Professional Documents
Culture Documents
The branch of knowledge that deals with the art and science of managing money
is called financial management. With liberalization and globalization of Indian
economy, regulatory and economic environments have undergone drastic
changes. This has changed the profile of Indian finance managers today. Indian
financial managers have transformed themselves from licensed raj managers to
well informed dynamic proactive managers capable of taking decisions of
complex nature in the present global scenario.
Traditionally, financial management was considered a branch of knowledge with
focus on the procurement of funds. Instruments of financing, formation, merger &
restructuring of firms, legal
and institutional frame work involved therein occupied the prime place in this
traditional approach.
Two Basic Functions of Financial Management
Procurement of Funds:
Funds can be obtained from different sources having different characteristics in
terms of risk, cost and control. The funds raised from the issue of equity shares
are the best from the risk point of view since repayment is required only at the
time of liquidation.
DEFINITION OF FINANCE
According to Khan and Jain, Finance is the art and science of managing
money.
Financial Management:
According to Oxford dictionary, the word finance connotes management of
money. Websters Ninth New Collegiate Dictionary defines finance as the
Science on study of the management of funds and the management of fund as
the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.
DEFINITION OF FINANCIAL MANAGEMENT
According to the Wheeler, Business finance is that business activity which
concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise.
According to the Guthumann and Dougall, Business finance can broadly be
defined as the activity concerned with planning, raising, controlling, administering
of the funds used in the business.
In the words of Parhter and Wert, Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating
in nonfinancial fields of industry.
According to Howard & Upton, Financial management is the application of the
planning & control functions of the finance function.
According to J. F. Bradley, Financial management is the area of business
management devoted to the judicious use of capital & careful selection of
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern. Profit maximization consists of the following
important features.
1. Profit maximization is also called as cashing per share maximization. It leads
to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.
Wealth maximization can be activated only with the help of the profitable
position of the business concern.
on the field of finance because, it is a very emerging part which reflects the entire
operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance
function.
He must have entire knowledge in the area of accounting, finance, economics
and management. His position is highly critical and analytical to solve various
problems related to finance. A person who deals finance related activities may be
called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate
the financial requirement of the business concern. He should estimate, how
much finances required to acquire fixed assets and forecast the amount needed
to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate
how the finance is mobilized and where it will be available. It is also highly critical
in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and
consider the reasonable and stable return from the investment. He must be well
versed in the field of capital budgeting techniques to determine the effective
utilization of investment. The finance manager must concentrate to principles of
safety, liquidity and profitability while investing capital.
4. Cash Management
Present days cash management plays a major role in the area of finance
because proper cash management is not only essential for effective utilization of
cash but it also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing,
production, personel, system, research, development, etc. Finance manager
should have sound knowledge not only in finance related area but also well
versed in other areas. He must maintain a good relationship with all the
functional departments of the business organization.
Department-I
Department-II
Department-III
Department-IV
Forecasting Funds
Managing Funds
Investing Funds
Finance
Manager
Acquiring Funds
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to
improve the profitability position of the concern with the help of strong financial
control devices such as budgetary control, ratio analysis and cost volume profit
analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of
the investors and the business concern. Ultimate aim of any business concern
will achieve the maximum profit and higher profitability leads to maximize the
wealth of the investors as well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability
and maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.
Nowadays financial management is also popularly known as business finance or
corporate finances. The business concern or corporate sectors cannot function
without the importance of the financial management.
Cost Of Capital
INTRODUCTION:
It has been discussed in lesson -4 that for evaluating capital investment
proposals according to the sophisticated techniques like Net Present Value and
Internal Rate of Return, the criterion used to accept or reject a proposal is the
cost of capital. The cost of capital plays a significant role in capital budgeting
decisions. In the present lesson the concept of cost of capital and the methods
for its computation are explained.
COST OF CAPITAL-KEY CONCEPTS:
The term cost of capital refers to the minimum rate of return a firm must earn on
its investments. This is in consonance with the firms overall object of wealth
maximization. Cost of capital is a complex, controversial but significant concept
in financial management.
The following definitions give clarity management.
Hamption J.: The cost of capital may be defined as the rate of return the firm
requires from investment in order to increase the value of the firm in the market
place.
James C. Van Horne: The cost of capital is a cut-off rate for the allocation of
capital to investments of projects. It is the rate of return on a project that will
leave unchanged the market price of the stock.
Soloman Ezra:Cost of Capital is the minimum required rate of earnings or the
cut-off rate of capital expenditure.
It is clear from the above definitions that the cast of capital is that minimum rate
of return which a firm is expected to earn on its investments so that the market
value of its share is maintained. We can also conclude from the above definitions
that there are three basic aspects of the concept of cost of capital:
i) Not a cost as such: In fast the cost of capital is not a cost as such, it is the
rate of return that a firm requires to earn from its projects.
ii) It is the minimum rate of return: A firms cost of capital is that minimum rate
of return which will at least maintain the market value of the share.
iii) It comprises three components:
K=ro+b+f
Where, k=cost of capital;
ro= return at zero risk level:
b = premium for business risk, which refers to the variability in operating profit
(EBIT) due to change in sales.
f = premium for financial risk which is related to the pattern of capital structure.
ii) Capital structure decisions: An optimal capital is that structure at which the
value of the firm is Value of the firm is maximum and cost of capital is the lowest.
So, cost of capital is crucial in designing optimal capital structure.
iii) Evaluation of final Performance: Cost of capital is used to evaluate the
financial performance of top management. The actual profitabily is compared to
the expected and actual cost of capital of funds and if profit is greater than the
cast of
capital the performance nay be said to be satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other
financial decisions as dividend policy, capitalization of profits, making the rights
issue, etc.
