

Creditors (one month) 40

Wages and Salaries:

Wages 30

Salaries (Overheads) 575

2,45

Add 20% for buffer cash and contingencies 49

Average working capital required 2,94

The various figures have been worked out as follows: -

Cost of raw material etc.

Monthly production 500 Units

Cost of material etc. per unit Rs 80

Period for which stock required 1 month

Hence amount locked up 500x80x1 Rs.40, 000

Cost of finished goods

Monthly Production 500 Units

Cost of production per unit Rs160- (80+60+20)

Period for which stock Required 2 months

Hence, amount locked up 500x 160x2 Rs.1, 60,000

Work-in-Process Stock

Monthly Production 500 Units

Cost of production per unit Rs. 160

Period for which stock required1/2

Month

Hence, amount locked up 500x 160x 2

1Rs. 40,000


161

NOTES


Greater disciplines in all segments of the production front may be attempted as

under:

a) The possibility of using substitute raw materials without affecting quality must be

explored in all seriousness. Research activities in this regard may be undertaken, with

financial assistance provided by the Government and the corporate sector, if any.

b) Attempts must be made to increase the productivity of the work force by proper

motivational strategies. Before going in for any incentive scheme, the cost involved

must be weighed against the benefit to be derived. Though wages in accounting are

considered a variable cost, they have tended to become partly fixed in nature due to the

influence of various legislative measures adopted by the Central or State Governments

in recent times. Increased productivity results in an increase in value added and this has

the effect of reducing labour cost per unit.

The managed costs should be properly scrutinised in terms of their costs and

benefits. Such costs include office decorating expenses, advertising, managerial salaries

and payments, etc. Managed costs are more or less fixed costs and once committed

they are difficult to retreat. In order to minimise the cost impact of such items, the

maximum possible use of facilities already created must be ensured. Further, the

management should be vigilant in sanctioning any new expenditure belonging to this

cost area.

The increasing pressure to augment working capital will, to some extent, be

neutralised if the span of the operating cycle can be i-educed. Greater turnover with

shorter intervals and quicker realisation of debtors will go a long way in easing the

situation.

Only when there is a pressure on working capital does the management become

conscious of the existence of slow-moving and obsolete stock. The management tends

to adopt ad hoc measures which are grossly inadequate. . Therefore, a clear-cut policy

regarding the disposal of slow-moving and obsolete stocks must be formulated and

adhered to. In addition to this, there should be an efficient management information

system reflecting the stock position from various standpoints.

The payment to creditors in time leads to building up of good reputation and

consequently it increases the bargaining power of the firm regarding period of credit for

payment and other conditions. Projections of cash flows should be made to see that

cash inflows and outflows match with each other. If they do not, either some payments

have to be postponed or purchase of some avoidable items has to be deferred.

3.11 Efficiency Criteria

Improved profitability of firm, to a great extent, depends on its efficiency in

managing working capital. A single criterion would not be sufficient to judge or evaluate

the efficiency in a dynamic area like working capital.


163

NOTES


Cash to Current Assets

If cash alone is a major item of current assets then it may be a good indicator of

the profitability of the organization, as cash by itself does not earn any profit, the

proportion should usually be kept low.

Sales to Cash Ratio

Sales to Cash Ratio=Sales/Average cash balance during the period.

Cash should be turned over as many times as possible, in order to achieve maximum

sales with minimum cash on hand.

Average Collection Period

(Debtors/Credit Sales) X 365

This ratio explains how many days of credit a company is allowing to its customers

to settle their bills.

Average Payment Period

Average payment period=(Creditors/Credit purchases) x 365

It indicates how many days of credit is being enjoyed by the company from its

suppliers.

Inventory Turnover Ratio (ITR)

ITR=Sales/Average Inventory

It shows how many times inventory has turned over to achieve the sales. Inventory

should be maintained at a level which balances production facilities and sales needs.

Working Capital to Sales

Usually expressed in terms of percentage, it signifies that for any amount of

sales a relative amount of working capital is needed. If any increase in sales is

contemplated it has to be seen that working capital is adequate. Therefore, this ratio

helps management in maintaining working capital which is adequate for the planned

growth in sales.

Working Capital to Net Worth

This ratio shows the relationship between working capital and the funds belonging

to the owners. When this ratio is not carefully watched, it may lead to:


165

NOTES


account holding customers to overdraw the account upto certain limit. It is a very common

foim of extending working capital assistance. Bill financing by purchasing or discounting

bills of exchange is another common form of financing. Here, the seller of goods on

credit draws a bill on the buyer and the latter accepts the same. The bill is discounted

for cash with the banker. This is a popular form.

Finance companies in the country About 50000 companies exist at present. They

provide services almost similar to banks. They provide need-based loans and sometimes

arrange loans from others for customers. Interest rate is higher. But timely assistance

may be obtained.

Indigenous bankers also provide financial assistance to small business and trades.

They charge exorbitant rates of interest by very much understanding.

Public deposits are unsecured deposits raised by businesses for periods exceeding a

year but not more than 3 years by manufacturing concerns and not more than 5 years

by non-banking finance companies. The RBI is regulating deposit taking by these

companies in order to protect the depositors. Quantity restriction is placed at 25% of

paid up capital + free services for deposits solicited from public is prescribed for non-

banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of

working capital financing is resorted to by well-established companies.

Advances from customers are normally demanded by producers of costly goods at

the time of accepting orders for supply of goods. Contractors might also demand advance

from customers. Where sellers market prevails, advances from customers may be

insisted. In certain cases, to ensure performance of contract an advance may be insisted.

Accrual accounts are simply outstanding suppliers of overhead service requirements.

Loans from directors, loans from group companies etc. constitute another source of

working capital. Cash rich companies lend to liquidity companies under liquidity crunch.

Commercial papers are usance promissory notes negotiable by endorsement and

delivery. Since 1990 CPs came into existence. There are restrictive conditions as to the

issue of commercial paper. CPs are privately placed after RBI’s approval with any

firm, incorporated or not, any bank or financial institution. Big and sound companies

generally float CPs.

Debentures and equity fund can be issued to finance working capital so that the

permanent working capital can be matchingly financed through long term funds.


167

NOTES


3.14 Working Capital Gap

i. In order to reduce the dependence of businesses on banks for working capital,

ceiling on bank credit to individual firms has been prescribed. Accordingly,

businesses have to compute the current assets requirement on the basis of

stipulations as to size. So, flabby inventory, speculative inventory cannot be

carried on with bank finance. Normal current liabilities, other than bank finance,

are also worked out considering industry and geographical features and factors.

Working capital gap is the excess of current assets as per stipulations over

normal current liabilities (other than bank assistance). Bank assistance for

working capital shall be based on the working capital gap, instead of the

current assets need of a business. This type of financing assistance by banks

was introduced on the basis of recommendations of Tandon Committee.

ii. Inventory and Receivables norms: The committee has suggested norms

for 15 major industries.

The norms proposed represent the maximum level for holding ventures and

receivables. They pertain to the following:

a) Raw materials including stores and other items used in the process of manufacture

b) Stock in process

c) Finished goods

d) Receivables and bills discounted and purchased.

Raw materials are expressed as so many months’ cost of production. Stock in process

is expressed as so many months’ cost of production. Finished goods and receivables

are expressed as so many months cost of sales and sales respectively.

iii) Lending norms: The lending norms have been suggested in view of the

realization that the banker’s role as a lender is only to supplement the borrower’s

resources. The committee has suggested three alternative methods for working out the

maximum permissible level of bank borrowings. Each successive method reduces the

involvement of short-term credit to finance the current assets, and increases the use of

long-term funds.

The first method provided for a maximum 75% of bank funding of the working

capital gap. That is, at least 25% of working capital gap must be financed through long-

term funds. The second method provided for full bank financing of working capital gap

based on 75% of current assets only. That is,25% of current assets should be financed

through long-term funds. 25% of current assets are greater than 25% of working capital

gap. Hence 2nd method meant more non-bank finance for working capital. The third

method provided for long-term fund financing of whole permanent current assets and

25% of varying current assets. That is bank financing will be limited to working capital

gap computed taking 75% of varying current assets only.


169

NOTES


3.15 Chore Committee Recommendations

Following the Tandon Committee the Chore Committee under the Chairmanship

of Shri. IC.B.Chore, of RBI, was constituted in April 1979. The terms of reference

were:

1. To review the working of cash credit system

2. To study the gap between sanctioned and utilized cash credit levels

3. To suggest measures to ensure better credit discipline

4. To suggest measures to enable banks to relate credit limits with output

levels.

The recommendations of the committee were:

1. To continue the present system of working capital financing, viz., credit,

bill finance and loan

2. If possible supplement cash credit system by bill and loan financing

3. To periodically review cash credit levels

4. No need to bifurcate cash credit accounts into demand loan and cash

credit components.

5. To fix peak level and non-peak level limits of bank assistance wherever,

seasonal factors significantly affect level of business activity.

6. Borrowers to indicate before commencement requirement of bank credit

within peak and sanctioned. A variation of 10% is to be tolerated.

7. Excess or under utilization beyond 10% tolerance level is to be

considered as irregularity and corrective actions are to be taken up.

8. Quarterly statements of budget and performance be submitted by all

borrowers having Rs.50 lakh working capital limit from the whole of

banking system.

9. To discourage borrowers depending on adhoc assistances over and

above sanctioned levels.

10. The second method of financing of working capital as suggested by the

Tandon committee be uniformly adopted by banks.

11. To treat as working capital term loan the excess of bank funding when

the switch over to the second method bank financing is adopted and

the borrower is not able to repay the excess loan.

3.16 Marathe Committee Recommendations

Later Marathe Committee was appointed to suggest meaningful credit

management function of the RBI.The recommendations of the committee include:


171

NOTES


helpful?

7. How would you as a Finance Manager control the need of increased working

capital on account of inflationary pressures? Narrate some real-life examples

you might have come across.

8. How would you judge the efficiency of the management of working capital in a

business enterprise? Explain with the help of hypothetical data.

9. Define working capital and describe its components

10. Bring out the kinds and concepts of working capital and the nature and

significance of each type of working capital

11. What do you mean by working capital management? What approaches would

you adopt to ensure effectiveness?

12. Discuss clearly the factors affecting the size and composition of working capital.

13. How would you plan the working capital requirements of a manufacturing

undertaking.

14. What is operating cycle? Explain its significance in the context of estimation of

working capital and ensuring efficient management of working capital.

15. Explain the different sources of working capital finance.

16. Discuss the terms of reference and recommendations of the Tandon Committee.

Give the impact on financing of working capital.

17. What are the recommendations of Chore Committee? Explain them.


173

NOTES


Further, with a view to fully understand and appreciate the high need for effective

monitoring and follow-up of sundry debtors, it may be very pertinent to mention here

that generally speaking, after the company’s investment in plant and machinery, and

stocks of inventory (mostly in that order), the sundry debtors constitute the third largest

and most important item of assets of the company.

Therefore, the imperative need of effective monitoring and control of all the

items of Sundry Debtors assume a highly important and strategic position in the area of

Corporate Financial Management.

