TTLM FM Iprm Retail - 1494604591951

MINISTRY OF COMMERCE & INDUSTRY
GOVERNMENT OF INDIA
IPRM- INTEGRATED PROGRAMME IN RETAIL

MANAGEMENT
SEMESTER- VIII
FINANCIAL MANAGEMENT
HANDBOOK
FDDI SCHOOL OF RETAIL MANAGEMENT
FDDI/TTLM/FM/IPRM Page 1
UNIT-1 Introduction to Financial Management
Introduction to Financial Management
Financial Management means the efficient and effective management of money (funds) in such a
manner as to accomplish the objectives of the organization. It is the specialized functions directly
associated with the top management. The significance of this function is not only seen in the
'Line' but also in the capacity of 'Staff' in overall administration of a company. It has been
defined differently by different experts in the field.
It includes how to raise the capital, how to allocate it i.e. capital budgeting. Not only about long
term budgeting but also how to allocate the short term resources like current assets. It also deals
with the dividend policies of the shareholders.
Finance is a field within economics that deals with the allocation of assets and liabilities over
time under conditions of certainty and uncertainty. Finance can also be defined as the science of
money management. A key point in finance is the time value of money, which states that one
unit of currency today, is worth more than one unit of currency tomorrow.
Finance aims to price assets based on their risk level and their expected rate of return. Finance
can be broken into three different sub-categories: public finance, corporate finance and personal
finance.
Whether your organization is large or small, effective financial management is an on-going

process featuring a cycle of good management habits. Sound procedures and internal controls
help ensure accurate accounting and high-quality reporting. Evaluation of the information in the
reports then informs planning and facilitates good management decisions. Regular evaluation of
the process leads to consistent improvement in financial management.
Definitions of Financial Management
 “Financial Management is the Operational Activity of a business that is responsible for

obtaining and effectively utilizing the funds necessary for efficient operation.” by Joseph
Massie
 “Business finance deals primarily with rising administering and disbursing funds by
privately owned business units operating in non-financial fields of industry.” – by Prather
and Wert
 “Financial Management is an area of financial decision making, harmonizing individual
motives and enterprise goals.” By Weston and Brigham
 “Financial management is the area of business management devoted to a judicious use of
capital and a careful selection of sources of capital in order to enable a business firm to move
in the direction of reaching its goals.” – by J.F.Bradlery
 “Financial management is the application of the planning and control function to the finance
function.” – by Archer & Ambrosio
 “Financial management may be defined as that area or set of administrative function in an
organization which relate with arrangement of cash and credit so that organization may have
the means to carry out its objective as satisfactorily as possible .“ - by Howard & Opton.
 Business finance can be broadly defined as the activity concerned with planning, raising,
controlling and administering of funds and in the business. “ by H.G Gathman & H.E
Dougall
Nature and objective of financial management
Financial management is concerned with the efficient acquisition and deployment of both short-
and long-term financial resources, to ensure the objectives of the enterprise are achieved.
Decisions must be taken in three key areas:
 Investment - both long-term investment in non-current assets and short-term investment

in working capital;
 Finance - from what sources should funds be raised?
 Dividends - how should cash funds be allocated to shareholders and how will the value of
the business be affected by this?
The investment decision
To operate, all business will need finance and part of the financial manager's role is to ensure this
finance is used efficiently and effectively to ensure the organisation's objectives are achieved.
This can be further broken down into two elements:
Investment appraisal considers the long-term plans of the business and identifies the right
projects to adopt to ensure financial objectives are met. The projects undertaken will nearly
always involve the purchase of non-current assets at the start of the process.
For a business to be successful, as well as identifying and implementing potentially successful

projects, it must survive day to day. Working capital management is concerned with the
management of liquidity - ensuring debts are collected, inventory levels are kept at the minimum
level compatible with efficient production, cash balances are invested appropriately and payables
are paid on a timely basis.
The financing decision
Before a business can invest in anything, it needs to have some finance. A key financial
management decision is the identification of the most appropriate sources (be it long or short
term), taking into account the requirements of the company, the likely demands of the investors
and the amounts likely to be made available.
The dividend decision
Having invested wisely, a business will hopefully be profitable and generate cash. The final key
decision for the financial manager is whether to return any of that cash to the owners of the
business (in the form of dividends) and if so, how much.
The alternative is to retain some of the cash in the business where it can be invested again to earn
further returns. This decision is therefore closely linked to the financing decision.
The decision on the level of dividends to be paid can affect the value of the business as a whole
as well the ability of the business to raise further finance in the future.
The following table illustrates the distinction between some of the tasks carried out by each
of these financial roles:
Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets is also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and
the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders?
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity
analysis. This will depend upon the proportion of equity capital a company is possessing
and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decisions have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansion, innovation, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.
Place of Financial Management in Organization Structure
In management, organisation's structure is divided on the basis of authorities and responsibilities

of employees. Just like marketing, personnel, research and development, finance is also function
of company. Company provides power to some authorities in its organisational structure to do
production, finance and sales function. In finance department, finance manager has powers
relating to treasury and control. He can delegate his power to his assistants.
Role of Finance Manager
In the area of finance and financial management, finance manager is important authority. Not
only to raise the finance of company, finance manager do also other lots of works for company.
We can explain his role in following words.
1. Role of Finance Manager for Raising Funds of Company
Finance manager checks different sources of company. He did not get fund from all sources.
First, he check his need in short term and in long term and after this he select best source of fund.
He has also power to change the capital structure of company for giving more benefit of
company.
2. Role of Finance Manager for Taking Maximum Benefits from Leverage
Finance manager uses both operating and financial leverage and try to use it for taking maximum
benefit from leverage.
3. Role of Finance Manager for International Financial Decision
Finance manager finds opportunities in international financial decision. In these opportunities, he

does the contracts of credit default swap, interest rate swap and currency swap.
4. Role of Finance Manager in Investment Decisions
Finance manager checks the net present value of each investment project before actual
investment in it. Net present value of project means what net profit at discount rate, will
company gets if company invests him money in that project. High NPV project will be accepted.
So, due to high responsibility, role of finance manager in this regard is very important.
5. Role of Finance Manager in Risk Management
Happening of risks means facing different losses. Finance manager is very serious on risk and its
management. He plays important role to find new and new ways to control risk of company. Like
other parts of management, he estimates all his risks, he organize the employees who are
responsible to control risk.He also calculates risk adjusted NPV. He meets all risk controlling
organisations like insurance companies, rating agencies at pervasive level. He is able to convert
company's misfortunes into fortunes. By good estimations of averse situations, he tries his best to
safeguard the money of company.
Interface of Financial Management with Other Functional Areas
Finance is the study of money management, the acquiring of funds (cash) and the directing of
these funds to meet particular objectives. Good financial management helps businesses to
maximize returns while simultaneously minimizing risks.
Financial management is an integral part of overall management and not merely a staff function.
It is not only confined to fund raising operations but extends beyond it to cover utilisation of
funds and monitoring its uses. These functions influence the operations of other crucial
functional areas of the firm such as production, marketing and human resources. Hence,
decisions in regard to financial matters must be taken after giving thoughtful consideration to
interests of various business activities. Finance manager has to see things as a part of a whole
and make financial decisions within the framework of overall corporate objectives and policies.
Let us discuss in greater detail the reasons why knowledge of the financial implications of their
decisions is important for the non-finance managers. One common factor among all managers is
that they use resources and since resources are obtained in exchange for money, they are in effect
making the investment decision and in the process of ensuring that the investment is effectively
utilized they are also performing the control function.
Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant location,
etc. In all these matters assessment of financial implications is inescapable impact on the
profitability of the firm. For example, he should have a clear understanding of the impact the
credit extended to the customers is going to have on the profits of the company. Otherwise in his
eagerness to meet the sales targets he is liable to extend liberal terms of credit, which is likely to
put the profit plans out of gear. Similarly, he should weigh the benefits of keeping a large
inventory of finished goods in anticipation of sales against the costs of maintaining that
inventory. Other key decisions of the Marketing Manager, which have financial implications,
are:
Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major part of the
investment in the form of equipment, materials and men. He should so organize his department
that the equipments under his control are used most productively, the inventory of work-in-
process or unfinished goods and stores and spares is optimized and the idle time and work
stoppages are minimized. If the production manager can achieve this, he would be holding the
cost of the output under control and thereby help in maximizing profits. He has to appreciate the
fact that whereas the price at which the output can be sold is largely determined by factors
external to the firm like competition, government regulations, etc. the cost of production is more
amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy
or lease etc. for which he has to evaluate the financial implications before arriving at a decision.
Top Management-Finance Interface
The top management, which is interested in ensuring that the firm’s long-term goals are met,
finds it convenient to use the financial statements as a means for keeping itself informed of the
overall effectiveness of the organization. We have so far briefly reviewed the interface of finance
with the non-finance functional disciplines like production, marketing etc. Besides these, the
finance function also has a strong linkage with the functions of the top management. Strategic
planning and management control are two important functions of the top management. Finance
function provides the basic inputs needed for undertaking these activities.
Economics – Finance Interface
The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity and
changes in economic policy. They must also be able to use economic theories as guidelines for
efficient business operation. The primary economic principle used in managerial finance is
marginal analysis, the principle that financial decisions should be made and actions taken only
when the added benefits exceed the added costs. Nearly all-financial decisions ultimately come
down to an assessment of their marginal benefits and marginal costs.
Accounting – Finance Interface
The firm’s finance (treasurer) and accounting (controller) activities are typically within the
control of the financial vice president (CFO). These functions are closely related and generally
overlap; indeed, managerial finance and accounting are often not easily distinguishable. In small
firms the controller often carries out the finance function, and in large firms many accountants
are closely involved in various finance activities. However, there are two basic differences
between finance and accounting; one relates to the emphasis on cash flows and the other to
decision making.
Environment of Corporate Finance
Corporate finance is the area of finance dealing with the sources of funding and the capital
structure of corporations and the actions that managers take to increase the value of the firm to
the shareholders, as well as the tools and analysis used to allocate financial resources. The
primary goal of corporate finance is to maximize or increase shareholder value.
Although it is in principle different from managerial finance which studies the financial
management of all firms, rather than corporations alone, the main concepts in the study of
corporate finance are applicable to the financial problems of all kinds of firms.
Investment analysis (or capital budgeting) is concerned with the setting of criteria about which
value-adding projects should receive investment funding, and whether to finance that investment
with equity or debt capital. Working capital management is the management of the company's
monetary funds that deal with the short-term operating balance of current assets and current
liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending
(such as the terms on credit extended to customers).[citation needed]
The terms corporate finance and corporate financier are also associated with investment banking.
The typical role of an investment bank is to evaluate the company's financial needs and raise the
appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and
“corporate financier” may be associated with transactions in which capital is raised in order to
create, develop, grow or acquire businesses.
Financial management overlaps with the financial function of the Accounting profession.
However, financial accounting is the reporting of historical financial information, while financial
management is concerned with the allocation of capital resources to increase a firm's value to the
shareholders.
An Overview of Corporate Finance & the Financial Environment
The financial environment is a vibrant part of the economy. Imagine what would happen if
companies and individuals couldn't access funds for operating purposes or lifestyle goals? Or
what the economy would look like if banks and insurance companies didn't provide deposit
services and risk coverage to clients? This scenario certainly could stifle economic growth and
crimp consumer spending. Corporate finance provides economic players the tools necessary to
thrive and expand.
Accounting Reports
Financial data summaries indicate to regulators and the public whether a new company is off to a
promising start. For an existing firm, these data sets tell investors whether the company is
trumping or bowing to the competition. Accounting reports include a balance sheet, an income
statement, an equity report and a cash flow statement.
Financial Analysis
An important part of corporate finance, financial analysis allows department heads to take a peek
at performance data and make sense of what drives the business. Segment supervisors do so by
calculating financial ratios, such as net profit margin and inventory-turnover ratio.
Financial Audits
A financial review is a tale of regulatory investigation, accounting acumen and operating

expertise. The review allows external auditors, usually certified public accountants, to pass
judgment on the books of publicly traded companies.
Securities Markets
Securities markets--also known as financial exchanges or stock markets--are a key component of

the financial environment. These financial platforms enable investors to buy and sell securities
for risk coverage or speculation. Examples include the New York Stock Exchange and London
Stock Exchange.
Financial Institutions
Financial institutions constitute a diverse array of companies, running the gamut from banks and
insurance companies to hedge funds, private-equity companies and credit unions.
Investment Products
Corporate finance helps a firm fund its operations by reaching out to the financial-services
sector. The company does so by selling investment products, such as stocks and bonds.
Financial Regulators
Government watchdogs oversee the activities of securities-exchange players to make sure

shrewd investors do not stake out their success on illegal trades. The most important financial
regulators include the U.S. Securities and Exchange Commission and U.K. Financial Services
Authority.
Financial Risks
These are exposures that companies must cope it, especially when they operate in the financial
environment. The most important are market and credit risks. Market risk arises from
unfavorable fluctuations in securities prices. Credit risk is the loss expectation resulting from a
debtor's non-payment of a loan.
Self-Check 1 Written Test
Name: _________________________ Date: _______________
Directions: Answer all the questions listed below. Illustrations may be necessary to aid some
explanations/answers.
1. What do you mean by the term Finance? 2
2. Define Financial Management (FM). 2
3. What are the objectives of FM? 5
4. What are the advantages of a balanced FM system? 5
5. What is the importance of FM in an organization? 5
6. What are the functions of Financial Management? 2
7. Explain the Indian Financial System. 15
8. Briefly explain the roles of finance department and finance manager. 15
9. What is Corporate finance mean? 2
10. Write short notes on:

a) Market Regulators b) NBFC c) Market Intermediaries 6
a) IFS b) Corporate Finance c) Unorganized Finance 6
UNIT-2 Sources of Financings
Sources of Capital:-
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets.
The WACC is the minimum return that a company must earn on an existing asset base to satisfy
its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies
raise money from a number of sources: common equity, preferred stock, straight debt,
convertible debt, exchangeable debt, warrants, and options, pension liabilities, executive stock
options, governmental subsidies, and so on. Different securities, which represent different
sources of finance, are expected to generate different returns. The WACC is calculated taking
into account the relative weights of each component of the capital structure. The more complex
the company's capital structure, the more laborious it is to calculate the WACC.
UNIT-3 TIME VALUE OF MONEY
Time Value of Money