CLASSIFICATION OF COST OF CAPITAL :
Cost of capital can be classified as follows:
i) Historical Cost and future Cost: Historical costs are book costs relating to
the past, while future costs are estimated costs act as guide for estimation of
future costs.
ii) Specific Costs and Composite Costs: Specific accost is the cost if a specific
source of capital, while composite cost is combined cost of various sources of
capital. Composite cost, also known as the weighted average cost of capital,
should be considered in capital and capital budgeting decisions.
iii) Explicit and Implicit Cost: Explicit cost of any source of finance is the
discount
rate which equates the present value of cash inflows with the present value of
cash
outflows. It is the internal rate of return and is calculated with the following
formula;
iv) Average Cost and Marginal Cost: An average cost is the combined cost or
weighted average cost of various sources of capital. Marginal cost of refers to the
average cost of capital of new or additional funds required by a firm. It is the
marginal cost which should be taken into consideration in investment decisions.
DETERMINATION OF CAST OF CAPITAL:
As stated already, cost of capital plays a very important role in making decisions
relating to financial management. It involves the following problems.
Problems in determination of cost of capital:
i) Conceptual controversy regarding the relationship between cost of capital and
capital structure is a big problem.
ii) Controversy regarding the relevance or otherwise of historic costs pr future
costs in decision making process.
iii) ReComputation of cost of equity capital depends upon the excepted rate of
return by its investors. But the quantification of expectations of equity
shareholders is a very difficult task.
iv) Retained earnings has the opportunity cost of dividends forgone by the
shareholders. Since different shareholders may have different opportunities for
reinvesting dividends, it is very difficult to compute cost of retained earnings.
v) Whether to use book value or market value weights in determining weighted
average cost of capital poses another problem.
NP Rs. 2,15,600
[net proceeds = Rs. 2,00,000 + 20,000 (2/100x2,20,000)]
Redeemable debt
The debt repayable after a certain period is known ad redeemable debt. Its cost
computed by using the following formula:
I+1/n (P-NP)
i) Before tax cost of debt =
(P+NP)
I = interest: P= proceeds at par;
NP = net proceeds; n = No. of years in which debt is to be redeemed
ii) After tax of debt = Before tax cost of debt x(1-t)
Example
A company issued Rs. 1,00,000 10% redeemble debentures at a discount of
50%. The cost of floatation amount to Rs. 3,000. The debentures are redeemable
after 5 years. Compute before
TAx and after tax Cost of debt. The rate is 50%.
Solution :
I+1/n (P-NP)
i) Before tax cost of debt = (P+NP)
10,000+1/5(1,00,000-92,000) = (1,00,000+92,000)
10,000-16000 11,000 = = =12.08% 96,000 96,000
[NP=1,00,000 5,000 3,000=92,000]
After tax cost of debt = Before tax cost x (1-t)=12.08X(1-.5)=6.04%
Solutions :
Cost of preference capital, (Kp) = D/NP
a) When issued at par:
Rs. 10,000 10,000
Solution
D + 1/n MV- NP
KP = 100
(MV+NP)
a) Cost of preference capital , if redeemable at par:
Rs. 1,00,000 +1/10 (10,00,000 10,00,00) Rs. 1,00,000
KP = x100 x100 = 10%
(10,00,000 +10,00,000) Rs. 10,00,000
b) If redeemable at a premium of 5% Kp =
Rs. 1,00,000 +1/10 (10,50,000 10,00,00)
KP = x100
(10,50,000 +10,00,000)
Rs. 1,00,000 + 5,000 Rs. 1,05,000
= X100 x100 = 10.24%
Rs. 10,25,000 Rs. 10,25,000
Example:
ABC Ltd plans to issued 1,00,000 new equity share of Rs. 10 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a
dividend of Rs. 1 per share and the growth rate in dividend is expected to be 5%.
Compute the cost of new issue share.
If the current the cost of new issue of shares.
Solution :
Cost of new equity shares = (Ke) = D/NP +g
Ke = 1 / (10-5-) + 0.05 = 1 / 9.5 + 0.05
= 0.01053 + 0.05
= 0.1553 or 15.53%
Kr = Ke = D/NP+g
However, while calculating cost of retained earnings, two adjustments should be
made:
a) Income-tax adjustment as the shareholders are to pay some income tax out of
dividends, and
b) adjustment for brokerage cost as the shareholders should incur some
brokerage cost while investment dividend income. Therefore, after these
adjustments, cost of retained earnings is calculated as:
Kr = Ke (1-t)(1-b)
Where, Kr = cost of retained earnings
Ke = Cost of equity
t = rate of tax
b = cost of purchasing new securities or brokerage cost.
Example
A firm s cost of equity (Ke) is 18%, the average income tax rate of shareholders
is 30% and brokerage cost of 2% is excepted to be incurred while investing their
dividends in alternative securities. Compute the cost of retained earnings.
Solution : Cost of retained earnings = (Kr) = Ke (1-t)(1-b)=18(1-.30)(1-.02)
=18x.7x.98=12.35%
WEIGHTED AVERAGE COST OF CAPITAL:
It is the average of the costs of various sources of financing. It is also known as
composite or overall or average cost of capital. After computing the cost of
individual sources of finance, the weighted average cost of capital is calculated
by putting weights in the proportion of the various sources of funds to the total
funds.
Weighted average cost of capital is computed by using either of the following two
types of weights:
1) Market value 2) Book Value
Market value weights are sometimes preferred to the book value weights as the
market value represents the true value of the investors. However, market value
weights suffer from the following limitations:
i) Market value are subject to frequent fluctuations.
ii) Equity capital gets more importance, with the use of market value weights.
Moreover, book values are readily available.
Average cost of capital is computed as followings:
Kw = KW
W
Where, Kw = weighted average cost of capital
X = cost of specific sources of finance
W = weights (proportions of specific sources of finance in the total)
The following steps are involved in the computation of weighted average cost of
capital:
i) Multiply the cost of each sources with the corresponding weight.
ii) Add all these weighted costs so that weighted average cost of capital is
obtained.
The weighted average cost of capital
(WACC) is a common topic in the financial management examination. This rate,
also called the discount rate, is used in evaluating whether a project is feasible or
not in the net present value (NPV) analysis, or in assessing the value of an asset.
Previous examinations have revealed that many students fail to understand how
to calculate or understand WACC.
Basically there are two approaches in finding the cost of equity: the dividend
growth approach and the capital asset pricing model (CAPM) approach. Using
the dividend approach,
Po = D1 / (Re - g)
where
Po is the current stock price or price of the stock in period 0.