2.LEARNING OBJECTIVES


• Meaning and computation of receivables

• Credit policy of organization

• Purpose and cost of maintaining receivables

• Causes for high sundry debtors

• Caridecations for formulation credit policy

• Education of credit worthiness of customers

• Decision tree for credit granting

• Monitoring of receivables

3.SECTION TITLE

3.1 Credit Policy

While formulating credit policies, we should vary the quantum and period of

credit, party-wise. For this purpose, we may broadly classify our parties (customers,

clilentele) under four different categories, on the basis of their integrity and ability (both

intention and strength) to pay in full and in due time. Accordingly, these may be classified

as under:

Category Degree of Risk

A No risk

B Little risk

C Some risk

D High risk

But, such an exercise should not be taken as just a onetime exercise. Such

classifications must, instead, be reviewed periodically, and revised upward or downward,

as the case may be. That is, if the performance of a particular party in category A seems

to be declining, in terms of promptness in payment, it could well be brought down from

Category A to say, Category B. And, similarly, based upon the past performance, as

per the company’s records, if some perceptible improvement is observed in some

category B, or even category C parties, these could as well be promoted to Category

A and B respectively, as the case be.


175

NOTES


takes care to evolve an all - comprehensive proforma of its invoices, such that no

relevant particulars may be lost sight of. Besides, with a view to ensuring that the invoice,

along with the relative bill of exchange and such other documents, have been duly

received by the party, an acknowledgement slip could also be provided as a tear off

portion of the relative forwarding letter itself, wherein all the relevant particulars details

of the various documents, etc., as also the full and correct postal address of the seller

company, are computer-printed at the appropriate place. This way, the buyer company,

at the receiving end, would have to just put its rubber stamp (not even signature) on the

acknowledgement slip, and to slip the (acknowledgement) slip in the window envelop

and post it. And, that is it. A specimen proforma of the suggested forwarding letter

along with the tear off portion containing the acknowledgement slip, is placed in Annexure

5.1 at the end of the Chapter.

When the efforts of typing acknowledgement letter are involved, mostly the

buyer companies are found to be adopting the easiest course of action. That is, they

just do not send any acknowledgement, whatsoever.

Step 5

Entries in the (i) Master Register (all comprehensive) and (ii) Ledger Accounts

(party-wise):

With a view to exercising effective control on all the Working Capital

Management sales effected, on a day-to-day basis, the companies may maintain a

Master Register; wherein all the particulars of all the sales effected on a particular day

may be entered, in serial order.

To facilitate calculation of the due dates of payment, separate sections in the

register (or separate files in the computer) should be maintained for parties enjoying the

credit for different periods, viz. 15 days, 30 days, 45 days, 60 days, 75 days, 90 days,

180 days, and so on.It will be better still, if separate sub-sections are also maintained

for parties falling under different categories like A, B and C (presuming that the parties

falling under the category “D” being the high risk will not be given any credit, whatsoever).

So, because this may facilitate the company’s effective follow-up programme in a scientific

and systematic manner, on the basis of the ABC analysis, whereby the quantum of

pressure and frequency and rigour of monitoring could be gradually increased in the

cases of B (as compared to A) and C (as compared to B) categories of sundry debtors.

That is, in case of category A, too much of close follow-up may not be required

until their payment pattern calls for their degradation from category A to category B,

and so on. Similarly, the parties under category B may require somewhat closer follow-


177

NOTES


Step 5

Similarly, in some cases, just by way of setting an example, and creating some

sense of fear, even civil suits may be filed, though not with the intention of bringing it to

its logical conclusion, but only as a demonstration of strong will that mean business.

As has already been stated earlier, along with the master register, the companies

must also maintain a separate ledger account for each party, wherein the date of sale,

particulars of sale, date of payment or return of the bills, etc. would be incorporated.

This way, you will be able to form an opinion regarding each party which may, in turn,

facilitate the review and revision of the categorization of each party periodically, and

adopting specific strategies for the continuation of the terms of the credit sales or

otherwise, depending upon the review data, revealed by the ledger account of the party

concerned.

Streamlined Enquiry Systems

Due care must be taken by the companies to identify one specific official to

attend to all the enquiries pertaining to sundry debtors, and all the other officials of the

company, including the telephone operators, must know it and know it well. Thus, any

call coming for such enquiries may invariably be put through to the right person, and

even if, by chance, it gets connected to some wrong number, the person concerned

would be able to transfer the call to the right person, in one go, instead of the call being

tossed over from one person to the other. Now, in almost all the companies, all the

relevant particulars will be available to the person, with the press of a button on the

computer, for clarification of any doubt or for replying to any query pertaining to the

bills with great ease.

Further, the official concerend would do well if he could note down all the

queries made by various sundry debtors so that when all these are listed category-wise,

the study and analysis may throw-up some light on how to streamline the proforma

invoice or such other systems, so that much of the queries could be eliminated.

Incidentally, it may be mentioned here that such enlisting of various complaints

received on different counts, may also be used to enable us to take some suitable

remedial measures pertaining to after-sales service, quality control, delayed despatch,

etc. We should, therefore, treat all the complaints as a free and frank feed back, an

opportunity to introspect and improve upon.

Besides, this will also enable the official of the company to raise some of his

own queries or else to seek some clarification or even to remind of some long over-due

payments, etc. But, care must be taken that you praise your query only after all the

queries of the caller have been answered to his entire satisfaction.


179

NOTES


DC-3 Charges like freight, insurance, postage, demmurages, bank charges, etc.

disallowed/deducted by the buyers, and are being contested by

DC-4 Litigation

[D] General Comments

Sundry Debtors may be dividend into four categories.

(I) Internal causes (IC 1 to 11) where the reasons could be the negligence or slackness

on the part of some in-house staff

(ii) External causes (EC 1 to 8) where the reasons lie somewhere outside the company

and its staff.

(iii) Dispute being the cause (DC 1 to 5) where the dispute regarding quality and/or

quantity or such other factors may be the main causes.

(iv) Miscellaneous causes (MC 1 to 3) where the causes are such which do not fall

under any of the aforesaid three categories.

The added advantage of the listing of the causes, with code numbers given in

the parentheses, would be, to facilitate all the different departments to submit the periodical

performance reports in regard to the sundry debtors, with the specific reasons, quoted

at the appropriate places, by way of the code numbers only, like 1C3, EC5, DC2 etc.

or MC1.

Besides, such list may force the departmental heads concerned to identify the

specific reasons to be quoted in their periodical reports, instead of the usual practice of

giving some causes or the other, mostly in general terms, which did not convey much

sense. But, this practice may facilitate the analyses of the various causes of high sundry

debtors, which, in turn, may go a long way in evolving some appropriate remedial

measures, promptly and well in time.

Formulation of Credit Policy

Credit policies need to be formulated by the top management, of course, in

consultation with the lower levels of management, as they are expected to have the real

feel and first-hand experience and information about the market trends as also about

the traders and the competitors.

Cash Discount

Cash discount is a very common mechanism of effecting and encouraging speedy

payments but of course, at a price. Therefore, before taking a decision about the period

and quantum of giving cash discount, we must first try to understand and appreciate the

financial implications of such a stand taken, mainly in terms of the quantum of interest

gained or lost. This can be best understood by taking some illustrative examples.


181

NOTES


Such errors may take place but only in some cases, and not in general, provided

due care is taken at the time of the evaluation of the credit-worthiness of the parties. In

such cases, the periodical review of the payment pattern of the respective parties may

be helpful in reclassification of some parties, and thereby rectifying the error, if any,

hopefully well in time.

3.6 Types of Credit Policy

Different dimensions of the credit policy may vary in different degrees and

shades. It may be categorised under three broad types:

(i) Liberal Credit Policy: A credit policy may be termed as liberal wherein some

other concessions and facilities are granted to the buyers, with the expectation that this

way the sales may pick up, and thereby, the cost of extra concessions granted can well

be taken care of, by the additional yield, resulting from the extra sales achieved therewith.

But then, such liberalization may as well lead to some additional quantum of bad debts,

related with the extra sales effected, as also the resultant higher blockage of funds in

sundry debtors, and a higher cost of collection, too. Therefore, all such inter-related

facts and factors must be duly considered while taking a decision regarding adoption

and execution of a specific credit policy, most suited under the given circumstances.

(ii) Strict Credit Policy: Under such credit policy, as against the liberal one, the minimum

possible concessions and relaxations are granted to the customers. And, as a result

thereof, the sales may get somewhat adversely affected. But, at the same time, the risk

of bad debts may as well be minirnized, and so will be the extent of blockage of funds

in sundry debtors and the collection efforts and expenses, too. Thus, the decision should

be based on the trade-off position of the positive and negative factors.

(iii) Medium (Moderate) Credit Policy: Such credit policy adopts the middle of the

road approach whereby a balance is tried to be struck in such a way that both the

quantum of additional sales and the resultant risk of bad debts may be kept at the

optimal levels, i.e., neither too high nor too low, but in about just the right measure.

Parameters of Credit Policy

The various dimensions on the basis of which a company may be said to be

adopting a rather liberal, strict or medium (moderate) credit policy may broadly be

classified under four different parameters. They are:

(i) Standard of credit,

(ii) Period of credit,

(iii) Cash discount, and

(iv) Effective monitoring and follow-up {i.e., Collection Efforts}.

Let us discuss all these four different parameters of credit policy one after the other.


183

NOTES


the 10th day (and not earlier) so as to reap the maximum benefit out of the cash discount

offered. And, if they were to decide, not to avail of the cash discount, they would,

invariably, pay the bill on the very last day, i.e., on the 30th day only.

Example

(A) From the point of view of the seller:

(i) 2/10 Net 30

In effect, it means that a discount of 2 per cent is to be given if the bill is paid earlier, just

by 20 days only (i.e., 30 less 10 = 20 days). That is, the loss, by way of interest, to the

seller (on Rs. 100) for 20 days is 2 per cent. Thus, the rate of interest per annum

(presuming 360 days to a year) would come to:

(2 x 360) / [100 (30-10)1 = 720/2000 = 0.36 or 36 %

(ii) Similarly, in the case of “1/15 net 45”, the cost, (to the seller) by way of interest, will

be:

(1 x 360) / [100 x (45-15)1 = 360/3000 = 0.12 or 12 %

(iii) And, in the case of “2/9 net 45”, the cost, (to the seller) by way of

interest, would be:

(2 x 360) / [100 (45-9)] = 720/3600 = 0.20 or 20%

(iv) And, “1.5/15 net 60” would mean:

(1.5 x 360) / [100 (60-15)] = 540/4500 = 0.12 or 12 %

(B) From the point of view of the buyer:

But, does it mean that the percentage of savings made by the buyer is also the

same (as the percentage of the cost incurred by the seller), or else it is a little more or

less? Let us, find it out, based upon the very first illustrative example, given above. That

is, “2/10 net 30”.

Here, from the point of view of the buyer, he stands to gain Rs. 2 when he has

to actually pay (Rs. 100 - Rs. 2/-) = Rs. 98/- only (instead of Rs. 100). That is, on an

investment or payment of Rs. 98/- only, he stands to gain Rs. 2/- in 20 days period. So,

on an annualized basis, he stands to gain

(2 x 360) / 98 x 20 = 36.666 percent or say, 36.67 percent.