One day in the town of Ceelo, Barbara is on her way back home after a very long day of
managing a small clothing store. Business is good, as evidenced by the new designer shades she
bought recently. After dinner that night, she turns on the television and accidentally falls asleep.
Inside Barbara's dream, an important announcement is taking place on TV. Within a few
seconds, they announce the winner of the $50 million lottery. When she looks at her hand, she
sees a lottery ticket, and after reviewing the numbers on it, Barbara finds that she has won the
lottery! How cool is that! When she calls the phone number on the television screen, a nice
young lady by the name of Jane answers the phone and asks her a very important question:
Would you rather receive a check for $50 million today or receive payments over the next 20
years totaling $60 million?
All of a sudden, Barbara wakes up from her dream and realizes that she was only dreaming, but
she does remember the key question that Jane asked her and begins to ponder it carefully. If
Barbara chose payments over the next 20 years, she'd get $3 million each year for 20 years in a
row, totaling $60 million, which definitely sounds like more than $50 million, doesn't it?
Assuming that she could invest $50 million today and earn a 5% interest rate on her money and
assuming that there are no taxes, what should Barbara do? As she ponders this important
question, she remembers an old saying that she learned as she was growing up - 'A bird in the
hand is worth two in the bush.'
Calculating the Time Value of Money

We'll come back to this later, but I want to direct your attention to another situation taking place
right now, as we speak, in the town of Ceelo.
Margie the cake baker earns a nice income. Although she spends most of the money she earns,
she saves some of it in a savings account at the bank. Suppose her savings account pays 5%
interest per year. The question she wants to answer is this: how much would she have to invest
today if she wants her account to be worth $100 a year from now? To answer this, Margie needs
to know more about the time value of money.
If Margie deposited $1 today, a savings account paying 5% interest per year would be worth
$1.05 a year from now. The original $1 is what we call the principal that Margie deposited, and
the $0.05 is the interest that the bank pays her as a reward for holding the money there. Because
the bank is willing to pay Margie interest for holding her savings at their financial institution,
money has a time value. In other words, it is worth more today than it is tomorrow.
Present Value of Money
Using the formula to find the present value of money
Whenever you hear a situation that involves the choice between a payment later or a payment
today, just think of the saying 'A bird in the hand is worth two in the bush.' I know some of you
may say that this finance stuff is for the birds, and if so, I can show you that it's real, as we take a
little trip through Bird-In-Hand, Pennsylvania, which is the name of a real town, by the way.
Here's what the time value of money means. Economists recognize that a dollar today is not the
same as a dollar in the future. Why not? Because I can take a dollar today and earn a return on it,
it takes more than a dollar in the future to equal a dollar today.
For example, if I can invest $1 and earn $0.05 on it over the next year, then that means that my
$1 today is worth $1.05 a year from now. It also means that a dollar bill given to me one year
from now would be worth less than a dollar today - specifically, about $0.95 - because I could
invest this amount and earn interest so that the money I invested plus the interest equals $1 a year
from today.
If Margie wants her savings account to be worth $100 a year from now, then she needs to know
what this future amount is worth today, which is what economists call the present value.
Present value is the amount of money today that is equivalent to a single payment or a stream of
payments earned in the future, invested at a certain interest rate. The formula for present value
takes a future payment, or payments, and discounts them using the interest rate to find the worth
of this money today. The higher the interest rate is, the lower the present value is today. The
lower the interest rate is, the higher the present value is today.
The present value of $100 one year later is going to be worth less than $100 today. Why?
Because of the 5% interest. To make things easy, Margie uses the formula for present value:
Present Value = FV / (1 + i)^n, where i is the interest rate and n is the number of time periods.
Let's use the formula to figure out the present value of a future $100 value, assuming a 5%
interest rate and a 1-year time span. FV stands for 'future value.' The future value that Margie
wants to grow her account to is $100. i stands for interest rate, which is 5% in this case, and n is
the number of periods. Margie has a 1-year time horizon, so, in this case, n = 1. Here's what the
calculation looks like that answers Margie's question:
$100 / (1 + .05)^1 = $95.24
So, Margie would have to invest $95.24 today when the interest rate is 5% in order to grow it to
$100 exactly one year from today.
Suppose the interest rate were 3% and the time horizon was 5 years instead. What would the
present value of $100 be in 5 years? This is what we'd get:
$100 / (1 + .03)^5 = $86.26
Now suppose Margie wants to know how much she'd need to invest today in order to have it
grow into $1 million in 20 years, if she assumes that she'll earn a 7% interest rate per year. Here's
what this looks like, accounting for the time value of money:
$1,000,000 / (1 + .07)^20
Don't even think of trying this in your head. You'd need a calculator, and you can split it up into
two calculations. First, enter 1.07^20, which equals 3.86968446. Now divide your future value of
$1,000,000 by this discount factor, and you'll get $258,419. What does this mean? If Margie
invests $258,419 today into an account earning 7% per year, then this money grows each and
every year at 7% until, after 20 years of waiting, she'll have $1 million.
Future Value of Money
The formula for finding the future value of money
The time value of money depends on two things - the time interval between now and when you
receive it, and the interest rate that money can be invested at in order to earn a return.
For example, $100 paid to you in 1 year is worth more than $100 paid to you in 5 years. The
longer the time interval, the less that future money is worth to you today and the greater the
return you'd expect to earn if you invested money today.
Likewise, $1 invested today at a 10% interest rate will pay you more than $1 invested at 5%. The
higher the interest rate you earn on your money, the greater the time value of money. Working
backwards, $1 paid to you in one year that can earn a 10% return would be worth less than $1
paid to you in 1 year at a 5% interest rate.
Now, let's look at this concept from the opposite point of view. $100 invested today at 5% for
exactly 1 year will be worth how much? To answer this, let's use the future value.
Future value is the future worth of an amount of money invested today, paying a certain interest
rate. If Margie invests $100 today in an account earning 5% per year, then 5% of $100 is $5, and
in exactly 1 year, her $100 turns into $105. How do we figure that out? By using the formula for
future value:
Future Value = PV * (1 + i)^n
PV stands for present value, which is $100 in this case. i is the interest rate, which we said was
5%, and n is the number of periods - in this case we're talking about years - specifically 1 year -
so n = 1. When you plug all this into the future value formula, the future value of Margie's $100
invested at 5% is equal to $100 * (1 + .05)^1 = $105.
Calculating the Price of a Bond

The formula for present value has a very important application. One of the basic types of
investments is called bonds. If you understand the concept of the time value of money, then the
idea of a bond is not much of a stretch.
A bond is a promise to pay an amount back in the future that is borrowed today. Very simply, it's
a debt, or a loan. They call it a bond, which is a type of security, because it can be bought or sold
in the free market, but it's really just a loan. When the U.S. government borrows money to fund
the operations of the government, it issues bonds and promises to make payments over time to
pay back the money it borrows. This is a government bond that can be bought and sold in the
free market, and to buy and sell something, you have to have a price. That's where the time value
of money comes in.
Since bonds pay an ongoing stream of fixed interest payments and market interest rates for new
bonds go up and down regularly, the price of an existing bond goes up and down whenever the
market interest rates change.
UNIT-4 Cost Of Capital
Meaning, Concept and Definition

The cost of capital of a firm is the minimum rate of return expected by its investors. It is
the weighted average cost of various sources of finance used by a firm. The capital used by a
firm may be in the form of debt, preference capital, retained earnings and equity shares. The
concept of cost of capital is very important in the financial management. A decision to invest in a
particular project depends upon the cost of capital of the firm or the cut off rate which is the
minimum rate of return expected by the investors. In case a firm is not able to achieve even the
cut off rate, the market value of its shares will fall. In fact cost of capital is the minimum rate of
return expected by its investors which will maintain the market value of shares at its present
level. Hence to achieve the objective of wealth maximisation, a firm must earn a rate of return
more than its cost of capital. The cost of capital of a firm or the minimum rate of return expected
by its investors has a direct relation with the risk involved in the firm. Generally, higher the risk
involved in a firm, higher is the cost of capital.
According to Solomon Ezra Cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditures.
Thus, we can say that cost of capital is that minimum rate of return which a firm, and, is
expected to earn on its investments so as to maintain the market value of its shares.
From the definitions given above we can conclude three basic aspects of the concept of cost of
capital:
(i) Cost of capital is not a cost as such. In fact, it is the rate of return that a firm
requires to earn from its projects.
(ii) It is the minimum rate of return. Cost of capital of a firm is that minimum rate of
return which will at least maintain the market value of the shares.
(iii) It comprises of three components. As there is always some business and financial
risk in investing funds in a firm, cost of capital comprises of three components:
(a) the expected normal rate of return at zero risk level, say the rate of interest
allowed by banks;
(b) the premium for business risk; and
(c) the premium for financial risk on account of pattern of capital structure.
Symbolically cost of capital may be represented as:

where, K = ro+b+f
K=Cost of capital
ro=Normal rate of return at zero risk level
b=Premium for business risk.
f=Premium for financial risk.
Significance of the Cost of Capital

The concept of cost of capital is very important in the financial management. It plays a
crucial role in both capital budgeting as well as decisions relating to planning of capital structure.
Cost of capital concept can also be used as a basis for evaluating the performance of a firm and it
further helps management in taking so many other financial decisions.
(1) As an Acceptance Criterion in Capital Budgeting: Capital budgeting decisions can be made
by considering the cost of capital. According to the present value method of capital budgeting, if
the present value of expected returns from investment is greater than or equal to the cost of
investment, the project may be accepted; otherwise the project may be rejected. The present
value of expected return is calculated by discounting the expected cash inflows at cut-off rate
(which is the cost of capital). Hence, the concept of cost of capital is very useful in capital
budgeting decision.
(2) As a Determinant of Capital Mix in Capital Structure Decisions: Financing the firm’s
assets is a very crucial problem in every business and as a general rule there should be a proper
mix of debt and equity capital in financing a firm’s assets. While designing an optimal capital
structure, the management has to keep in mind the objective or maximising the value of the firm
and minimising the cost of capital. Measurement of cost of capital from various sources is very
essential in planning the capital structure of any firm.
(3) As a basis for evaluating the Financial Performance: The concept of cost of capital can be
used to ‘evaluate the financial performance of top management’. The actual profitability of the
project is compared to the projected overall cost of capital and the actual cost of capital of funds
raised to finance the project. If the actual profitability of the project is more than the projected
and the actual cost of capital, the performance may be said to be satisfactory.
(4) As a Basis for taking other Financial Decisions: The cost of capital is also used in making
other financial decisions such as dividend policy, capitalisation of profits, making the rights issue
and working capital.
Classification of Cost
(1) Historical cost and Future Cost: Historical costs are book costs which are related to the past.
Future costs are estimated costs for the future. In financial decisions future costs are more
relevant than the historical costs. However, historical costs act as guide for the estimation of
future costs.
(2) Specific Cost and Composite Cost: Specific cost refers to the cost of a specific source of
capital while composite cost is combined cost of various sources of capital. It is the weighted
average cost of capital. In case more than one form of capital is used in the business, it is the
composite cost which should be considered for decision-making and not the specific cost. But
where only one type of capital is employed the specific cost of that type of capital may be
considered.
(3) Explicit Cost and Implicit Cost: An explicit cost is the discount rate which equates the
present value of cash inflows with the present of cash outflows. In other words it is the internal
rate of return.
where, Io, is the net cash inflow at zero point of time,