D1 is the dividend in period 1
Re is the cost of equity
g is the dividend growth rate
Re = D1 / Po + g
This approach only applies to dividend-paying stock as we need to determine the
dividend growth rate. The other approach is the CAPM, which was developed by
Sharpe, a Nobel Prize winner in economics in 1990.
Re = Rf + Bex (Rm - Rf )
Using CAPM, the risk free rate (Rf ) and market return (Rm) have to be found, as
does the stocks beta. There are many arguments about how best to determine
the risk free rate, market return and the beta. However, CAPM is relatively more
commonly used than the dividend growth model since most stocks do not have a
stable dividend history. When calculating the cost of debt, we do not use the
coupon rate of the bond as reference. Rather, we use the yield rate. For
example, if a bond has coupon rate of 3% and a market price of 103, this implies
that the actual yield is less than 3%. Let me use an example to illustrate. On the
equity side, a company has 50 million shares with market price of $80 per share.
The beta of the stock is 1.15 and market risk premium is 9%. The risk-free rate is
5%. On the debt side, the company has $1 billion outstanding debt (face value).
The current price of the debt
is 110 and the coupon rate is 9%: the company pays semi-annual coupons with
15 years to maturity. Assume the tax rate is 15%.
To find the cost of equity,
Re = 5 + 1.15(9) = 15.35%
Remember the market risk premium is Rm-Rf. Since this is given, we need not
deduct 5% from 9%. To find cost of debt, we turn to the bond pricing equation
and find r.
P = C x [1 - 1/(1 + r )t]/r + F x 1/(1 + r )t
We may assume the face value of individual bond = $1,000. Since C = $45
remember its a semiannual payment), t = 30, P = $1,100,
F=$1,000, we find that r = 3.9268%.
(You may need to use a computer or estimation method to find r.)
Since the cost of debt is given on an annual basis, Rd = 2 x 3.9268% =
7.854%. In calculating WACC, we use the after-tax cost of debt. (This is
because interest payments are eligible for tax deductions.) If the interest rate is
7.854%, taking into account the tax deduction, the actual interest rate must be
lower. Thus the after tax
cost of debt is 7.854% x (1-15%) = 6.6759%.
A useful way of checking your answer is to remember that, for most companies,
the cost of debt (before tax) is usually lower than the cost of equity. If you
calculate Re to be less than Rd, you have probably made a mistake. We have
the cost of debt and cost of equity; now we need to find the firms value. The
values are as follows:
Companies MUST consider the cost of financing they receive in the form of
equity or debt if they are to manage their finances better; cheaper finance cost to
the company means higher profitability and in most cases, superior cash flow.
Generally, the cost of EQUITY has no tax effect but the cost of DEBT finance to
companies are technically SUBSUDISED by tax since INTEREST (cost of Debt)
can be claimed for tax purposes in so far as it is wholly, exclusively and
necessarily incurred for business purposes.
The Cost of Equity
Assumptions of the Dividend Valuation Model (DVM) Investors only buy shares to
acquire a future dividend stream. All investors have homogeneous (i.e. identical)
expectations of this future dividend stream. The stock market is extremely
efficient at pricing securities. Present Value (PV) of dividend stream = current
share price
(current market price of share).
An Example:
Assuming CONSTANT dividend streams of income (Investors perspective) A plc
has paid a dividend of 50p per share for many years. This is expected to
continue for the foreseeable future. A plcs current share price is 2.50 ex div.
You are required to calculate the cost of equity of X plc, Ke.
Solution:
Present value (PV) of dividend stream = current share price (see
assumption 4 above please)
50p
Ke
= 250p _ Ke =
250 p
50 p = 20% per annum
Note:
Current share price used is Ex. Div. (i.e. without the next dividend
payment).
Constant dividend divided by Cost of Equity equals Current share Price
Assuming INCREASING dividend streams of income (Investors
perspective)
To deal with an increasing perpetuity we need a formula.
PV of dividends = current share price
K g D e 1 = P0 or K e = 0 1 P D + g
An Example
D plc has just paid a dividend of 30p per share. Shareholders
expect dividends to grow at 5% pa. The current share price is 1.80
ex div.
D1 = 30p x 1.05 = 31 p
P0 = 180 p
Ke = 0 1 P D + g = 180p
31 + 5 = 22%
Note: If the market capitalisation is given in cum div terms it will need to be
converted to the ex div equivalent for use in the formula
If given profit and loss and balance sheet information growth can be estimated as
follows:
First we calculate the retention or plough back rate from the profit and loss
account. (If 100% profit is retained = 100% retention rate)
Retention rate = profit after tax
retained profit 100%
Secondly we calculate the return on capital employed (ROCE)
from the profit and loss account and balance sheet (as normally
done in Ratio analysis or Interpretation of Accounts)
ROCE = opening net assets
profit after tax 100%
Redeemable debentures
A redeemable debenture will pay the holder interest for a number of years, then
will be redeemed for a capital sum by the company (i.e. company will BUY BACK
debt Debentures). Here an IRR computation is appropriate.
An Example
N plc has some 10 per cent coupon debentures in issue redeemable in five years
at par. They are currently trading at 90 ex int. Interest is paid annually. Tax is at
30%.
Solution
The cost of debt would be the IRR of the following debt flows (as they affect the
company) estimated by interpolation in the usual way:
Cash flow
t0 90.00 Benefit to company of retaining debentures
t1 t5 (7.0) Net of tax interest cost
t5 (100.0) Redemption cost
Cost of retained earnings (ks) is the return stockholders require on the companys
common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a)CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate
the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (r m).
The next step is to estimate the companys beta (b i), which is an estimate of the
stocks risk. Inputting these assumptions into the CAPM equation, you can then
calculate the cost of retained earnings.
Formula
For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained
earnings for Newco using the CAPM approach?
Answer:
Formula
ks = long-term bond yield + risk premium
Formula
g = (retention rate)(ROE) = (1-payout rate)
(ROE)
Example: discounted cash flow approach
Assume Newcos stock is selling for $40; its expected return on equity (ROE) is
10%, next years dividend is $2 and the company expects to pay out 30% of its
earnings. What is the cost of retained earnings for Newco using the discounted
cash flow approach?