Thus, we see that the buyer is a gainer by a slightly higher percentage, as

compared to the seller, because, the buyer gains the same amount by investing or paying

a little lesser amount than Rs. 100)- (i.e. Rs. 981- only). But, the loss of the seller is on

the full Rs. 100/- i.e., instead of getting Rs. 100/-, he gets a little less, i.e., Rs. 98/-, in

the example under consideration.


185

NOTES


experiences of their past performance and dealings with us. But this seldom

seems to have been resorted to, in most of the companies.

2. No serious and sincere effort seems to have been made to meticulously

analyse the balance sheet and profit and loss account of the companies,

with a view to making a realistic assessment and appraisal of their financial

position. It has hardly been observed that some companies have asked for

some break-ups of certain items (say, of inventories or bad debts), to see

through the elements of window dressing, if any.

3. Prospective customers are required to give, at least, two or three references,

but no serious attempt seems to have been made by most of the companies

to verify the position from such references.

4. Independent credit rating agencies have, of late, appeared on the scene

like CRISIL, ICRA, etc., but the credibility and dependability of their credit

ratings may be a little doubtful. The credit rating agencies had given

satisfactory credit rating to ‘MS Shoes’ and ‘CRB Finance Company’, but

their assessment had proved to be totally wrong and contrary to facts.

Besides, the practice of seeking professional help from such credit rating

companies to ascertain and assess the financial position of the prospective

customers does not seem to be very common, as opposed to the conditions

prevailing in the USA, and other developed countries.

5. Some companies attempt to get the opinion of the bankers on the prospective

customers from the letters’ bank, but, as has already been observed earlier,

their opinions, though given in strict confidence and without any obligation,

are written in such general and vague terms that these do not seem to be of

much help and practical utility.

(C) Effective Monitoring and Control of Sundry Debtors

Though the various tools and techniques, systems and strategies, of effective

monitoring of sundry debtors, are very well known to the executives of most of the

companies, very few companies have been found to have evolved some systematic

mechanism of effective monitoring and follow-up of sundry debtors on some sound,

systematic and scientific lines. A lot seems to have been left to be desired. Some

companies have been found to be working out the average collection period, but not

party-wise. They may do the ageing analysis but only in absolute terms and not in terms

of percentage, etc.

3.8 Factoring

Factoring is a unique financial innovation. It is both a financial as well as a

management support to a client. It is a method of converting a non-productive, inactive

asset (i.e., hook debts) into a productive asset (viz., cash) by selling book debts

(receivables) to a company that specialises in their collection and administmtion.’ For a

number of companies, cash may become a scarce resource if it takes a long time to


187

NOTES


Financial assistance

Often factors provide financial assistance to the client by extending advance

cash against book debts. Customers of “clients” become debtors of a factor and have

to pay to him directly in order to settle their obligations. Factoring thus involves an

outright purchase of debts, allowing full credit protection against any bad debts and

providing fmancial accommodation against the firm’s book debts. In the U.S.A., the

maximum advance a factor provides is equal to the amount of factored receivables less

the sum of (i) the factoring commission, (ii) interest on advance, and (iii) reserve that the

factor requires covering bad-debts losses. The amount of reserve depends on the quality

of factored receivables and usually ranges between 5 to 20 per cent in the U.S.A.

In view of the services provided by a factor, factoring involved the purchase of

a client’s book debts with the purpose of facilitating credit administration, collection

and protection. It is also a means of short-term fmancing. It provides protection against

the default in -paying for book debts. For these services, the factor, however, charges

a fee from the client. Thus factoring has a cost.

Other services

In developed countries like the U.S.A factors provide many other services.

They include: (i) providing information on prospective buyers; (ii) providing financial

counselling; (iii) assisting the client in managing its liquidity and preventing sickness; (iv)

financing acquisition of inventories; (v) providing facilities for opening letters of credit

by the client etc.

3.10 Factoring and Short-Term Financing

Although, factoring provides short-term financial accommodation to the client,

it differs from other types of short-term credit in the following manner:

• Factoring involves sale of book debts. Thus the client obtains advance cash

against the expected debt collection and does not incur a debt.

• Factoring provides flexibility as regards credit facility to the client. He can obtain

cash either immediately or on due date or from time to time, as and when he

needs cash such flexibility is not available from formal sources of credit.

• Factoring is a unique mechanism, which not only provides credit to the client

but also undertakes the total management of client’s book debts.

Factoring and Bills Discounting

Factoring should be distinguished from bill discounting. Bill discounting or invoice

discounting consists of the client discounting bills of exchange for goods and services

on buyers, and then discounted it with bank for a charge. Thus, like factoring, bill


189

NOTES


(b) What are the main shortcomings and limitations connected with obtaining bank

references and what are the pragmatic approaches for overcoming them?

8. (a) Credit management practices, in Indian Companies, suffer from several

deficiencies. What are these and what are the adverse effects of each of them in

actual practice?

(b) What are the specific suggestions that you would like to make with a view to

streamlining and strengthening the present practices of management of credit

(Sundry Debtors) by the industries in India?

9. “Ageing Analysis” is an effective tool for monitoring and follow-up of sundry

debtors. However, for better results, it is desirable to do the ageing analysis:

(i) Not only “Period-wise”, but also “Party-wise”, and

(ii) Not only in “absolute terms” (of Rs.) but also in “percentage terms”.

Explain and illustrate, by using suitable examples.

10. Explain the objective of credit policy? ‘What is an optimum credit policy? Discuss.

11. Is the credit policy that maximizes expected operating profit an optimum credit

policy? Explain.

12. What benefits and costs are associated with the extension of credit?

13. How should they be combined to obtain an appropriate credit policy?

14. What is the role of credit terms and credit standards in the credit policy of a firm?

15. What are the objectives of the collection policy? How should it be established?

16. What shall be the effect of the following changes on the level of the finn’s receivables:

(a) Interest rate increases.

(b) The general economic conditions slacken.

(c) Production and selling costs increase.

(d) The firm changes its credit terms from “2/10, net 30” to “3/10, net 30.”

17. ‘The credit policy of a company is criticised because the bad debt losses have

increased considerably and the collection period has also increased.’ Discuss under

what conditions thiscriticism may not be justified.

18. What credit and collection procedures should be adopted in case of individual

accounts? Discuss.

19. How would you monitor book debts? Explain the pros and cons of various methods.

20. What is factoring? What functions does it perform?

21. Explain the features of various types of factoring.

22. Define factoring. How does it differ from bills discounting and short-term financing?


191

NOTES


1. INTRODUCTION

The importance and imperative need for effectively managing and controlling

all the items of inventory in a company can be judged from the fact that generally these

comprise the largest component of the total assets of a company, second only to the

items of plant and machinery. In terms of percentage of the total assets of a manufacturing

company, all the three components of inventory, taken together, generally account for

around 25 to 30 per cent of the total assets of the company. Thus, the importance of

effectively managing and controlling the inventory of a company can hardly be over-

emphasised.



• The nature of inventory and its role in working capital management

• Purpose and compenents of inventories

• Types of inventories and costs associated with it.

• Determination of EOQ and Economic production quantity.

• Inventory planning

• Various methods of pricing inventories

• Special techniques like ABC analysis and VED analysis

3.SECTION TITLE

3.1Components of Inventories

The term ‘inventory’ comprises three components. They are:

1. Raw materials (also consumable stores and spares),

2. Work-in-process (also known as stock-in-process, process), and

3. Finished goods.

Let us now discuss all these three items, one by one.

1. Raw Materials are those basic inputs, which are used to manufacture the finished

products.

2. Work-in-process, however, is the intermediary stage that comes after the stage of

raw materials, but just before the stage of finished goods.

3. The finished goods, in turn, comprise the end products, that is, the goods at their

final stage of production, ready for sale in the market.

Supposing, a company is in the business of production of breads. In this case,

the wheat flour, baking powder, etc., would comprise the raw materials. And, when the

flour is put in the relative moulds, which in turn, are placed in the furnace, this stage is


193

NOTES


finished goods are ready for transportation (movement) to the godown(s) or to the

company’s sales outlets.

Thus, as the production process involves several stages of production, the

aggregate quantum and value of the raw materials, lying at the different stages of

production, all taken together, comprise the stocks of process inventory.

And, thus, if the entire process (from the raw material stage till the stage

immediately preceding the finished goods stage) takes say, ten days, and the average

production of the item is 1000 units per day, the average quantity of such process

inventories would be equal to:

Average stocks-in-process, multiplied by the time days required to complete

all the processes, i.e., 1000 x 10 days = 10,000 units.

3.3 Movement Inventories

Movement inventories are usually referred to the inventories of finished goods,

to be transferred from the factory to the company’s godowns, warehouses, or sales

depots. Thus, if the average daily sales at the company’s sales depot are 250 units and

the transit time (for transporting the finished goods from the factory to the sales depots)

is 10 days, the average movement inventories, as per the aforesaid formula, would be:

250 units x 10 days = 2500 units, or

250 units x Rs. 5/- x 10 days = Rs. 12,500/-

3.4 Organization Inventories

Organization inventories, on the other hand, comprise the items of raw materials

and finished goods stored and stocked in the company’s godowns, to be supplied to

the factory or to the sales depots, as and when they would requisition for the required

number, weight, volume, etc., of the specific items of raw materials and finished goods,

respectively.

Here, it may be mentioned that the moment the stocks of raw materials and

finished goods are issued from the company’s godown(s), these items are excluded

from the organisation inventories and these, in turn, are included in the Working Capital

process inventories (though these raw materials may actually be put into the production

process a little later), or in the movement inventories (even if the stocks of the finished

goods may be lying in the company’s show-rooms, unsold).

Now, a natural question, that may arise, could be that if the inventory carrying

cost is so huge and material to affect the profitability of the company, favourably or

unfavourably, why should the companies, at all, have organization inventories, too, in


195

NOTES


the overall interests and requirements if the other departments, too, in the fore front,

inasmuch as all the departments inter-dependent with each other.

At this stage, it may be quite pertinent to examine the rationale behind keeping

the in-process inventory, too, (though these do not constitute a part of organization

inventory, as such).

Let us, at the very outset, clarify that though the in-process inventory refers to

work-in-process inventory only, it is different from the process or movement inventory,

discussed earlier, even though a part of the work-in-process inventory may represent

process or movement inventory, too.

Now, as regards the rationale behind keeping the in-process inventory, it may

be mentioned here that it provides some flexibility and latitude in the scheduling of

production, so as to ensure efficient production schedule and higher capacity utilisation

of plant and machinery. Further, in case there is no stock of in-process inventory, some

bottlenecks may be caused sometime somewhere in the production process, which

may ultimately result in delay in production and non utilisation of the installed capacity at

the optimum possible level. These factors, naturally, will culminate in adversely affecting

the financial gains of the company.

3.5 Economic Order Quantity (EOQ)

In regard to the management of inventories (specially the inventories of raw

materials) two primary questions naturally arise. They are:

(a) Order size, i.e., what should be the ideal size of the order?

(b) Order Level, i.e., at what level of the stocks should the next order be placed?