Ot is the outflow of cash in period 1, 2 and n.
k is the explicit cost of capital.
Implicit cost also known as the opportunity cost is the cost of the opportunity foregone is order
to take up a particular project.
(4) Average Cost and Marginal Cost: An average cost refers to the combined cost of various
sources of capital such as debentures, preference shares and equity shares. It is the weighted
average cost of the costs of various sources of finance. Marginal cost of capital refers to the
average cost of capital which has to be incurred to obtain additional funds required by a firm. In
investment decisions, it is the marginal cost which should be taken into consideration.
Determination of Cost of Capital
It has already been stated that the cost of capital plays a crucial role in the decisions
relating to financial management. However, the determination of the cost of capital of a firm is
not an easy task because of both conceptual problems as well as uncertainties of proposed
investments and the pattern of financing. The major problems concerning the determination of
cost of capital are discussed as below:
Problems in determining Cost of Capital
1. Conceptual controversies regarding the relationship between the cost of capital and
the capital structure : Different theories have been propounded by different authors explaining
the relationship between capital structure, cost of capital and the value of the firm. This has
resulted into various conceptual difficulties. According to the Net Income Approach and the
traditional theories both the cost of capital as well the value of the firm have a direct relationship
with the method and level of financing. In their opinion, a firm can minimise the weighted
average cost of capital and increase the value of the firm by using debt financing. On the other
hand, Net Operating Income and Modigliani and Miller Approach prove that the cost of capital is
not affected by changes in the capital structure or say that debt equity mix is irrelevant in
determination of cost of capital structure determination of cost of capital and the value of a firm.
However, the M and M approach is based upon certain unrealistic assumptions such as, there is a
perfect market or the expected earnings of all the firms have identical risk characteristic, etc.
2. Problems in computation of cost of equity: The computation of cost of equity capital
depends upon the expected rate of return by its investors. But the quantification of the
expectations of equity shareholders is a very difficult task because there are many factors which
influence their valuation about a firm.
3. Problems in computation of cost of retained earnings: It is sometimes argued that
retained earnings do not involve any cost but in reality, it is the opportunity cost of dividends
foregone by its shareholders. Since different shareholders may have different opportunities for
investing their dividends, it becomes very difficult to compute the cost of retained earnings.
4. Problems in assigning weights: For determining the weighted average cost of capital,
weights have to be assigned to the specific cost of individual source of finance. The choice of
using the book value of the source or the market value of the source poses another problem in the
determination of capital.
COMPUTATION OF SPECIFIC SOURCE OF FINANCE

Computation of each specific source of finance, viz, debt, preference share capital equity
share capital and retained earnings is discussed as below:
1. Cost of Debit
The cost of debt is the rate of interest payable on debt. For example, a company issues
Rs. 1,00,000 debentures at par; the before tax cost of this debt issue will also be 10%. By way of
formula, before-tax-cost of debt may be calculated as:
(i) Kdb =
where, Kdb = Before tax cost of debt
I = Interest
and P = Principal
In case the debt is raised at premium or discount, we should consider P as the amount of
the net proceeds received from the issue and not the face value of securities. The formula may be
changed to
(ii) Kdb = (where, NP = Net Proceeds)

Further, when debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as the interest is allowed as a deductable expense in computation tax. Hence, the
effective cost of debt is reduced. The after tax cost of debt may be calculated with the help of
following formula;
(iii) Kda = Kdb (1-t) =
where, Kda = After tax cost of debt
t = Rate of tax.
Cost of Redeemable Debt

Usually, the debt is issued to be redeemed after a certain period during lifetime of a firm.
Such a debt issue is known as Redeemable debt. The cost of redeemable debt capital be
computed as:
(iv) Before-tax cost of debt
where, I = Interest
N = Number of years in which debt is to be redeemed
P = Proceeds at par
NP = Net Proceeds
(v) After tax cost of debt, Kda = Kdb (1-t)
where,
Illustration1: A Company issues shares of Rs.10,00,000, 10% redeemable debentures at
a discount of 5%. The cost of floatation amount to Rs.30,000. The debentures are redeemable
after 5 years. Calculate before tax and after tax cost of debt assuming tax rate of 50%.
Solution:
Before-tax cost of debt,
=
(NP=Rs. 10,00,000-50,000 (discount) – 30,000 cost of floatation)
=
After tax cost of debt, Kda = Kdb (1-0.5)
= 12.09 (1-0.5) = 6.04%
Cost of Debt Redeemable at Premium

Sometimes debentures are to be redeemed at a premium; i.e at more than the face value
after the expiry of a certain period. The cost of such debt redeemable at premium can be
computed as below:
(i) Before tax cost of debt,
where, I = Interest
n = Number of years in which debt is to be redeemed
RV= Redeemable value of debt
NP = Net Proceeds
(ii) After-tax cost of debt,
Kda= Kdb (1-t)
Illustration2: A 5-year Rs.100 debenture of a firm can be sold for a net price of
Rs.96.50. The coupon rate of interest is 14 %per annum and debenture will be redeemed at 5%
premium on maturity. The firm tax rate is 40%. Compute the after tax cost of debentures.
Solution:
=
After-tax cost of debt,

Kda = Kdb (1-t)
= 15.58 (1-0.4) = 15.58 x 0.6 = 9.35%
Cost of Debt Redeemable in Instalments

Financial institutions generally require principal to be amortised in instalments. A
company may also issue a bond or debenture to be redeemed periodically. In such a case,
principal amount is repaid each period instead of a lump sum at maturity and hence cash period
include interest and principal. The amount of interest goes on decreasing each period as it is
calculated on decreasing each period as it is calculated on the outstanding amount of debt. The
before-tax cost of such a debt can be calculated as below:
or, Vd=
or, Vd =
where, Vd = Present value of bond or debt
I1, I2....In = Annual interest (Rs.) in period 1,2... and so on.
P1,P2...Pn=Periodic payment of principal in period 1, 2, and so on.
n = Number of years to maturity
Kd = Cost of debt or Required rate of return.
Cost of Existing Debt

If a firm wants to compute the current cost of its existing debt, the current market yield of
the debt should be taken into consideration. Suppose a firm has 10% debentures of Rs. 100 each
outstanding on January 1, 1994 to be redeemed on December 31, 2000 and the new debentures
could be issued at a net realisable price of Rs. 90 in the beginning of 1996, the current cost of
existing debt will be computed as:
Further, if the firm’s tax rate is 40% the after-tax cost of debt will be:
Kda = Kdb (1-t)
= 12.63 (1-0.4)
= 7.58%
Cost of Zero Coupon Bonds
Sometimes companies issue bonds or debentures at a discount from their eventual maturity
value and having zero interest rate. No interest is payable on such debentures before their
redemption and at the time of redemption the maturity value of the bond is to be paid to the
investors. The cost of such debt can be calculated by finding the present values of cash flows as
below:
(i) Prepare the cash flow table using an arbitrary assumed discount rate to discount the
cash flows to the present value.
(ii) Find out the net present value by deducting the present value of the outflows from
the present value of the inflows.
(iii) If the net present value is positive apply higher rate of discount.
(iv) If the higher discount rate still gives a positive net present value increase the discount
rate further until the UPV becomes negative.
(v) If the NPV is negative at this higher rate the cost of debt must be between these two
rates.
Illustration 3: X Ltd. has issued redeemable zero coupon bonds of Rs. 100 each at a discount
rate of Rs. 60 repayable at the end of fourth year. Calculate the cost of debt.
Cash Flow Table At Various Assumed Discount Rates

Year Cash flow Discount Factor P.V. at 12% Discount P.V. at
(Rs.) at 12% Rs. Factor at 14% Rs.
14%
0 60 1.000 (60) 1.000 (60)
4 100 0.636 63.60 0.592 59.20
3.60 -0.80
Cost of Debt (Kd) = 12+
= 12+ = 13.64%
Floating or Variable Rate Debt

The interest on floating rate debt changes depending upon the market rate of interest
payable on gilt edged securities or the prime lending rate of the bank. For example, suppose a
company raises debt from external sources on the terms of prime lending rate of the bank plus
four percent. If the prime lending rate of the bank is 8% p.a. the company will have to pay
interest at the rate of 12% p.a. Further, if the prime lending rate falls to 6% p.a. the company
shall pay interest at only 10% p.a.
Illustration 4: ABC Ltd. raised a debt of Rs. 50 lakhs on the terms that interest shall be
payable at prime lending rate of bank plus three percent. The prime lending rate of the bank is 7
per cent. Calculate the cost of debt assuming that the corporate rate of tax is 35%.
Solution:
Before-tax cost of debt,
Kdb = 7%+3% = 10%
After-tax cost of debt,
Kda = Kdb (1-t)
= 10% (1-0.35) = 10% (0.65) = 6.5%
Real or Inflation Adjusted Cost of Debt

In the days of inflation, the real cost of debt is much loss than the nominal cost as the
fixed amount is payable irrespective of the fall in the value of money because of price level
changes. The real cost of debt can be calculated as below:
Real Cost of Debt =

2. Cost of Preference Capital
A fixed rate of divided is payable on preference shares. Though dividend is payable at the
discretion of the Board of directors and there is no legal binding to pay dividend, yet it does not
mean that preference capital is cost free. The cost of preference capital is a function of dividend
expected by its investors i.e. its stated dividend. In case dividends are not paid to preference
shareholders, it will affect the fund raising capacity of the firm. Hence, dividends are usually
paid regularly on preference shares except when there are no profits to pay dividends. The cost
of preference capital which is perpetual can be calculated as:
Kp =
where Kp = Cost of Preference Capital
D = Annual Preference Dividend
P = Preference Share Capital (Proceeds.)
Further, if preference shares are issued at Premium or Discount or when costs of
floatation are incurred to issue preference shares, the nominal or par value of preference share
capital has to be adjusted to find out the net proceeds from the issue of preference shares. In such
a case, the cost of preference capital can be computed with the following formula:
Kp=
It may be noted that as dividend are not allowed to be deducted in computation of tax, no
adjustment is required for taxes.
Sometimes Redeemable Preference Shares are issued which can be redeemed or
cancelled on maturity date. The cost of redeemable preference share capital can be calculated as:
where, Kpr = Cost of Redeemable Preference Shares
D = Annual Preference dividend
MV = Maturity Value of Preference Shares
NP = Net proceeds of Preference Shares
Illustration 5: A company issues 10,000 shares 10% Preference Shares of Rs. 100 each. Cost of
issue is Rs. 2 per share. Calculate cost of preference capital if these shares are issued (a) at par,
(b) at a premium of 10% and (c) at a discount of 5%.
Solution:
Cost of Preference Capital, Kp =
(a)
(b) =
= 9.26%
(c) =
=10.75%
3. Cost of Equity Share Capital

The cost of equity is the maximum rate of return that the company must earn on equity
financed portion of its investments in order to leave unchanged the market price of its stock.’
The cost of equity capital is function of the expected return by its investors. The cost of equity is
not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend
at a fixed rate every year. Moreover, payment of dividend is not a legal binding. It may or may
not be paid. But it does not mean that equity share capital is a cost free capital. The cost of equity
can be computed in following ways:
(a) Dividend Yield Method or Dividend/Price Ratio Method : According to this method,
the cost of equity capital is the ‘discount rate that equates the present value of expected future
dividends per share with the net proceeds (or current market price) or a share’. Symbolically.
Ke =
where, Ke = Cost of Equity Capital
D = Expected dividend per share
NP = net proceeds per share
and MP = Market Price per share.
Illustration 6: A company issues 1000 equity shares of Rs. 100 each at a premium of 10%. The
company has been paying 20% dividend to equity shareholders for the past five years and
expects to maintain the same in the future also. Compute the cost of equity capital, Will it make
any difference if the market price of equity share is Rs. 160?
Solution:
Ke = D/NP
=
If the market price of a equity share is Rs. 160
Ke = D/MP
(b) Dividend yield plus growth in dividend method : When the dividends of the firm are
expected to grow at a constant rate and the dividend pay out ratio is constant this method may be
used to compute the cost of equity capital. According to this method the cost of equity capital is
based on the dividends and the growth rate.
Ke =
where, Ke = Cost of equity capital
D1 = Expected Dividend per share at the end of the year
NP = Net proceeds per share
G = Rate of growth in dividends
Do = previous year’s dividend.
Further, in case cost of existing equity share capital is to be calculated, the NP should be
changed with MP (market price per share) in the above equation.
Ke =
Illustration7: (a) A company plans to issue 1000 new shares of Rs. 100 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 10
per share initially and the growth in dividends is expected to be 5%. Compute the cost of new
issue of equity shares.
(b) If the current market price of an equity share is Rs. 150, calculate the cost of existing equity
share capital.
Solution:
(a) Ke =
(b) Ke =
(c) Earning Yield Method : According to this method, the cost of equity capital is the
discount rate that equates the present values of expected future earnings per share with the net
proceeds (or, current market price) of a share. Symbolically:
Ke =
=
where, the cost of existing capital is to be calculated:
Ke =
=
(d) Realised Yield Method: One of the serious limitations of using dividend yield method
or earnings yield method is the problem of estimating the expectations of the investors regarding
future dividends and earnings. It is not possible to estimate future dividends and earnings
correctly; both of these depend upon so many uncertain factors. To remove this drawback,
realised yield method which takes into account the actual average rate of return realised in the
past may be applied to compute the cost of equity share capital. To calculate the average rate of
return realised, dividend received in the past along with the gain realised at the time of sale of
shares should be considered. The cost of equity capital is said to be the realised rate of return by
the shareholders. This method of computing cost of equity share capital is based upon the
following assumptions:
(a) The firm will remain in the same risk class over the period.
(b) The shareholders expectations are based upon the past realised yield.
(c) The investors get the same rate of return as the realised yield even if they invest elsewhere;
(d) The market price of shares does not change significantly.
4. Cost of Retained Earning

