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Corporate Finance
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Corporate Finance
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corporate finance
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COURSE DESIGN COMMITTEE
TOC Reviewer Content Reviewer

Ms. Dimple Pandey Mr. Chetan Jain
Assistant Professor, NMIMS Global Visiting Faculty, NMIMS Global
Access - School for Continuing Education Access - School for Continuing Education
Specialization: Finance Specialization: Finance
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Author: Preeti Marwah

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Reviewed By: Chetan Jain
Copyright:
2015 Publisher
ISBN:
978-93-5119-751-5
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
NMIMS Global Access - School for Continuing Education School Address
V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India.
NMIMS Global Access - School for Continuing Education

CONTENT S
CHAPTER NO. CHAPTER NAME PAGE NO.
1 An Introduction to Finance 1
2 Time Value of Money 27
3 Capital Budgeting 45
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4 Sources of Finance 65
5 Capital Structure Management 101

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6 Leverages 141
7 Dividend Policy 165

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8 Working Capital Management 187

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9 Receivables and Inventory Management 211
10 Budget and Budgeting 235
11 Case Studies 257

c o r p o r at e fin a n ce
c u r r i c ulum
An Introduction to Finance: Concept of Finance, Scope of Finance, Functions of Finance, Con-

cept of Financial Management, Objectives of Financial Management, Analysing Financial Busi-
ness Decisions
Time Value of Money: Time Value of Money, Future Value of Cash Flow, Present Value of Cash Flow
Capital Budgeting: Concept of Capital Budgeting, Techniques of Capital Budgeting, Project Selec-
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tion and Evaluation, Capital Budgeting Problems, Capital Rationing, Sensitivity Analysis in Capital
Budgeting
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Source of Finance: Financial Market, Long-Term Sources of Finance, Medium Term Sources of
Finance, Short-Term Sources of Finance, Overseas Sources of Finance
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Capital Structure Management: Capital Structure Management, Capitalisation, Theories of Cap-

ital Structure Management, Cost of Capital
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Leverages: Concept of Leverages in Finance, Financial Leverage, Operating Leverage, Combined

Leverage
Dividend Policy: Dividend Policy, Factors Determining Dividend Policy, Types of Dividend Policy,
Approaches to Dividend Policy, Forms of Dividend Payment
Working Capital Management: Concept of Working Capital Management, Principles of Work-

ing Capital Management, Factors Affecting Working Capital Management, Methods for Assessing
Working Capital, Financing of Working Capital Requirement, Asset Securitisation (Way for Raising
the Working Capital), Working Capital Factoring

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Receivables and Inventory Management: Concept of Receivables Management, Credit Policies and
Credit Terms, Collection Policies, Concept of Inventory Management, Tools and Techniques of Invento-
ry Management, Reorder Point, Safety Stock
Budget and Budgeting: Concept of Budget, Types of Budget, Budgeting as Tool of Cost Control, Advan-
tages and Limitations of Budgeting, Zero-Based Budgeting (ZBB), Rolling Budget, Cash Budget
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Ch a
1 p t e r
AN INTRODUCTION TO FINANCE
CONTENTS
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1.1 Introduction
1.2 Concept of Finance
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Self Assessment Questions
Activity
1.3 Scope of Finance
Activity
1.4 Functions of Finance
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1.4.1 Functions of a Finance Manager

1.4.2 Functions of a Controller
1.4.3 Functions of a Treasurer
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Activity
1.5 Concept of Financial Management
Activity
1.6 Objectives of Financial Management
1.6.1 Profit Maximisation
1.6.2 Wealth Maximisation
1.6.3 Difference Between Profit Maximisation and Wealth Maximisation
1.6.4 Value Maximisation
Activity
1.7 Analysing Financial Business Decisions
1.7.1 Cost-Volume-Profit Analysis
1.7.2 Break-Even Analysis
1.7.3 Marginal Costing

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CONTENTS
1.7.4 Margin of Safety

Activity
1.8 Summary
1.9 Descriptive Questions
1.10 Answers and Hints
1.11 Suggested Reading for Reference
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AN INTRODUCTION TO FINANCE 3
Introductory Caselet
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Brew & Bite’s Financial Decision
Brew & Bite is a fast food and coffee parlour bar that also offers
delivery of snacks and drinks to local offices and shops. The food
and drinks parlour has proved to be very successful in the recent
years owing to excellent food quality and delivery services. As a
result, the demand for its food delivery has increased substantial-
ly. Jessy, the owner, aims to expand the parlour’s delivery system
and intends to increase the number of motorbikes used for deliv-
ering snacks and drinks to home and offices in the city. In this re-
gard, Jessy approaches a nearby financial firm for seeking advice
on raising funds for purchasing four additional motorbikes.
After analysing the financial details of Brew & Bite, the financial
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consultants offer Jessy the following advice:
Jessy could apply for a bank loan, which provides long-term fi-
nance with a fixed rate of interest and amount of repayments.
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She could use the Bank Overdraft facility, which is a short-
term finance option.
Jessy could also use the credit from her suppliers.
Of these options, Jessy chooses the option of taking a bank loan

and repaying it in fixed periods at a fixed interest rate.
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4 Corporate finance
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learning objectives
After studying the chapter, you will be able to:

>> Explain the concept, scope and functions of finance
>> Describe the concept of financial management
>> Explain the objectives of financial management, such as
profit maximisation, wealth maximisation, and value max-
imisation
>> Analyse financial business decisions through cost-vol-
ume-profit analysis and break-even analysis
1.1 INTRODUCTION
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An organisation needs finance for its various activities, operations,
and projects. It needs to ensure that there is enough finance at ev-
ery stage of development, i.e., right from incorporation to maturity.
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In the incorporation stage, the organisation needs finance to develop
its basic infrastructure, such as establishing plants and machinery. In
the development stage, it requires finance to expand its business op-
erations by entering into joint ventures and mergers and acquisitions,
and funding working capital requirements. Thereafter, in the matu-
rity stage, the organisation needs finance to stay competitive in the
business through effective advertisement and constant improvement
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in its products. The process of managing the funds of an organisation

is called financial management.
Financial management aims to achieve three major objectives in an

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organisation. Firstly, it ensures that there is enough finance available

for different business activities. Secondly, financial management aims
to find profitable options for organisations to invest their funds. Fi-
nally, it focuses on the judicial and rationale use of funds to increase
the financial efficiency of the organisation. Hence, a finance manager,
possessing good knowledge of the financial management process, can
help the organisation to lower the cost of availing funds and maximise
returns on them.
This chapter starts by explaining the concept of finance. It also ex-

plains the scope and functions of finance. Further, it explains the con-
cept of financial management. In addition, the chapter focusses on the
objectives of financial management. Towards the end, it explains the
analysis of financial business decisions.
1.2 CONCEPT OF FINANCE

According to Encyclopaedia of Britannica, “Finance is an act of pro-
viding means of payment.”

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The word finance is derived from the French word fine, meaning to
pay, settle, or finish. Thus, we can define finance as a science of man-
aging money. It includes all activities that are connected with funds.
Finance can be defined from the corporate and business point of

view. Corporate finance involves the financial decisions that an or-
ganisation makes in its daily business operations. It aims to utilise
the capital, which the organisation has, to make more money while
simultaneously reducing risks of certain decisions. Thus, business de-
cisions that involve the decision pertaining to identification of sources
of capital for funding corporations are corporate financial decisions.
Business finance, on the other hand, encompasses various activities
and disciplines concerning the management of money and other valu-
able assets. Therefore, it can be concluded that business finance has a
broader approach than corporate finance.
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Approaches to finance has undergone three major changes. These ap-
proaches can be explained as follows:
The first approach stated to the concept of finance is that it is a
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means of procuring funds by corporate enterprises to meet their
financial requirements.
The second approach stated that finance is related to all the func-
tional areas of the organisation, such as marketing, production,
and research and development.
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The third approach, also called the modern/managerial approach

to finance, is a balanced and most widely acceptable approach.
It states that finance is concerned with procuring and investing
funds in profitable projects.
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self assessment Questions
1. __________ involves the financial decisions that an organisation

makes in its daily business operations.
Activity
Suppose you have to explain the concept of finance to a non-finan-

cial person. How will you do that?
1.3 SCOPE OF FINANCE

An organisation needs finance to acquire assets, manufacture goods,
offer high quality services, procure raw materials, pay its employees
and invest in development and expansion projects. Finance is re-
quired in various areas of an organisation, which are as follows:

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Production: It refers to the process of converting raw material into

finished goods. In the production area, finance serves as a means
of payment for various operations such as purchasing raw materi-
al, plant and machinery, tools, and technological expertise.
Marketing: It needs finance to carry out important functions, such
as sales, advertising, and distribution. In sales function, the organ-
isation needs finance to promote its products via sales promotion
activities. In advertising function, the organisation needs finance
to use various advertising modes like print and electronic media.
In distribution function, the organisation needs finance to either
purchase or rent distribution centres, along with arranging trans-
portation to supply goods to these centres.
Human Resource: It refers to the workforce within the organisa-
tion, who works towards achieving the required targets. The or-
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ganisation requires finance to recruit, select, train, and promote
employees.
Research and Development: It requires finance to develop new
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products or improve existing products. Usually, organisations
maintain a separate financial reserve, only allocated for its re-
search and development activities.
2. In the advertising function, an organisation needs finance

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to promote its products via sales promotion activities. (True/

False)
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Activity
Find out at least three areas (other than the ones mentioned above)
where finance is required. Use the Internet to gather necessary in-
formation.
1.4 FUNCTIONS OF FINANCE

If there is enough finance, an organisation can invest in various proj-
ects. The functions of finance are majorly influenced by four types of
decisions, which are as follows:
Investment Decision: It involves decisions concerning whether
to invest in a particular project or not. These decisions are also
known as capital budgeting decisions. An organisation needs to
take the following aspects into consideration while making invest-
ment decisions:
It need to compute the profitability expected from any new in-
vestments.

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It need to compare the required rate of return against the pro-

spective return on the new investment.
Financing Decision: It involves choosing various financial sources
to invest in various long-term and short-term projects. The aim of
financing decision is to decide from when, where, and how funds
should be collected to meet the organisation’s investment decision.
This decision determines the proportion of equity and debt in the
capital structure of an organisation.
Dividend Decision: It deals with decisions regarding dividend
distribution. The organisation needs to decide on dividend decla-
ration or whether to keep the whole amount of profit as retained
earnings. When the organisation decides to pay dividends to its
shareholders, it needs to establish the dividend amount. The rate
at which the dividend is distributed is known as dividend payout
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ratio.
Liquidity Decision: It deals with decisions related to the require-
ments of current or liquid assets in an organisation. The organi-
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sation invests in both current and fixed assets. In an organisation,
liquidity decisions are taken to ensure that sufficient funds are
available to meet daily financial needs.
1.4.1 FUNCTIONS OF A FINANCE MANAGER
A finance manager aims to efficiently allocate and use the resources

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of on organisation. He/She is responsible for procuring funds from

the market so as to reduce risks and cost. The functions of a finance
manager are as follows:
Forecasting and planning: It involves predicting the need of funds
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for both short-term (working capital requirements) and long-term

purposes (capital investment).
Determining the capital structure: It involves selecting the op-
timum equity amount and debt capital in the total capital of the
organisation.
Raising sufficient fund: It involves gathering sufficient finance to
meet long-term and short-term investment needs.
Designing investment policy: It involves formulating investment
policy, using various capital budgeting tools, such as payback
method, Accounting Rate of Return (ARR), Internal Rate of Re-
turn (IRR), and Net Present Value (NPV).
Planning dividend decision: It involves determining whether the
earning has to be retained in the business or distributed among
shareholders.
Financial negotiation: It includes negotiating with various finan-
cial institutions and banks with a purpose to raise funds on favour-
able terms and conditions.

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Cash management: It includes providing cash supply on time to

maintain the liquidity position and managing the working capital
need of the organisation.
1.4.2 FUNCTIONS OF A CONTROLLER
A controller is a person responsible for establishing and executing in-

ternal controls over an organisation’s accounting and financial proce-
dures. In addition, the controller can also compare the actual financial
performance of the organisation with the planned performance. The
functions of the controller are as follows:
Keeping a record of all transactions in the general ledger and
sub-ledger
Handling the short-term financing as well as reconciliation trans-
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actions
Looking into areas of taxation and insurance
Acting as a planning director
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Preparing financial information reports
Looking into the regulatory aspects and helping in the implemen-
tation of organisation’s financial policies
1.4.3 FUNCTIONS OF A TREASURER
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A treasurer has a regulatory role over all aspects of financial man-

agement and works closely with other members of the management
to maintain the organisation’s finances. Some of the major roles of a
treasurer are as follows:
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General financial oversight: These responsibilities involve over-

seeing budgets, accounts and financial statements of the company,
liaising with designated staff about financial matters, ensuring ap-
propriate financial systems and controls are in place, record-keep-
ing, compliance with relevant legislation, etc.
Fund raising: These responsibilities include ensuring that funds
are raised at the least possible cost by complying with relevant
legislation and effective financial systems and controls are in place
for monitoring and reporting, etc.
Financial planning and budgeting: These responsibilities involve
preparing and presenting budgets for new and existing invest-
ments, advising on financial implications of strategic and opera-
tional plans, presenting revised financial forecasts, etc.
Financial reporting: These responsibilities involve presenting
regular reports on the organisation’s financial position, advising
on an organisation’s reserves and investment policy.