Answer:
Solution,
If the company issues new preference shares, the cost of preference capital
would be:
Kp = Annual dividend / Net proceeds after floatation costs, if any.
Example: A limited company issues 8% preference shares which are
irredeemable. The face value of share is $100 but they are issued at $105. The
floatation cost is $3 per share.
Kp = $8/($105-$3) = 7.84%
If the floatation costs are expressed as percentage, the formula will take the
following shape:
= 8.27%
(100 + 97) / 2
An Example irredeemable debentures
M plc has some 8 per cent coupon irredeemable debentures in issue trading at
90 ex int. Corporation tax is 30 per cent with no lag in payment. Interest is paid
annually.
Solution
PV of aftertax interest = current debenture price
8(1 0.30) Kd = 90
Kd =90
5.60 = 6.2% per annum
Note: The calculation is made Ex. Int. (meaning Exclusive of the next Interest to
be received)
Redeemable debentures
A redeemable debenture will pay the holder interest for a number of years, then
will be redeemed for a capital sum by the company (i.e. company will BUY BACK
debt Debentures). Here an IRR computation is appropriate.
An Example
N plc has some 10 per cent coupon debentures in issue redeemable in five years
at par. They are currently trading at 90 ex int. Interest is paid annually. Tax is at
30%.
Solution
The cost of debt would be the IRR of the following debt flows (as they affect the
company) estimated by interpolation in the usual way:
Cash flow
t0 90.00 Benefit to company of retaining debentures
t1 t5 (7.0) Net of tax interest cost
t5 (100.0) Redemption cost
DEBENTURES
KINDS OF DEBENTURES
(a)Bearer Debentures:
They are registered and are payable to the bearer. They are negotiable
instruments and are transferable by delivery.
(b) Registered Debentures:
They are payable to the registered holder whose name appears both on the
debentures and in the Register of Debenture Holders maintained by the
company. Registered Debentures can be transferred but have to be registered
again. Registered Debentures are not negotiable instruments. A registered
debenture contains a commitment to pay the principal sum and interest. It also
has a description of the charge and a statement that it is Issued subject to the
conditions endorsed therein.
deep discount bonds for Rs 1 lakh repayable after 25 years were sold at a
discount price of Rs. 2,700.
(n) Zero-Coupon Convertible Note:
A zero-coupon convertible note can be converted into shares. If choice is
exercised investors forego all accured and unpaid interest. The zero-coupon
convertible notes are quite sensitive to changes in interest rates.
(o) Secured Premium Notes (SPN) with Detachable Warrants:
SPN which is issued along with a detachable warrant, is redeemable after a
notice period, say four to seven years. The warrants attached to it ensures the
holder the right to apply and get allotted equity shares; provided the SPN is fully
paid.
There is a lock-in period for SPN during which no interest will be paid for an
invested amount. The SPN holder has an option to sell back the SPN to the
company at par value after the lock in period. If the holder exercises this option,
no interest/ premium will be paid on redemption. In case the SPN holder holds its
further, the holder wili be repaid the principal amount along with the additional
amount of interest/ premium on redemption in instalments as decided by the
company. The conversion of detachable warrants into equity shares will have to
be done within the time limit notified by the company.
(p) Floating Rate Bonds:
The rate on the floating Rate Bond is linked to a benchmark interest rate like the
prime rate in USA or LIBOR in eurocurrency market. The State Bank of India's
floating rate bond was linked to maximum interest on term deposits which was 10
percent. Floating rate is quoted in terms of a margin above or below the bench
mark rate. The-floor rate in the State Bank of India case was 12 per cent. Interest
rates linked to the bench mark ensure that neither the borrower nor the lender
suffer from the changes in interest rates. When rates are fixed, they are likely to
be inequitable to the borrower when interest rates fall subsequently, and the
same bonds are likely to be inequitable to the lender when interest rates rise
subsequently.
Chapter-2
techniques in order to determine which project has potential to yield the most
return over an applicable period of time.
Capital budgeting is the process which enables the management to decide
which, when and where to make long-term investments. With the help of Capital
Budgeting Techniques, management decide whether to accept or reject a
particular project by making analysis of the cash flows generated by the project
over a period of time and its cost. Management decides in favor of project if the
value of cash flows generated by the project exceeds the cost of undertaking that
project.
Must always lead to the correct decision when choosing among mutually
exclusive projects.
of time where as the benefits of the expenditure are realized at all points of time in future.
The following are some of the elements of capital expenditure.
1) Cost of acquisition or purchase in permanent assets such as land and building
plant and machinery etc.
2) Cost of addition, expansion, improvement or alteration in the fixed asset.
3) Research and development product cost etc.
Definition:According to CHARLES-T-HORANGREEN Capital budgeting is long term
planning for making and financing a proposed capital outlay.
According to RICHARD & GREENLAW Capital Budgeting is acquiring inputs
with long run return.
According to LYNCH Capital Budgeting consist in planning & development of
available capital for the purpose of maximizing the long term profitability of the
concern.
NEED & IMPORTANCE OF Capital Budgeting:1) It involves large investment of funds.
2) The large funds are invested more or less on permanent basis.
3) This decision is irreversible in nature.
4) It has long term effect on profitability.
PROCESS OF CAPITAL BUDGETING OR STEPS IN C.B.:1) Identification of investment proposal.
2) Screening the proposal.
3) Evaluation of various proposals.
4) Fixing priorities.
5) Preparation of budget.
6) Implementing proposals.
7) Performance review.
METHODS OR TECHNIQUES OF CAPITAL BUDGETING:Traditional Method:a) Pay Back period
b) Average rate of return method (ARR)
A. PAYBACK PERIOD (PBP)
The term payback period refers to the period in which the product will generate the
necessary cash to recover the initial investment.
Accept or Reject criteria:The selection of the project is based on the earning capacity of the project. A cut off
period for the project is fixed if the payback period is lower than the cut off period such
projects are accepted.
CALCULATIONS OF PAYBACK PERIOD:I.
20,000-00
2) The project cost Rs. 5,00,000-00 gives annually a profit of Rs. 80,000-00 after
depreciation at 12% p.a. But before tax of Rs. 50%, calculate the PBP.