It is sometimes argued that retained earnings do not involve any cost because a firm is not
required to pay dividends on retained earnings. However, the shareholders expect a return on
retained profits. Retained earnings accrue to a firm only because of some sacrifice made by the
shareholders in not receiving the dividends out of the available profits.
The cost of retained earnings may be considered as the rate of return which the existing
shareholders can obtain by investing the after tax dividends in alternative opportunity of equal
qualities. It is, thus, the opportunity cost of dividends foregone by the shareholders. Cost of
retained earnings can be computed with the help of following formula:
Kr =
where,
Kr = Cost of retained earnings
D = Expected dividend
NP = Not proceeds of share issue
G = Rate of growth.
Computation of Weighted Average Cost of Capital
Weighted average cost of capital is the average cost of the costs of various source of
financing. Weighted average cost of capital is also known as composite cost of capital, overall
cost of capital or average cost of capital. Once the specific cost of individual sources of finance
is determined, we can compute the weighted average cost of capital by putting weights to the
specific costs of capital in proportion of various sources of funds to total. The weights may be
given either by using thebook value of source or market value of source. If there is a difference
between market value and book value weights, the weights, the weighted average cost of capital
would also differ. The market value weighted average cost would be overstated if market value
of the share is higher than book value and vice versa. The market value weights are sometimes
preferred to the book value weights because the market value represents the true value of
investors. However, the market value weights suffer from the following limitations:
(i) It is very difficult to determine the market values because of frequent fluctuations.
(ii) With the use of market value weights, equity capital gets greater importance.
For the above limitations, it is better to use book value which is readily available. Weighted
average cost of capital can be computed as follows:
Kw =
Kw = Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source of finance
Illustration1: A firm has the following capital structure and after-tax costs for the different
sources of funds used:
Source of Funds Amount Proportion After-tax cost

Rs. % %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100
You are required to compute the weighted average cost of capital.
Solution:
Computation of Weighted Average Cost of Capital
Source of Funds Proportion % Cost % Weighted Cost %
Proportion Cost
(W) (X)
(XW) %
Debt 25 5 1.25
Preference shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
Weighted Average Cost of 9.60%
Capital
Illustration2: Continuing illustration 1, the firm has 18,000 equity shares of Rs. 100 each
outstanding and the current market price is Rs. 300 per calculate the market, value weighted
average cost of capital assuming that the market values and book values of the debt and
preference capital are same.
Solution:
Amount Proportion % Cost Weighted Cost
(Rs.) W %X Proportion Cost
Sources of Funds
XW
Debt 15,00,000 18.52 5 0.93
Preference Capital 12,00,000 14.81 10 1.48
Equity Share Capital
(18000 shares @ Rs. 300) 54,00,000 66.67 12 8.00
81,00,000 100
Weighted Average Cost of Capital 10.41%
Marginal Cost of Capital
The marginal cost of capital is the weighted average cost of new capital calculated by
using the marginal weights. The marginal weights represent the proportion of various sources of
funds to be employed in raising additional funds. In case, a firm employs the existing proportion
of capital structure and the component costs remain the same the marginal cost of capital shall be
equal to the weighted average cost of capital. But in practice, the proportion and /or the
component costs may change for additional funds to be raised. Under this situation the marginal
cost of capital shall not be equal to weighted average cost of capital. However, the marginal cost
of capital concept ignores the long-term implications of the new financing plans, and thus,
weighted average cost of capital should be preferred for maximisation of shareholder’s wealth in
the long-run.
Illustration3: A firm has the following capital structure and after-tax costs for the different
sources of funds used:
Source of Funds Amount(Rs.) Proportion (%) After-tax Cost(%)
Debt 4,50,000 30 7
Preference Capital 3,75,000 25 10
Equity Capital 6,75,000 45 15
15,00,000 100
(a) Calculate the weighted average cost of capital using book-value weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the project as below.
Debt Rs. 3,00,000
Preference Capital Rs. 1,50,000
Equity Capital Rs. 1,50,000
Assuming that specific costs do not change, compute the weighted marginal cost of capital.
Solution:
Computation of Weighted Average Cost of Capital (WACC)
Source of Funds Proportion (%) (W) After tax cost (%) Weighted Cost %
(X) (XW) %
Debt 30 7 2.10
Preference Capital 25 10 2.50
Equity Capital 45 15 6.75
Weighted Average Cost of Capital (WACC) 11.35%
Computation of Weighted Marginal Cost of Capital (WMCC)
Source of Funds Marginal Weights After tax cost (%) Weighted Marginal
Proportion (%) (W) (X) Cost %
Debt 50 7 3.50
Preference Capital 25 10 2.50
Equity Capital 25 15 3.75
Weighted Marginal Cost of Capital (WMCC) 9.75%
Cost of Equity Using Capital Asset Pricing Model (CAPM)

The value of an equity share is a function of cash inflows expected by the investors and risk
associated with cash inflows. It is calculated by discounting the future stream of dividends at
required rate of return called capitalization rate. The required rate of return depends upon the
element of risk associated with investment in share. It will be equal to the risk free arte of
interest plus the premium for risk. Thus required rate of return Ke for the share is,
Ke = Risk – free rate of interest + Premium for risk
According to CAPM, the premium for risk is the difference between market return from
diversified portfolio and risk free rate of return. It is indicated of beta coefficient (b):
Risk – premium= (Market return of a diversified portfolio – Risk free return) x b I =b I (Rm - Rf )
Thus, cost of equity, according to CAPM can be calculated as below:
Ke = Rf + b I (Rm - Rf )
where, Ke = Cost of equity capital
Rf = Risk free rate of return
Rm = Market return of a diversified portfolio
b I = Beta coefficient of the firm’s portfolio
Illustration3: You are given the following facts about a firm:
1.Risk free rate of return is 11%.
2.Beta co-efficient bI of the firm is 1.25.
Compute the cost of equity capital using Capital Asset Pricing Model (CAPM) assuming a
market return of 15 percent next year. What would be the cost of equity if bI rises to 1.75.
Solution:
when bI = 1.25
Ke =11% +1.25(15%-11%)
=11%+5% =16%
when bI =1.75 Ke= 11%+1.75(15%-11%)
=11%+7%
=18%
Illustration 4: The following is an extract from the financial statement of KPN Ltd.
Rs.lakhs (Operating
Profit 105
Less :Interest on debentures 33
72
Less: Income –tax (50%) 36

Net
Profit 36
Equity Share capital (shares of Rs.10 each) 200
Reserves and Surplus 100
15%Non-convertible
debentures (of Rs.100 each) 220
520
The market price per equity share Rs.12 and per debenture Rs.93.75.
1.What is the earning per share?
2. What is the percentage cost of capital to the company for the debenture funds and the equity?
Solution:
1.Calculation of Earnings per Share:

Earnings Per Share (EPS) = Profit After Tax/ No. Of Equity Shares
= 36,00,000/20,00,000=Rs.1.80
2.Computation of Percentage Cost of Capital.
a) Cost of Equity Capital:
Cost of Equity (Ke) = D/MP
or Ke (%)= 1.80/12 *100= 15%
where D = expected earnings per share
and MP= Market price per share.
b) Cost of Debenture Funds:
At Book Value At Market Value
(Rs. Lakhs) (Rs.
Lakhs)
Value of 15% debenture 220.00 206.25
Interest cost for the year 33.00 33.00
Less: Tax at 50% 16.50 16.50
Interest cost after tax 16.50 16.50
Cost of Debenture Fund

(%) 16.50/220 x100 16.50/206.25x100
= 7.5% = 8%.
Illustration5: Given below is the summary of the balance sheet of a company as at
31st December, 1999:
Liabilities Rs. Assets Rs.
Equity share capital
20,000 shares of Rs.100 each 2,00,000 Fixed Assets 4,00,000
Reserves and surplus 1,30,000 Investments 50,000
8% debentures 1,70,000 Current assets 2,00,000
Current Liabilities
Short term loans 1,00,000
Trade creditors 50,000
6,50,000 6,50,000
You are required to calculate the company’s weighed average cost of capital using balance
sheet valuations: The following additional information is also available:
(1) 8%Debentures were issued at par.
(2) All interests payments are up to date and equity dividends is currently 12%.
(3) Short term loan carries interest at 18% p.a
(4) The shares and debentures of the company are all quoted on the Stock Exchange and
current Market prices are as follows:
Equity Shares Rs.14 each
8% Debentures Rs.98 each.
(5) The rate of tax for the company may be taken at 50%.
Solution:
Calculation of the Cost of Equity: Rs.
Equity
Share 2,00,000
Reserves and Surplus 1,30,000

Equity (Shareholder’s )Fund 3,30,000
Book Value Per Share = 3,30,000/20,000 =Rs.16.50.

Equity Dividend Per Share = 12/100*10 =Rs.1.20
Therefore, Cost Of Equity (%)= 1.20/16.50*100= 7.273 %
Computation of Weighted Average Cost of Capital:

Capital Structure or
Type of Capital Amount (Rs) Before Tax After Tax Weighted Average cost Cost%
(Rs.) Cost%
Equity Funds 3,30,000 7.273% 7.273% 24,000

Debentures 1,70,000 8% 4% 6,800
Total 5,00,000 30,800
Weighted Average Cost of Capital = 30,800/5,00,000*100 =6.16 %.
Summary of Formulae
S.No Purpose Formula
1 Before tax cost of debt

Kdb =
2 After cost of debt

Kda = Kdb (1-t) =
3 Before tax cost of redeemable debt
4 After tax cost of redeemable debt
Kda = Kdb (1-t)
5 Cost of debt redeemable at premium
6 Cost of debt redeemable in instalments
Vd =
7 Cost of irredeemable preference share capital
Kp =
8 Cost of redeemable preference share capital
Cost of equity –dividend yield approach

9
Cost of equity – dividend yield plus constant

growth
10
Ke =
Cost of retained earnings
11
Weighted average cost of capital
Ke =
12
Cost of equity – CAPM approach
13 Kr =
Kw =
Instruction Sheet Self-learning guide 4
This learning guide is developed to provide you the necessary information regarding the
following content coverage and topics –
 Introduction and basics of Capital Expenditure Decisions

 Nature of investment decisions
 The Process of capital Budgeting
 Financial Appraisal of a project
 Appraisal criteria
 Discounted and Non-Discounted Methods.
 Inflation and Capital Budgeting - Risk Analysis and Capital Budgeting
 Certainty Equivalent Factor; Risk Adjusted Discounting Rate
 Decision Tree; Independent and Dependent Risk Analysis
 Replacement Decisions, Sensitivity Analysis
This guide will also assist you to attain the learning outcome stated in the cover page.
Specifically, upon completion of this Learning Guide, you will be able to
 Understand Capital Expenditure Decisions
 Learn the Type of Financial Appraisal of a project
 Perform – Discounted and Non Discounted Appraisals
 Apply Decision Tree
UNIT-5 INVESTMENT DECISIONS
Basics of Capital Expenditure Decisions
What is Capital Budgeting?
Capital budgeting is defined as the process of planning for projects on assets with cash flows of a
period greater than one year.
These projects can be classified as:
1. Replacement decisions to maintain the business