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Banking, book-keeping and record-keeping: These responsibil-

ities include managing organisation’s bank accounts, setting up
appropriate systems for book-keeping, payments, and petty cash,
ensuring proper record keeping of transactions, etc.
Control of fixed assets and stock: These responsibilities include
ensuring that assets are insured, and there are proper records of
purchase and consumption of the organisation’s stock.
It can be concluded that a treasurer is responsible for ensuring that

effective financial systems and procedures have been established and
complied with, by everyone in the organisation.
3. A controller is the chief accounting manager of an organisation.
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Activity
Visit a manufacturing company near your locality. Find out the func-
tions of the finance manager and write a brief note for the same.
1.5 CONCEPT OF FINANCIAL MANAGEMENT

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According to J. C. Van Horne, “Financial Management is concerned

with the acquisition, financing, and management of assets with some
overall goal in mind.”
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Financial Management can be defined as the function involved in

the management of financial resources. These functions include fund
raising, working capital management, capital budgeting, and capital
structure designing of an organisation. Financial management also
determines the future strategies related to expansion, diversification,
joint venture, and mergers and acquisitions.
There are three major elements of financial management, which are

as follows:
Financial Planning: It refers to scheduling the use of financial re-
sources, such as collection of funds, deciding the fund amount, and
ensuring low cost and risk in the raised finance. In the short term,
funds may be required to meet operational and working capital
requirements, such as paying for current liabilities and purchases
made on credit whereas, in the long term, finance is needed to
carry out mergers and acquisitions, expansion, and diversification
of the organisation.
Financial Control: It refers to the process of supervising and mon-
itoring the organisation’s financial operations. It helps to rectify

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any financial operations errors and ensures there is efficient utili-

sation of resources needed to accomplish the goal of the organisa-
tion within the allotted time-frame.
Financial Decision-Making: It helps the organisation in taking
various decisions that involves effective use of funds. Some of the
major financial decisions include investing in a project, distribut-
ing dividend, and maintaining liquidity.
4. Which of the following refers to the process of supervising and

monitoring the organisation’s financial operations?
a. Financial control
b. Financial decision-making
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c. Financial planning
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Activity
Suppose your friend wants to learn the concept of financial man-

agement from you. How will you explain it to him/her?
OBJECTIVES OF FINANCIAL
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1.6
MANAGEMENT
Financial management ensures that all available financial resources are
used efficiently to achieve the financial objectives of an organisation.
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The main objective of financial management is to increase the profit

of the organisation. However, the organisation also wants to increase
wealth and value by maximising returns to shareholders. The objec-
tives of financial management are detailed in the next few sections.
1.6.1 PROFIT MAXIMISATION
In today’s highly competitive environment, organisations aim to in-

crease their profits. Profit maximisation is one of the basic objectives
of all organisations due to the following reasons:
Required for organisation’s survival: It implies that organisa-
tions which are capable of making profit in the long run, adapt to
changes and compete with others can only survive.
Meeting the other organisational objectives: An organisation
must increase its profits in order to finance its various activities on
a continuous basis
Measuring growth: An organisation can only grow on the bases of
the profits it generates.

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Measuring efficiency: It refers to estimating the capability of an or-

ganisation to use its funds rationally, i.e., if an organisation is earn-
ing high profit, then it is said to be efficient. Hence, profit maximi-
sation is an indicator of efficiency of the organisation. It is also the
most important element to judge the credibility of an organisation.
There has also been a lot of criticism of the profit maximisation ap-
proach due to the following reasons:
Different objectives of an organisation: Organisations tend to
focus on objectives other than profit maximisation, for example,
targeting sales maximisation.
Ignoring social aspect: It is also considered to ignore the welfare
of the society. If an organisation wants to survive in the long run, it
must consider the effects of its operations on the society.
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Adopting narrow approach: It is also criticised that the previous
performance and future business aspects are ignored and only the
current profit maximisation is being focussed.
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Ignoring the long-term objectives: It is considered to be short-
term in nature, i.e. it, ignores long-term objectives like wealth
maximisation.
1.6.2 WEALTH MAXIMISATION
Economists recommend this approach to overcome the limitations of

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profit maximisation. The aim of wealth maximisation approach is to max-

imise the wealth of shareholders by increasing Earning Per Share (EPS).
Some of the benefits of the wealth maximisation approach are as follows:
Superior to profit maximisation: It is considered a superior ap-
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proach to profit maximisation as it focuses on the long-term growth

and development of an organisation.
Fulfilling the goals of different departments: It helps to achieve
the goals of various departments, such as production, marketing,
and human resource of an organisation. If the organisation has suffi-
cient wealth, then it can easily fulfil the needs of all its departments.
Increase in EPS: It helps in increasing the value of shares due
to increase in overall wealth of the organisation. This approach
focuses on the appreciation of EPS by increasing the profitability
and productivity of the organisation.
Efficient allocation of resources: It indicates increase in pro-
ductivity and decrease in the cost of production. This approach
ensures that the organisational resources are used effectively to
achieve the objectives of the organisation.
Ensuring social interest: It considers the welfare of the society
and effects that will have on it as a result of its operations. This ap-
proach promotes the use of eco-friendly techniques of production
to ensure the social interest of the organisation.

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However, the wealth maximisation approach also has certain limita-

tions, which are as follows:
Useful for large organisations only: It is considered suitable for
large organisations only as small organisations have limited finan-
cial resources, and hence they prefer to maximise their profit first.
Distribution of dividends: Organisations following the wealth
maximisation approach aim to maximise shareholders’ wealth.
Therefore, such organisations distribute a portion of their profits
as dividends to the shareholders. However, the organisations may
choose to retain the earnings for investing in profitable projects.
1.6.3 DIFFERENCE BETWEEN PROFIT MAXIMISATION

AND WEALTH MAXIMISATION
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The difference between the profit maximisation and wealth maximis-
ation approach as is shown in Table 1.1:
Table 1.1: Difference between Profit Maximisa-

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tion and Wealth Maximisation
Profit Maximisation Approach Wealth Maximisation Approach
It aims to raise the profit of the It aims to raise the wealth of the
organisation. shareholders.
It determines the effectiveness of It determines the financial stability
the organisation. of the organisation.
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It satisfies the short-term objectives It satisfies the long-term objectives

of an organisation. of an organisation.
It does not consider descriptive the It involves the descriptive approach
approach as it is aimed to achieve as it achieves the long-term objec-
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the short-term objectives. tives. (The descriptive approach fo-

cuses on the previous performance
and future business aspects of an
organisation.)
It does not give a clear view on It distributes the earnings among
whether the earnings would be dis- shareholders as dividend.
tributed or retained in the organi-
sation.
It does not involve directly raising It involves directly raising the EPS
the EPS of an organisation. The of an organisation. The growth in
profitability of the organisation indi- the value of the shares increases the
rectly increases EPS. wealth of the shareholders.
It does not consider the time value It takes into consideration the time
of money. The profit maximisation value of money. The wealth maxi-
approach is based on the belief that misation approach recognises that
“higher the profit better is the pro- cash benefits emerging from a pro-
posal”. In principle, the approach ject in different time zones would
considers only the present profits of not be identical in value.
an investment ignoring the impact
of timing on the value of returns.

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1.6.4 VALUE MAXIMISATION
Value maximisation can be defined as the managerial function in-

volved in the appreciation of the long-term market value of an organ-
isation. The total value of an organisation comprises all the financial
assets, such as equity shares, preference shares and warrants, and it
increases when the value of its shares increases in the market.
The main objective of an organisation is to increase the market val-

ue of its equity shares. The value of these shares is considered as a
benchmark to measure the performance of the organisation. Value
maximisation is similar to wealth maximisation, in a way that it focus-
es on maximising the value of shares that in turn means increasing
the wealth of shareholders. However, value maximisation is a broader
concept than wealth maximisation as value maximisation aims to in-
crease not only the value of its equity shares but also the value of all
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its financial assets. If an organisation is able to increase its value then
it can generate sufficient returns to pay dividend to the shareholders
and finance all its activities, operations and projects.
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5. Which of the following is defined as the managerial function

involved in the appreciation of the long-term market value of
an organisation?
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a. Profit maximisation
b. Value maximisation
c. Wealth maximisation
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Activity
Compare wealth maximisation and value maximisation. Write a

brief note on the comparison. Use the internet to avail necessary
resources.
ANALYSING FINANCIAL BUSINESS

1.7
DECISIONS
When decisions are taken regarding the allocation of an organisation’s
financial resources in the most efficient manner, it is called financial
business decisions. Before investing in a project, the organisation
needs to determine the feasibility of every available option. For ex-
ample, an organisation wishes to invest in a garment-manufacturing
project. Before investing in the project, it needs to estimate the cost
of manufacturing garments. Further, it needs to decide the probable
profit from the project. If the cost incurred in manufacturing gar-

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ments is less than the expected profit, then it would be feasible for the
organisation to go ahead with the project. This process of determining
the feasibility of a project is known as financial analysis. A feasibility
study includes a detailed analysis of a project or investment avenue in
order to predict the results of a specific future course of action.
An organisation can perform financial analysis by using various tools,

which are described in following few sections.
1.7.1 COST-VOLUME-PROFIT ANALYSIS
Cost-Volume-Profit (CVP) analysis determines the change in profit

with respect to changes in sales volume and cost. Let us consider an
example. Suppose the sales volume of an organisation increases, and
to meet the increased sales volume, the organisation needs to maxi-
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mise its production. The revenue also increases with the sales volume.
This occurs as revenue is the amount that is received by the organi-
sation after selling its goods and services. On the other hand, with in-
crease in production, the cost also increases because the organisation
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needs to recruit new employees and buy raw material. The profit is
computed by deducting cost of production from the revenue generat-
ed. Since the values of both the revenue (because the sales volume has
changed) and cost have changed; hence, the amount of profit would
also change. CVP analysis measures the change in profit because of
changes in sales volume and cost. It helps the organisation in calculat-
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ing the expected profit at a given level of sales volume and production.
The importance of CVP analysis for a finance manager is as follows:

It helps in accurate profit forecasting.
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It helps in budget preparation to determine sales, costs, and prof-

its at different stages of production.
CVP analysis helps in establishing price policy by forecasting the
effects of economic changes.
It determines the overhead cost to be charged at various stages of
production.
The techniques of CVP analysis are widely used in management ac-

counting. Some of these techniques are as follows:
Fixed Cost and Variable Cost: It determines the cost involved in
the production of goods. Fixed cost remains constant for a specif-
ic level of production over a certain time-period. However, it may
change, if the production level increases beyond a limit. Variable
cost changes with each unit of production and it is directly pro-
portional to the level of production. If the production of goods in-
creases, then the variable cost also increases and vice versa. For
example, the cost incurred for setting up plants and machineries
are considered fixed cost, as this cost does not change with the pro-

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duction level. On the other hand, the cost associated with labour
and raw material change with the production level; therefore, this
type of cost is variable cost.
Profit-Volume Ratio: It determines the relationship between prof-
it and volume of production. The profit increases with the increase
in the volume of production and decreases with decrease in the
volume of production.
Differential Costing: It refers to the costing technique that mea-
sures the variation in the total cost of production with the change
in the level of business operation. It helps the management of an
organisation to forecast the profit at different levels of production.
Break-Even Analysis: It refers to the determination of the point
where sales revenue is equal to the total cost involved in the pro-
duction process.
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Margin of Safety Ratio: It refers to the ratio of sales and profit
of an organisation. Margin of safety is defined as the difference
between the actual sales and break-even sales of an organisation.
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Sales Mix Analysis: It refers to the process of establishing a rela-
tionship between sales variable and the CVP of an organisation.
It helps in analysing changes in the sales mix on the CVP of an
organisation.
In an organisation, the Profit/Volume (P/V) ratio represents the CVP

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ratio. the P/V ratio is computed by dividing total contribution by total

sales. The formula used to calculate the P/V ratio is as follows:
Profit/Volume (P/ V ratio) = Total contribution/Total sales
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However, the following formulae is also needed to calculate the P/V

ratio:
Marginal cost = Total variable cost or Total cost – Fixed cost or
Direct material + Direct labour + Direct expenses + Variable
Overheads
Or
Marginal cost= Variable cost
Contribution = Selling price – Variable cost
Profit = Contribution – Fixed cost

Fixed cost = Contribution – Profit
Contribution = Fixed cost + Profit
A high P/V ratio indicates that the organisation is generating a huge

profit. Therefore, a high P/V ratio is always favourable for organisa-
tion.