But, before deliberating to find out the answers to the above questions, let us

first try to understand the distinguishing features of the three types of costs involved in

the management of inventories:

(i) Ordering costs,

(ii) (Inventory) carrying costs, and

(iii) Shortage costs.

Let us now discuss these costs, in detail, one by one.

These include the expenses in respect of the following items:

(i) Cost of requisitioning items(s)

1.Ordering Costs

Ordering costs pertain to placing an order for the purchase of certain items of

raw. These include the expenses in respect of the following items:


197

NOTES


Stock out of finished goods, however, may result in the dissatisfaction of the

customers and the resultant loss of sales.

It, however, is relatively very difficult to actually measure the shortage cost

when it results due to the failure to meet the demands of the customers instantaneously,

out of the existing stocks. This is so because such costs may have ramifications, both in

the short-term as also in the long term. Besides, these costs are somewhat intangible in

nature, and consequently difficult to assess quantitatively.

It has also been observed that some of the companies, with a view to reducing

total ordering costs, prefer to order larger quantities. But, this way the level of inventory

becomes higher, and thereby the inventory carrying costs also go up. Further, if the

company decides to carry a safety stock of inventory so as to mitigate or reduce the

stock out costs, or shortage costs, its carrying costs, in turn, would go up further.

Thus, with a view to keeping the total costs, pertaining to management of

inventory, at the minimum level, we may have to arrive at the optimal level where the

total costs, i.e., total ordering costs plus total inventory carrying costs, are minimal. To

achieve this end result, we may have to work out the Economic Order Quantity (EOQ).

3.6 Basic Economic Order Quantity (EOQ) Model

At the very outset, it is to clarify here that we are going to discuss only the basic

EOQ model, one of the simplest inventory models. There are, in fact, a large number of

other inventory models, depending upon various variables and assumptions.

Assumptions of the Basic EOQ Model

It may further be clarified here that the basic EOQ model is based on various

assumptions, which are given hereunder:

1. The estimate of usage (demand or consumption) of the item of inventory for a

given period (usually one year) is known accurately.

2. The usage (demand or consumption of the various items of inventory) is equal

(even), throughout the period.

3. There is no lead time involved. That is, the item of inventory can be supplied

immediately on the receipt of the order itself; there being virtually no time lag

between placing of an order and the receipt of the goods. Consequently, there

is no likelihood of stock out, at any stage. Therefore, the shortage cost (or

stock out cost) is not being taken into account, as if it is nil.

4. Thus, there remain only two distinct costs involved in computing the total costs,


199

NOTES


Components of Inventory Carrying Costs

Inventory carrying costs comprise various items, some of which are given

hereunder:

(i) Storage Costs

That is, the rental payable will be proportionately higher as more space would

be required to store higher level of inventory.

(ii) Handling Charges

That is, when higher stocks will be stored, handling charges like unloading and

stacking charges, at the time of receipt of the goods, etc., involving man power, may

also go up.

(iii) Insurance Premium

Similarly, the amount of insurance premium payable, for fire insurance, theft

insurance, flood and such other natural calamity insurance, etc., will also be higher.

(iv) Wastages

It has generally been observed that if more than sufficient stocks of inventory

are stored, there is a usual tendency to consume more than what is actually required,

resulting in extra avoidable wastages.

To bring home the point, let us take a common place example. Supposing there is a

huge stock of medical bills proforma, these may, at times, be used even as paper plates,

etc. But, if these proforma were in short supply, people may take care not to waste a

single form.

(v) Damage and Deterioration

In the event of storing more than required level of stocks of raw materials and

finished goods, there is every chance that the goods may deteriorate in quality, like the

whiteness of papers gets diminished (it turns yellowish) with the passage of time. Some

chemicals or medicines also have limited shelf-life, where after these may turn useless.

Stocks of cement, in rainy season, are fraught with grave risk of turning into stones,

and, thus, becoming useless.

(vi) Technical Obsolescence

In the modern age of technological advancements, the pace of goods and

commodities becoming obsolete has become fast enough. Thus, more than necessary


201

NOTES


Order Point

This can well be done by ensuring that the order is placed when sufficient

balance of stock is still left to take care of the lead-time. But, for doing so accurately,

we may have to know the rate of usage of materials as also the lead-time, exactly and

in definite terms. In that case the ordering level would simply be as under:

Lead time (in number of days for procurement) multiplied by average usage

per day. i.e. Order Point = Lead time (in days) x Daily Usage.

Safety Stock

But then, in actual practice, one can neither estimate the lead time nor the daily

usage so accurately and exactly. We can, at best, make some reasonable estimates.

But, in that case, the possibility of some error, howsoever small, can hardly be eliminated

completely.

And, therefore, we should, to be on the safer side, take into account the element

of such uncertainty, too. Accordingly, we should always keep some safety stock with

us to meet such eventualities.

And, as such, the order point should be computed by adding the quantum of

sufficient safety stocks, too.

Thus, the order point can well be computed as:

EOQ + [lead time (in days) x daily usage] + safety stock

But, how to compute the safety stock? In fact, it is a managerial decision and,

therefore, it largely depends upon the inventory policy as also the organisational culture

of the company. It may, accordingly, be high or low, or even medium.

This, however, does not mean that we should try to cut it too fine, either.

Otherwise, a lot of the valuable time of the Materials Manager and the Purchase

Department would get wasted in the fire-fighting operations in procuring the materials,

in the nick of time, and incur the avoidable expenses relating to such crash purchases.

The best policy, in regard to keeping the safety stock, would ideally be - neither

“too much”, nor “too little”, but “just right”. But, it is easy said than done. However, the

considered opinion that, by some trial and error method, we may be able to arrive at a

nearly optimal level of safety stocks, in due course of time.

3.12 Other Variable Factors Affecting EOQ

In finding out the EOQ or order level or safety stock, etc., we have, in the

preceding pages, made certain assumptions that some other factors do not vary, though


203

NOTES


(say 65%) in terms of value. As against this, in cases of certain other items of inventory,

a very large percentage of the total number of items of inventory (say 70%) may account

for a much smaller percentage (say 10%) in terms of their total value. And, likewise, a

medium percentage of some items (say 20%) may account for a medium percentage

(say 25%) in terms of their total value. These are classified as category A, B and C

respectively. ABC analysis is also referred to as VED (Vital, Essential and Desirable)

analysis.

We may put the aforesaid statements in a tabular form as under:

The main (or even sole) purpose of classifying the inventories into these three

categories, A, B, and C, is to vary the pressure and intensity of control, in terms of the

value of the items of inventory.

To put it differently, while the entire stocks (say 100%), of the items in category

“A” must be very closely monitored and controlled, the monitoring and control of say,

10% of the items of category “C”, could be considered enough to serve the purpose.

And, in the case of “B” category of items, the monitoring and control of say 25% of the

item alone may be taken as sufficient.

3.14 Categorization of Items for ABC Analysis

Now, let us see how do we usually proceed to classify the various items of

inventories into the three categories viz., A, B, and C. The procedure involves the

following steps, in a sequential order:

Step 1

Rank all the items of inventory, in a descending order, based upon their annual usage

value, and serially number them, from I to n.

Step 2

Record the totals of annual consumption values of all the items separately and

store them as a percentage of the total value of consumption.


205

NOTES


(b) But, if it is higher than EOQ, 000 will be the EOQ or the quantity eligible for

bulk discount, depending upon which one of these two will be beneficial [i.e.,

when the resultant difference will be a positive (+ve) figure].

A New Clue to EOQ:

That is, after finding out the EOQ in terms of the nearest integer figure, we

should find out the number of orders. And, this again, should be converted into the

nearest integer number. Based on this figure as the number of orders, we should calculate

the EOQ, which will be the EOQ in real terms. Besides, we should bear in mind the

concepts of EOP and EOR, too, at this stage.

3.15 Components of Inventory Carrying Costs:

(i) Storage Cost

(ii) Handling Charges

(iii) Insurance Charges

(iv) Wastages

(v) Damage/Deterioration

(vi) Technical Obsolescence, Blockage of funds and cost of capital, and opportunity

cost connected therewith.

3.16 Advantages of High Inventory:

(a) High Stocks of Raw Materials

(i) Bulk purchase at cheaper rate with quantity discount. [Better, if bulk annual purchase

is ordered, but the delivery and payments are to be made in phases, to the mutual

advantages of both the parties. It is an optimal strategy).

(ii) Seasonal purchases, being cheaper and sure.

(iii) No Stock-out cost and risk.

(iv) In inflationary economy, it may be gainful.

(v) Savings of ordering cost and the connected hazels of loading and unloading, etc.

(b) High Stocks of Finished Goods:

(i) It may facilitate instant delivery, out of the shelf, and, thus, to have an edge

over the competitors. [But, better to have only a small ready stock and the rest to be

produced on receipt of the order, on priority basis].

(ii) Thus, the “Golden Mean” is the most basic management mantra, pertaining

to the management of inventory, too.

15. Lead Time

It represents the time lag between placement of order and the actual receipt of

goods.


207

NOTES


8. What are the various factors) elements involved in the inventory carrying costs?

Explain with the help of some illustrative examples.

9. (a) Explain the following terms with the help of some illustrative examples:

(i) Lead time, (ii) order point, and (iii) safety stock.

(b) How is the reorder level ascertained? Explain with the help of an illustrative example.

10. (a) What do you understand by the term “ABC Analysis”? Explain with the help of

illustrative examples, the procedure adopted for doing the ABC analysis.

(b) What purpose does ABC Analysis serve in the context of inventory policy, monitoring,

management and control? Explain, with the help of some suitable illustrative examples.

(c) In what other two areas (other than the area of inventory management) can the

ABC Analysis be used with immense advantage? Name them and explain each of

them with the help of some illustrative examples.

11. The state of affairs in the area of management of inventory in most of the Indian

companies leaves a lot to be desired.

(a) What are the various factors responsible for such dismal state of affairs?

(b) What corrective steps would you suggest to streamline and improve the system of

inventory management and control in India?

12. Distinguish between EOQ and OOQ (Optimum Order Quantity) when quantity

discount is available. Elucidate your point by citing suitable illustrative examples.

13. Distinguish between JIT (Just In Time) and JIC (Just In Case) approaches towards

inventory management and control.

(i) Cite suitable illustrative examples to clarify your point.

(ii) Which one of the above noted two approaches, in your considered opinion, should

be adopted by any company? Give reasons for your answer.

14. (a) What are the comparative advantages and disadvantages of carrying too high or

too low stocks of inventories of:

(i) Raw materials, and (ii) finished goods?

Explain, with the help of some illustrative examples.

(b) What, in your considered view, would be the right approach in this area? Give

convincing reasons for your answer.


209

NOTES


3.SECTION TITLE

3.1 Why is Cash Needed?

The demand for liquid assets like cash, whether by individuals or firms, is normally

attributed to three behavioral motives, viz., the transaction motive, the precautionary

motive and the speculative motive.

The transaction motive for holding cash is helpful in the conduct of everyday

ordinary business such as making of purchases and sales. The amount of cash needed,

however, differs from business to business and from firm to firm depending on the

frequency of cash transactions. Retail trade, for example, requires a higher ratio of cash

to sales and of cash to total assets. Firms having seasonal business will need greater

amount of cash during the season.