2. Existing product or market expansion
3. New products and services
4. Regulatory, safety and environmental
5. Other, including pet projects or difficult to evaluate projects
Additionally, projects can also be classified as mutually exclusive or independent:
- Mutually exclusive projects indicate there is only one project among all possible projects
that can be accepted.
- Independent projects are potential projects that are unrelated, and any combination of
those projects can be accepted.
The Importance of Capital Budgeting
Capital budgeting is important for many reasons:
- Since projects approved via capital budgeting are long term, the firm becomes tied to the
project and loses some of its flexibility during that period.
- When making the decision to purchase an asset, managers need to forecast the revenue
over the life of that asset.
- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the
strategic plan of the company.
The Process of capital Budgeting:
Financial Appraisal of a project
Project appraisal is a generic term that refers to the process of assessing, in a structured way, the
case for proceeding with a project or proposal. In short, project appraisal is the effort of
calculating a project's viability. It often involves comparing various options, using economic
appraisal or some other decision analysis technique
Process
 Initial Assessment
 Define problem and long-list
 Consult and short-list
 Develop options
 Compare and select Project appraisal
Types of appraisal
 Technical appraisal
 project appraisal
 commercial and marketing appraisal
 Financial/Economic appraisal
 Organisational or management appraisal
 Cost-benefit analysis
 Economic appraisal
 Cost-effectiveness analysis
 Scoring and weighting
Example of a Dam
Figure 4 indicates some of the topics to consider in a project appraisal for the construction of a
dam to provide hydroelectric power. It shows those environmental/social services not
traditionally costed (green) as well as those costs that can be estimated directly from current
market data (blue) and/or by reference to markets (dotted line).
The non-market impacts may be priced via the monetary evaluation methods indicated in the
Figure above where feasible. Note the different approaches for value and price. If the disparity
between these seems likely to be large then the demand curve approach is considered to be most
useful. Disparity occurs if the price charged for the good is very low yet the "intrinsic value" or
the value that people place on the good is very high. For example in the case of clean water, the
price for access to water in the UK is very low yet people would pay almost any amount to
ensure a basic supply.
Evaluation Techniques of Capital Budgeting or Project Appraisal
Capital budgeting is making long-run planning decisions for investment in project. Evaluation
techniques of capital budgeting can be classified into two categories.
1. Traditional Methods
2. Discounted Cash Flow Methods
1. Traditional Method
Traditional method does not consider the time value of money. It assumes that present value is
equal to future value. Traditional method is also known as on discounted or unsophisticated
method. There are two methods of evaluation:
i) Pay Back Period (PBP)
ii) Accounting Rate Of Return (ARR).
2. Discounted Cash Flow Method
Discounted cash flow method is based on the concept of the time value of money. It is more
practicable concept of decision making. The discounted cash flow method assumes that present
value of any amount is not equal to future value. The present value is much more worth than
future value. So, before evaluating any project, first of all the estimated cash flows must be
converted into present value. To convert into present value from the future value is known as
discounted value. On the basis of discounted value, it makes decision. So, it is known as
discounted cash flow method. The following methods are used under discounted cash flow
method:
i) Net Present Value (NPV)
ii) Profitability Index (PI)
iii) Internal Rate `of Return (IRR)
Net Present Value
Net present value (NPV) is used to estimate each potential project's value by using a discounted
cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the
incremental cash flows from the project. The NPV is greatly affected by the discount rate, so
selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision.
This should reflect the riskiness of the investment, typically measured by the volatility of cash
flows, and must take into account the financing mix. Managers may use models, such as the
CAPM or the APT, to estimate a discount rate appropriate for each particular project, and use the
weighted average cost of capital (WACC) to reflect the financing mix selected. A common
practice in choosing a discount rate for a project is to apply a WACC that applies to the entire
firm, but a higher discount rate may be more appropriate when a project's risk is higher than the
risk of the firm as a whole.
Internal Rate of Return
The internal rate of return (IRR) is defined as the discount rate that gives a net present value
(NPV) of zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for non-mutually exclusive
projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at
the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive
projects, the decision rule of taking the project with the highest IRR, which is often used, may
select a project with a lower NPV.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual
annual profitability of an investment. Accordingly, a measure called "Modified Internal Rate of
Return (MIRR)" is often used.
Profitability Index
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio
(VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking
projects, because it allows you to quantify the amount of value created per unit of investment.
Defining Risks in Capital Budgeting
The process of capital budgeting must take into account the different risks faced by corporations
and their managers.
Capital budgeting (or investment appraisal) is the planning process used to determine whether an
organization's long-term investments are worth pursuing. The risk that can arise here involves
the potential that a chosen action or activity (including the choice of inaction) will lead to a loss.
There are numerous kinds of risks to be taken into account when considering capital budgeting.
Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan
of firm managers. There are different ways to measure and prepare to deal and plan for these
risks, including sensitivity analysis, scenario analysis, and break-even analysis among others.
TERMS
Capital Budgeting
The planning process used to determine whether an organization's long term investments, such as
new machinery, replacement machinery, new plants, new products, and research development
projects are worth pursuing.
Risk
The potential that a chosen action or activity (including the choice of inaction) will lead to a loss
(an undesirable outcome).
Capital Budgeting
Capital budgeting (or investment appraisal) is the planning process used to determine whether an
organization's long term investments, such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth pursuing. When taking on this
planning process, managers must take into account the potential risks of the investment not
panning out the way they plan for it to, for any number of reasons. In order to discuss this
further, we should look into defining the concept or risk.
Risk
Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to
a loss (an undesirable outcome). The notion implies that a choice having an influence on the
outcome exists (or existed). Potential losses themselves may also be called "risks.”
Possible Business Risks
This chart represents a list of the possible risks involved in running an organic business. Risks
such as these affect sales, which in turn affect the amount of operating leverage a company
should utilize.
There are numerous kinds of risks to be taken into account when considering capital budgeting
including:
1. Corporate risk
2. International risk (including currency risk)
3. Industry-specific risk
4. Market risk
5. Stand-alone risk
6. Project-specific risk
Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan
of firm managers. For example, market risk involves the risk of losses in position due to
movement in market positions.
There are different ways to measure and prepare to deal with risks as well. One such way is to
conduct a sensitivity analysis. Sensitivity analysis is the study of how the uncertainty in the
output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty
in the model input.
A related practice is uncertainty analysis which focuses rather on quantifying uncertainty in

model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another
method is scenario analysis, which involves the process of analyzing possible future events by
considering alternative possible outcomes.
For example, a financial institution might attempt to forecast several possible scenarios for the
economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to
forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might
consider sub-sets of each of the possibilities. It might further seek to determine correlations and
assign probabilities to the scenarios. Then it will be in a position to consider how to distribute
assets between asset types (i.e., asset allocation). The institution can also calculate the scenario-
weighted expected return (which figure will indicate the overall attractiveness of the financial
environment). It may also perform stress testing, using adverse scenarios.
Decision trees
are a major component of many finance, philosophy and decision analysis university classes, yet
many students and graduates fail to understand the purpose behind studying this topic. However,
these statistical representations often play an integral role in the corporate finance and economic
forecasting setting, and also have been paramount to investment theory and practice.
Decision Tree Basics
The basics of decision trees are organized as follows: An individual has to make a decision such
as whether or not to undertake a capital project, or must choose between two competing
ventures; this is often depicted with a decision node. The decision is based on the expected
outcomes of undertaking the particular course of action; the outcome would be something like
"earnings are expected to increase (decrease) by $5 million ($3 million)," and are represented
with end nodes. However, since the events indicated by end nodes will be determined in the
future, their occurrence is currently uncertain. As a result, chance nodes specify the probability
of a specific end node coming to fruition.
Decision tree analysis involves forecasting future outcomes and assigning probabilities to those
events. As the list of potential outcomes, which are contingent on prior events, become more
dynamic with complex decisions, Bayesian probability models have to be implemented to
determine priori probabilities.
Assigning probabilities and forecasting the net benefits/losses given certain economic states is a
challenging feat beyond the scope of this article. Rather than these complicated issues, we will
focus on the general purposes that decision trees serve in "the real world."
Replacement Projects
A replacement project is an undertaking in which the company eliminates a project at the end of
its life and substitutes another investment.
KEY POINTS
The cash flow analysis must take all cash flow components into account, such as opportunity
costs and depreciation and maintenance expense.
The replacement project's cash flows are the additional inflows and outflows to be provided by
the prospective replacement project.
The comparison between the replacement and the current project informs the decision whether to
undertake the replacement and, if applicable, at what point replacement should occur.
TERMS
Capital budgeting
The budgeting process in which a company plans its capital expenditure (the spending on assets
of long-term value).
Sunk cost
A cost that has already been incurred and which cannot be recovered to any significant degree.
Opportunity cost.
The cost of an opportunity forgone (and the loss of the benefits that could be received from that
opportunity); the most valuable forgone alternative.
Definition
The possibility of replacement projects must be taken into account during the process of capital
budgeting and subsequent project management. A replacement project is an undertaking in
which the company eliminates a project at the end of its life and substitutes another investment.
This replacement project can serve the purpose of replacing an expiring investment with a new,
identical one, or replacing an existing investment that is producing unfavorable results with one
that management believes will perform better.
When analyzing a project, and ultimately deciding whether it is a good investment decision or
not, one focuses on the expected cash flows associated with the project. These cash flows form
the basis for the project's value, usually after implementing a method of discounted cash flow
analysis. Most projects have a finite useful life. Analysis can be undertaken in order to determine
when the optimum point of replacement will be, as well as if replacement is a viable option in
the first place. To accomplish this, one analyzes the cash flows of the current project in relation
to the expected cash flows from the replacement project .
Replacing a window sill vs. keeping the old one
Replacement project analysis tells a company whether the costs of a replacement project provide
a suitable return on investment.
Analysis
The net cash flows for a project take into account revenues and costs generated by the project,
along with more indirect implications, such as sunk costs, opportunity costs and depreciation
costs related to the project. All of these considerations taken together allow management to
consider the project's incremental cash flows, which are inflows and outflows the project
produces over predictable periods of time. Discounted cash flow analysis should be undertaken
for both the existing project and the potential replacement project. These analyses can then be
used to compare the expected profitability of both projects; which will, in theory, lead
management to make the right decision regarding the investments.
In general, there will be some sort of cash inflow from ending the old project -- for example,
from the terminal value realized upon the sale of existing equipment -- and a subsequent cash
outflow to begin the new project. The loss of expected future cash flows from the previous
project, or opportunity cost, must also be taken into account. A general form that can be used to
analyze these cash flows is:
Increase in Net Income + (Depreciation on New Investment - Depreciation on Old

Investment)
Sensitivity Analysis for Capital Budgeting
Capital budgeting refers to the process by which a business determines whether to take on a
certain project. The analysis involves estimating the amount of money the business has to invest
and the amount of revenue the project will generate. Sensitivity analysis provides additional
insight for the business to make the investment decision.
Methods
A business may use various methods to determine the financial effects of a certain project. The
business may calculate the amount of time it will take for the project to generate enough income
to cover the investment expenses. The company may also estimate the cash flow from the project
over time and calculate whether the project will lead to a profit or a loss. Another way is to
calculate the discount rate at which the project will break even.
Risk
All methods of capital budgeting involve making assumptions and estimates about the project's
future performance. The business's managers then use the results of the calculations to make
their decisions. However, the assumptions and estimates may turn out to be inaccurate and the
project may produce unexpected results. Instead of turning a profit in the second year of
operations, for example, the business may only break even because of bad economic conditions.
Related Reading: Techniques in Capital Budgeting Decisions
Sensitivity Analysis
Sensitivity analysis helps a business estimate what will happen to the project if the assumptions
and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or
estimates in a calculation to see the impact on the project's finances. In this way, it prepares the
business's managers in case the project doesn't generate the expected results, so they can better
analyze the project before making an investment.
Calculation
In capital budgeting calculations, sensitivity analysis changes one assumption or estimate at a

time to see how the results change. For example, a business may expect to earn $500, $1,000 and
$1,000 in the first three years of a project. If the business makes an initial investment of $2,500,
it will recoup its expenses in three years. However, the project may perform better than expected,
generating $2,000 yearly in its second and third year. The business will then break even in two
years.
UNIT-6 Working Capital Management
Working Capital Management
Definition of 'Working Capital Management'
A managerial accounting strategy focusing on maintaining efficient levels of both components of

working capital, current assets and current liabilities, in respect to each other. Working capital
management ensures a company has sufficient cash flow in order to meet its short-term debt
obligations and operating expenses.
Working capital (abbreviated WC) is a financial metric which represents operating liquidity
available to a business, organization or other entity, including governmental entity. Along with
fixed assets such as plant and equipment, working capital is considered a part of operating
capital. Gross working capital equals to current assets. Net working capital (NWC) is calculated
as current assets minus current liabilities.
It is a derivation of working capital that is commonly used in valuation techniques such as DCFs
(Discounted cash flows). If current assets are less than current liabilities, an entity has a working
capital deficiency, also called a working capital deficit.
Calculation
The basic calculation of the working capital is done on the basis of the gross current assets of the
firm.
Basic formula
 Working capital = Gross Current assets

 Net working capital = Current assets – Current liabilities.
Management of working capital
Guided by the above criteria, management will use a combination of policies and techniques for
the management of working capital. The policies aim at managing the current assets (generally
cash and cash equivalents, inventories and debtors) and the short term financing, such that cash
flows and returns are acceptable.
1. Cash management. Identify the cash balance which allows for the business to meet day to
day expenses, but reduces cash holding costs.
2. Inventory management. Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials—and minimizes reordering
costs—and hence increases cash flow. Besides this, the lead times in production should
be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid over production—see Supply chain
management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity
3. Debtor’s management. Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will
be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts
and allowances.
4. Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors
to cash" through "factoring".
Components of current assets and current liabilities
Objectives of Working Capital Management
The two main objectives of working capital management are:

 to ensure the organization has sufficient working capital resources to function and grow
 to improve profitability by keeping the investment in working capital to the minimum
required
These two objectives may conflict. For example, whilst an excessively conservative approach to
working capital management may provide ample liquidity it may also reduce profits because
excessive funds tied up in working capital will not be available to invest in profitable
opportunities.
Factors Affecting Working Capital Or Determinants Of Working Capital
Requirements Of working capital depend upon various factors such as nature of business, size of
business, the flow of business activities. However, small organization relatively needs lesser
working capital than the big business organization. Following are the factors which affect the
working capital of a firm:
1. Size of Business
Working capital requirement of a firm is directly influenced by the size of its business operation.
Big business organizations require more working capital than the small business organization.
Therefore, the size of organization is one of the major determinants of working capital.
2. Nature of Business
Working capital requirement depends upon the nature of business carried by the firm. Normally,
manufacturing industries and trading organizations need more working capital than in the service
business organizations. A service sector does not require any amount of stock of goods. In
service enterprises, there are less credit transactions. But in the manufacturing or trading firm,
credit sales and advance related transactions are in large amount. So, they need more working
capital.
3. Storage Time or Processing Period
Time needed for keeping the stock in store is called storage period. The amount of working
capital is influenced by the storage period. If storage period is high, a firm should keep more
quantity of goods in store and hence requires more working capital. Similarly, if the processing
time is more, then more stock of goods must be held in store as work-in-progress.
4. Credit Period
Credit period allowed to customers is also one of the major factors which influence the
requirement of working capital. Longer credit period requires more investment in debtors and
hence more working capital is needed. But, the firm which allows less credit period to
customers’ needs less working capital.
5. Seasonal Requirement
In certain business, raw material is not available throughout the year. Such business
organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow
and process them during the entire year. Thus, a huge amount is blocked in the form of raw
material inventories which gives rise to more working capital requirements.
6. Potential Growth or Expansion Of Business
If the business is to be extended in future, more working capital is required. More amount of
working capital is required to meet the expansion need of business.
7. Changes In Price Level
Change in price level also affects the working capital requirements. Generally, the rise in price
will require the firm to maintain large amount of working capital as more funds will be required
to maintain the sale level of current assets.
8. Dividend Policy
The dividend policy of the firm is an important determinant of working capital. The need for
working capital can be met with the retained earnings. If a firm retains more profit and
distributes lower amount of dividend, it needs less working capital.
9. Access To Money Market
If a firm has good access to capital market, it can raise loan from bank and financial institutions.
It results in minimization of need of working capital.
10. Working Capital Cycle
When the working capital cycle of a firm is long, it will require larger amount of working
capital. But, if working capital cycle is short, it will need less working capital.
11. Operating Efficiency
The operating efficiency of a firm also affects the firm's need of working capital. The operating
efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets
in turn results in more fund release for working capital.
Aggressive Working Capital
An aggressive working capital policy is one in which you try to squeeze by with a minimal
investment in current assets coupled with an extensive use of short-term credit. Your goal is to
put as much money to work as possible to decrease the time needed to produce products, turn
over inventory or deliver services. Speeding up your business cycle grows your sales and
revenues. You keep little money on hand, cut slow-moving inventory and unnecessary supplies
to the bone and stretch out your bill payments for as long as possible. The one payment you
cannot delay is interest -- your creditors can sue you, force you into bankruptcy and liquidate
your assets. You would also want to avoid missing tax payments.
Conservative Working Capital
Companies in volatile or seasonal industries such as tourism, farming or construction might