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Alternatively, you can calculate the P/V ratio by using the following
formulae:
P/V ratio = Contribution/Sales
As contribution = Sales – Variable cost

P/V ratio = (Sales – Variable costs)/ Sales
Or P/V ratio = 1 – (Variable costs/Sales)
An increase in contribution would indicate an increase in profit, as

fixed costs are assumed constant at all levels of production.
Therefore, P/V ratio = Change in contribution/Change in sales
The P/V ratio establishes the relationship between contribution and

sales and is vital to study the profitability of operations in an organisa-
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tion. The higher the P/V ratio, the more will be the profit and vice versa.
1.7.2 BREAK-EVEN ANALYSIS

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Break-even analysis is a technique used to determine whether or not
the given level of production would be profitable for an organisation.
It is conducted by finding out the Break-Even Point (BEP) of an or-
ganisation. BEP refers to a point where total cost is equal to total rev-
enue of an organisation. In other words, it is a point where there is no
profit or no loss for the organisation. If the revenue goes beyond this
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point then the organisation earns profit. However, if the revenue goes
below BEP then the organisation incurs loss. Figure 1.1 shows the
break even point:
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Figure 1.1: Break-Even Point
In the figure OA represents the change in income at varying levels of

output. OB represents the total fixed costs in the business. As output

n o t e s
increases, variable costs are incurred, which implies that total costs
(fixed + variable) also increase. At low levels of output, costs are high-
er than income. At the point of intersection, P, costs are exactly equal
to income, and thus, organisation incurs no loss, no profit at this level
of output.
Let us now look at an example. Suppose an organisation is involved in

the manufacturing of dinnerware. The cost involved in manufactur-
ing 1000 dinnerware is `10,000 and the revenue generated by selling
dinnerware is `15,000. In such a case, the organisation earns sufficient
profit of `5,000; therefore, it would remain in the business. However, if
the organisation receives only `10,000 by selling its dinnerware, then
it is neither incurring profit nor loss. The organisation is said to be
operating at BEP; therefore, it should try to increase its sales. If the
organisation gets `8,000 by selling its dinnerware, then it is incurring
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losses. In such a situation, the organisation may consider the option of
closing down its business activities. Hence, break-even analysis helps
the organisation in assessing its current financial situation. It also
helps the organisation in determining the profitable level of output.
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BEP can be calculated by using the following methods:
1. Contribution Margin Method
BEP (Unit) = Fixed Cost / Contribution per unit
BEP (`) = Fixed Cost / P-V Ratio
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= Break-even unit × Selling price per unit

P-V Ratio = (Contribution / Sales) × 100
Desired Sales = (Fixed Cost + Desired Profit) / P-V Ratio
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Also, note that at BEP

Contribution = Fixed Cost
2. Equation Method
The equation method is derived from the income equation:
Net Profit = Sales – Total Cost
= Sales – (Fixed Cost + Variable Cost)
Or, Sales = Net Profit + Fixed Cost + Variable Cost
SP(S) = FC + VC(S) + P
Where, S = Number of unit sold at the BEP

SP = Selling Price per unit
FC = Total Fixed Cost
VC = Variable Cost per unit
P = Net Profit

n o t e s
At the break-even point, P = 0

Therefore, SP (S) = FC + VC(S)
Or FC = SP (S) – VC (S)
Or S (SP – VC) = FC
Or, S = FC / (SP – VC)
BEP can be calculated from the sales aspect by using the
following formulae:
BEP of sales = (Fixed cost/Contribution per unit) * Selling price
per unit
Or = Break-even output × Selling price per unit
Or = (Fixed costs/Total contribution) × Total sales
S
Or = Fixed cost/1 – (Variable cost per unit/Selling price per unit)
Or = Fixed cost/P/V ratio
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An organisation can calculate three types of BEP as per its require-
ments. These three types are as follows:
Cost BEP: It indicates a situation where the costs under two alter-
natives are equal. If an organisation has two investment projects
of same cost, cost BEP helps in selecting the best alternative. The
formula to calculate cost BEP is as follows:
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Cost BEP (in units) = Increase in fixed cost/saving in variable cost

per unit
Cash BEP: It indicates a production level at which cash inflow
is equal to cash outflow. The organisation divides the total cost
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into two categories to find out the cash inflow and cash outflow.
The first category consists of fixed cost that does not require im-
mediate cash outflow (However, some fixed cost, such as rentals
and salaries might need immediate outflow before the operations
starts.) or cash inflow. For example, the settlement of depreciation
reserves does not need urgent cash outflow or cash inflow. Howev-
er, the second category is variable cost which requires immediate
cash outflow or cash inflow. For example, the payment for pur-
chase of raw materials needs immediate cash outflow. Cash BEP
can be computed by using the following formula:
Cash BEP (of output) = Cash Fixed Costs/Cash Contribution per
unit
Composite BEP: It refers to a method used by the finance manager
of an organisation dealing with various products. In this method,
BEP of several products is computed at the same time. Composite
BEP can be computed by using the following formulae:
Composite BEP (in units) = Composite fixed costs/Composite con-
tribution per unit

n o t e s
Composite BEP (of sales) = Total fixed costs/Composite P/V ratio

Composite BEP (of sales) = (Total fixed costs × Total sales)/Total
contribution
Composite P/V ratio = (Total contribution/Total sales) × 100
The break-even analysis is based on the following assumptions:

Cost is segregated into fixed cost and variable cost.
Fixed cost remains constant at each production level.
Variable cost varies whenever output changes.
Selling price remains constant for each production level.
Production and sales remain constant.
Operational efficiency of the organisation stays the same.
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The advantages of BEP are as follows:
It assists in budgeting, forecasting, and controlling organisational
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cost.
It helps in forecasting the profit or loss of the organisation with the
proportionate changes in the cost and volume of production.
It helps in product decision, pricing of the product, and selection
of the channel of distribution.
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Ithelps in studying the relation between the cost, profit, and vol-
ume of production.
It helps in determining the margin of safety for the organisation.
It helps the management of an organisation in making various de-
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cisions, such as estimating the future strategy and better place-

ment of the product in the market.
Some of the limitations of BEP are as follows:

It does not give any solution to the problems related to the estima-
tion of prices for special products, such as luxury items.
It focuses only on the profit and not on the profitability of an or-
ganisation. It does not consider the impact of increase in the cap-
ital of the organisation on the production of goods. As most of the
organisations have limited capital; hence, the usage of capital for
increasing the production would affect other necessary activities
It does not offer any solution to address the risk and uncertainty
involved in the employment of the capital.
It focuses only on the short-term objective and profitability of the
organisation.

n o t e s
It cannot differentiate between fixed and variable costs in some

situations.
It does not find applicability in organisations with flexible plant
capacity.
Illustration:
Calculate the break-even points in terms of sales units from the fol-
lowing information:
Selling price/unit = `150
Variable cost/unit = `70
Total Fixed Cost = `16,000
What would be the sales at the break-even point?
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Solution:
Break-even point in units = 16,000/ (150-70)

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= 16,000/80
= 200 units.
Break-even point sales = `150 × 200 = `30000
Illustration: ABC company is involved in manufacturing a single

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product. The company has invested `9, 00,000 as fixed cost. The vari-
able cost is `450/unit. The company sells its products at `900/unit. Cal-
culate the break-even production level.
Solution:
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At break-even point: Sp * Q = Vp*Q + FC

900 × Q = 450× Q + 9,00,000
900 Q = 450Q + 9,00,000
450Q = 9, 00,000
Q = 2000 units.
Therefore, the company will achieve breakeven at 2000 units.
1.7.3 MARGINAL COSTING
Marginal costing is also known as direct costing and is one of the es-
sential financial tools, that helps the finance manager to study the be-
haviour of cost and its impact on the profitability of an organisation.
It is the change in the total cost of production when an additional unit
of product is produced. Therefore, it is the cost incurred in producing
an extra unit of product. It can be defined as the process of calculating
the marginal cost and its effect on profit as a result of change in pro-

n o t e s
duction. The term contribution refers to the difference between sales

and marginal cost.
Hence:
Marginal Cost = Variable Cost (Direct labour) + Direct Material
+ Direct Expenses + Variable Overheads
Contribution = Sales – Marginal Cost.
Marginal cost indicates how much total cost changes for a given
change in the quantity of output. As changes in total cost are equal to
total variable cost in the short run (total fixed cost is fixed), marginal
cost is the change in either total cost or total variable cost. In a nut-
shell, marginal costs are the variable costs associated with increasing
output in the short run.
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The advantages of marginal costing are as follows:
It helps in efficient budgeting as it is easy to understand.
It proves to be a very effective technique for short-term costing.
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It helps in better understanding the relationship between cost,
price, and volume.
It avoids under-or over-absorption of the capital and other organ-
isational resources.
It provides valuable information for financial decision making.
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It helps in studying the impact of production and sales policy on

the competitive position of the organisation.
The limitations of marginal costing are as follows:

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It limits the use of marginal cost in future decision making because

marginal cost is determined from the historical data and the man-
agerial decisions need the use of current data.
It does not consider the importance of fixed cost in the production
process.
It calculates incorrect stock valuation due to lack of fixed cost in
the valuation of stock.
It does not prove useful for long-term purposes.
It is difficult to contrast fixed and variable cost.
1.7.4 MARGIN OF SAFETY
Margin of Safety (MoS) indicates the amount of sales that is above the
break-even point. In other words, MoS indicates the amount by which
an organisation’s sales could decrease before the company become
unprofitable.
In break-even analysis, MoS is an indicator of the extent by which ac-

tual or projected sales exceed the sales at the break-even point. MoS

n o t e s
can be calculated using the following formulae:

MOS = Budgeted Sales − Break-even Sales
MOS (in terms of %) = (Budgeted Sales − Break-even Sales)/
Budgeted Sales
MoS is a measure of risk. It represents the drop in an organisation’s

sales which would not impact its profit levels significantly. A high mar-
gin of safety indicates that the organisation can withstand fluctuations
in sales. A drop in sales greater than the margin of safety results in a
net loss for the period.
Let us understand this with the help of the following illustration:
Illustration: The following information is related to ABC Ltd. Which

is engaged in the production and sales of small plastic containers for
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storage purposes:
Sales price per unit `40
Variable cost per unit `32
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Total fixed cost `7,000
Budgeted Sales `40,000
Solution:
Breakeven Sales Units = `7,000 ÷ (`40 - `32) = 875 units

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Budgeted Sales Units = `40,000 ÷ `40 = 1,000 units
Margin of Safety (%) = (1,000 − 875) ÷ 1,000 = 12.5%

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This implies that a drop in sales above 12.5% of the current sales level
would result in net loss for ABC Ltd.
Figure 1.2 depicts an MOS chart of the example :
Figure 1.2: MOS Chart

n o t e s
As shown in Figure 1.2, sales volume is depicted on the X-axis and

profit is reflected on the Y-axis. The sales line and total cost line in-
tersect each other at BEP. Fixed cost is parallel to the X-axis as at any
level of the sales volume, the fixed cost would remain constant. When
the organisation moves beyond BEP, MOS would occur.
6. When sales volume increases, revenue also increases. (True/

False)
7. __________ means the difference between the actual sales
volume and the sales volume at BEP.
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Activity
A table fan manufacturing organisation has the capacity to produce

5000 fans per annum. The marginal cost of each fan is ` 2000, and
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each fan is sold for ` 2500, while fixed overheads are ` 120000 per
annum. Calculate the BEP for output and sales. What would be the
profit of the organisation, if the production of output is 90% of the
capacity?
1.8 SUMMARY
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Corporate finance involves the financial decisions that an organi-

sation makes in its daily business operations.
An organisation needs finance to obtain assets, manufacture
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goods, offer high quality services, procure raw materials, pay its
employees and invest in development and expansion projects.
A controller is the chief accounting manager of an organisation
who is responsible for investigating the operational areas to find
out inefficiencies. The responsibilities include evaluation Finan-
cial Performance, updating the management about investment av-
enues and other areas
The treasurer is responsible to maintain the funds of the organisa-
tion to ensure their rationale and judicious use.
Financial management determines the future strategies related to ex-
pansion, diversification, joint venture, and mergers and acquisitions.
The main objective of financial management is to increase the
profit of the organisation.
The aim of wealth maximisation approach is to maximise the
wealth of shareholders by increasing EPS.
The Cost-Volume-Profit (CVP) analysis determines the change in
profit with respect to changes in sales volume and cost.

n o t e s
BEP refers to a point where total cost is equal to total revenue of

an organisation.
Margin of Safety (MOS) means the difference between actual sales
volume and the sales volume at BEP.
key words
Financial Management: It refers to the managing the sources

and utilisation of funds in an organisation.
Risk-return Trade-off: It refers to an optimal point found at the
intersection of risk and return associated with an investment
project.
Retained Earnings: It refers to the part of the profit retained by
the organisation for further investment.
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Liquidity: It refers to the capability of an organisation to meet
short-term financial needs.
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Profitability: It refers to the excess of earning over expendi-
ture.
Dividend: It refers to the part of profit distributed among share-
holders.
Capital Structure: It refers to the proportion of debt and equity
in the total capital of an organisation.
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1.9 DESCRIPTIVE QUESTIONS

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1. What is the scope of finance?

2. What are the functions of a finance manager?
3. The following information is available about a manufacturing
plant:
Selling price/unit = ` 120
Variable cost per unit = ` 72
Total fixed cost = ` 36,000
Budgeted Sales = ` 2,40,000
Calculate the following:
Breakeven Sales Units
Budgeted Sales Units
Margin of Safety (%)

n o t e s
1.10 Answers and hints
answers for Self Assessment Questions
Topic Q. No. Answers

Concept of Finance 1. Corporate finance
Scope of Finance 2. False
Functions of Finance 3. True
Concept of Financial 4. a. Financial control
Management
Objectives of Finan- 5. b. Value maximisation
cial Management
Analysing Financial 6. True
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Business Decisions
7. Margin of Safety (MoS)
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HINTS FOR Descriptive Questions
1. Finance is required in various areas of an organisation, i.e.
production, marketing, human resource and research and
development. Refer to Section 1.3 Scope of Finance.
2. The finance manager is responsible to procure funds from
the market so as to reduce the risk and cost. Refer to Section
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1.4 Functions of Finance.