The precautionary motive is concerned with predictability of cash inflows and

outflows. Higher the predictability of cash, lower is the amount needed against

emergencies or contingencies. This motive for holding cash is also influenced by the

ability of the firm to obtain additional cash on short notice through short-term borrowings.

A minimum reservoir of cash must always be kept in hand to meet the unexpected

payments and other contingencies.

The speculative motive for holding cash is concerned with availing the

opportunities arising from unexpected developments, e.g. an abnormal increase in prices.

However, keeping additional cash for speculative purpose is not common in business.

3.2 Determining Optimal Cash Balance

Holding of excessive cash is a non-profitable proposition, as idle cash does not

earn any income. Similarly shortage of cash may deprive the business unit of availing the

benefits of cash discounts, and of taking advantage of other favorable opportunities. It

may even lead to loss of credit-worthiness on account of default in paying liabilities

when the same becomes due. Hence, every organization, irrespective of its size and

nature, has to determine the appropriate or optimum cash balance that it would need.

A firm’s cash balance, generally, may not be constant overtime. It would

therefore be worthwhile to investigate the maximum, minimum and average cash needs

over a designated period of time.

You are aware that cash is needed for various transactions of the organization.

Maintenance of a cash balance however has an opportunity cost in the following ways:

a) Cash can be invested in acquiring assets such as inventory, or for purchasing securities.

Opportunities for such investments may be lost if a certain minimum cash balance is

held.


211

NOTES


purchase materials from which goods are produced. Production of these goods involves

use of funds for paying wages and meeting other expenses. Goods produced are sold

either on cash or credit. In the latter case the pending bills are received at a later date.

The firm thus receives cash immediately or later for the goods sold by it. The cycle

continues repeating itself.

The diagram in above figure only gives a general idea about the channels of

flow of cash Managing Cash in a business. The magnitude of the flow in terms of time is

depicted in the diagram given in Figure IV. The following information is reflected by

Figure IV:


213

NOTES


can be derived by delaying disbursements. Trade credit is a costless source of funds for

it allows us to pay the creditors only after the period of credit agreed upon. The dues

can be withheld till the last date. This will reduce the requirement for holding large cash

balances. Some firms may like to take advantage of cheque book float which is the time

gap between the date of issue of a cheque and the actual date when it is presented for

payment directly or through the bank.

Investment of Idle Cash Balances

Two other important aspects in cash management are how to determine

appropriate cash balance and how to invest temporarily idle cash in interest earning

assets or securities. The first part relating to the theory of determining appropriate cash

balance has already been discussed earlier. Now we shall discuss the investment of idle

cash balances on temporary basis. Cash by itself yields no income. If we know that

some cash will be in excess of our need for a short period of time, we must invest it for

earning income without depriving ourselves of the benefit of liquidity of funds. While

doing this, we must weigh the advantages of carrying extra cash (i.e. more than the

normal requirement) and the disadvantages of not carrying it. The carrying of extra cash

may be necessitated due to its requirement in future, whether predictable or unpredictable.

The experience indicates that cash flows cannot be predicted with complete accuracy.

Competition, technological changes, unexpected failure of products, strikes and

variations in economic conditions make it difficult to predict cash needs accurately.

Investment Criteria

When it is realized that the excess cash will remain idle, it should be invested in

such a way that it would generate income and at the same time ensure quick re-conversion

of investment in cash. While choosing the channels for investment of any idle cash

balance for a short period, it should be seen that (i) the investment is free from default

risk, that is, the risk involved due to the possibility of default in timely payment of

interest and repayment of principal amount; (ii) the investment shall mature in a short

span of time; and (iii) the investment has adequate marketability. Marketability refers to

the ease with which an asset can be converted back into cash. Marketability has two

dimensions price and time-which are inter-related. If an asset can be sold quickly in

large amounts at a price determinable in advance, the asset will be regarded as highly

marketable and highly liquid. The assets, which largely satisfy the aforesaid criteria, are:

Government Securities, Bankers’ Acceptances and Commercial Paper.

3.4 Cash Budgeting

Planning cash and controlling its use are very important tasks. If the future cash

flows are not properly anticipated, it is likely that idle cash balances may be created


215

NOTES


LONG TERM SOURCES OF FINANCE

Lesson I

Indian Capital and Stock Market

1. Introduction

2. Learning objectives

3. Section Title

3.1 Financial Assets

3.2 Financial Intermediaries

3.3 Financial markets

3.4 Relationship between New issue market and stock

exchange

3.5 Functions of stock exchanges (Secondary markets)

3.6 Functions of New issues/primary market

3.7 Issue mechanism

Have you Understood?

1. INTRODUCTION

Capital markets are a sub-part of the financial system. Conceptually, the financial

system includes a complex of institutions and mechanisms which affects the generation

of savings and their transfer to those who will invest. It may be said to be made of all

those channels through which savings become available for investments. The main

elements of the financial system are a variety of (i) financial instruments/assets/securities,

(ii) financial intermediaries/institutions and (iii) financial markets.

UNIT V


217

NOTES


• Convenience

Financial intermediaries convert direct/primary securities into a more convenient

vehicle of investment. They divide primary securities of higher denomination into indirect

securities of lower denomination. They also transform a primary security of certain

maturity into an, indirect security of a different maturity. For instance, as a result of the

redemption/repurchase facility available to unitholders of mutual funds, maturities on

units would conform more with the desires of the investors than those on primary

securities.

• Lower Risk

The lower risk associated with indirect securities results from the benefits of

diversification of investments. In effect, the financial intermediaries transform the small

investors in matters of diversification into large institutional investors as the former shares

proportionate beneficiary interest in the total portfolio of the latter.

• Expert Management

Indirect securities give to the investors the benefits of trained, experienced and

specialised management together with continuous supervision. In effect, financial

intermediaries place the individual investors in the same position in the matter of expert

management as large institutional investors.

• Low Cost

Low cost is the benefits of investment through financial intermediaries are available

to the individual investors at relatively lower cost due to the economies of scale.

The major financial intermediaries are banks, insurance organisations, both life

and non-life/ general, mutual funds, non-banking financial companies and so on.

3.3 Financial Markets

Financial markets perform a crucial function in the financial system as facilitating

organisations. Unlike financial intermediaries, they are not a source of funds but are a

link and provide a forum in which suppliers of funds and demanders of loans/investments

can transact business directly. While the loans and investments of financial intermediaries

are made without the direct knowledge of the suppliers of funds (i.e. investors), suppliers

in the financial market know where their funds are being lent/invested. The two key

financial markets are the money market and the capital market.

• Money Market

The money market is created by a financial relationship between suppliers

and demanders of short-term funds which have maturities of one year or less. It

exists because investors (i.e. individuals, business entities, government and financial

institutions) have temporarily idle funds that they wish to place in some type of

liquid asset or short-term interest-earning instrument. At the same time, other entities/


219

NOTES


which may be defined as securities which have been issued already and granted stock

exchange quotation. The stock exchanges, therefore, provide a regular and continuous

market for buying and selling of securities. The usual procedure is that when an enterprise

is in need of funds, it approaches the investing public, both individuals and institutions,

to subscribe to its issue of capital. The securities thus floated are subsequently purchased

and sold among the individual and institutional investors. There are, in other words, two

stages involved in the purchase and sale of securities. In the first stage, the securities are

acquired from the issuing companies themselves and these are, in the second stage,

purchased and sold continuously among the investors without any involvement of the

companies whose securities constitute the stock-intrude except in the strictly limited

sense of registering the transfer of ownership of the securities. The section of the industrial

securities market dealing with the first stage is referred to as the NIM, while secondary

market covers the second stage of the dealings in securities.

Nature of Financing

Another aspect related to the separate functions of these two parts of the

securities market is the nature of their contribution to industrial financing. Since the

primary market is concerned with new securities, it provides additional funds to the

issuing companies either for starting a new enterprise or for the expansion or

diversification of the existing one and, therefore, its contribution to company financing is

direct. In contrast, the secondary markets can in no circumstance supply additional

funds since the company is not involved in the transaction. This, however, does not

mean that the stock markets have no relevance in the process of transfer of resources

from savers to investors. Their role regarding the supply of capital is indirect. The usual

course in the development of industrial enterprise seems to be that those who bar the

initial burden of financing a new enterprise, pass it on to others when the enterprise

becomes well established. The existence of secondary markets which provide,

institutional facilities for the continuous purchase and sale of securities and, to that extent,

lend liquidity and marketability, play an important part in the process.

Organisational Differences

The two parts of the market have organisational differences also. The stock

exchanges have, organisationally speaking, physical existence and are located in a

particular geographical area. The NIM is not rooted in any particular spot and has no

geographical existence. The NIM has neither any tangible form any administrative

organisational set up like that of stock exchanges, nor is it subjected to any centralised

control and administration for the consummation of its business. It is recognised only by

the services that it renders to the lenders and borrowers of capital funds at the time of

any particular operation. The precise nature of the specialised institutional facilities

provided by the NIM is described in a subsequent section.


221

NOTES


The second dimension of the mutual interdependence of the two parts of the

market is that the prices of new issues are influenced by the price movements on the

stock market. The securities market represents an important case where the stock-

demand-and-supply curves, as distinguished from flow-demand-and-supply curves,

exert a dominant influence on price determination. The quantitative predominance of

old securities in the market usually ensures that it is these which set the tone of the

market as a whole and govern the prices and acceptability of the new issues. Thus, the

flow of new savings into new securities is profoundly influenced by the conditions

prevailing in the old securities market—the stock exchange.

3.5 Functions of Stock Exchanges (Secondary Markets

Stock exchanges discharge three vital functions in the orderly growth of capital

formation:

(i) Nexus between savings and investments, (ii) Market place and (iii) Continuous price

formation.

Nexus between Savings and Investment

First and foremost, they are the nexus between the savings and the investments

of the community. The savings of the community are mobilised and channelled by stock

exchanges for investment into those sectors and units which are favoured by the

community at large, on the basis of such criteria as good return, appreciation of capital,

and so on. It is the preference of investors for individual units as well as industry groups,

which is reflected in the share price, that decides the mode of investment. Stock exchanges

render this service by arranging for the preliminary distribution of new issues of capital,

offered through prospectus, as also offers for sale of existing securities, in an orderly

and systematic manner. They themselves administer the same, by ensuring that the various

requisites of listing (such as offering at least the prescribed minimum percentage of

capital to the public, keeping the subscription list open for a minimum period of days,

making provision for receiving applications at least at the prescribed centres, allotting

the shares against applications on a fair and unconditional basis) are duly complied with

Members of stock.

Exchanges also assist in the flotation of new issues by acting (i) as brokers, in

which capacity they, inter alia, try to procure subscription from investors spread all

over the country, and (ii) as underwriters. This quite often results in their being required

to nurse new issues till a time when the new ventures start making profits and reward

their shareholders by declaring reasonable dividends when their shares command

premiums in the market. Stock companies also provide a forum for trading in rights

shares of companies already listed, thereby enabling a new class of investors to take up

a part of the rights in the place of existing shareholders who renounce their rights for

monetary considerations.