adopt conservative working capital policies to buffer against risk. If you employ a conservative
working capital policy, there’s plenty of cash in the bank, your warehouses are full of inventory
and your payables are all up to date. Employees need not turn in their old pencils before they are
allowed to have new ones. If you compute the working capital ratio -- current assets divided by
current liabilities -- a conservative policy might yield a ratio above 2.0. That is, you have more
than $2 in current assets for every dollar of short-term liabilities. Conservatively managed
working capital will help lower your risks of short-term cash shortages but might hurt your long-
term profitability, because excess cash doesn’t earn much of a return.
Working Capital Cycle/Operating Cycle
A continuous process starting from payment of cash for purchasing raw material, production,
stocking, selling until obtaining money from debtors.
It is a cycle involving—- conversion of cash into raw material > conversion of raw material into
WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors
and > conversion of debtors into cash.
OC = R+W+F+D-C
i.e.
Duration of Operating Cycle = Raw mat. Period + WIP period +Finished goods period +Debtors
collection period –Creditors payment period
CALCULATION OF W. CAP. CYCLE
i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days
Annual Purchases
ii) WIP duration = WIP stock X 365 days
Cost of Prodn.
iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days
Cost of Goods Sold
iv) Debtors Collection Period = Debtors X 365 days
Credit Sales
LESS :
i) Creditors Payment Period = Creditors X 365 days
Credit Purchases
Evaluating Working Capital Management
Cash flows can be evaluated using the cash conversion cycle -- the net number of days from the
outlay of cash for raw material to receiving payment from the customer. Because this number
effectively corresponds to the time that the firm's cash is tied up in operations and unavailable
for other activities, management generally aims for a low net count.
Profitability can be evaluated by looking at return on capital (ROC). This metric is determined
by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds
the cost of capital, firm value is enhanced and profits are expected in the short term.
Important working capital ratios
As always, ratios need to be understood and interpreted in relation to a firm's strategy. Planation
of the Operating Working Capital Ratios:
Working Current Assets - Current An indication of a firm's ability to grow, expand, and
Capital Liabilities take advantage of opportunities.
Working Sales / Working Capital Indicates how efficiently working capital is being
Capital used to generate sales. The higher the number the
Turnover better.
Accounts Purchases / Accounts Indicates how quickly payables are being
Payable Payable paid. Since accounts payable often times is similar
Turnover to cost-free financing, to a point, usually a slower
rate is preferred. That is, when financing is cheap or
free, repayment of the debt should be extended for as
long as possible. "Cost of Goods Sold" might be
substituted for "Purchases."
Day's 365 Days / Accounts To calculate Day's payables, simply take the number
Payables Payable Turnover calculated by the "Accounts Payable Turnover, and
divide it by 365 days. This will indicate the average
number of days the firm is taking to pay its accounts
payables. e.g. If the terms of accounts payable are
such that outstanding accounts payable are to be paid
in 60 days, then the day's payables should also be
close to 60 days.
Accounts Credit Sales / Accounts Indicates how quickly customers are paying on their
Receivable Receivable accounts. Accounts receivable is a big use of cash
Turnover and so a rapid turnover is good. i.e. The bigger the
number, the better. (usually). "Sales" might be
substituted for "Credit Sales."
Day's 365 Days / Accounts Indicates the number of days on average customers
Receivables Receivable Turnover are taking to pay on their accounts.
Inventory Cost of Goods Sold / Indicates how rapidly inventory is being
Turnover Inventory sold. Usually, the faster inventory is sold, the more
profitable the firm will be. Firms with rapid turnover
might include grocery stores, donut shops, etc. A
larger inventory turnover number is usually preferred
over a smaller number.
Day's 365 Days / Inventory Indicates on average how long inventory sits on a
Inventory Turnover firm's shelves.
UNIT-7 Capital Structure and Dividend decisions
Leverage
How Long Is Your Lever?
"Give me a lever long enough and a fulcrum on which to place it and I shall move the
world." Archimedes (287 - 212BC)
The word, leverage, has been passed around every corner of the financial universe over the past
several months. For better or worse, it has become a popular word -- one that brings that instant
gratification of, "Yes, leverage is what I need. And anyone using it must be wise." As investors
have recently learned, leverage can work for you or it can work against you. Today, we'll start
with the basics of leverage then cite a few of the many uses of the term that has been used for
centuries. Hopefully, you will discover just how long your lever is...
General Definition
First, leverage can be generally defined, in the physical sense, as an assisted advantage. As a
verb, to leverage means to gain an advantage through the use of a tool. For example, a heavy
object is more easily lifted with a lever than it is unassisted. Think of a hinge that assists in
opening a heavy door or a pulley that helps lift large objects otherwise unmovable
Leverage in finance
More recently, leverage has become an automatic term for a business, individual or other entity
utilizing borrowed money (aka "other people's money") for financial gain. Businesses have
recently used leverage to strategically change their financial structure by purchasing more
company stock with low interest rate loans or by expanding their business by purchasing other
businesses, in the form of "leveraged buyouts."
Financial leverage is assumed to always be intended as a wise use of resources, such as a tax
advantage for the corporation and/or an increase in the return on the shareholder's investment;
however, it can have negative outcomes. Companies (and individuals, alike) that are highly
leveraged increase the risk of bankruptcy; therefore risk erosion of their share price (for the
individual, personal net worth) as well as their borrowing capacity (additional financing ability,
bond/credit rating).
Recently, examples of leverage working against the user have shown their ugly results in the
form of subprime mortgage resets, hedge fund implosions, credit market contagion, and broad
stock market jitters. I've referred to this poor usage of leverage and its messy outcome as part of
the cycle of greed.
Where leverage is found
 Individuals leverage their savings when buying a home by financing a portion of the
purchase price with mortgage debt.
 Individuals leverage their exposure to financial investments by borrowing from their
broker.
 Securities like options and futures contracts are bets between parties where the principal
is implicitly borrowed/lent at very short t-bill rates.[2]
 Equity owners of businesses leverage their investment by having the business borrow a
portion of its needed financing. The more it borrows, the less equity it needs, so any
profits or losses are shared among a smaller base and are proportionately larger as a
result.[3]
 Businesses leverage their operations by using fixed cost inputs when revenues are
expected to be variable. An increase in revenue will result in a larger increase
in operating income.[4][5]
 Hedge funds may leverage their assets by financing a portion of their portfolios with the
cash proceeds from the short sale of other positions.
A Useful Way to Picture a Company
Although the following is not technically correct, it useful to think of a company as being made
up of two "black boxes." Divide the company up into
(1) Operating managers and
(2) Financial managers.
Operating managers work in departments such as production, marketing, purchasing, shipping,

etc. Their job is to produce and sell the company's products (and/or services). The financial
managers have backgrounds in finance and accounting. Their major responsibilities are to
manage the company's cash flow, arrange for suitable financing, and to minimize the taxes paid
through sound tax planning.
As a result of their efforts, the operating managers generate cash that flows into the company in
the form of sales. They subtract the expenses generated by their departments (i.e., operating
expenses) and what is left is EBIT, or net operating income. In essence, the operating managers
are telling the financial managers, "Here is the profit that we have earned for the company.
We're now turning it over to you. Try to keep as much of it as you can for the owners by
minimizing the financial costs (i.e., cost of capital) and the taxes that have to be paid."
The financial managers then try to exercise sound management techniques to minimize the
financing costs and taxes. They subtract the expenses of their departments, and then turn over
the remainder or earnings after taxes, to the shareholders.
If you picture a company in this way, it's easy to visualize the operating and financial leverage of
a company. Operating leverage deals with the relationship of EBIT to Sales, the two items on
either side of the operating "box." More exactly,
Operating leverage is the percentage change in EBIT divided by the percentage change in Sales.
Financial leverage deals with the relationship of Earnings After Taxes to EBIT, the two items on
either side of the financial "box." More exactly,
Financial leverage is the percentage change in EAT divided by the percentage change in EBIT.
The degree of magnification of income is determined by the level of fixed costs within the boxes.
If there is a high level of fixed cost within either box, the output of that box may be several times
the input of that box (in percentage terms). For example, a 1% change in sales may lead to a 3%
change in EBIT (a magnification of 3x caused by the fixed operating expenses). That 3% change
in EBIT may lead to a 6% change in EAT (a magnification of 2x caused by the fixed financial
expenses). Notice that, in this example, the Total Leverage will be 6x, i.e., the percentage
change in EAT will be 6 times the percentage change in Sales.
What is Operating Leverage?
Breakeven analysis shows us that there are essentially two types of costs in a company's cost
structure -- fixed costs and variable costs. Operating leverage refers to the percentage of fixed
costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to
variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the
firm is said to have high operating leverage. These firms use a lot of fixed costs in their business
and are capital intensive firms.
A good example of capital intensive business firm are the automobile manufacturing companies.
They have a huge amount of equipment that is required to manufacture their product -
automobiles. When the economy slows down and fewer people are buying new cars, the auto
companies still have to pay their fixed costs such as overhead on the plants that house the
equipment, depreciation on the equipment, and other fixed costs associated with a capital
intensive firm. An economic slowdown will hurt a capital intensive firm much more than a
company not quite so capital intensive.
You can compare the operating leverage for a capital intensive firm, which would be high, to the
operating leverage for a labor intensive firm, which would be lower. A labor intensive firm is
one in which more human capital is required in the production process. Mining is considered
labor intensive because much of the money involved in mining goes to paying the workers.
Service companies that make up much of our economy, such as restaurants or hotels, are labor
intensive as well. They all require more labor in the production process than capital costs.
In difficult economic times, firms that are labor intensive typically have an easier time surviving
than capital intensive firms.
What does operating leverage really mean? It means that if a firm has high operating leverage, a
small change in sales volume results in a large change in EBIT and ROIC, return on invested
capital. In other words, firms with high operating leverage are very sensitive to changes in sales
and it affects their bottom line quickly.
What is Financial Leverage?
Financial leverage refers to the amount of debt in the capital structure of the business firm. If you
can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet.
Operating leverage refers to the left-hand side of the balance sheet - the plant and equipment
side. Operating leverage determines the mix of fixed assets or plant and equipment used by the
business firm. Financial leverage refers to how the firm will pay for it or how the operation will
be financed.
As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's
operations, can really improve the firm's return on equity and earnings per share. This is because
the firm is not diluting the owner's earnings by using equity financing. Too much financial
leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios we use in determining the amount of financial leverage we have in a
business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a
business firm to equity.
What is Combined, or Total, Leverage
Combined, or total, leverage is the total amount of risk facing a business firm. It can also be
looked at in another way. It is the total amount of leverage that we can use to magnify the returns
from our business. Operating leverage magnifies the returns from our plant and equipment or
fixed assets. Financial leverage magnifies the returns from our debt financing. Combined
leverage is the total of these two types of leverage or the total magnification of returns. This is
looking at leverage from a balance sheet perspective.
It is also helpful and important to look at leverage from an income statement perspective.
Operating leverage influences the top half of the income statement and operating income,
determining return from operations. Financial leverage influences the bottom half of the income
statement and the earnings per share to the stockholders.
The concept of leverage, in general, is used in breakeven analysis and in the development of the
capital structure of a business firm.
Definition of 'Capital Structure'
A mix of a company's long-term debt, specific short-term debt, common equity and preferred
equity. The capital structure is how a firm finances its overall operations and growth by using
different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.
In finance, capital structure refers to the way a corporation finances its assets through some
combination of equity, debt, or hybrid securities. A firm's capital structure is then the
composition or 'structure' of its liabilities.
For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20%
equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this
example is referred to as the firm's leverage.
In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio
is the proportion of the capital employed of the firm which come from outside of the business
finance, e.g. by taking a short term loan etc.
We all know that capital structure is combination of sources of funds in which we can include
two main sources' proportion. One is share capital and other is Debt. All four theories are just
explaining the effect of changing the proportion of these sources on the overall cost of capital
and total value of firm.
If I have to write theories of capital structure in very few lines, I will only say that it propounds
or presents the effect on overall cost of capital and market or total value of firm, if I change my
capital structure from 50: 50 to any other proportion. First 50 represent the share capital and
second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure
in simple and clean words.
1st Theory of Capital Structure
Name of Theory = Net Income Theory of Capital Structure
This theory gives the idea for increasing market value of firm and decreasing overall cost of
capital. A firm can choose a degree of capital structure in which debt is more than equity share
capital. It will be helpful to increase the market value of firm and decrease the value of overall
cost of capital. Debt is cheap source of finance because its interest is deductible from net profit
before taxes. After deduction of interest company has to pay less tax and thus, it will decrease
the weighted average cost of capital.
For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase
the market value of firm and its positive effect on the value of per share.
High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of
financial leverage will be helpful to for maximize the firm's value.
2nd Theory of Capital Structure
Name of Theory = Net Operating income Theory of Capital Structure
Net operating income theory or approach does not accept the idea of increasing the financial
leverage under NI approach. It means to change the capital structure does not affect overall cost
of capital and market value of firm. At each and every level of capital structure, market value of
firm will be same.
3rd Theory of Capital Structure
Name of Theory = Traditional Theory of Capital Structure
This theory or approach of capital structure is mix of net income approach and net operating
income approach of capital structure. It has three stages which you should understand:
Ist Stage
In the first stage which is also initial stage, company should increase debt contents in its equity
debt mix for increasing the market value of firm.
2nd Stage
In second stage, after increasing debt in equity debt mix, company gets the position of optimum
capital structure, where weighted cost of capital is minimum and market value of firm is
maximum. So, no need to further increase in debt in capital structure.
3rd Stage
Company can gets loss in its market value because increasing the amount of debt in capital
structure after its optimum level will definitely increase the cost of debt and overall cost of
capital.
4th Theory of Capital Structure
Name of theory = Modigliani and Miller
MM theory or approach is fully opposite of traditional approach. This approach says that there is
not any relationship between capital structure and cost of capital. There will not effect of
increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor's expectations. Investors'
expectations may be further affected by large numbers of other factors which have been ignored
by traditional theorem of capital structure.
Introduction- Dividend Policy