3. Solution:
Breakeven Sales Units = `36,000 ÷ (`120 – `72) = 750 units
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Budgeted Sales Units = 2,40,000/120 = 2,000 units

Margin of Safety (%) = (2,000 – 750) ÷ 2,000 = 62.5%
1.11 SUGGESTED READING FOR REFERENCE
SUGGESTED READINGS
Vernimmen, P., et al. (2011). Corporate Finance: Theory and Prac-

tice. (3rd ed.). Chichester, UK: John Wiley & Sons, Ltd.
Kapil, S. (2010). Financial Management. Pearson.
Khan,M., & Jain, P. (1985). Management accounting and financial
management. New Delhi: Tata McGraw-Hill.

n o t e s
E-REFERENCES
Basiccollegeaccounting.com. (2014). Explain the objectives, func-

tions, roles of a Finance Manager « Introduction « Financial Man-
agement « College Accounting Coach. Retrieved from, <http://
basiccollegeaccounting.com/2008/05/explain-the-objectives-func-
tions-roles-of-a-finance-manager/>
Pages.stern.nyu.edu.
(2014). Introduction to Corporate Finance.
Retrieved from, <http://pages.stern.nyu.edu/~adamodar/New_
Home_Page/background/cfin.htm>
Tutor2u.net. (2014). Introduction to Financial Management. Re-
trieved from, <http://www.tutor2u.net/business/accounts/finance_
management_intro.htm>
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Ch a
2 p t e r
TIME VALUE OF MONEY
CONTENTS
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2.1 Introduction
2.2 Time Value of Money
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Activity
2.3 Future Value of Cash Flow
2.3.1 Future Value of Single Cash Flow
2.3.2 Future Value of Annuity
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Activity
2.4 Present Value of Cash Flow
2.4.1 Present Value of Single Cash Flow
2.4.2 Present Value of Annuity
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Activity
2.5 Summary

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land aCQuisition AT FUTUREX Private limited
Futurex Pvt. Ltd. is on the lookout for sites to acquire land. It

has explored various sites to establish its infrastructure. It finally
selects a site that seems to be suitable from all aspects, starting
from production to marketing. The company contacts the bank to
finance the acquisition of the land through a lease contract. The
company sanctioned a loan of `10,00,000 at the rate of 15% per
annum.
Mr. R.C. Gupta has been recruited as the new Finance manager in
Futurex Pvt. Ltd. The management has assigned him the respon-
sibility to finalise the contract with the bank.
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TIME VALUE OF MONEY 29
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learning objectives

>> Explain the concept of time value of money
>> Discuss the future value of cash flow
>> Explain the present value of cash flow
2.1 INTRODUCTION
Time value of money indicates the change in the value of money over a
period of time at a specific rate of interest. For example, the time value
of `100 after one year at the rate of 20% p.a. would be `120. It means
that the value of `100 at present and value of `120 after one year would
S
be the same to the receiver if the rate of interest is 20% p.a. Further,
the time value of money indicates that the value of the same amount
of money is more at present as compared to the future.
IM
Time value of money is widely used by an organisation while taking
important financial and investment decisions. The organisation needs
to invest its money in various projects to generate profit. Generally,
an organisation has various options in which it can invest its money.
Before finalising an option, it compares the time value of money of all
the available other options.
M
In addition, it is important to note that time value of money depends

on the rate of interest, i.e., if the rate of interest is high, time value
of money would also be high and vice versa. The organisation would
select the option that provides the highest value of the money in the
N
future. Hence, the concept of time value of money is important in the

financial management of an organisation.
In this chapter, you will study concept of the time value of money. Fur-
ther, you will study the future value of single cash flow and annuity.
Towards the end of this chapter, you will study the concept of present
value of single cash flow and annuity.
2.2 TIME VALUE OF MONEY

Time value of money analyses the value of a unit of money at various
times. We can say that a rupee received today is more valuable than a
rupee received in the future. This is because the money received in the
future involves risk and money available at present offers investment
opportunities. For example, a person has an option to receive `1000
now or after one year. The person would prefer `1000 now because he/
she can invest the money and earn interest on it. However, after one
year it may be possible that the individual would not receive `1000
because of uncertainty. Moreover, it may be possible that the value of

n o t e s
money depreciates over time. Hence, in such a case, `1000 received at

present is more valuable than `1000 received after one year.
A person values the money available at present due to the following

reasons:
Investment options: It indicates the various ways in which money
can be invested. Interest and growth can be possible on the invest-
ed money and hence, the amount of money available today is more
valuable than in the future.
Priority for consumption: It points to the fact that individuals
give priority to consumption over investment. This is because they
think that the future investments are uncertain. They are of the
opinion that in future, the value of money may depreciate due to
inflation; therefore, they prefer to have money available at present
S
rather than at a future date.
Risk factor: It indicates that risk and uncertainty is always linked
with money to be received in future as the market conditions are
IM
volatile in nature. Various factors, such as inflation, recession, and
government policies may influence the value of money to be re-
ceived in future date. Hence, the organisation or individual prefers
to avail money at the present.
Time value of money is estimated in two ways: future value of cash

flow and present value of cash flow, which are discussed in detail in
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the following sections.
1. Time value of money analyses the value of a unit of money at

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various times. (True/False)

2. __________ indicates that risk and uncertainty is always linked
with money to be received in the future as market conditions
are volatile in nature.
3. Name the two ways in which time value of money can be
estimated.
Activity
Suppose you come across a person who wants to invest a certain

amount of money and the person wants you to explain the concept
of time value of money. How will you do that?
2.3 FUTURE VALUE OF CASH FLOW

The future value of cash flow is defined as a technique that calculates
the value of cash at a fixed time in the future at a specific compound

n o t e s
interest rate. Let us take an example. Assume Mr. Hari has deposited
a specific amount of money in a bank for two years. At the end of two
years, he would get the amount equal to the original amount depos-
ited and the interest earned on it. The amount received is called the
future value of the principal amount deposited.
If an individual purchases some investment policies then he/she con-

siders the future value of initial investment and returns earned on it.
Since, the future investments involve risk; the individual compares
the risk factor with total future value of the investment, i.e. the initial
investment along with the returns. If the future value is greater than
the risk associated with the investment, the investment is considered
to be favourable.
2.3.1 FUTURE VALUE OF SINGLE CASH FLOW
S
The future value of single cash flow is defined as the valuation of an
amount of money at a particular period of time in future. It depends
on the rate of compound interest earned on the amount of money in-
IM
vested, i.e. if the rate of compound interest is high then the future
value of single cash flow is also higher. Generally, people calculate the
future value of single cash flow while investing in saving schemes,
bonds, mutual funds, and derivative markets.
Let us take an example:

M
Illustration: Assume Mr. Amjad invests `10000 at the interest rate of

5 per cent compounded annually for three years in a business. At the
end of the first year, he gets `10500, which is considered as the princi-
pal for the next year. At the end of the second year, he receives `11025,
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which is considered as the principal for the third year. Finally, he gets
`11576.25, which is the total amount received by him at the end of
third year and is the future value of single cash flow. The calculation
of the future value of single cash flow is shown in Table 2.1:
Table 2.1: Calculation of Future Value of

Single Cash Flow
Year 1 2 3
Principal (original) amount 10000 10500 11025
Rate of interest 0.05 0.05 0.05
Interest amount 500 525 551.25
New principal 10000 10500 11025
Future value 10500 11025 11576.25
The mathematical formula used to calculate the future value of single

cash flow is as follows:
FVn = P (1+i)n

n o t e s
where,
FVn= Amount at the end of n years
P =Principal at the beginning of the year
i = Rate of interest
n =Number of years
In the preceding example, the method used to calculate the future

value is as follows:
A = P (1+i) (1+i) (1+i) = P (1+i) 3
= 10,000(1+0.05)3 = 11,576.25
The term within the bracket (1+i) n is called as Compound Value Fac-
tor (CVF) of single cash flow and its value depends on i and n.
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If the value of i and n are positive, the value of CVF is always greater
than one.
IM
Therefore, the preceding formula can be written as:
Amount at the end of n year = Principal at the beginning * compound

value factor
A = P * CVFi, n
= `10,000 × 1.158 = `11,580
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CVF of single cash flow of `1 at different rates is shown in Table 2.2:
Table 2.2: CVF of Single Cash Flow of `1 at

Different Rates
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Interest rate
Period 1% 2% 3% 4% 5% 10% 15% 20%
1 1.010 1.020 1.030 1.040 1.050 1.100 1.150 1.200
2 1.020 1.040 1.061 1.082 1.103 1.210 1.323 1.440
3 1.030 1.061 1.093 1.125 1.158 1.331 1.521 1728
4 1.041 1.082 1.126 1.170 1.216 1.464 1.749 2.074
5 1.051 1.104 1.159 1.217 1.276 1.611 2.011 2.488
6 1.062 1.126 1.194 1.265 1.340 1.772 2.313 2.986
7 1.072 1.149 1.230 1.316 1.407 1.949 2.660 3.583
8 1.083 1.172 1.267 1.369 1.477 2.144 3.059 4.300
9 1.094 1.195 1.305 1.423 1.551 2.358 3.518 5.160
10 1.105 1.219 1.344 1.480 1.629 2.594 3.046 6.192
When the rate of interest is compounded semi-annually, the interest

is calculated twice a year. The calculation of the future value of single
cash flow when the rate of interest is compounded semi-annually is
depicted with the help of the following example:

n o t e s
Illustration: Assume Mr. Yashwant has invested `100 at the interest

rate of 8% compounded semi-annually for two years in a business.
He receives 4% interest compounded semi-annually four times in two
years. The calculation of the future value of `100 at the end of two
years is shown in Table 2.3:
Table 2.3: Calculation of Future Value of `100 at

the End of Two Years
Year 6 Months 1 Year 18 Months 2 Years
Initial amount 100 104 108.16 112.48
Rate of interest 0.04 0.04 0.04 0.04
Interest 4 4.16 4.32 4.50
amount
New principal 100 104 108.16 112.48
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Future value 104 108.16 112.48 117
The preceding table shows that Mr. Yashwant receives `117 at the end
of two years compounded semi-annually at the rate of 4 per cent.
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When the rate of interest is compounded quarterly, the inter-
est is calculated four times in a year. In such a case, the calcu-
lation of the future value of single cash flow will be as shown in
Table 2.4:
Table 2.4: Calculation of Future Value

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of Single Cash Flow

Months
Year 3 6 9 12 15 18 21 24
Initial 100 102 104.04 106.12 108.24 110.40 112.60 114.85
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amount
Rate of 0.02 0.02 0.02 0.02 0.02 0.02 0.02 0.02
interest
Interest 02 2.04 2.08 2.12 2.16 2.20 2.25 2.30

amount
New 100 102 104.04 106.12 108.24 110.40 112.60 114.85
principal
Future 102 104.04 106.12 108.24 110.40 112.60 114.85 117.15
value
The calculation shows that Mr. Yashwant receives `117.15 at the end
of two years, when the rate of interest is compounded quarterly at the
rate of 2 per cent.
2.3.2 FUTURE VALUE OF ANNUITY
A fixed amount of cash paid or received at a regular interval of time is

called annuity. For example, the fixed amount of premium paid at reg-
ular intervals by an individual on an insurance policy is called annuity.

n o t e s
If an individual buys property, such as house or land, on instalments

then annuity helps in calculating the monthly instalments paid by the
individual. The calculation of the future value of annuity helps the in-
vestors to estimate the amount of return on investment and compare
the risk and returns linked with the investment. The future value of
annuity is calculated with the help the of following example:
Illustration: Mr. K. K. Prasad deposits `100 for five years at the in-
terest rate of 5 % compounded annually in a bank. It means that de-
posited amount would increase at the rate of 5 per cent compounded
annually for the next four years. The amount at the end of the first
year would become the principal for the next year and this process
continues for the next three years. In the fifth year, no interest would
be generated as Mr. Prasad would withdraw the money.
The calculation of the future value of annuity is as follows:
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= `100 (1.05)4 + `100 (1.05)3 + `100 (1.05)2 + `100 (1.05)1 + `100
= `100 (1.216) + `100 (1.158) + `100 (1.103) + `100 (1.050) + `100
IM
= `121.55 + `115.76 + `110.25 + `105.50 + `100
= `553.05
The compounding value of annuity of `100 at the rate of 5 per cent are
shown in Figure 2.1:
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End of Year
N
Figure 2.1: Compound Value Factor of `100 at 5 Per Cent
The mathematical formula to calculate the future value of annuity is

as follows:
FVA5 = A (1+i) 4 + A (1+i) 3 + A (1+i) 2 + A (1+i) + A
= A [(1+i) 4 + (1+i) 3 + (1+i) 2 + (1+i) + 1]
= A [(1+i) 4– 1/i]
When the time period extended to n years, the equation can be re-writ-
ten as:
FVAn = P [(1+i) n – 1/i]

n o t e s
where,
FVAn = Future Value of Annuity of cash flow
P =Principal at the beginning of the year
n = Number of years
(1+i) n – 1/i=Compound Value Factor for an Annuity (CVFA) of
cash flow
CVFA depends on the values of i and n. If i and n have positive values,

then the future value of annuity would always be positive.
FVAn = P × CVFA
= `100 × 5.526 = `552.60
S
CVFA of `1 at different rates is shown in Table 2.5:
Table 2.5: CVFA of `1 at Different Rates