223

NOTES


New issues can be classified in various ways. The first of new issues are by

new companies and old companies. This classification was first suggested by R.F.

Henderson. The distinction between new also called initial and old also known as further,

does not bear any relation to the age of the company. The securities issued by companies

for the first time either after the incorporation or conversion from private to public

companies are designated as initial issues, while those issued by companies which already

have stock exchange quotation, either by public issue or by rights to existing shareholders,

are referred to as further or old.

The new issues by corporate enterprise can also be classified on the basis of

companies seeking quotation, namely, new money issues and no new money issues.

The term new money issues refers to the issues of capital involving newly created shares;

no new money issues represent the sale of securities already in existence and sold by

their holders. The new money issues provide funds to enterprises for additional capital

investment. According to Merrett and others,5 new money refers to the sum of money

equivalent to the number of newly created shares multiplied by the price per share

minus all the administrative cost associated with the issue. This money may not be used

for additional capital investment; it may be used wholly or partly to repay debt. Henderson

uses the term in a rather limited sense so that it is the net of repayment of long-term debt

and sums paid to vendors of existing securities. The differences in the approaches by

Merrett and others, on the one hand, and Henderson, on the other, arise because of the

fact that while the concern of the former is with both flow of funds into the market as

well as flow of money, Henderson was interested only in the latter.

However, two types of issues are excluded from the category of new issues.

First, bonus/ capitalisation issues which represent only book-keeping entries, and, second,

exchange issues by which shares in one company are exchanged for securities of another.

The general function of the NIM, namely, the channelling of investible funds

into industrial enterprises, can be split from the operational stand-point, into three services

(i) Origination,(ii) Underwriting, and (iii) Distribution. The institutional set-up dealing

with these can be said to constitute the NIM organisation. In other words, the NIM

facilitates the transfer of resources by providing specialist institutional facilities to perform

the triple-service function.

Origination

The term origination refers to the work of investigation and analysis and

processing of new proposals. These two functions8 are performed by the specialist

agencies which act as the sponsors of issues. One aspect is the preliminary investigation

which entails a careful study of technical, economic, financial, and legal aspects of the

issuing companies. This is to ensure that it warrants the backing of the issue houses in


225

NOTES


3.7 Issue Mechanism

The success of an issue depends, partly, on the issue mechanism. The methods

by which new issues are made are: (i) Public issue through prospectus, (ii) Tender/

Book building, (iii) Offer for sale (iv) Placement and (v) Rights issue.

Public Issue through Prospectus

A common method followed by corporate enterprises to raise capital through

the issue of securities is by means of a prospectus inviting subscription from the investing

public. Under this method, the issuing companies themselves offer directly to the general

public a fixed number of shares at a stated price, which in the case of new companies is

invariably the face value of the securities, and in the case of existing companies, it may

sometimes include a premium amount, if any. Another feature of public issue method is

that generally the issues are underwritten to ensure success arising out of unsatisfactory

public response.

The foundation of the public issue method is a prospectus, the minimum contents

of which are prescribed by the Companies Act, 1956. It also provides both civil and

criminal liability for any misstatement in the prospectus. Additional disclosure requirements

are also mandated by the SEBI. The contents of the prospectus, inter alia, include: (i)

Name and registered office of the issuing company; (ii) Existing and proposed activities;

(iii) Board of directors; (iv) Location of the industry; (v) Authorised, subscribed and

proposed issue of capital to public; (vi) Dates of opening and closing of subscription

list; (vii) Name of broker, underwriters, and others, from whom application forms along

with copies of prospectus can be obtained; (viii) Minimum subscription; (ix) Names of

underwriters, if any, along with a statement that in the opinion of the directors, the

resources of the underwriters are sufficient to meet the underwriting obligations; and (x)

A statement that the company will make an application to stock exchange(s) for the

permission to deal in or for a quotation of its shares and so on.

The public issue method through prospectus has the advantage that the

transaction is carried on in the full light of publicity coupled with approach to the entire

investing public. Moreover, a fixed quantity of stock has to be allotted among applicants

on a non-discriminatory basis. The issues are, thus, widely distributed and the danger

of an artificial restriction on the quantity of shares available is avoided. It would ensure

that the share ownership is widely diffused, thereby contributing to the prevention of

concentration of wealth and economic power.

A serious drawback of public issue, as a method to raise capital through the

sale of securities, is that it is a highly expensive method. The cost of flotation involves

underwriting expenses, brokerage, and other administrative expenses. The administrative

cost includes printing charges of prospectus, advertisement/publicity charges,

accountancy charges, legal charges, bank charges, stamp duty, listing fee, registration


227

NOTES


by the company and the price paid by the public does not become additional funds, but

it is pocketed by the issuing houses or the existing shareholders.

Placement Method

Yet another method to float new issues of capital is the placing method defined

by London Stock Exchange as “sale by an issue house or broker to their own clients of

securities which have been previously purchased or subscribed”. Under this method,

securities are acquired by the issue houses, as in offer for sale method, but instead of

being subsequently offered to the public, they are placed with the clients of the issue

houses, both individual and institutional investors. Each issue house has a list of large

private and institutional investors who are always prepared to subscribe to any securities

which are issued in this manner. Thus, the flotation of the securities involves two stages:

In the first stage, shares are acquired by the issuing houses and in the second stage, they

are made available to their investor-clients. The issue houses usually place the securities

at a higher price than the price they pay and the difference, that is, the turn is their

remuneration. Alternatively, though rarely, they may arrange the placing in return for a

fee and act merely as an agent and not principal.

Another feature of placing is that, the placing letter and the other documents,

when taken together, constitute a prospectus/offer document and the information

concerning the issue has to be published. In this method, no formal underwriting of the

issue is required as the placement itself amounts to underwriting since the issue houses

agree to place the issue with their clients. They endeavour to ensure the success of the

issue by carefully vetting the issuing company concerned and offering generous

subscription terms.

Placing of securities

Securities that are unquoted is known as private placing. The securities are

usually in small companies but these may occasionally be in large companies. When the

securities to be placed are newly quoted, the method is officially known as stock exchange

placing.

The main advantage of placing, as a method of issuing new securities, is its

relative cheapness. This is partly because, many of the items of expenses in public issue

and offer for sale methods like underwriting commission, expense relating to applications

and allotment of shares, and so on are avoided. Moreover, the stock exchange

requirements relating to contents of the prospectus and its advertisement are less onerous

in the case of placing.

Its weakness arises from the point of view of distribution of securities. As the

securities are offered only to a select group of investors, it may lead to the concentration

of shares into a few hands who may create artificial scarcity of scrips in times of hectic

dealings in such shares in the market.


229

NOTES


The above discussion shows that the available methods of flotation of new

issues are suitable in different circumstances and for different types of enterprises. The

issue mechanism would vary from market to market.


1. Discuss the main elements of the financial system.

2. Explain briefly financial assets/instruments.

3. Describe briefly the functions of financial intermediaries.

4. Explain briefly the two key financial markets.

5. Write a brief note on the differences between the new issue market and the

stock exchanges.

6. What are the similarities between the NIM and the stock market?

7. What are the functions of the stock exchanges?

8. Briefly discuss the functions of the NIM.

9. What are the different methods of flotation of issues in the primary market?


231

NOTES


• The different types for long term capital instruments

• Merits and demerits of equity and preference share capital

• Different types of debentures and their merits and demerits.

• Different modes of capital issues

• SEBI Guidelines on public issues.

3.SECTION TITLE

3.1 Sources of Capital

Broadly speaking, a company can have two main sources of funds. Internal

and external, Internal sources refer to sources from within the company External sources

refer to outside sources.

Internal sources consist of depreciation provision, general reserve fund or free

reserve — retained earnings or the saving of the company. External sources consists of

share capital, debenture capital, loans and advances (short term loans from commercial

banks and other creditors, long term loans from finance corporations and other creditors).

Share capital is considered as ownership or equity capital whereas debentures and

loans constitute borrowed or debt capital. Raising capital through issue of shares,

debentures or bonds is known as primary capital sourcing. Otherwise it is called new

issues market.

Long-term sources of finance consist of ownership securities y shares and

preference shares) and creditor-ship securities (debentures, towing from the financing

institutions and lease finance). Short-term sources of finance consists of trade credit,

short-term loans from banks and financial institutions and public deposits.

3.2 Long-Term Capital Instruments

Corporate securities also known as company securities are said to be the

documentary media of raising capital by the joint stock companies. These are of two

classes: Ownership securities; and Creditor-ship securities.

Ownership Securities

Ownership securities consist of shares issued to the intending investors with the

right to participate in the profit and management of the company. The capital raised in

this way is called ‘owned capital’. Equity shares and securities like the irredeemable

preference shares are called ownership securities. Retained earnings also constitute

owned capital.

Creditor-ship Securities

Creditor-ship securities consist of various types of debentures which are

acknowledgements of corporate debts to the respective holders with a right to receive


233

NOTES


of the equity shareholders is also high as compared preference shares or

debentures.

3. Equity dividend is payable from post-tax earnings. Unlike interest” paid on

debt capital, dividend is not deductible as an expense from the profit for taxation

purposes. Hence cost of equity is high Sometimes, dividend tax is paid, further

rising cost of equity share capital.

4. The issuing of equity capital causes dilution of control of the equity holders.In

times of depression, dividends on equity shares reach low be which leads to

drastic fall in their market values.

5. Excessive reliance on financing through equity shares reduces the capacity of

the company to trade on equity. The excessive use of equity shares is likely to

result in over capitalization of the company.

3.4 Preference Shares

Preference shares are those which catty priority rights in regard to the payment

of dividend and return of capital and at the same time are subject to certain limitations

with regard to voting rights.

The preference shareholders are entitled to receive the fixed rate of dividend

out of the net profit of the company. Only after the payment of dividend at a fixed rate

is made to the preference shareholders, the balance of it will be used for paying dividend

to ordinary shares. The rate of dividend preference shares is mentioned in the prospectus.

Similarly in the event of liquidation the assets remaining after payment of all debts of the

company are first used for returning the capital contributed by the preference

shareholders.

Types of Preference Shares

There are many forms of preference shares. These are:

1. Cumulative preference shares

2. Non-Cumulative preference shares

3. Participating preference shares

4. Non-participating preference shares

5. Convertible preference shares

6. Non-convertible preference shares

7. Redeemable preference shares

8. Ir-redeemable preference shares

9. Cumulative convertible preference shares

Merits of Preference shares

1. The preference shares have the merits of equity shares without their limitations.


235

NOTES


3.5 Debentures

A debenture is a document issued by a company as an evidence of a debt due

from the company with or without a charge on the assets of the company. It is an

acknowledgement of the company’s indebtedness to its debenture-holders. Debentures

are instruments for raising long-term debt capital. Debenture holders are the creditors

of the company.

In India, according to the Companies Act, 1956, the term debenture includes

“debenture stock, bonds and any other securities of company whether constituting a

charge on the assets of the company or not”

Debenture-holders are entitled to periodical payment of interest agreed rate.

They are also entitled to redemption of their capital as per the terms. No voting rights

are given to debenture-holders. Under section 117 of the companies Act, 1956,

debentures with voting rights cannot be issued. Usually debentures are secured by

charge on or mortgage of the assets of the company.