The term dividend refers to that profits of a company which is distributed by company
among its shareholders. It is the reward of the shareholders for investments made by them in the
shares of the company. A company may have preference share capital as well as equity share
capital and dividends may be paid on both types of capital. The investors are interested in
earning the maximum return on their investments and to maximize their wealth on the other
hand, a company needs to provide funds to finance its long-term growth. If a company pays out
as dividend most of what it earns, then for Business requirements and further expansion it will
have to depend upon outside resources such as issue of debt or a new shares. Dividend policy of
a firm, thus affects both long-term financing and wealth of shareholders.
Concept and Significance
The dividend decision is one of the three basic decisions which a financial manager may
be required to take, the other two being the investment decisions and the financing decisions. In
each period any earning that remains after satisfying obligations to the creditors, the government
and the preference shareholders can either be retained or paid out as dividends or bifurcated
between retained earnings and dividends. The retained earnings can then be invested in assets
which will help the firm to increase or at least maintain its present rate of growth.
In dividend decision, a financial manager is concerned to decide one or more of the following:
- Should the profits be ploughed back to finance the investment decisions?
- Whether any dividend be paid? If yes, how much dividend be paid?
- When these dividend be paid? Interim or final.
- In what form the dividend be paid? Cash dividend or Bonus shares.
All these decisions are inter-related and have bearing on the future growth plans of firm.
If a firm pays dividend it affects the cash flow position of the firm but earns the goodwill among
investors who therefore may be willing to provide additional funds for financing of investment
plans of firm. On the other hand, the profits which are not distributed as dividends become an
easily available source of funds at no explicit costs.
However, in case of ploughing back of profits ,the firm may loose the goodwill and
confidence of the investors and may also defy the standards set by other firms. Therefore, in
taking dividend decision, the financial manager has to consider and analyse various factors.
Every aspects of dividend decision is to be critically evaluated. The most important of these
considerations is to decide as to what portion of profit should be distributed which is also known
as dividend payout ratio.
Dividend Decision and Valuation of Firms
The value of the firm can be maximized if the shareholders wealth is maximized. There
are conflicting views regarding the impact of dividend decision on valuation of the firm.
According to one school of thought, dividend decision does not affect shareholders wealth and
hence the valuation of firm. On other hand, according to other school of thought dividend
decision materially affects the shareholders wealth and also valuation of the firm. We have
discussed below the views of two schools of thought under two groups:
1. The Relevance Concept of Dividend a Theory of Relevance.
2. The Irrelevance Concept of Dividend or Theory of Irrelevance.
The Relevance Concept of Dividend
The advocates of this school of thought include Myron Gordon, James Walter and
Richardson. According to them dividends communicate information to the investors about the
firm’s profitability and hence dividend decision becomes relevant. Those firms which pay higher
dividends will have greater value as compared to those which do not pay dividends or have a
lower dividend pay out ratio. It holds that dividend decisions affect value of the firm.
We have examined below two theories representing this notion: (i) Walter’s Approach
and (ii) Gordon’s Approach.
(i) Walter’s Approach: Prof. Walter’s model is based on the relationship between the
firms (a) return on investment i.e. r and (b) the cost of capital or required rate of return i.e. k.
According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of return on its
investment than the required rate of return, the firm should retain the earnings. Such firms are
termed as growth firm’s and the optimum pay-out would be zero which would maximize value
of shares.
In case of declining firms which do not have profitable investments i.e. where r<k, the
shareholder would stand to gain if the firm distributes it earnings. For such firms, the optimum
payout would be 100% and the firms should distribute the entire earnings as dividend.
In case of normal firms where r=k the dividend policy will not affect the market value of
shares as the shareholders will get the same return from the firm as expected by them. For such
firms, there is no optimum dividend payout and value of firm would not change with the change
in dividend rate.
Assumptions of Walter’s model

(i) The firm has a very long life.
(ii) Earnings and dividends do not change while determining the value.
(iii) The Internal rate of return ( r ) and the cost of capital (k) of the firm are constant.
(iv) The investments of the firm are financed through retained earnings only and the firm
does not use external sources of funds.
Walter’s formula for determining the value of share
Where P = Market price per share

D = Dividend per share
r = internal rate of return
E = earnings per share
ke = Cost of equity capital.
Criticism of Walter’s Model
Walter’s model has been crticised on account of various assumptions made by Prof Walter in
formulating his hypothesis.
(i) The basic assumption that investments are financed through retained earnings
only is seldom true in real world. Firms do raise fund by external financing.
(ii) The internal rate of return i.e. r also does not remain constant. As a matter of
fact, with increased investment the rate of return also changes.
(iii) The assumption that cost of capital (k) will remain constant also does not hold
good. As a firm’s risk pattern does not remain constant, it is not proper to assume that
(k) will always remain constant.
(ii) Gordon’s Approach : Another theory which contends that dividends are relevant is
Gordon’s model. This model which opinions that dividend policy of a firm affects its value is
based on following assumptions:-
1. The firm is an all equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate,
(g=br) is also constant.
5. ke >br
Gordon argues that the investors do have a preference for current dividends and there is a
direct relationship between the dividend policy and the market value of share. He has built the
model on basic premise that investors are basically risk averse and they evaluate the future
dividend/capital gains as a risky and uncertain proposition. Investors are certain of receiving
incomes from dividend than from future capital gains. The incremental risk associated with
capital gains implies a higher required rate of return for discounting the capital gains than for
discounting the current dividends. In other words, an investor values current dividends more
highly than an expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that dividend policy is relevant,
as investors prefer current dividends as against the future uncertain capital gains. When investors
are certain about their returns they discount the firm’s earnings at lower rate and therefore
placing a higher value for share and that of firm. So, the investors require a higher rate of return
as retention rate increases and this would adversely affect share price.
Symbolically: -
where P = Market price of equity share

E = Earnings per share of firm.
b = Retention Ratio (1 – payout ratio)
r = Rate of Return on Investment of the firm.
Ke = Cost of equity share capital.
br = g i.e. growth rate of firm.
The Irrelevance Concept of Dividend
The other school of thought on dividend policy and valuation of the firm argues that what
a firm pays as dividends to share holders is irrelevant and the shareholders are indifferent about
receiving current dividend in future. The advocates of this school of thought argue that dividend
policy has no effect on market price of share. Two theories have been discussed here to focus on
irrelevance of dividend policy for valuation of the firm which are as follows:
1. Residual’s Theory of Dividend
According to this theory, dividend decision has no effect on the wealth of shareholders or
the prices of the shares and hence it is irrelevant so far as valuation of firm is concerned. This
theory regards dividend decision merely as a part of financing decision because earnings
available may be retained in the business for re-investment. But if the funds are not required in
the business they may be distributed as dividends. Thus, the decision to pay dividend or retain
the earnings may be taken as residual decision. This theory assumes that investors do not
differentiate between dividends and retentions by firm. Their basic desire is to earn higher return
on their investment. In case the firm has profitable opportunities giving higher rate of return than
cost of retained earnings, the investors would be content with the firm retaining the earnings to
finance the same. However, if the firm is not in a position to find profitable investment
opportunities, the investors would prefer to receive the earnings in the form of dividends. Thus, a
firm should retain earnings if it has profitable investment opportunities otherwise it should pay
them as dividends.
Under the Residuals theory, the firm would treat the dividend decision in three steps:
o Determining the level of capital expenditures which is determined by the investment

opportunities.
o Using the optimal financing mix, find out the amount of equity financing need to support the
capital expenditure in step (i) above
o As the cost of retained earnings kr is less than the cost of new equity capital, the retained
earnings would be used to meet the equity portions financing in step (ii) above. If available
profits are more than this need, then the surplus may be distributed as dividends of
shareholder. As far as the required equity financing is in excess of the amount of profits
available, no dividends would be paid to the shareholders.
Hence, in residual theory the dividend policy is influenced by (i) the company’s
investment opportunities and (ii) the availability of internally generated funds, where dividends
are paid only after all acceptable investment proposals have been financed. The dividend policy
is totally passive in nature and has no direct influence on the market price of the share.
2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner in support of
theory of irrelevance. They maintain that dividend policy has no effect on market prices of shares
and the value of firm is determined by earning capacity of the firm or its investment policy. As
observed by M.M, “Under conditions of perfect capital markets, rational investors, absence of
tax discrimination between dividend income and capital appreciation, given the firm’s
investment policy, its dividend policy may have no influence on the market price of shares”.
Even, the splitting of earnings between retentions and dividends does not affect value of firm.
Assumptions of MM Hypothesis
(1) There are perfect capital markets.
(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to effect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates applicable to
dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in value of
the firm results from payment of dividend, will be exactly off set by achieve in market price of
shares because of external financing and there will be no change in total wealth of the
shareholders. For example, if a company, having investment opportunities distributes all its
earnings among the shareholders, it will have to raise additional funds from external sources.
This will result in increase in number of shares or payment of interest charges, resulting in fall in
earnings per share in future. Thus whatever a shareholder gains on account of dividend payment
is neutralized completely by the fall in the market price of shares due to decline in expected
future earnings per share. To be more specific, the market price of share in beginning of period is
equal to present value of dividends paid at end of period plus the market price of shares at end of
period plus the market price of shares at end of the period. This can be put in form of following
formula:-
P0 = D1 + P 1
1 + Ke
where
PO = Market price per share at beginning of period.
D1 = Dividend to be received at end of period.
P1 = Market price per share at end of period.

Ke = Cost of equity capital.
The value of P1 can be derived by above equation as under.
The MM Hypothesis can be explained in another form also presuming that investment
required by the firm on account of payment of dividends is financed out of the new issue of
equity shares.
In such a case, the number of shares to be issued can be computed with the help of the
following equation:
Further, the value of the firm can be ascertained with the help of the following formula:
where,
m = number of shares to be issued.
I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital.
n = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nPO = Value of the firm.
This equation shows that dividends have no effect on the value of the firm when external
financing is used. Given the firm’s investment decision, the firm has two alternatives, it can
retain its earnings to finance the investments or it can distribute the earnings to the shareholders
as dividends and can arise an equal amount externally. If the second alternative is preferred, it
would involve arbitrage process. Arbitrage refers to entering simultaneously into two
transactions which exactly balance or completely offset each other. Payment of dividends is
associated with raising funds through other means of financing. The effect of dividend payment
on shareholder’s wealth will be exactly offset by the effect of raising additional share capital.
When dividends are paid to the shareholder, the market price of the shares will increase. But the
issue of additional block of shares will cause a decline in the terminal value of shares. The

market price before and after the payment of the dividend would be identical. This theory thus
signifies that investors are indifferent about dividends and capital gains. Their principal aim is to
earn higher on investment. If a firm has investment opportunities at hand promising higher rate
of return than cost of capital, investor will be inclined more towards retention. However, if the
expected return is likely to be less than what it would cost, they would be least interested in
reinvestment of income. Modigiliani and Miller are of the opinion that value of a firm is
determined by earning potentiality and investment policy and never by dividend decision.
Criticism of MM Approach
MM Hypothesis has been criticized on account of various unrealistic assumptions as
given below.
1. Perfect capital markets does not exist in reality.
2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital
gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
Lets Sum Up
· Dividend decision is an important decision, which a financial manager has to take.
It refers to that profits of a company which is distributed by company among its
shareholders.
· There has been a difference of opinion on the effect of dividend policy on value of
firm. Two schools of thought have emerged on relationship between dividend policy
and value of firm.
· On one hand Walter model and Gordon model consider dividend as relevant for
value of firm as investors prefer current dividend over future dividend.
· On other hand Residuals Approach and MM Model consider dividend is irrelevant
for value of firm. The detention of profit for re-investment is important. MM Model
have introduced arbitrage process to prove that value of firm remain same whether
firm pays dividend or not.