IM
Interest rate
Period 1% 2% 3% 4% 5% 10% 15% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.100 2.150 2.200
3 3.030 3.060 3.091 3.122 3.153 3.310 3.473 3.640
M
4 4.060 4.122 4.184 4.246 4.310 4.641 4.993 5.368

5 5.101 5.204 5.309 5.416 5.526 6.105 6.742 7.442
6 6.152 6.308 6.468 6.633 6.802 7.716 8.754 9.930
7 7.214 7.434 7.662 7.898 8.142 9.487 11.067 12.916
N
8 8.286 8.583 8.892 9.214 9.549 11.436 13.579 16.499

9 9.369 9.755 10.159 10.589 11.027 13.579 16.786 20.799
10 10.462 10.950 11.464 12.006 12.578 15.937 15.937 20.304
4. __________ is defined as a technique that calculates the value of

cash at a fixed time in the future at a specific compound interest
rate.
5. If the future value is lesser than the risk associated with the
investment, the investment is considered favourable for the
individual. (True/False)
6. __________ is defined as the valuation of an amount of money
at a particular period of time in future.
7. The future value of single cash flow depends on the rate of
compound interest incurred on the amount of money invested.
(True/False)

n o t e s
8. A fixed amount of cash paid or received at regular intervals of

time is called __________.
9. Calculation of the future value of annuity helps investors to
estimate the amount of return on investment and compare the
risk and returns linked with the investment. (True/False)
Activity
Explain the concept of future value of cash flow to a non-resident

Indian who wants to invest in India.
2.4 PRESENT VALUE OF CASH FLOW
S
The present value of cash flow indicates the current value of the fu-
ture cash flow over a fixed period of time at a specified rate of return.
The present value of cash flow is always lesser than the future value
IM
of cash flow because in the future the amount of compound interest is
added to the total value of cash flow to obtain the future value of cash
flow. However, in the present value, the amount of compound interest
is deducted from the future value of cash flow. Hence, the method to
calculate the present value of cash flow is called discounting.
M
2.4.1 PRESENT VALUE OF SINGLE CASH FLOW
The present value of single cash flow enables to determine the present
value of future cash flow. As previously discussed, the present value of
cash flow is generally lesser than the future value of cash flow. Thus,
N
we can establish that in the future value of cash flow, there is always
some appreciation in the value of money. However, in the present val-
ue of cash flow, there is always some depreciation in the value of the
money.
Illustration: Mr. Aditya invests in a certain business and is assured to

get `1000 at the rate of 5 per cent after three years. The present value
can be calculated by discounting the future amount of `1000 in the
present, which is as follows:
At the given interest rate of 5 per cent,

Value after four years = `1000
Value after three years = `1000(1/1.05)
Value after two years = `1000(1/1.05)2
Value after one year = `1000(1/1.05)3
Value now = `1000 (1/1.05)4

n o t e s
The mathematical formula to calculate the present value of single cash

flow is as follows:
A= P (1+i) n
or
PVn = A/ (1+i) n
where,
PVn =Present Value of single cash flow
A = Amount at the end of n years.
n = Number of years
PVn= 1000/(1 + 0.05)4 = 1000/1.276 = 783.70
S
The term within the bracket (1+i) n is known as the discount factor
or Present Value Factor (PVF) of single cash flow. The value of PVF
depends on i and n.
IM
When the i and n are positive, the discount factor would be less than 1.
We can re-arrange the preceding formula as:

Present Value of cash = Future Value of cash * discount factor
PVn = A × PVF
M
P = `1000/ (1+0.05)4
= `1000/1.275 = `784.
PVF of single cash flow of `1 at different rates is shown in Table 2.6:

N
Table 2.6: PVF of Single Cash Flow of `1

at Different Rates
Interest rate
Period 1% 2% 3% 4% 5% 10% 15% 20%
1 0.990 0.980 0.971 0.962 0.952 0.909 0.870 0.833
2 0.980 0.961 0.943 0.925 0.907 0.826 0.756 0.694
3 0.971 0.942 0.915 0.889 0.864 0.751 0.658 0.579
4 0.961 0.924 0.888 0.855 0.823 0.683 0.572 0.482
5 0.651 0.906 0.863 0.822 0.784 0.621 0.497 0.402
6 0.942 0.888 0.837 0.790 0.746 0.564 0.432 0.335
7 0.933 0.871 0.813 0.760 0.711 0.513 0.376 0.279
8 0.923 0.853 0.789 0.731 0.677 0.467 0.327 0.233
9 0.914 0.823 0.766 0.703 0.645 0.424 0.284 0.194
10 0.905 0.820 0.744 0.676 0.614 0.386 0.247 0.162

n o t e s
2.4.2 PRESENT VALUE OF ANNUITY
The present value of annuity is defined as the discounted value of the

future cash flow in the present time. In simpler terms, it is the sum of
total present value of single cash flow over the year. The present value
of annuity is also called the discounting value of annuity.
Illustration: Mr. P. K. Chandra lends `100 at interest rate of 5 per cent

for five years. What would be the present value of annuity?
The present value of `100 received at the end of first year is P =

100/1.05 = `95.23, at the end of second year is P = 100/(1.05)2 = `90.70,
at the end of third year is P=100/ (1.05)3= `86.38, at the end of the
fourth year is P =100/ (1.05)4 = `82.27, and after five year it would be
S
100/ (1.05)5 = `78.35.
Therefore, the sum of the present value at the end of each year com-
prises the present value of annuity of `100 at the end of five years. The
IM
calculation of the present value of annuity is as follows:
PVAn = 100/ (1.05)+ 100/ (1.05)2 + 100/ (1.05)3 + 100/ (1.05)4 + 100/
(1.05)5
= 95.23 + 90.70 + 86.38 + 82.27 + 78.35
= `432.93
M
where,
PVAn = Present Value of Annuity
The discounting value of annuity of cash flow of `100 at the rate of 5

N
per cent is shown in Figure 2.2:
Figure 2.2: Discounting Value Factor of `100 at the

Rate of 5 Per Cent
The mathematical formula to calculate the present value of annuity of

cash flow is as follows:

n o t e s
PVAn = A / [ {1-(1/ 1+ r)n }/r]
where,
PVAn =Present Value of annuity of cash flow
A = Amount at the end of n years
n = Number of years
The term within the bracket {1-(1/ 1+ r)n }/r is known as the discount-
ing value factor or Present Value Factor of Annuity (PVFA) of cash
flow whose value depends on the values of r and n.
If the value of r and n are positive, then the present value of annuity
is also positive.
S
Therefore,
PVAn = A × PVFA
`100 * 4.329 = `432.93
IM
The discounting value factor of annuity of cash flow of `1 at different
rates is shown in Table 2.7:
Table 2.7: Discounting Value Factor of Annuity

of `1 at Different Rates
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Interest rate
Period 1% 2% 3% 4% 5% 10% 15% 20%
1 0.990 0.980 0.971 0.962 0.952 0.909 0.870 0.833
2 1.970 1.942 1.913 1.886 1.859 1.736 1.626 1.528
N
3 2.941 2.884 2.829 2.775 2.723 2.487 2.283 2.16

4 3.902 3.808 3.717 3.630 3.546 3.170 2.855 2.589
5 4853 4.713 4.580 4.452 4.329 3.791 3.352 2.991
6 5.795 5.601 5.417 5.024 5.076 4.355 3.784 3.326
7 6.728 6.742 6.230 6.002 5.786 54.868 4.160 3.605
8 7.652 7.325 7.020 6.733 6.463 5.335 4.487 3.837
9 8.566 8.162 7.786 7.435 7.108 5.759 4.772 4.031
10 9.471 8.983 8.530 8.111 7.722 6.145 5.019 4.192
10. __________ indicates the current value of the future cash flow
over a fixed period of time at a specified rate of return.
11. The present value of cash flow is always greater than the
future value of cash flow. (True/False)

n o t e s
12. The method to calculate the present value of cash flow is

called __________.
13. The present value of annuity is defined as the discounted
value of the future cash flow in the present time. (True/False)
14. The present value of annuity is also called __________.
Activity
A friend of yours wants to invest and requires your help regarding

clarification on the concept of present value of cash flow. How will
you explain?
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2.5 SUMMARY
Time value of money analyses the value of a unit of money at var-
ious times.
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A person values the money available at present due to investment
options, priority for consumption and risk factor.
The time value of money is estimated in two ways: future value of
cash flow and present value of cash flow.
The future value of cash flow is defined as a technique that calcu-
M
lates the value of cash at a fixed time in future at a specific com-

pound interest rate.
The future value of single cash flow is defined as the valuation of
an amount of money at a particular period of time in future.
N
The calculation of future value of annuity helps the investors to

estimate the amount of return on investment and compare the risk
and returns linked with the investment.
The present value of cash flow indicates the current value of future
cash flow over a fixed period of time at a specified rate of return.
The present value of single cash flow enables to determine the
present value of future cash flow.
The present value of annuity is the sum of total present value of
single cash flow over the year.
The present value of annuity is also called discounting value of
annuity.

n o t e s
key words
Annuity: It refers to a fixed sum of money or insurance paid to

someone continuously every year, even for the rest of their life.
Depreciation: It refers to the decrease in the value of an asset
over time due to use, wear and tear, etc.
Inflation: It refers to an overall increase in prices but decrease
in the purchasing value of money.
Recession: It refers to the overall economic decline where trade
and all industrial activities get reduced.
Risk Factor: It refers to a change or element which affects the
value of an asset like interest rate, inflation, market return, etc.
S
1. Explain the concept of time value of money.
IM
2. What are the reasons for a person to value the money available
at present?
3. Discuss the future value of single cash flow with examples.
4. Describe the future value of annuity with examples.
M
5. Let us assume that an investor is going to receive USD 1000 at

the end of every year for the next 5 years. After receiving the
amount, the investor will invest the entire amount at the rate of
5% per annum. Calculate the total amount of money that would
be received by the investor at the end of the 5 years period.
N
6. Explain the present value of annuity with examples.

Time Value of Money 1. True
2. Risk factor
3. Future value of cash flow
and present value of cash
flow
Future Value of Cash 4. The future value of single
Flow cash flow
5. False

n o t e s

6. The future value of single
cash flow
7. True
8. Annuity
9. True
Present Value of Cash 10. The present value of cash
Flow flow
11. False
12. Discounting
13. True
14. Discounting value of
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annuity
hints for Descriptive Questions

IM
1. Time value of money analyses the value of a unit of money at
various times. Refer to Section 2.2 Time Value of Money.
2. A person values the money available at present due to investment
options, priority for consumption and risk factor. Refer to Section
2.2 Time Value of Money.
M
3. The future value of single cash flow is defined as the valuation

of an amount of money at a particular period of time in future.
Refer to Section 2.3 Future Value of Cash Flow.
4. A fixed amount of cash paid or received at a regular interval of
N
time is called annuity. Refer to Section 2.3 Future Value of Cash

Flow.
5. The future value of the annuity would be equal to:
(1 + 0.05) − 1
USD 1000 * = USD 1000 *5.525 = USD 5525
0.05
Refer to Section 2.4 Present Celue of Cash Flow.
6. The present value of annuity is defined as the discounted value of

future cash flow in the present time. Refer to Section 2.4 Present
Value of Cash Flow.
SUGGESTED READINGS
Vernimmen, P., et al. (2011). Corporate Finance: Theory and Prac-

tice. (3rd ed.). Chichester, UK: John Wiley & Sons, Ltd.

n o t e s
Kapil, S. (2010). Financial management. Pearson.