Calculation of cash inflow
Earnings Rs.
Before (-) tax at 50%
80,000-00
40,000-00
40,000-00
60000
100000
100000
1) A project requires an initial cash outlay of Rs. 1,00,000-00 and generates cash inflows
as under.
Year
Cash inflows
1
2
3
4
5
6
7
8
10000
20000
25000
40000
10000
10000
10000
5000
10000
20000
25000
40000
10000
10000
10000
5000
10000
30000
55000
95000 1st year
105000 2nd year
115000
125000
130000
Calculation of PBP
Machine X
CI
CCI
15000
15000
20000
35000
25000
60000
15000
75000
10000
85000
Year
1
2
3
4
5
PBP =
Machine Y
CI
CCI
5000
5000
15000
20000
20000
40000
30000
70000
20000
90000
1st year
2nd year
60000 - 35000
= 2 + 15000
70000 - 40000
= 3 + 10000
25000
30000
= 2 + 0.6 = 2.6
= 3 + 0.33 = 3.33
2 years 7 months
3 years 4 months
Since machine X PBP is less compare to machine Y that means machine X takes 2
years and seven months to payback 50,000-00 and machine Y takes 3 years and 4
months to payback 50000-00. Therefore as finance the investment on X to be accepted
and machine Y should be rejected.
3) From the following information suggest which project should be selected.
Particulars
Cost of project
Net cash flows
1
2
3
4
5
6
Project A Project B
180000
180000
80000
64000
40000
20000
15000
40000
42000
60000
80000
32000
5000
Calculation of PBP
Year
1
2
Project A
CI
CCI
80000 80000
64000 144000 1st year
Year
1
2
Project B
CI
CCI
40000 40000
42000 82000
3
4
5
6
PBP =
40000
2000
15000
3
4
5
6
60000
80000
32000
5000
142000
222000
254000
259000
1st year
2nd year
184000 - 144000
= 2 + 36000
222000 - 142000
= 3 + 38000
40000
= 2 + 0.9 = 2.9
2 years 11 months
80000
= 3 + 0.475 = 3.475
3 years 6 months
According to the PBP method project A should be accepted for investment because it
takes less time (2.0) when compare to project B which takes 3.475.
4) Determine PBP for the following project which requires cash outflow of Rs. 10000/-&
generates the cash inflow of Rs. 2000/-, Rs.4000/-, Rs.3000/- & Rs. 2000/- in the 1st, 2nd,
3rd, & 4th, years respectively.
Year
1
2
3
4
Cash inflows
2,000
4,000
3,000
2,000
PBP =
CCI
2,000
6,000
9,000- 1st year
11,000-II year
5) The following information relating to the machines are available for consideration.
Advice the management which of the 2 machines is preferable.
Particulars
Cost of investment
Estimated life
Machine A
25000
7 years
Machine B
40000
9 years
3,000
4,000
5,000
6,000
7,000
7,200
7,500
7,500
7,500
2,000
5,000
6,000
7,000
8,000
12,000
13,000
13,200
13,400
Calculate PBP
Year
1
2
3
4
5
6
7
8
9
PBP =
CI
3000
4000
5000
6000
7000
7200
7500
Machine A
Year
CCI
3000
1
7000
2
12000
3
18000
4
25000 III year
5
32200
6
39700
7
39700
8
39700
9
Machine B
CI
CCI
2000
2000
5000
7000
6000 13000
7000 20000
8000 28000
12000 40000
13000 53000
13200 66200
13400 79600
I year
II year
According to this method project A should be selected because if takes less time
to PB the investment compare to machine B
II AVERAGE RATE OF RETURN or ACCOUNTING RATE OF RETURN:This method takes into A/c the earnings expected from the investment over there
whole life. If is known as a/c ing rate of return.
ACCEPT OR REJECT CRITERIA:The expected return is determined & the project which has a higher rate of return
than the minimum rate of return called the cut-off rate is accepted & the project which
gives a lower expected rate of return than the minimum rate is rejected.
NOTE
Cash inflow or profit here means profit after fax & after dep
METHODS OF ARR:- or RETURN ON INVESTMENT
1) Average rate of return method :ARR= Average annual profit (after dep & after fax) x100
Net investment
a) Where average annual profit= Total profit
No. years
b) Net investment = original investment-scrap value
2) Return per unit of invt method:
RPU= Total profit (AT & D) x100
Net investment
Return on average investment method:RAI = Total profits (AT & D)
Average investment
Where a) Average investment =Total (original) investment
2
3) Average return or average investment method:Average annual profits x100
Average investment
a) Average investment = original investment-scrap value
2
III.
480000
x 100
Average investment
T.P. = 240000
Average investment = original investment scrap value
2
= 240000 20000 = 480000 = 240000
2
= 240000 = 100%
240000
IV.
Average investment
240000
2) Calculate ARR from the data given below cost of the investment Rs. 630000/-,
scrap value at the end of 5 years Rs. 30,000-00. It is expected to yield profit after
depreciation and taxes during the 5 years.
Year
Profit
I.
1
50000
2
70000
3
80000
4
60000
5
40000
III.
600000
x 100 = 300000 x 100 = 100%
Average investment
300000
Average investment
300000
3) Calculate ARR from the following information cost of the project 10,00,000-00,
scrap value 4,00,000-00, it is expected to generate the cash inflows as under.
Year
Profit
I.
50000
70000
80000
60000
40000
600000
III.
600000
Average investment
300000
Average investment
300000
4) Calculate average rate of return for projects A and B from the following
information.