Types of debentures

Debentures can be various types. They are:

1. Registered debentures

2. Bearer debentures or unregistered debentures

3. Secured debentures

4. Unsecured debentures

5. Redeemable debentures

6. Irredeemable debentures

7. Fully convertible debentures

8. Non-convertible debentures

9. Partly convertible debentures

10. Equitable debentures

11. Legal debentures

12. Preferred debentures

13. Fixed rate debentures

14. Floating rate debentures

15. Zero coupon debentures

16. Foreign currency convertible debentures

Registered debentures: Registered debentures are recorded in a register of debenture-

holders with full details about the number, value and types of debentures held by the

debenture-holders. The payment of interest and repayment of capital is made to the


237

NOTES


Preferred debentures: Preferred debentures are those which are paid first in the L

time of winding up of the company. The debentures have priority over other debentures

Fixed rate debentures: Fixed rate debentures carry a fixed rate of interest Now a

days this class is not desired by both investors and issuing institutions.

Floating rate debentures: Floating rate debentures carry floating interest rate coupons.

The rates float over some benchmark rates like bank rate, LIBOR etc.

Zero-coupon debentures: Zero-coupon debentures are merest coupons. Interest on

these is paid on maturity called as deep-discount debentures.

Foreign Currency convertible debentures: Foreign currency convertible debentures

are issued in overseas market in the currency of the country where the flotation takes

place. Later these are converted into equity, either GDR. ADR or plain equity.

Merits of debentures

1. Debentures provide funds to the company for a long period without diluting its

control, since debenture holders are not entitled to vote.

2. Interest paid to debenture-holders is a charge on income of the company and is

deductible from computable income for income tax purpose whereas dividends

paid on shares are regarded as income and are liable to corporate income tax.

The post-tax cost of debt is thus lowered.

3. Debentures provide funds to the company for a specific period. Hence, the

company can appropriately adjust its financial plan to suit its requirements.

4. Since debentures are generally issued on redeemable basis, the company can

avoid over-capitalisation by refunding the debt when the financial needs are no

longer felt.

5. In a period of rising prices, debenture issue is advantageous. The burden of

servicing debentures, which entail a fixed monetary commitment for interest

and principal repayment, decreases in real terms as the price level increases.

6. Debentures enable company to take advantage of trading on equity and thus

pay to the equity shareholders a dividend at a rate higher than overall return on

investment.

7. Debentures are suitable to the investors who are cautious and who particularly

prefer a stable rate of return with no risk. Even institutional investors prefer

debentures for this reason.

Demerits of Debentures

1. Debenture interest and capital repayment are obligatory payments. Failure to

meet these payment jeopardizes the solvency of the firm.


239

NOTES


Significance of convertible issues:

The convertible security provides the investor with a fixed return from a bond

(debenture) or with a specified dividend from preferred stock (preference shares). In

addition, the investor gets an option to convert the security (convertible debentures or

preference shares) into equity shares and thereby participates in the possibility of capital

gains associated with, being a residual claimant of the company. At the time of issue, the

convertible security will be priced higher than its conversion value. The difference

between the issue price and the conversion value is known as conversion premium. The

convertible facility provides a measure of flexibility to the capital structure of the company

to company which wants a debt capital to start with, but market wants equity. So,

convertible issues add sweeteners to sell debt securities to the market which want

equity issues.

Convertible preference shares: The preference shares which carry the right of

conversion into equity shares within a specified period, are called convertible preference

shares. The issue of convertible preference shares must be duly authorized by the articles

of association of the company.

Convertible debentures: Convertible debentures provide an option to their holders

to convert them into equity shares during a specified period at a particular price. The

convertible debentures are not likely to have a good investment appeal, as the rate of

interest for convertible debentures is lesser than the non-convertible debentures.

Convertible debentures help a company to sell future issue of equity shares at a price

higher than the price at which the company’s equity shares may be selling when the

convertible, debentures are issue. By convertible debentures, a company gets relatively

cheaper financial resource for business growth. Debenture interest constitutes tax

deductible expenses. So, till the debentures are converted, the company gets a tax

advantage. From the investors’ point of view, convertible debentures prove an ideal

combination of high yield, low risk and potential capital appreciation.

3.8 Different Modes of Capital Issues

Capital instruments, namely, shares and debentures can be issued to the market

by adopting any of the four modes: Public issues, Private placement, Rights issues and

Bonus issues. Let us briefly explain these different modes of issues.

Public Issues

Only public limited companies can adopt this issue when it wants to raise capital

from the general public. The company has to issue a prospectus as per requirements of

the corporate laws in force inviting the public to subscribe to the securities issued, may

be equity shares, preference shares or debentures/bonds. A private company cannot

adopt this route to raise capital. The prospectus shall give an account of the prospects


241

NOTES


Under section 81 of the Companies Act 1956, where at any time after the

expiry of two years from the formation of a company, or at any time after the expiry of

one year from the allotment of shares being made for the first lime after its formation,

whichever is earlier, it is proposed to increase the subscribed capital of the company by

allotment of further shares, then such further shares shall be offered to the persons who,

at the date of the offer, are holders of the equity shares of the company, in proportion as

nearly as circumstances admit, to the capital paid on those shares at that date. Thus the

existing shareholders have a pre-emptive right to subscribe to the new issues made by

a company. This right has at its root in the doctrine that each shareholder is entitled to

participate in any further issue of capital by the company equally, so that his interest in

the company is not diluted.

Significance of rights issue

1. The number of rights that a shareholder gets is equal to the number of shares

held by him.

2. The number rights required to subscribe to an additional share is determined by

the issuing company.

3. Rights are negotiable. The holder of rights can sell them fully or partially.

4. Rights can be exercised only during a fixed period which is usually less than

thirty days.

5. The price of rights issues is generally quite lower than market price and that a

capital gain is quite certain for the share holders.

6. Rights issue gives the existing shareholders an opportunity for the protection of

their pro-rata share in the earning and surplus of the company.

7. There is more certainty of the shares being sold to the existing shareholders. If

a rights issue is successful it is equal to favourable image and evaluation of the

company’s goodwill in the minds of the existing shareholders.

Bonus Issues

Bonus issues are capital issues by companies to existing shareholders whereby

no fresh capital is raised but capitalization of accumulated earnings is done. The shares

capital increases, but accumulated earnings fall. A company shall, while issuing bonus

shares, ensure the following:

1. The bonus issue is made out of free reserves built out of the genuine profits and

shares premium collected in cash only.

2. Reserves created by revaluation of fixed assets are not capitalized

3. The development rebate reserves or the investment allowance reserve is

considered as free reserve for the purpose of calculation of residual reserves

only.


243

NOTES


3. The quantum of issue, whether through a right or public issue, shall not exceed

the amount specified in the prospectus/letter of offer. No retention of over

subscription is permissible under any circumstances, except the special case of

exercise of green-shoe option.

4. Within 45 days of the closures of an issue a report in a prescribed form with

certificate from the chartered accountant should be forwarded to SEBI to the

lead managers.

5. The gap between the closure dates of various issues eg., Rights and Indian

public should not exceed 30 days.

6. SEBI will have right to prescribe further guidelines for modifying the existing

norms to bring about adequate investor protection, enhance the quality of

disclosures and to bring about transparency in the primary market.

7. SEBI shall have right to issue necessary clarification to these guidelines to remove

any difficulty in its implementation.

8. Any violation of the guidelines by the issuers/intermediaries will be punishable

by prosecution by SEBI under the SEBI Act

9. The provisions in the Companies Act, 1956 and other applicable laws shall be

complied in connection with the issue of shares and debentures.


1. Discuss the sources of long-term finance of a company.

2. Critically evaluate equity shares a source of finance both the point of (i) the

company and (ii) investing public.

3. Discuss the features of preference shares and evaluate preference share capital

from the company’s point of view.

4. What are right shares? Explain the significance of the same from the company’s

and investors’ view point.

5. Define ‘debenture’ and bring out its salient features as an instrument of corporate

financing.

6. Explain the different types of debentures that may be issued by a company.

7. What are the advantages and disadvantages of debenture finance to a company?

8. List out the SEBI guidelines for issuing bonus shares.


245

NOTES


1. The applicant concerned include the following should have obtained industrial

license or should have made some kind of commitment, where necessary

2. The applicant should have obtained/applied for permission of the Securities

and Exchange Board of India to issue capital, wherever necessary

3. The applicant should have obtained the approval of the Government regarding

the terms of technical and/or financial collaboration agreement, if any.

4. The applicant should have a clearance from the Capital Goods Committee in

respect of the machinery proposed to be imported

5. The applicant should have selected a site for the location of the factory and has

prepared a detailed ‘project report’.

After the receipt of the filled up application in triplicate in the case of non-corporate

units and quadruplicate in the case of corporate bodies, the project is appraised by a

team of technical, financial and economic officers of the Corporation from several angles

— technical, financial, economic, managerial and social.

3.2 Appraisal by Financial Insitution:

1.Technical Appraisal

The technical appraisal of the project involves a critical analysis of the following:

1. Feasibility of the selected technical project and its suitability in Indian conditions.

2. Location of the project in relation to the sources and availability of inputs —

raw materials, water, power, transport, skilled and unskilled labour and in relation

to the market to be served by the product/service.

3. Adequacy of the plant and machinery and their specifications

4. Adequacy of the plant layout

5. Arrangements for securing technical know-how, if necessary

6. Availability of skilled and unskilled labour and arrangements for training for the

labourers.

7. Provision for the disposal of factory effluents and utilisation of byproducts if

any.

8. Whether the process proposed for selection is technically sound up-to-date

etc.

Another important feature of technical appraisal relates to the technology to be

adopted for the project. In case of new technical processes adopted from abroad,

attention is to be paid to the terms and conditions.

2.Economic Appraisal

The economic appraisal of a project involves:

1. Consideration of natural and industrial property of the project and contribution

to the national economy of the country in terms of contribution to GDP, down

stream and upstream projects.


247

NOTES


totally less developed areas and projects that stimulated small scale industries are

considered to serve the society well. The social benefits are more. The social cost of

pollution consumption of scarce resources, etc. is also to be weighed.

Conditions for Assistance from Financial Institutions

Different financial institutions stipulate different kinds of conditions depending

on the nature of the project, the borrower etc. The main conditions of a term loan are as

follows:

1. The borrower (applicant) has to obtain all relevant Government clearances

such as licensing, capital goods clearance for imported machines, import license,

clearance from pollution control board, etc.

2. For consortium loan, the borrower has to satisfy all the institutions participating

in lending

3. Concurrence of the financial institution is necessary for repayment of any existing

loan or long-term liabilities.

4. The term loan agreement may stipulate the debt-equity ratio to be followed by

the company.

5. As long as the loan is outstanding, the declaration of dividend is made subject

to the institution’s approval.

6. The term lending institution reserves the right to nominate one or more directors

in the management of the company.

7. Once the loan agreement is signed, any major commercial agreements such as

orders for equipment, consultancy, collaboration agreement, selling agency

agreement etc. and further expansion need the concurrence of the term lending

institution.