E-REFERENCES
Getobjects.com.(2014). Time Value of Money (TVM) Concepts. Re-

trieved from, <http://www.getobjects.com/Components/Finance/
TVM/concepts.html>
Studyfinance.com.(2014). StudyFinance: Time Value of Money.
Retrieved from, <http://www.studyfinance.com/lessons/timeval-
ue/?page=01>
Zenwealth.com.(2014). The Time Value of Money. Retrieved from,
<http://www.zenwealth.com/businessfinanceonline/TVM/Time-
S
ValueOfMoney.html> IM
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Ch a
3 p t e r
CAPITAL BUDGETING
CONTENTS
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3.1 Introduction
3.2 Concept of Capital Budgeting
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3.2.1 Process of Capital Budgeting
Activity
3.3 Techniques of Capital Budgeting
3.3.1 Traditional Techniques (ARR; Payback Period Method)
3.3.2 Discounted Cash Flow Techniques (NPV, IRR)
M
3.3.3 Time-Framed Methods (Profitability Index, Net Terminal Value Method)

Activity
3.4 Project Selection and Evaluation
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Activity
3.5 Capital Budgeting Problems
3.5.1 Ranking Conflicts in NPV and IRR
3.5.2 Multiple IRRs
Activity
3.6 Capital Rationing
Activity
3.7 Sensitivity Analysis in Capital Budgeting
Activity
3.8 Summary

46 Corporate Finance
n o t e s
Capital Budgeting Dilemma at

Miners india limited
Miners India Limited is an iron ore company that extracts iron

ore from an open pit mine. In a year, Miners India extracts about
1,00,000 tonnes of iron ore. If the extract is immediately sold after
removal of dirt, rocks, and other impurities, the company draws
a sum of `1000 per ton. The cost of extraction is estimated to be
about 70% of the net realisable value. The company is willing to
invest in a new processing facility. Instead of selling the ore, the
company has an alternative to further process 25% of the output.
This would cost an additional `100 per ton of the product. The
processed ore is estimated to draw up to `1600 per ton. However,
for additional processing, the company would require to install
S
equipment worth `100 Lakh. The equipment would be subject to
a depreciation of 25% per annum and a useful life of about 5 years.
The working capital requirement would increase by approximate-
IM
ly `10 lakh per year. Corporate tax rate is 35% and the cut-off rate
for the investment is 15%. The company needs to review the situ-
ation to analyse whether or not it should install the equipment to
benefit from the proposed project.
M
N

CAPITAL BUDGETING 47
n o t e s
learning objectives

> Describe the concept of capital budgeting
> Explain various techniques of capital budgeting
> Discuss project selection and evaluation
> Explain capital budgeting problems
> Describe capital rationing
> Explain sensitivity analysis in capital budgeting
3.1 INTRODUCTION
S
An organisation undertakes several projects with different capital
requirements, rates of return, and time duration. For example, some
projects may need investment over a longer duration, whereas others
need investments only in the initial years. Since all projects require
IM
investments, an organisation should make project selection decisions
prudently to ensure the optimum utilisation of funds invested. Wrong
project selection may lead to huge organisational losses. Moreover, the
reputation and goodwill of the organisation may also get affected.
An organisation needs to determine the capital requirements of a proj-

M
ect and the returns expected from it, before selecting a project. This
can be aided by capital budgeting, which is a process of estimating the
actual profitability of a project. In other words, capital budgeting is a
process that enables planning of the investment projects of an organ-
isation in the long run. The long-term investments of an organisation
N
can be buying and replacing of fixed assets, new product launching or

expansion of current products, and research and development. The
capital budgeting process can be effective if an organisation deter-
mines the overall capital expenditure for a project that is expected
to generate returns over a specific time period. An organisation uses
various techniques, such as net present value, internal rate of return,
payback period, sensitivity analysis, and decision tree analysis to es-
timate the total expenditure for a project and rate of return yielded
from it. .
In this chapter, you will study the concept of capital budgeting. Fur-
ther, the chapter explains the various techniques of capital budgeting.
It also explains project selection and evaluation. In addition, the chap-
ter focuses on the capital budgeting problems and capital rationing.
Towards the end, it elaborates on sensitivity analysis in capital bud-
geting.

n o t e s
3.2 CONCEPT OF CAPITAL BUDGETING

Capital budgeting can be defined as a process of allocating the re-
sources of the organisation in long-term investment projects to gen-
erate profit. The organisation’s long-term investment projects may be
to expand, grow, diversify, modernise, etc. Capital budgeting is consid-
ered to be a highly complex process because it needs the involvement
of top management to select and evaluate the approved projects. The
top management chooses a specific project after taking into consider-
ation its feasibility and profitability. Capital budget is prepared, imple-
mented, and reviewed continuously by the organisation. Some of the
important aspects of capital budgeting are as follows:
It affects the competitive position of organisation in the long run.
It needs a large sum of capital because it comprises investment in
S
long-term assets.
It refers to a one-time process that cannot be either reversed or
withdrawn.
IM
It consists of the risk element as it is futuristic in approach.
From the aforementioned definitions, we can infer that capital bud-

geting is an essential process for any organisation. The significance of
capital budgeting is as follows:
Long-term Applications: It implies that capital budgeting deci-
M
sions are useful for an organisation in the long run as these deci-
sions have a direct impact on the cost structure and future pros-
pects of the organisation. Moreover, these decisions affect the
organisation’s growth rate. Hence, an organisation has to take
N
capital decisions carefully. For example, additional investments in

various assets can cause shortage of capital to the organisation,
whereas insufficient investments may restrict the growth of the or-
ganisation.
Competitive Position of an Organisation: It means an organisa-
tion can plan its investment in various fixed assets via capital bud-
geting. Moreover, capital investment decisions help the organisa-
tion to estimate its future profits. All these decisions have a major
impact on the competitive position of an organisation.
Cash Forecasting: It indicates that an organisation needs sufficient
funds for its investment decisions. With the help of capital budget-
ing, an organisation is aware of the required amount of cash, thus,
ensuring availability of cash at the right time. This further helps
the organisation to achieve its long-term goals.
Maximisation of Wealth: It means that the long-term investment
decisions of an organisation helps in protecting the interest of
shareholders in the organisation. If an organisation has invested in
a planned manner, shareholders would also be interested to invest

n o t e s
in the organisation and in this way, the wealth of the organisation

can be maximised.
3.2.1 PROCESS OF CAPITAL BUDGETING
Decisions regarding capital budgeting and investment are very im-

portant for a firm as it is on the basis of these decisions that matters
related to the risk, growth and profitability of an organisation are
taken. This process is also known as investment decision making or
planning capital expenditure. Capital budgeting helps organisations
to utilise its capital in the best way, expecting the best returns from it.
Organisations perform capital budgeting in the following five steps:
1. Exploring opportunities: In this step, an organisation identifies
various opportunities that it can benefit from.
2. Evaluating opportunities: This involves evaluating the
S
opportunities on the basis of various aspects, such as their
feasibility with the mission and strategies of the organisation.
3. Determining cash flow: This involves determining the cash flow
IM
of the evaluated projects. This helps in having a clear picture of
expenditure on the projects.
4. Selecting projects: After the evaluation of various aspects,
such as feasibility, profitability, time frame and expenditure, the
projects are finally selected.
5. Implementing capital budgeting: This step involves
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implementing the capital budgeting on the basis of the decisions

made earlier. Here, you must note that implementation is not
a part of capital budgeting; however, organisations must know
how to implement decisions.
N
1. Capital budgeting is also known as investment decision

making. (True/False)
2. Determining cash flows helps in having a clear picture of the
_____of project.
3. Implementation is a part of capital budgeting. (True/False)
4. _________can be defined as a process of allocating the
resources of organisation in long-term investment projects to
generate profit.
Activity
Make a group of your friends and discuss the importance of capital

budgeting.

n o t e s
3.3 TECHNIQUES OF CAPITAL BUDGETING

Capital budgeting helps organisations to evaluate the expected rate of
return on investments. This helps in assessing the feasibility of vari-
ous projects in the long run. Figure 3.1 shows various techniques to
evaluate capital budgeting:
Evaluation of
Capital Budgeting
Discounted Time-
Traditional
Cash Flow Framed
Techniques
Techniques Method
S
Internal Net
Average Pay back Net Present
Rate of Profitability Terminal
Rate of Period Value
Return Index Value
Return Method Method
Method Method
IM
Figure 3.1: Different Techniques for the Evaluation of Capital
Budgeting
3.3.1 TRADITIONAL TECHNIQUES (ARR; PAYBACK

M
PERIOD METHOD)
Traditional methods of capital budgeting only determine the profit-

ability of an investment project, ignoring the time factor completely.
The two traditional methods used in the evaluation of capital budget-
N
ing are as follows:

Average Rate of Return (ARR): Also known as accounting rate of
return, this method is based on the basic concepts of bookkeeping
and uses accounting information to evaluate capital budgeting. It
does not take into account the time period involved in the calcula-
tion of the rate of return of cash flow. The mathematical formula to
calculate ARR is as follows:
Average annual profit after taxes
ARR = ×100
Average annual investment over the life of the project
The average annual profit after taxes is determined by dividing
the total profit after taxes of all years by number of years of life
of the project. On the other hand, the average annual investment
over the life of the project is determined by dividing the sum of
each year of investment with the expected life of the project.
Illustration: Let us assume that an organisation invests `1, 20,000
on an average in a year in a project. The average annual revenue
received by the organisation from the project is `1,50,000. Calcu-
late the ARR of the project.

n o t e s
Solution:
Average annual profit = Average annual revenue – average annual
cost = 1,50,000 – 1,20,000 = 30,000.
30, 000
ARR = ×100 = 25%.
1, 20, 000
Payback Period Method: This method uses the qualitative ap-
proach to evaluate capital budgeting. Payback period refers to the
time in which the initial cash outflow of a project is expected to be
recovered from the cash inflows generated by the project. It is one
of the simplest investment appraisal techniques. This method is an
important determinant of whether or not to undertake a project.
Typically, longer payback periods are undesirable for investment
propositions.
S
The mathematical formula to calculate the payback period is as
follows:
IM
Illustration: Let us assume that the total investment required
throughout the lifetime of a project is `150,000, and the project will
give an annual return of `30,000. Calculate the payback period.
Solution:
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The payback period of the project would be = 1, 50,000/30,000 = 5

years.
3.3.2 DISCOUNTED CASH FLOW TECHNIQUES (NPV, IRR)

N
Discounted cash flow techniques help in determining the time value

of money of a project. The following are the techniques to determine
discounted cash flow:
Net Present Value Method (NPV): It is the difference between the
present value of cash inflows and cash outflows in a given project.
This method is also used to evaluate the profitability of a project.
The formula to calculate NPV is as follows:
NPV = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 +…..+ Cn/(1+r)n – I0
n
Ct
NPV
= ∑ (1 + r)
t =1
n
− I0
Where,
Ct= Net cash received at the end of year t
I0 = Initial investment outlay

n o t e s
r = Discount rate/the required minimum rate of return on invest-

ment in a project
n = Time duration of the project (in years)
Figure 3.2 shows the steps involved in calculating the NPV of a
project:
Forecasting Cash Flows
Estimating the Required Rate of Return
Calculating the Present Value of Cash Flows
S
Finding NPV
IM
Figure 3.2: Calculating NPV
The steps of calculating NPV (as shown in Figure 3.2) are explained
as follows:
1. Forecasting cash flows: It involves estimating the cash inflows
and cash outflows in a project for a specific period. An accurate
estimation of cash flows helps in determining the actual profit-
M
ability of the project.

2. Estimating the required rate of return: It involves determin-
ing the required rate of return on a project on the basis of the
present value of the cash flows. Generally, the opportunity cost
N
of the capital is taken as the required rate of return.

3. Calculating the present value of cash flows: It involves cal-
culating the present value of cash inflows and cash outflows.
The method of calculating the present value of cash flow is dis-
cussed earlier in the chapter.
4. Finding NPV: It is the final step to calculate NPV and involves
subtracting the present value of cash outflows from the present
value of cash inflows. A project should be accepted if its NPV is
positive (NPV>0) and rejected if its NPV is negative (NPV<0).
An organisation may or may not accept the project if the NPV
is equal to zero. Let us consider an illustration:
Illustration:
What is the Net Present Value (NPV) of a project requiring an ini-
tial investment of `250,000 and providing monthly cash inflow of
`60,000 for the next 12 months? Assume that the required rate of
return of the company is 12%.

n o t e s
Solution:
In the problem, initial investment = `2,50,000
Net cash inflow per period = `60,000
Number of periods = 12
Discount rate per period = 12% ÷ 12 = 1%
The NPV of the project = Present value of the future cash flows-
Initial investment
= `60,000 × (1 − (1 + 1%) ^-12) ÷ 1% − `2, 50,000
= `60,000 × (1 − 1.01^-12) ÷ 0.01 − `250,000
= `60,000 * (1- 0.88744922527)÷ 0.01 − `250,000
= `6, 75,304.64 - `2, 50,000
S
= `425304.64
Table 3.1 shows the criteria for accepting or rejecting a project on
the basis of its NPV:
IM
Table 3.1: Rule of Selecting a Project in
the NPV Method
Accept NPV>0
Reject NPV<0
M
May Accept or Reject NPV=0
The following are the advantages of using the NPV method:

Accurate Profitability Measurement: It takes into account
N
all the cash flows that occur throughout the life of a project to
provide exact profitability measures. Accurate measurement
of the profitability of a project helps in maximising the share-
holders’ wealth.
Value-Additivity: This refers to the principle that the net pres-
ent value of a set of independent projects is equal to the sum
of the net present values of the individual project. It is deter-
mined by adding the present values of all the cash flows. For
example, we can determine the present value of an annuity by
calculating the present value of each independent cash flow
and adding up all the present values together.
Though NPV is one of the most cost-effective methods of capi-
tal budgeting there is also a significant drawback of this meth-
od. The calculations in the NPV method are based on forecast-
ing cash flows that keep occurring throughout the course of a
project. In real life, forecasting cash flows is a difficult process.

n o t e s
Internal Rate of Return Method: It is used to determine the dis-

count rate that makes the NPVs of all cash flows arising out of any
project equal to zero. This method does not take into account any
external factors, such as inflation. IRR also denotes the interest
rate at which the NPVs of all expenses made on a project (cash out-
flow) equals to the NPVs of all the benefits or income arising out of
the project (cash inflow). IRR is one of the time-based methods to
analyse the capital investment decisions.
Let us consider the following example:
ABC Ltd. is an organisation that is planning to start a new project.
The total cost of the project is `20000 at present. It is estimated
that the project will give returns of `12000, `10000, and `8000 at the
end of the first, second, and third year, respectively.
Assuming that the discount rate r will make NPV of the project
S
equal to zero:
12000/ (1+r) +10000/ (1+r)2 +8000/ (1+r)3 – 20000 =0
IM
Where, r= IRR of the project
If we determine r by solving the equation, we can find out the IRR
of the project, which would make the NPV of the project equal to
zero.
There are alternative ways to calculate IRR. The simplest of these
methods is as follows:
M
1. Estimate the value of r (discount rate), and calculate the NPV

of the project at that value.
2. If NPV is close to zero, then IRR is equal to r.
N
3. If NPV is greater than 0, then increase r and go to step 5.