Investment
Expected life
Project A
30000
5 years
Project B
40000
6 years
Project A
3000
3000
3000
2000
1000
Project B
6000
6000
5000
3000
2000
12000
1000
23000
=1200
Net Investment
A=2400 x100
=2400
30000
=8%
B= 3833 x100
=23000
40000
=9.58%
2) ARR= Total Profit x100
Net Investment
A= 12000x100
30000
= 40%
= 23000x100
4000
= 57.5%
3) ARR= Total Profit x100
Average Investment
A= 12000 x100
2
= 30000
15000
=80%
B= 23000 x100
2
= 15000
= 40000
20000
=11.5%
3) ARR= Average annual Profit x100
Average investment
A= 2400 x100
15000
=16%
B= 3833 x100
20000
=19.165%
4) Calculate ARR from the following information cost of the project
1000000/-, scrap value 4.00.000/- . It is expected to generate the cash
inflows as under additional 1.00.000/year
C. I
1
50000
2
60000
3
70000
4
80000
5
90000
= 600000
2
= 300000
ARR = 70000 x100
300000
= 23.33%
ARR = Average Annual Profit
x100
Average Investment
Average Investment = Original Investment scarper value+ additional
2
= 1000000 400000 + 100000+ 400000
2
= 600000 + 500000
2
= 300000 + 500000
= 800000
ARR = 70000 x 100
800000
8.75%
MODERN OR DISCOUNTED CASH FLOW
III
2
30000
3
50000
4
20000
.909
.826
0.75
0.683
Year C.I.
1
40000
2
30000
3
50000
4
20000
1,12,350
1,00,000
N.P.V.
12350
A firm where cost of capital is 10% is considering to mutually exclusive project X and Y.
The details of which are
Particulars
Capital outlay
Cash inflows
-1
2
3
4
5
Project X
70000
10000
20000
30000
45000
60000
Project Y
70000
50000
40000
20000
10000
10000
Compute NPV at 10%. The present value factors are given below.
Year
P.V. 10%
1
0.909
2
0.826
3
0.751
4
0.683
5
0.621
CI
10000
20000
30000
45000
60000
PV 10%
0.909
0.826
0.751
0.683
0.621
Less:
Investment
NPV
PV of CI
9090
16520
22530
30735
37260
116135
70000
45135
Year
1
2
3
4
5
CI
50000
40000
20000
10000
10000
PV 10%
0.909
0.826
0.751
0.683
0.621
Less:
Investment
NPV
PV of CI
45450
33040
15020
6830
6210
106550
70000
36550
Since the NPV of project X is greater than (45135) project Y (36550) it is advisable to
accept project X and reject project Y.
3) From the following information suggest which project should be accepted under
project A PBP
NPV project B
Particulars
Cost of project
Project A
180000
Project B
180000
Dis F
10%
Net C.I.
Year
1
2
3
4
5
6
Project A
8000
64000
40000
20000
15000
Project B
40000
42000
60000
80000
32000
5000
PV
0.564
0.909
0.826
0.751
0.683
0.621
CI
80000
64000
40000
20000
15000
PV 10%
0.909
0.826
0.751
0.683
0.621
0.564
Less:
Investment
NPV
PV of CI
72720
52864
30040
12420
8460
176504
180000
-3496
Year
1
2
3
4
5
6
CI
40000
42000
60000
80000
32000
5000
PV 10%
0.909
0.826
0.751
0.683
0.621
0.564
Less:
Investment
NPV
PV of CI
36360
34692
45060
54640
19872
2820
193444
180000
13444
Calculation of PBP
Year
1
2
3
4
5
6
PBP =
CI
80000
64000
40000
20000
15000
Project A
CCI
80000
144000 I year
184000 II year
184000
204000
219000
Year
1
2
3
4
5
6
Project B
CI
CCI
40000 40000
42000 82000
60000 142000
80000 222000
32000 254000
5000 259000
I year
II year
184000 - 144000
= 2 + 36000
222000 - 142000
= 3 + 38000
40000
= 2 + 0.9 = 2.9
2 years 11 months
80000
= 3 + 0.475 = 3.48
3 years 6 months
Project X
20000
5 years
Project Y
30000
5 years
Cash inflows:
Project X
Project Y
1
5000
20000
2
10000
10000
3
10000
5000
4
3000
3000
5
2000
2000
Project X
CI
PV 10%
5000
0.909
10000
0.826
10000
0.751
3000
0.683
2000
0.621
Less:
Investment
PV of CI
4545
8260
7510
2049
1242
23606
20000
Year
1
2
3
4
5
CI
20000
10000
5000
3000
2000
Less:
Project Y
PV 10%
0.909
0.826
0.751
0.683
0.621
Investment
PV of CI
18180
8260
3755
2049
1242
33486
30000
NPV
3606
NPV
3486
5) Raja Ltd. wants to replace its existing plant. It has 3 proposals 1,2,3. The plants under
the 3 proposals are expected to cost Rs. 2,50,000-00 each and has an estimated life of
5 years, 4 years and 3 years respectively. The companies required rate of return is
10%. The anticipated net cash inflows after taxes for the 3 plants are as follows.
Years
1
2
3
4
5
Plant 1
80000
60000
60000
60000
180000
Plant 2
110000
90000
85000
35000
-
Plant 3
130000
110000
20000
-
Which of the above proposals would you recommend to the management for acceptance?
Use NPV technique for evaluation. The present value of Re.1 at 10% for each of the 5
years is given below.
Capital Budgeting Tools
Payback Period
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index
Payback Period
Payback period is the time duration required to recoup the investment committed
to a project. Business enterprises following payback period use "stipulated
payback period", which acts as a standard for screening the project.
Decision Rules
C. Mutually Exclusive Projects
In the case of two mutually exclusive projects, the one with a lower payback
period is accepted, when the respective payback periods are less than or
equivalent to the stipulated payback period.
Project A
Project B
Investment
10,000
10,000
Cash inflow
6-years
6-years
Year -1
3,000
2,000
Year -2
3,500
2,500
Year -3
3,500
2,500
Year -4
1,500
2,500
Year -5
1,500
3,000
Year -6
3,000
5,500
Payback period
16,000
3 years
18,000
4 years & 2 months
Example
Project A
Cumulative
Project B
Cumulative
cash inflows
cash inflows
of Project A
of Project B
Year -1
3,000
3,000
2,000
2,000
Year -2
3,500
6,500
2,500
4,500
Year -3
3,500
10,000
2,500
7,000
Year -4
1,500
11,000
2,500
9,500
Year -5
1,500
13,000
3,000
12,500
Year -6
3,000
16,000
5,500
18,000
Example
Payback period for Project A = 3 years (cumulative cash inflows = outflows)
Payback period for Project B = 4 years + 500/3000 = 4 years and 2 months.