UNIT-8 Emerging Issues: Derivatives, Merger and Acquisition
Risk is a complex topic. There are many types of risk, and many ways to evaluate and measure
risk. In the theory and practice of investing, a widely used definition of risk is:
“Risk is the uncertainty that an investment will earn its expected rate of return.”
Note that this definition does not distinguish between loss and gain. Typically, individual
investors think of risk as the possibility that their investments could lose money.They are likely
to be quite happy with an investment return that is greater than expected - a “positive surprise.”
However, since risky assets generate negative surprises as well as positive ones, defining risk as
the uncertainty of the rate of return is reasonable. Greater uncertainty results in greater likelihood
that the investment will generate larger gains, as well as greater likelihood that the investment
will generate larger losses (in the short term) and in higher or lower accumulated value (in the
long term.)
In financial planning, the investment goal must be considered in defining risk. If your goal is to
provide an acceptable amount of retirement income, you should construct an investment
portfolio to generate an expected return that is sufficient to meet your investment goal. But
because there is uncertainty that the portfolio will earn its expected long-term return, the long-
term realized return may fall short of the expected return. This raises the possibility that available
retirement funds fall short of needs - that is, the investor might outlive the investment portfolio.
This is an example of "shortfall risk." The magnitude and consequences of the potential shortfall
deserve special consideration from investors. However, since the uncertainty of return could also
result in a realized return that is higher than the expected return, the investment portfolio might
"outlive" the investor. Therefore, considerations of shortfall risk are subsumed by considering
risk as the uncertainty of investment return.

Business Risk
Business risk is just one portion of the risk that determines a business firm's future return on
equity. Business risk is the risk that a firm's shareholders face if the firm has no debt. It is the
risk inherent in the firm's operations. It rises from economic uncertainty which leads to
uncertainty about future profits and capital requirements.
One component of business risk is variability in product demand. Customers always have to have
food so in difficult economic times, the Publix grocery store chain will have less product
variability than Ford Motor Company. Customers don't have to buy new cars during periods of
economic uncertainty. Most business firms also have variability in product sales prices and input
costs. Firms that are slower to bring new products to market expose themselves to more business
risk. Think of the American automobile companies. Foreign car companies brought fuel efficient
cars to market faster than American car companies, exposing them to more business risk.
If a business firm has high fixed costs and their costs do not decline as demand declines, then the
firm has high operating leverage which means high business risk.
Definition of 'Risk-Return Tradeoff'

The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-
risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are
associated with high potential returns. According to the risk-return tradeoff, invested money can
render higher profits only if it is subject to the possibility of being lost.
Introduction to Risk and Return
The risks associated with investment are:-
1. Inflation risk : Due to inflation, the purchasing power of money gets reduced.
2. Interest rate risk : Due to an economic situation prevailing in the country, the interest rate
may change.
3. Default risk : The risk of not getting investment back. That is, the principal amount
invested and / or interest.
4. Business risk : The risk of depression and other uncertainties of business.

5. Socio-political risk : The risk of changes in government, government policies, social
attitudes, etc.
The returns on investment usually come in the following forms:-
1. The safety of the principal amount invested.

2. Regular and timely payment of interest or dividend.
3. Liquidity of investment. This facilitates premature encashment, loan facilities,
marketability of investment, etc.
4. Chances of capital appreciation, where the market price of the investment is higher, due
to issue of bonus shares, right issue at a lower premium, etc.
5. Problem-free transactions like easy buying and selling of the investment, encashment of
interest or dividend warrants, etc.
The simple rule of investment management is that:-
1. The higher the risk, the greater will be the returns.

2. Similarly, lesser the risk, the lower will be the returns.
This rule of investment management is depicted in the following diagram:-

The above diagram showing risk and return indicates that:-
1. Low risk instruments such as small savings, and bank deposits bring low returns.
2. Medium risk instruments such as company deposits and non-convertible debentures will
earn medium returns.
3. High-risk securities like equity shares, and convertible debentures will earn higher
returns.
Measuring the rate of return
Definition of 'Rate Of Return'
The gain or loss on an investment over a specified period, expressed as a percentage increase
over the initial investment cost. Gains on investments are considered to be any income received
from the security plus realized capital gains.
'Rate Of Return' Explained
A rate of return measurement can be used to measure virtually any investment vehicle, from real
estate to bonds and stocks to fine art, provided the asset is purchased at one point in time and
then produces cash flow at some time in the future. Financial securities are commonly judged
based on their past rates of return, which can be compared against assets of the same type to
determine which investments are the most attractive. In finance, return is a profit on an
investment. It comprises any change in value, and interest or dividends or other such cash flows
which the investor receives from the investment.
Ambiguously, return is also used to refer to a profit on an investment, expressed as a proportion

of the amount invested. This is also called the holding period return.
A loss instead of a profit is described as a negative return.
Rate of return is a profit on an investment over a period of time, expressed as a proportion of the
original investment. The time period is typically a year, in which case the rate of return is
referred to as annual return.

Return, in the second sense, and rate of return, are commonly presented as a percentage.
ROI is an abbreviation of return on investment, i.e. return per dollar invested. It is a measure of
investment performance, as opposed to size (c.f. return on equity, return on assets, return on
capital employed).
Calculation
The return, or rate of return, can be calculated over a single period, or where there is more than
one time period, the return and rate of return over the overall period can be calculated, based
upon the return within each sub-period.
Single-period Return
where:
= final value, including dividends and interest
= initial value
For example, if you hold 100 shares, with starting price is 10 USD, then the starting value is 100
x 10 USD = 1,000 USD.
If you then collect 0.50 USD per share in cash dividends, and the ending share price is 9.80
USD, then at the end you have 100 x 0.50 USD = 50 USD in cash, plus 100 x 9.80 USD = 980
USD in shares, totalling a final value of 1,030 USD.
The change in value is 1,030 USD - 1,000 USD = 30 USD, so the return is 30 / 1,000 = 3%.

Risk and expected Return Concepts
Expected return is calculated as the weighted average of the likely profits of the assets in the
portfolio, weighted by the likely profits of each asset class. Expected return is calculated by
using the following formula:
Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnRn
Example: Expected Return
For a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect the stock fund to return 10% and the bond
fund to return 6% and our allocation is 50% to each asset class, we have the following:
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
Expected return is by no means a guaranteed rate of return. However, it can be used to forecast
the future value of a portfolio, and it also provides a guide from which to measure actual returns.
Let's look at another example. Assume an investment manager has created a portfolio with Stock
A and Stock B. Stock A has an expected return of 20% and a weight of 30% in the portfolio.
Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the
portfolio?
E(R) = (0.30)(0.20)+(0.70)(0.15) = 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%.

Sources of Risk-Portfolios and risk
Types of risk
Below are descriptions of different types of investment risks.
Portfolio theory makes an important distinction between two types of risks:
 Unsystematic risk: the measure of risk associated with a particular security; also known
as diversifiable risk. This risk can be mitigated by holding a diversified portfolio of many
different stocks in many different industries.
 Systematic risk: also known as market risk. Systematic risk is faced by all investors due
to market volatility. This risk cannot be diversified away. This is the type of risk most
people are referring to when they casually use the term "risk" when discussing
investments.
Some additional risks faced by all investments include:
 Liquidity risk--the risk that an asset cannot be sold when desired or in sufficient
quantities because opportunities are limited. Treasury securities (with the exception of
inflation protected Treasury bonds) have the least liquidity risk.
 Political risk--the risk to an investment due to changes in the law or political regime.
Potential changes in tax law or changes in a country's structure of governance are sources
of political risk.
Stocks, bonds and cash are all subject to inflation risk--the risk that one's investment will not
keep pace with inflation. This risk can be mitigated by investing in inflation-protected Treasury
bonds, such as TIPS or I-bonds.
Stocks and corporate bonds are subject to financial risk--the risk due to the capital structure of a
firm. Corporate debt magnifies financial risk to a company's stocks and bonds.

Bond investors also face the following major risks:
 Interest rate risk--the risk associated with changes in asset price due to changes in interest
rates. Bonds and bond funds face this type of risk. As interest rates rise, prices on existing
bonds decline and vice versa. Interest rate risk is greater for bonds with longer maturities,
and lower for bonds having short maturities.
 Credit risk--the risk of default. Holders of corporate and municipal bonds face this risk.
Other risks applicable to bond investments include:
 Call risk--the risk that a bond issuer, after a decline in interest rates, may redeem a bond
early, forcing the bond holder to find a replacement investment that may not pay as well
as the original bond.
 Reinvestment risk--the risk that earnings from current investments will not be reinvested
at the same rate of return as current investment yields. Coupon payments from a bond
may suffer reinvestment risk if they cannot be reinvested at the same rate as the bond's
yield.
Investors in international stocks and bonds are also exposed to currency risk, the risk caused
from changes in currency exchange rates. Investments in currencies other than the one in which
the investor purchases most goods and services are subject to currency risk.
Investors using actively managed funds are exposed to management risk--the risk that fund or
portfolio managers will under-perform benchmarks due to their management decisions or style.
Investors can avoid this risk by selecting passively-managed index funds.
Individual investors are exposed to two additional risks:
 Shortfall risk--the risk the portfolio will not provide sufficient returns to meet the
investor's goal(s). Shortfall risk is one of the most significant risks investors face.
 Longevity risk--the risk an investor will outlive his/her money.

CAPM
Definition of 'Capital Asset Pricing Model - CAPM'

A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure (beta)
that compares the returns of the asset to the market over a period of time and to the market
premium (Rm-rf).
'Capital Asset Pricing Model - CAPM' Explained
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the
CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a
stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2
and the expected market return over the period is 10%, the stock is expected to return 17%
(3%+2(10%-3%)).
COMPONENTS OF CAPITAL ASSET PRICING MODEL
The capital asset pricing model (CAPM) is an equilibrium pricing model. The CAPM measures
how much a given asset's return is affected by the movement of the overall market. The S&P 500
is often the benchmark index used in the model. The first component of the CAPM is the beta or
risk associated with the asset. Thus, the beta for a asset is calculated based on the asset's returns,
Ri, relative to returns from the market, Rm:

The second component of the CAPM is the expected rate of return for an asset based on the beta
coefficient and the risk free rate of return and the market wide risk premium. The reference point
for the risk free rate in the U.S. is the return on a treasury bond.
For an example let us say that stock A has a beta (Bi = .5%), the risk free rate of return (Rf =
4%) and the expected rate of return for the market (Rm = 10%). You would calculate the
expected rate of return for the asset as follows:

For Additional Study:
Suggested readings:-
Fund of Financial Management 5ed
Prasanna Chandra
Financial Management
Khan & Jain
GULATI
Financial Management:
Sheeba Kapil
Sudhindra Bhat
I.M. Pandey
Fundamentals of Financial Management, 6e
Prasanna Chandra

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MINISTRY OF COMMERCE & INDUSTRY

IPRM- INTEGRATED PROGRAMME IN RETAIL

FDDI SCHOOL OF RETAIL MANAGEMENT

Introduction to Financial Management

Whether your organization is large or small, effective financial management is an on-going

 “Financial Management is the Operational Activity of a business that is responsible for

Decisions must be taken in three key areas:

 Investment - both long-term investment in non-current assets and short-term investment

The investment decision

For a business to be successful, as well as identifying and implementing potentially successful

The financing decision

The dividend decision

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

1. To ensure regular and adequate supply of funds to the concern.

1. Estimation of capital requirements: A finance manager has to make estimation with

In management, organisation's structure is divided on the basis of authorities and responsibilities

1. Role of Finance Manager for Raising Funds of Company

2. Role of Finance Manager for Taking Maximum Benefits from Leverage

3. Role of Finance Manager for International Financial Decision

Finance manager finds opportunities in international financial decision. In these opportunities, he

4. Role of Finance Manager in Investment Decisions

Top Management-Finance Interface

Economics – Finance Interface

Accounting – Finance Interface

A financial review is a tale of regulatory investigation, accounting acumen and operating

Securities markets--also known as financial exchanges or stock markets--are a key component of

Government watchdogs oversee the activities of securities-exchange players to make sure

Name: _________________________ Date: _______________

1. What do you mean by the term Finance? 2

2. Define Financial Management (FM). 2

3. What are the objectives of FM? 5

4. What are the advantages of a balanced FM system? 5

5. What is the importance of FM in an organization? 5

6. What are the functions of Financial Management? 2

7. Explain the Indian Financial System. 15

8. Briefly explain the roles of finance department and finance manager. 15

9. What is Corporate finance mean? 2

10. Write short notes on:

Time Value of Money

Calculating the Time Value of Money

Present Value of Money

Future Value of Money

The formula for finding the future value of money

Calculating the Price of a Bond

Meaning, Concept and Definition

Symbolically cost of capital may be represented as:

Significance of the Cost of Capital

where, Io, is the net cash inflow at zero point of time,

COMPUTATION OF SPECIFIC SOURCE OF FINANCE

(ii) Kdb = (where, NP = Net Proceeds)

Cost of Redeemable Debt

Cost of Debt Redeemable at Premium

After-tax cost of debt,

Cost of Debt Redeemable in Instalments

Cost of Existing Debt

Cash Flow Table At Various Assumed Discount Rates

Cost of Debt (Kd) = 12+

Floating or Variable Rate Debt

Real or Inflation Adjusted Cost of Debt

Real Cost of Debt =

Cost of Preference Capital, Kp =

3. Cost of Equity Share Capital

4. Cost of Retained Earning

Name: ___________ Date: _