4. If NPV is smaller than 0, then decrease r and go to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.
Let us look at an illustration for better understanding:
Illustration: Calculate the IRR of an investment with an initial
cash outflow of `2, 13,000. The cash inflows during the first, sec-
ond, third and fourth years are expected to be `65,200, `96,000,
`73,100 and `55,400 respectively.
Solution: Let us assume that the discount rate, r = 10%
NPV at 10% discount rate = `18,372
As NPV is greater than zero, increase discount rate
Let r = 13 %; NPV at 13% discount rate = `4,521
The value is still greater than zero, thus, increase the discount rate
further.

n o t e s
Let r = 14%; NPV at 14% discount rate = `204

Also, if r = 15%; NPV at 15% discount rate = (`3,975)
As, NPV at r = 14% is closer to zero, therefore, IRR ~ 14%
A project should be accepted if its IRR is greater than the cost of
the capital invested in the project. On the other hand, a project
must be rejected if its IRR is less than the cost of the capital of the
project. In this method, the profitability of a project is represented
as a percentage, which is very easy to compare with the cost of
capital. The following are some advantages of the IRR method:
Helps in making accurate measurements of profitability of
a project by considering all the cash flows made during the
course of a project
S
Helps in determining the exact profitability of the project by
considering its TVM factor
Helps in increasing the wealth of shareholders
IM
Some of the main disadvantages of the IRR method are as follows:
Different rates of returns: It may calculate multiple rates of
returns for which the NPVs of all cash flows would become
equal to zero. In such situations, it becomes difficult for the
project manager to select a particular rate from all the given
rates, which leads to difficulty in selecting the project.
M
Value-Additivity: Unlike NPV, the value additivity principle is

not applicable in the IRR method.
3.3.3 TIME-FRAMED METHODS (PROFITABILITY INDEX,

N
NET TERMINAL VALUE METHOD)
Time-framed methods take into consideration the time factor while

evaluating capital budgeting. These methods are explained in the fol-
lowing points:
Profitability Index: It is the ratio of the present value of the cash
inflow to the present value of the cash outflow. The profitability
index method is based on the time value of money and is intended
to maximise the wealth of the shareholders. The mathematical for-
mula to calculate profitability index is as follows:
Present value of cash inflow
Profitability Index =
Present value of cash outflow
Illustration: If the present value of cash inflows in a project is
`7,50,000 and the present value of the cash outflows is `3,00,000,
calculate the profitability index.

n o t e s
Solution: The profitability index would be = `7,50,000/ `3,00,000

= 2.5. Profitability index is very similar to the NPV method as it
also measures the difference between cash inflow and cash out-
flow in an organisation.
The profitability index should be greater than one for the selec-
tion of a project. This method is also used to measure the relative
cash surplus of an organisation by comparing the cash inflow and
outflow.
Net Terminal Value Method: In this method, the returns gener-
ated from a project are reinvested in the same project. In other
words, cash inflow is reused in the project till it is completed.
S
5. Capital budgeting helps organisations to evaluate the expected
rate of return on investments. (True/False)
6. Traditional methods of capital budgeting only determine the
IM
___ of an investment projects.
7. ______ is also known as accounting rate of return.
8. IRR takes into account the time period involved in the
calculation of the rate of return of cash flow. (True/False)
9. _________is the difference between the present value of cash
M
inflows and cash outflows in a given project.

10. In case NPV is greater than 0, the project should be rejected.
(True/False)
N
Activity
Compare IRR and, the payback method of capital budgeting.
3.4 PROJECT SELECTION AND EVALUATION

Project selection and evaluation are among the key financial deci-
sion-making processes in an organisation. These decisions affect the
profitability and competitiveness of the organisation in the long run.
The organisation selects only those projects for which the NPV and
IRR values are positive. There are two types of projects in an organ-
isation: independent projects and mutually exclusive projects. These
projects are shown in Figure 3.3:

n o t e s
Project
Independent Mutually
Project Exclusive Project
Figure 3.3: Types of Projects
The following points explain the types of projects:

Independent Projects: These projects are independent of other
projects handled by the organisation. This implies that the selec-
tion or rejection of an independent project does not affect other
S
projects. The selected independent project should meet the mini-
mum required standards and norms set by the organisation, such
as its NPV should be greater than zero and IRR should exceed the
expected rate of return.
IM
Mutually Exclusive Projects: These projects are exclusive in the
sense that their selection rules out the possibility to opt other proj-
ects. Suppose an organisation wants to buy a machine and has
three contenders in line with different investment plans. The proj-
ects of all the three contenders are mutually exclusive; however,
the organisation would select the contender who offers the most
M
lucrative deal.

N
11. An organisation selects only those projects in which the NPV

and IRR values are negative. (True/False)
12. There are two types of projects in an organisation: independent
projects and __________.
Activity
Write a note on project selection and evaluation.
3.5 CAPITAL BUDGETING PROBLEMS

Capital budgeting is a complex activity. There are certain problems
faced in capital budgeting, which are discussed in the following sec-
tions of the chapter.

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3.5.1 RANKING CONFLICTS IN NPV AND IRR
A project is considered profitable if its acceptance excludes the accep-

tance of one or more projects. IRR methods may result in contradic-
tions when:
Projects have different life expectancies.
Projects have different sizes of investments.
Projects whose cash flow may differ over time.
3.5.2 MULTIPLE IRRs
There can be multiple IRRs when the sign of the cash flow is changed
more than once. It is said that when a project has multiple IRRs, it
may be more convenient to compute the IRR of the project with the
S
benefits reinvested.

IM
13. A project is considered _____ if its acceptance excludes the
acceptance of one or more projects.
14. There can be multiple IRRs when the sign of the cash flow is
changed more than ______.
M
Activity
Make a group of your friends and discuss the issues in capital bud-
geting.
N
3.6 CAPITAL RATIONING

Capital rationing is a concept in which the management of an organi-
sation restricts the approval of further projects to minimise the invest-
ment of capital. Such rationing decisions are taken by organisations
when their financial condition is not very favourable or when they
have already accepted many independent investment proposals. In
such a situation, the organisation approves only those projects, which
yield higher rate of return to improve its competitiveness and prof-
itability in the long run. There are two types of capital rationing, as
Type of Capital
Rationing
Internal Capital External Capital

Rationing Rationing
Figure 3.4: Types of Capital Rationing

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Capital rationing helps organisations to maintain profitability by ap-

proving the best investment proposal out of all the alternatives avail-
able. The types of capital rationing (as shown in Figure 3.4) are dis-
cussed in brief:
Internal Capital Rationing: Here, the organisation stops taking
projects due to internal factors. For example, managers are unable
to select the approved profitable project due to limited funds.
External Capital Rationing: Here, the organisation stops taking
projects due to external factors. For example, suppose an organ-
isation wants to raise capital from the market by issuing deben-
tures but due to unstable market conditions, it fails to do so.
S
15. _______is a concept in which the management of an
organisation restricts the approval of further projects to
minimise the investment of capital.
16. Capital rationing helps organisations to maintain profitability
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by approving the best investment proposal out of all the
alternatives available. (True/False)
17. In internal capital rationing, an organisation stops taking
projects due to ______ factors.
18. In _____ capital rationing, on organisation stops taking projects
M
due to external factors.
Activity
N
Make a group of your friends and discuss the concept of capital

rationing.
SENSITIVITY ANALYSIS IN CAPITAL

3.7
BUDGETING
Sensitivity analysis is done to analyse the degree of responsiveness of
the dependent variable for a given change in any of the independent
variables. In other words, sensitivity analysis is a method in which the
results of a decision are forecasted, if the actual performance deviates
from the expected or assumed performance. For example, a project
manager needs to forecast the total cash flow of a project. The cash
flow depends on the revenue earned and cost incurred in a project.
The revenue earned from the project depends on various factors, such
as sales and market share. Similarly, if we want to find out the NPV
or IRR of the project, we need to make the accurate predictions of
independent variables. Any change in the independent variables can
change the NPV or IRR of the project. The following steps are per-
formed to do a sensitivity analysis:

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1. Identifying all the variables that affect the NPV or IRR of the
project
2. Establishing a mathematical relationship between the
independent and dependent variables
3. Studying and analysing the impact of the change in the variables
Sensitivity analysis helps in providing different cash flow estimations

in the following three circumstances:
Worst or pessimistic condition: It refers to the most unfavourable
economic situation for the project.
Normal condition: It refers to the most probable economic envi-
ronment for the project.
Optimistic condition: It indicates the most favourable economic
S
environment for the project.
Let us consider the example of sensitivity analysis given in Table 3.2:

IM
Table 3.2: Example of Sensitivity Analysis
Particulars Project A Project B
Initial Cash Outlays 200000 300000
Cash Inflow Estimates
Most Optimistic 50000 80000
M
Expected or Most Likely 40000 60000

Most Pessimistic 20000 40000
Required Rate of Return 0.10 0.10
Economic Life 10 years 10 years
N
Now, the NPV of each of the projects can be calculated by using

the formula of NPV. Table 3.3 shows the calculation of the NPV of
project A:
Table 3.3: Calculation of NPV of Project A

Expected Cash Inflows Present Value NPV
Most Likely 245782 45782
Most Pessimistic 122891 -77109
Table 3.4 shows the calculation of the NPV of project B:
Table 3.4: Calculation of NPV of project B

Expected Cash Inflows Present Value NPV
Most Likely 368674 68674
Most Pessimistic 245782 -54218

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From the above tables, we can see that the extent of loss in project B
is less than that of project A. However, the extent of profit in project B
is more than that of project A. Therefore, the project manager should
select project B.
19. _____is done to analyse the degree of responsiveness of

the dependent variable for a given change in any of the
independent variables.
20. Cash flow depends on the revenue earned and cost incurred
in a project. (True/False)
21. Any change in ______ variables can change the NPV or IRR of
a project.
S
Activity
Write a note on sensitivity analysis in capital budgeting.

IM
3.8 SUMMARY
An organisation should take project selection decisions very pru-
dently to ensure the optimum utilisation of funds invested.
The capital budgeting process can be effective if an organisation
M
determines the overall capital expenditure for a project that is ex-

pected to generate returns over a specific time period.
The capital budgeting can be defined as a process of allocating the
resources of the organisation in the long-term investment projects
N
to generate profit.
Cash forecasting indicates that an organisation needs sufficient
funds for its investment decisions.
Decisions regarding the capital budgeting and investment are very
important for a firm as it is on the basis of these decisions that mat-
ters related to the risk, growth and profitability of an organisation
are taken.
Capital budgeting helps organisations to evaluate the expected
rate of return on investments.
Payback period method uses the qualitative approach to evaluate
capital budgeting.
Value-additivity is determined by adding the present values of all
the cash flows.
Time-Framed methods take into consideration the time factor
while evaluating capital budgeting.
Capital rationing is a concept in which the management of an or-
ganisation restricts the approval of further projects to minimise
the investment of capital.

n o t e s
key words
Capital Budgeting: It is a process of allocating the resources of

the organisation in the long-term investment projects to gener-
ate profit.
Net Present Value Method (NPV): It is the difference between
the present value of cash inflows and cash outflows in a given
project.
Profitability Index: It is the ratio of the present value of the
cash inflow to the present value of the cash outflow.
Net Terminal Value Method: In this method, the returns gen-
erated from a project are further reinvested in the same project.
Sensitivity Analysis: It is a method in which the results of a
S
decision are forecasted.

IM
1. Discuss the concept of capital budgeting.
2 Explain the significance of capital budgeting.
3. Explain the process of capital budgeting.
4. What are the various techniques to evaluate capital budgeting?
M
5. Explain the following techniques:

a. Average Rate of Return
b. Payback Period Method
6. How would you determine the discounted cash flow in a project?
N
7. List the advantages of using the NPV method.