(Note: Interpolation technique is used here to identify the exact period at which
cumulative cash inflows will be equal to outflows. The amount required to equate
is Rs.500, while the returns from the 5th year is 3,000. Hence the addition time
duration required to compute the payback period is (500/3000) x 12 which is 2
months. The interpolation technique is used based on the assumption that cash
inflows accrue uniformly throughout the year.)
Management Science-II Pro
The investment decision will be to choose Project A with a payback period of 3
years and reject Project B with a payback period of 4 years and 2 months.
Accounting Rate Of Return
Accounting rate of return is the rate arrived at by expressing the average annual
net profit (after tax) as given in the income statement as a percentage of the total
investment or average investment. The accounting rate of return is based on
accounting profits. Accounting profits are different from the cash flows from a
project and hence, in many instances, accounting rate of return might not be
used as a project evaluation decision. Accounting rate of return does find a place
in business decision making when the returns expected are accounting profits
and not merely the cash flows
Computation Of Accounting Rate Of Return
The accounting rate of return using total investment.
or
Sometimes average rate of return is calculated by using the following
formula:
Where average investment = total investment divided ment Science-II
Indian Institute of
Decision Rules
A. Capital Rationing Situation
Select the projects whose rates of return are higher than the cut-off rate
Arrange them in the declining order of their rate of return and
Select projects starting from the top of the list till the capital available
is exhausted.
The Profit (after tax) component of the cash inflows for each project are given in
the next slide.
Example
Net Profit After Tax
Year
1
Project A
1,580
Project B
280
2
3
4
5
6
Total Net Profit After Tax
Average Annual Net
2,080
2,080
80
80
80
5,980
5,980/6=996.6
1,080
1,080
1,080
2,580
1,880
7,980
7,980/6=1330
Profit
-II
Example
Taking into account the working capital released in the 6th year and salvage
value of the investment, the total investment will be (10,000-1,500) Rs.8500 and
the average investment will be (8500/2) Rs.4250 for each project.
The rate of return calculations are:
Net profit after tax as a percentage of total investment
Project A
Project B
The investment decision will be to select Project B since its rate of return is
higher than that of Project A if they are mutually exclusive. If they are
independent projects both can be accepted if the minimum required rate of return
is 11.7% or less.
Management Science-II Prof
Net Present Value (Npv)
Net present value of an investment/project is the difference between present
value of cash inflows and cash outflows. The present values of cash flows are
obtained at a discount rate equivalent to the cost of capital.
Computation Of Net Present Value (Npv)
When the cash outflow is required for only one year i.e., in the present year,
then the Net present value is calculated as follows:
"I" is the initial investment (cash outflow) required by the project
Decision Rules
A. "Capital Rationing" situation
Select projects whose NPV is positive or equivalent to zero.
project corresponds to a discount rest factor of 4.100 indicates that the present
value of one Rupee annuity for 5 years at 7%
2000 = 8200.
ue
LEVERAGES
A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be
equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's
variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The
company's annual interest expense amounts to $100,000 annually. If we increase
Newco's EBIT by 20%, how much will the company's EPS increase?
Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase
21.2%.
Introduction
The capital budgeting of a firm, it has to decide the way in which the capital
projects will be financed. Every time the firm makes an investment decision, it is
the same time making a financing decision also. For example, a decision to build
a new plant or to buy a new machine implies specific way of financing that
project. Should a firm employ equity or debt or credit? What are implies of the
debt-equity mix? What is an appropriate mix of debt and equity?
the share may be affected by the capital structure initially at the time of its
promotion. Subsequently, whenever funds have to be raised to finance
investments, a capital structure decision is involved. A demand for raising funds
generates a new capital structure since a decision has to be made as to the
quantity and forms of financing. This decision will involve an analysis of the
existing capital structure and the factors, which will govern the decision at
present. The dividend decision, is, in a way, a financing decision. The company's
policy to retain or distribute earnings affects the owners' claims. Shareholders'
equity position is strengthened by retention of earnings. Thus, the dividend
decision has a financing decision of the company may affect its debt-equity mix.
The debt-equity mix has implications for the shareholders' earnings and risk,
which in turn, will affect the cost of capital and the market value of the firm.
Does the way in which the investment projects are financed matters?
How does financing affect the shareholders' risk, return and value?
Does there exist an optimum financing mix in terms of the maximum value
of the firms shareholders?
Controls the quality of accounts: quality of account means how long the
customer takes to repay the credit granted and the probability of default. The
probability of default is measured by the bad-debt loss ratio which is the
proportion of account receivable that is uncollected.
Credit should be extended if the expected profit from the credit sale is
greater than the expected profit from refusing credit. If paid as agreed, the
profit margin will be realized on the sale; if payment is not received, the firm loses
the cost of sales. Refusing credit makes no profit
Credit terms : Conditions under which credit extended must be repaid
Credit period :Time allowed for payment
Cash discount: allowed if payment is made within a specific period of time. It
specified as % of the invoiced amount. For example: credit terms of (2/10, net
30) mean that customer can deduct 2% of the invoice amount if payment is made
within 10 days from the invoice date. If payment is not made within the 10 days,
then full invoice amount is due in 30 days from invoice days. Cash discount is
used to speedup the collection of account receivable.
Collection efforts: Methods employed in an attempt to collect payment on past
due
Accounts
Balance between leniency and alienating customers
Sending notices
Telephoning
Collection agency
Legal action
Inventory Management
Types of Inventory
Raw materials inventory
Stores of items used in production
Quantity discounts: by large quantity to get discount on price
Assure supply in times of scarcity
Work-in-process inventory
Items at some intermediate state of completion
Size related to length and complexity of production cycle
Finished goods inventory
Items ready and available for sale
Permits prompt filling of orders
Costs Associated with an Inventory Policy
Ordering costs: Costs of placing and receiving an order of goods, including
inspecting shipments, handling payment, follow up calls and letters.
Carrying costs: Costs of holding inventory for a given period of time, including
storage and handling cost, obsolescence and deterioration cost, and opportunity
cost of funds invested in inventory.