8. The borrower is not permitted to create any additional charge on the assets

without the knowledge of the financial institutions.

9. The financial institutions may appoint suitable personnel in the areas of marketing,

research and development, depending upon the nature of the project.

10. The promoters cannot dispose their shareholders without the consent of the

lending institutions. This is stipulated for keeping the promoters involved as

long as the institutions are involved in the business.

3.3 Puplic Deposits

Deposits with companies have come into prominence in r cent years. Of these

the more important one are the deposits accepted by trading and manufacturing

companies. The Indian Central Banking Enquiry Committee in 1931 recognized the

importance of public deposits in the financing of cotton textile industry in India in general

and at Ahmedabad in particular. The growth of public deposits has been considerable.

From the company’s point of view, public deposits are a major source of finance to

meet the working capital needs. Due to the credit squeeze imposed by the Research

Bank of India on bank loans the corporate sector during 1970s 1980s and also due to


249

NOTES


loans accepted from the public and guaranteed by the directors. Now the term

deposit covers “an money received by a non-banking company by way of

deposit or loan or in any other form but excludes money raised by way of share

capital or contributed as capital by proprietors”.

ii. The second aspect of the Reserve Bank’s regulation is the limit on the period of

such deposit. Formerly, in order to avoid direct competition with short-term

public deposits, companies were prohibited from accepting deposits for a period

of less than 12 months. But the 1973 amendment reduced the period to less

than 6 months. The short-term deposit is now pegged down to 10 per cent of

the garagate of the paid-up capital and free reserves of the company while

secured and unsecured deposits shall not exceed 15 per cent and 25 per cent,

respectively, of the paid-up capital and free reserves.

iii. The Reserve Bank has made obligatory on the part of the companies accepting

deposits to regularly file the returns, giving detailed information about them,

their repayment, etc. so that the Reserve Bank can verify whether the companies

adhere to the restrictions. However such statements are not filed and the Reserve

Bank’s action to prevent a defaulting company from accepting any deposit fails

to afford any protection to the existing depositors.

iv. The Reserve Bank has stipulated that while issuing newspaper advertisements

(or even the application forms) soliciting such deposits, certain specified

information regarding the financial position and the working of the company

must accompany. This clause is often mis-ued as much advertisement often

carried words like “as per Reserve Bank directive”, thereby giving a wrong

impression that these deposits are actually governed by the Reserve Bank.

Now such advertisements would be illegal and attract penal provision prescribed

in this behalf. Similarly, the catalogues and handouts issued by brokers stating

that the companies mentioned therein had complied with Reserve Bank directives

would also attract the penal provision.

v. The Reserve Bank has entrusted the auditors of the companies with additional

responsibilities of reporting to it that the provision under the Act has been strictly

followed by the company.

vi. The Reserve Bank has issued a broad “RBI Directives on Company Deposit in

order to clarify its role in protecting the depositors. The bank has reiterated

that the deposits or loans are fully protected or are absolutely safe merely

because the companies claimed to have complied with the RBI directives and

that they should not presume that the Reserve Bank can come to their rescue in

the event of failure of a company to meet its obligations.


1. What do you mean by Public Deposits? Explain their merits and

demerits.

2. Explain the types of appraisal to be made in sanctioning project

finance.


251

NOTES


high inflationary pressures and set back in industrial and finance sector. In the year

1991, Sri P.V. Narasimha Rao’s government with a view to bring inflation under control

and to restore normalcy. In the economy introduced the new industrial policy was

introduced.

Liberalization in industrial licensing, foreign investment, foreign technology

agreements, disinvestment of public sector units and MRTP Act amendments were

introduced. The new import and export policy brought series of changes in the economic

environment. All these attracted the financial sector. Both primary and secondary markets

started functioning as per the requirements of the market. New financial products were

introduced. Technology in banks and customer service have improved. Competitive

financial market was created focusing on needs of customers. This resulted in the

witnessing of new financial instruments in the market Viz., Leasing, Hire-purchase

Factoring, Forfeiting, Global Depository Receipts, Venture capital etc.,


On going through this lesson, you will be conversant with

• Definition and meaning of venture capital

• Characteristic features of venture fund

• Venture capital investment process

• Stages of financing

• Types of organizations

• Venture capital financing in India

• Guidelines on venture funds capital

• Present scenario of venture capital financing

The new financial instrument ‘Venture Capital’ is discussed in detail.

3.SECTION TITLE

3.1 Definition

Venture Capital

It is defined as long-term funds in equity or semi-equity form to finance hi-tech

projects involving high risk and yet having strong potential of high profitability.

The term ‘Venture Capital’ refers to capital investment made in a business or

industrial enterprise, which carries elements of risk and insecurity and the probability of

business hazards. Capital investment may assume the form of either equity or debt or

both as a derivative instrument, The risk associated with the enterprise could be so high

as to entail total loss or be so insignificant as to lead high gains. Generally, the investment

is made in the form of equity with the prime objective being capital gains as the business

prospers. Equity investment enables the investor to the investment into cash when

required.


253

NOTES


3.4 Venture Capital Investment Process

Financing of a High tech., project under venture capital has following steps.

They are:

1. Establishment of contact between the entrepreneur and the venture

capitalist: The Prospective entrepreneur, with his know how prepares a project report

establishing there in the possibility of marketing a commercial product. This can be

done with the help of auditor, professional or a merchant banker. The business consists

of five important feasibility reports namely, Technical, Financial, Managerial, Marketing

and Socio-economic feasibility. The formal application in duplicate will be submitted to

venture capital investor.

2. Preliminary Evaluation: After the preliminary evaluation of the report is

completed, venture capital investor normally discusses the investment plan for the project

with the banker. During this stage close net work is expected from the management

team, to implement the project.

3. Detailed Approval: In addition to the close discussion with the management

team, a detailed appraléal of project is undertaken. Techno-economic feasibility will be

examined by involving the executives of the Venture capital Investor and the management

professional. If required they may even consult the experts In the similar field to take a

decision.

4. Sensitivity Analysis: The Forecasted results of sales and profits are tested

and analysed. The risks and threats will be evaluated by using sensitivity analysis.

Sensitivity analysis helps the evaluators to predict the probable risks and returns

associated with the project. This formally clears the project for investment.

5. Investment in the project: The terms and conditions of venture capital

assistance will be finalised according to the requirement of the project. The amount of

funds required, profile of the business, the life time technology and the possible

competition in the business will be looked into. A formal agreement is entered between

the technocrat and investor stating therein the role of and share of management in the

new project.

6. Monitoring the Project and post investment support: The venture capitalist

role begins with financing the project. It is a general practice of the Investor to appoint

an executive director to have closer look in to the project. The executive director

assists the project in developing strategies, decision-making and planning. The process

of interaction with the technocrat increases the healthy environment in carrying the day-

to-day business affairs.


255

NOTES


and negotiate the terms and conditions with the entrepreneur with regard to sharing the

management.

(c) Second round of financing: This type of financing is required when the

project incurs loss or inability to yield sufficient profits. The reasons could be due to

internal or external factors. At this stage, if the venture capitalists is fully aware of the

genuine reasons for the loss, he should decide on second round financing, or he may

seek the support of new investor. This is a complex process as the original investor may

express his inability to further finance the project or entrepreneur must have lost the

confidence with the original investor or he may wishes to broad base the investment

pattern. Lot of bargaining has be done to coordinate the financing with original investor

and with the technocrat or promoter.

(2) Later Stage Financing

Later stage financing is considered to be the easy means of assistance. The

reason being, the product launched has not only reached the boom period but also

indicator further expansion and growth. Hence it is a easy means of financing with low

risk profile. The real problem associated at this stage is entrepreneur not be willing to

give majority of his stake to the venture capitalists but may accept for more number of

executive directors in the board. This means of is also known as expansion finance,

replacement capital, management buy out and turn around capital.

(a) Expansion finance: Later stage financing is executed to expand the market,

production or to establish warehouses etc., Export trade activities may also be considered

for financing the project.

(b) Replacement capital): Under this stage, the promoter may prefer to buy

the entire equity stake of the project by approaching some other financiers. He may

also wish to increase his holding by buying more number of equity shares. Replacement

capital) is normally preferred at the time of public issues. If the company is unlisted,

getting capital gains on the fresh issues needs more time, tilt then replacement capital

can be obtained in the form of convertible preference shares from the second financier.

(c) Management Buy out (MBO): This may be offered in two ways namely.

‘Management buy out’ or ‘Management buy int. In management buy out, venture

capitalist help the management of a company to buy or take over the ownership of the

business. This would help the management to reshuffle or reengineer the entire project.

In management buy in strategies, outsides prefers to buy the existing business.

This means of financing is less risky, it is not considered as venture capital and has wide

criticism.


257

NOTES


unavoidable with ‘minimum loss’. There are alternative routes of disinvestment practiced

in a real life situation. They are:

(a) Going public

(b) Sale of shares to entrepreneurs

(c) Sale of the company to another company

(d) Finding a new investor

(e) Liquidation

(a) Going Public: Most of the venture capital assisted firms prefers to go in for

public issue to recover their investments with profits. This process not only help the

entrepreneur but also the investor in different ways. The main benefit of going public

increases the liquidity of the business firm. This liquidity will increase the percentage

returns over the private placements. (If it were sold through private placements). The

public issues provides another opportunity for the business firm to list its shares in the

stock market. Once the shares are listed, it increases the image of the organization. In

addition to this, it increases and attracts efficient persons to work in the organization. In

addition to this, the commercial banks and financial institutors will forward to offer

different types of loans. If the firm wishes to raise additional capital for expansion and

growth, it could be done easily through the public issue.

However, going public is not an easy route to exit or venture capital assisted

units because, it has to observes several legal for’ of stock exchange. The company

must also disclose part a considerable ar1t of information at the time of issuing the

shares; this could be a sales threat with the global competition. Employees may ask for

better comfort with huge hike in the salaries and perks. The expenditure incurred

during the course of the issue in also substantially high, which may affect the profitability.

As the company is going for public issue, its social responsibility increases and they

have to be accountable to all the organs of the society, which burdens the financial

affairs of the company. With all these demerits or bottlenecks going public for exit route

is widely used in seal life situations.

(b) Sale of shares to entrepreneur: Some times, promoter may prefers to have exit

route through, Over The Counter Exchange by entering into bought out deals with the

member of O.T.C. He may purchase the shares with a view of entering in to the primary

market at the later stage.

In certain circumstances, an entrepreneur himself prefers to buy the entire shares.

He may even buy the shares with the help of his own group-even the employees are

allowed to do so at an agreed price for buying such shares. If necessary, the entrepreneur

may approach financial institutions for loans. The price at which the stake of the V. C.

assisted may be done as several methods. Viz.,


259

NOTES


entrepreneur decides to close down the operations. Hence, it takes the firm to liquidation.

The reason for such a exercises would be many viz., stiff competition, technological

failure, poor management by the entrepreneur etc.,


1. Define the term ‘Venture Capital’

2. Explain the process Venture Capital investment.

3. Mention the different characteristic features of Venture Capital

4. What is early stage financing? Explain.

5. What is later stage financing? Explain.

Financial Management

Documents

Transcript of Financial Management