Stockout costs: Incurred when a firm is unable to fill an order, including losing
sales and the extra cost of placing special orders or work overtime to produce the
needed product.
Just-in-time inventory (JIT): The firm does not carry inventory. Once the order
is received from customers, the order for raw material is placed with the supplier
and the product is manufactured. JIT method is used to reduce inventory cost by
supplying Inventory at exactly the right time and in exactly the right quantities.
Example, Dell Computer Co.
Purchasing resources
These activities create funds flows that are both unsynchronized and uncertain.
Unsynchronized because cash disbursements (for example, payments for
resource purchases) usually take place before cash receipts (for example
collection of receivables). They are uncertain because future sales and costs,
which generate the respective receipts and disbursements, cannot be forecasted
with complete accuracy.
CASH
DEBTORS
INVENTORIES
Holding the fixed assets constant varying the current assets bring about such
trade off. Current assets tend to fluctuate with output.
This relationship between the current assets and output levels is shown in the
figure given bellows:
ASSET
LEVEL
FIXED ASSETS
CURRENT ASSETS
25000
50000
TIME
Sources: financial management I.M.Pandey
AGGRESSIVE APPROCH
In this case the profitability will be higher but the firm has lowest and
correspondingly the greatest risk. Therefore it should be the goal of the
management to select the level of current assets that optimizes the firms rate of
return.
In aggressive approach the firm losses more of short term financing. Under
this approach the firm finances its temporary current assets and also a part of
performance current assets through short-term sources. Some extremely
aggressive firms may even finance a part of their fixed assets with short term.
The relatively higher use of short term financing makes the firm more risky. This
is illustrated in the fig given below
TEMPORARY CURRENT ASSETS
TIME
Sources: Financial Management I.M.Panday
And short term finance for temporary current assets. The term hedging refers the
process of matching the maturities of debts with maturity of financial needs.
TIME
Sources: Financial Management I.M.Panday
PRINCIPLE: 2
PRINCIPLE OF COST OF CAPITAL
Capital should be invested in each component of working capital as long as
the equity position of the firm increases. This principle is based on the concept
that each rupee invested in fixed or working capital should contributed to the net
worth of the firm.
PRINCIPLE: 3
PRINCIPLE OF EQUITY POSITION
The type of capital used to finance working capital directly affects the amount
of risks that a firm assumes as well as the opportunities for gain or loss and cost
of capital. There are two approaches of financing, which a firm can adopt viz. the
hedging approach and margin of safety approach.
Margin of safety approach
Involves financing a portion of the firm expected seasonal funds
requirement on long-term basis as illustrated below.
Margin of safety approach
Thus in this approach the firm reduces the risk of fund availability
Thus in this approach the firm reduces the risk of fund availability by
employing long term funds to finance a portion of the seasonal
requirements, but the profitability is also reduced on account of higher cost
In many lines at business (e.g., sugar and fur industry) operation are highly
seasonal and as a result working capital requirements vary greatly during the
year. The capital required to meet the seasonal needs of industry is termed as
seasonal working capital on Other hand special working capital, is that part of the
variable working capital is required for financing special operations, such as
Seasonality of operations
Firms Credit Policy
Production Policy
Availability of Credit
Price Level Changes
Dividend Policy
Distribution Policy
Growth and Expansion Activities
Length of operation Cycle
Operating Efficiency
Proportion of Fixed Assets to Total Assets
Introduction of New Products
Hazards and Contingencies inherent in a Particular type of Business
Explanation for the some of the above factors is as follows:
1. Nature and size of the Business
A firm which sells predominantly on cash basis has modest working
capital, while the manufacturing concern like machine tools unit, which sells
largely on credit, has very substantial working capital management.
2. Seasonality of operations
In case of firm manufacturing ceiling fans, working capital needs increases
considerably during the summer months and decreases during the winter period.
3. Production Policy
In the case of manufacturers of ceiling fans are the pronounced seasonal
fluctuations in its sales. They maintain a steady production through out the year
rather than intensifying the production policy during the peak business season.
4. Credit Policy
If the concern has a strict credit policy then the working capital need will be low
and if the credit terms are liberal then working capital need will be high.
5. Availability of credit:-
If the credit is available at generous term working capital need will be low and
if the terms are not generous then working capital will be high.
Current Assets[%]
10-20
20-30
30-40
40-50
50-60
60-70
70-80
80-90
Fixed Assets[%]
80-90
70-80
60-70
50-60
40-50
30-40
20-30
10-20
SOURCES OF FINANCE
INTRODUCTION:
Finance is essential for all organisations in order to carryout its activities and to achieve the target
of the enterprise.The business cannot run without adequate finance,that is why finance is called
"lifeblood of business".
MEANING:
It means the agencies or services from which the funds are obtained or collected .it includes
method of raising finance and period for which funds are required.
The financial requirements can be classified into two groups.
1.Fixed capital /longterm financial requirements:This capital is required to meet the capital
expenditure
for
purchase
of
fixed
assets
such
as
land&building,plant&machinery,furniture&fixture....etc.
2.Working capital/short term financial requirement :This capital is required to meet day to day
expences such as purchase of materials ,payment of salaries&wages...etc.
a)Long term sources:more than one year eg:-equity and preference shares,debentures,retained
earnings,long term loans...etc.
b)Short term sources:minimum one year eg:-public deposit,trade credit,short term loans etc....
2.On the basis of ownership:
a)Own capital:eg :-share capital,reserves and surplus,retained earnings...etc
b)Borrowed capital:eg:-debenture ,public deposits,loans ...etc
3.On the basis of sources ofgenerations:
a).Internal source:eg:-retained earnings, depreciation....etc
b)External source:eg:-shares,debentures,loans ...etc.
However the most popular form to classify sources of finance is as follows:
SHORT TERM
MEDIUM TERM
LONG TERM
1.Indegeneous
bankers
1.issue
of
debentures
1.issue of shares
2.customers advaces
2.ploughingback of profits
3.trade credit
3.bank loans
4.public deposits
5.factoring
5.fixed deposits
6.accruals
7.deferred incomes
7.instalment credit
gfgc-n.r.pura