8. Suppose that the initial investment required in a project is `1,
20,000 and the project is expected to give a monthly return of
`20,000 per month for the next 12 months. Also assume that the
required rate of return of the firm is 12% per year. Calculate the
NPV in case there is no salvage value of the project.
9. In the previous problem, should the company accept the project?
3.10 ANSWERS and hints
Topic Q.No. Answers

Concept of Capital 1. True
Budgeting
2. Expenditure

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Topic Q.No. Answers

3. False
4. Capital budgeting
Techniques of Capital 5. True
Budgeting
6. Profitability
7. Average Rate of Return (ARR)
8. False
9. Net present value
10. False
Project Selection and 11. False
Evaluation
S
12. Mutually exclusive projects
Capital Budgeting 13. Profitable
Problems
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14. Once
Capital Rationing 15. Capital rationing
16. True
17. Internal
M
18. External
Sensitivity Analysis in 19. Sensitivity analysis
Capital Budgeting
20. True
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21. Independent
HINTS FOR DESCRIPTIVE QUESTIONS

1. The capital budgeting can be defined as a process of allocating
the resources of the organisation in the long-term investment
projects to generate profit. Refer to Section 3.2 Concept of
Capital Budgeting.
2. The significance of capital budgeting can be explained in the
terms of long-term applications, cash forecasting, etc. Refer to
Section 3.2 Concept of Capital Budgeting.
3. Decisions regarding the capital budgeting and investment are
very important for a firm as it is on the basis of these decisions
that matters related to the risk, growth and profitability of an
organisation are taken. Refer to Section 3.2 Concept of Capital
Budgeting.
4. Capital budgeting helps organisations to evaluate the expected
rate of return on investments. Refer to Section 3.3 Techniques of
Capital Budgeting.

n o t e s
5. Traditional methods of capital budgeting only determine the

profitability of an investment project, ignoring the time factor
completely. Refer to Section 3.3 Techniques of Capital Budgeting.
6. Discounted cash flow techniques help in determining the time
value of money of a project. Refer to Section 3.3 Techniques of
Capital Budgeting.
7. The advantages of using the NPV method are accurate
profitability measurement and value-additivity. Refer to Section
3.3 Techniques of Capital Budgeting.
8. In the problem, Initial Investment = `1, 20,000
Net Cash Inflow per Period = `20,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
The NPV of the project = Present Value of the Future Cash
S
Flows- Initial Investment
= `20,000 × (1 − (1 + 1%) ^-12) ÷ 1% − `1,20,000
= `20,000 × (1 − 1.01^-12) ÷ 0.01 − `1,20,000
IM
= `20,000 * (1- 0.88744922527) ÷ 0.01 − `1,20,000
= `2,25,101.54 - `1,20,000
= `105101.54
Refer to Section 3.3 Techniques of Capital Budgeting.
9. The NPV of the project is `105101.54. The project should be
M
accepted since it gives a positive NPV.

Refer to Section 3.3 Techniques of Capital Budgeting.

N
Suggested Readings
Damodaran, A. (2006). Damodaran on valuation. Hoboken, N.J.:
John Wiley & Sons.
Khan, M., & Jain, P. (1985). management accounting and financial
E-REFERENCES
Prenhall.com, (2014). Capital Budgeting. [online] Available at:
http://www.prenhall.com/divisions/bp/app/cfl/CB/CapitalBudget-
ing.html.
AccountingCoach.com, (2014). What is capital budgeting? | Ac-
countingCoach. [online] Available at: http://www.accountingcoach.
com/blog/what-is-capital-budgeting.
Cliffsnotes.com, (2014). Capital Budgeting Techniques. [online]
Available at: http://www.cliffsnotes.com/more-subjects/account-
ing/accounting-principles-ii/capital-budgeting/capital-budget-
ing-techniques.

Ch a
4 p t e r
SOURCES OF FINANCE
CONTENTS
S
4.1 Introduction
4.2 Financial Market
IM
4.2.1 Capital Market
4.2.2 Money Market
Activity
4.3 Long-Term Sources of Finance
4.3.1 Shares
M
4.3.2 Debentures
4.3.3 Difference between Shares and Debentures
4.3.4 Term Loans
4.3.5 Mezzanine Debt
N
4.3.6 Loans from Financial Institutions

Activity
4.4 Medium-Term Sources of Finance
4.4.1 Lease Finance
4.4.2 Hire Purchase
4.4.3 Venture Capital
4.4.4 Public Deposits
4.4.5 Retained Earnings
Activity
4.5 Short-Term Sources of Finance
4.5.1 Trade Credit
4.5.2 Customer Advances
4.5.3 Instalment Credit
Activity

CONTENTS
4.6 Overseas Sources of Finance

4.6.1 ADR
4.6.2 GDR
4.6.3 ECB
Activity
4.7 Summary
S
IM
M
N

SOURCES OF FINANCE 67
n o t e s
CAPITAL STRUCTURE OF SHIVA PAINTS
Mr. Anand Dixit was the president of Shiva Cements Ltd, which
was incorporated in 1991. The registered office of the organisa-
tion was at Kanpur. Till 1996, the organisation was the largest
seller of cement in India. In the same year, Mr. Dixit decided to
enter the paint industry under the brand name of Shiva Paints.
He put forth his proposal at a board meeting and it was accept-
ed. However, long-term and medium-term financing was needed
for the new project. Mr. Rajiv Pandey, the finance manager of the
organisation, prepared the capital structure for the new invest-
ment project and explained it to Mr. Dixit. According to the capi-
tal structure, 40% of capital was to be generated by issuing shares,
30% from term loans, 20% from public deposits and 10% from re-
S
tained earnings of the parent organisation. Mr. Pandey was not
in favour of raising capital by issuing shares because he did not
want the interference of shareholders in the internal decisions of
the organisation. The product was launched in the market in 1999
IM
by the team effort of Shiva Paints and Shiva Cements. The new
product got a good start in the market. However, after the end of
two financial years, Shiva Paints found that it was incurring loss-
es. This was because the paint market was filled with MNCs that
were selling better-quality paints at a low price, and other organ-
isations were strongly advertising their products. The moderate
M
profits of Shiva Paints were spent in paying interests of loans and

meeting other expenses. In 2002, the public deposits matured and
Shiva Paints paid its liability from the profits made by Shiva Ce-
ments. Mr. Pandey was forced to resign and Mr. Alok Mukherjee
was appionted as the finance manager by Mr. Dixit.
N

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learning objectives

>> Explain the concepts of financial market, capital market and
money market
>> Describe long-term sources of finance such as shares, de-
bentures, term loans and mezzanine debt
>> Discuss medium-term sources of finance such as lease fi-
nance, hire purchase, venture capital, public deposits and
retained earnings
>> Explain short-term sources of finance such as trade credit,
customer advances and instalment credit
>> Describe the terms ADR, GDR and ECB
S
4.1 INTRODUCTION
IM
The previous chapter discussed capital budgeting which is a process
of allocating the resources of the organisation in the long-term in-
vestment projects to generate profit. This chapter focuses on various
sources of finance available to organisations.
The very existence of an organisation depends on the availability of

sufficient finance. The organisation requires finance for meeting its
M
various long-term and short-term needs. Long-term finance is re-

quired to fund the projects with long-gestation period, while short-
term finance is meant for projects that may need a few months to a
year for completion. In any organisation, capital comprises equity
N
(shares offered by an organisation and retained earnings) and debt

(obtained by borrowing). The ratio of debt to equity determines the
capital structure of an organisation and it varies from organisation to
organisation. Debt and equity are two important sources of long-term
financing. The maturity period of the long-term sources of finance is
more than 10 years. An organisation involved in international finan-
cial activities generally opts for the international market for financing
capital. International financing provides many options for long-term
financing at low cost and risk. MNCs operating in the international
financial market have to follow the rules and regulations of the capital
market of a particular country. Equity shares are offered by MNCs in
foreign countries in the form of depository receipts of that country.
An organisation also requires short-term finance to ensure smooth-

ness and efficiency in its day-to-day activities and operations. Short-
term financing helps in maintaining the financial stability in an or-
ganisation by keeping a balance between current assets and current
liabilities. In addition, it needs short-term finance on a regular basis
to procure raw materials, provide wages and salaries and maintain a

n o t e s
smooth production cycle. If the organisation fails to maintain a suffi-

cient pool of short-term finance, its production process may be ham-
pered. Therefore, the availability of short-term finance plays an im-
portant role in the efficient financial management of the organisation.
This chapter starts with the concept of financial market. Further, it ex-
plains the capital and money markets under financial market. Next, it
explains the long-term sources of finances such as shares, debentures
and term loans. It also explains the medium-term sources of finance
such as lease finance, hire purchase, venture capital, public deposits,
etc. In addition, it describes the short-term sources of finance such as
trade credit, customer advances and instalment credit. The chapter
also explains various overseas sources of finance that facilitate access
to foreign money such as ADR (American Depositary Receipt), GDR
(Global Depositary Receipt) and ECBs (External Commercial Borrow-
S
ings).
4.2 FINANCIAL MARKET

IM
A financial market is a place where investors trade securities and
commodities. It acts as a forum through which demanders and sup-
pliers of funds can perform business transactions. The demanders of
funds are known as borrowers and the suppliers are known as lend-
ers. The financial market provides numerous services such as fund
raising, risk distribution, international trading and capital formation.
M
It is divided into capital market and money market to differentiate the

sources of long-term and short-term finance. Capital market is regu-
lated by Securities and Exchange Board of India (SEBI) and money
market is regulated by the Reserve Bank of India (RBI). The changes
in finance market demonstrate the rise and decline of the economy.
N
In the absence of a financial market, an individual or an organisation

may find it difficult to raise funds at the time of need. Therefore, the
existence of a financial market is imperative to facilitate the smooth
functioning of an organisation. Financial market includes financial in-
termediaries and stock exchange.
Figure 4.1 shows the structure of a financial market:
Financial Market
Capital Market Money Market
Figure 4.1: Structure of a Financial Market

n o t e s
4.2.1 CAPITAL MARKET
Capital market is a type of financial market where debt capital and

equity share capital are raised by different business enterprises. It
provides opportunities to enterprises to raise funds for more than a
year. It facilitates an organisation to raise funds for long-term projects.
If an organisation raises long-term finance then it has to repay its debt
during its life time. Capital market can be classified into two types:
primary market and secondary market, as shown in Figure 4.2:
Capital Market
Primary Market Secondary Market
S
Figure 4.2: Classification of Indian Capital Market
IM
PRIMARY MARKET
Primary market is a part of the stock market (financial market) where

new securities are issued. Any organisation can raise long-term funds
by issuing new stock or bonds in the primary market. The character-
istics of a primary market are as follows:
M
It deals in fresh securities.

It issues new share certificates to investors for the shares they pur-
chase.
N
It facilitates organisations to raise funds for their growth and ex-

pansion.
It facilitates capital formation in the economy.
It allows only equity shareholders to redeem their financial assets.
When an organisation issues shares in the primary market for raising

funds, it is known as Initial Public Offer (IPO). However, the organi-
sation needs to hire underwriting firms for assistance if they wish to
issue an IPO. Underwriting firms act as advisors and assist organisa-
tions in selling shares at the best market prices.
The following steps need to be taken for issuing an IPO:

Appointing underwriters who can take liability of the under sub-
scription; underwriters are entitled to get maximum 2.5% commis-
sion on the amount underwritten.
Appointing bankers who can act as collection agents and provide
short-term loans for the IPO

n o t e s
Appointing registrars who can keep records of collected funds

Drafting prospectus along with the copies of agreements entered
with underwriters, bankers, and registrar; these documents are
then sent to the registrar of companies of the state where the or-
ganisation is located.
Printing and dispatching application forms for underwriters and
bankers
Filling
initial application of the stock exchange where the issue is
proposed to be listed
Making statutory announcement about opening and closing dates
of the issue in newspapers
Processing applications for issuing shares and then allotting shares
S
Establishing the liability of underwriter in case of under subscrip-
tion
Allotting shares as prescribed by SEBI
IM
While performing the preceding steps, an organisation should consid-
er the following points:
Eligibility for an IPO: This refers to the pre-requisites of an IPO.
An organisation becomes eligible to conduct an IPO if it has a good
record of paying dividends for at least three years consecutively.
If a financial institution has appraised a project proposed by an
M
organisation and found it profitable, then it has to finance at least

10% of the proposed project. For example, if you wish to start a
car manufacturing project and a commercial bank has found your
project profitable, then the bank has to invest minimum 10% of the
N
overall cost of the project.

Right of issue: This involves issuing shares to existing sharehold-
ers on a pro rata basis as per Section 81 of the Indian Companies
Act, 1956. Shareholders may forfeit the right of issue of an organ-
isation by passing a special resolution. This would enable the or-
ganisation to issue shares to the general public.
SEBI guidelines for IPOs: These are the instructions that need to
be taken care of while issuing an IPO. The guidelines provided by
SEBI on disclosure and investor protection for IPOs are as follows:
The minimum threshold level of public holding should be 25%
for all listed companies.
The existing listed companies with a listing of less than 25%
public holding should reach the minimum 25% level by an an-
nual addition of not less than 5% to public holding.

n o t e s
For the new listing companies, if the post issue capital of the
company calculated at offer price is above `4000 crore, the
company may be allowed to issue IPO with 10% public share-
holding complying with the minimum shareholding require-
ment of 25% by an annual adding of not less than 5%.
A company may increase its public shareholding by less than
5% in a year if such increase brings its public shareholding to
the level of 25% in that year.
The requirement for additional listings would remain the same
as the conditions for initial listing.
Every listed company shall maintain a public shareholding of not less

than 25%. If the public shareholding of a listed company falls short
of 25% at any time, such a company would need to bring the public
S
shareholding to 25% within a maximum period of 12 months from the
date of such fall.
IM
SECONDARY MARKET
Secondary market is a market where already issued securities and

financial instruments, such as stocks, bonds, options, and futures, are
sold and purchased. It is also known as the market for existing bonds
and securities. In a primary market, investors buy securities directly
from their initial issuers, but in a secondary market, securities once
M
sold in the primary market are resold and repurchased. Generally, a

secondary market fulfils the short-term fund requirement of an organ-
isation.
Following are the characteristics of a secondary market:

N
Transfers securities from initial purchasers to other buyers and

speculators
Needs high liquidity
Indicates the growth of an economy
Deals with high fluctuation in prices of securities
RELATIONSHIP BETWEEN PRIMARY MARKET AND SEC-

ONDARY MARKET
In primary market, fresh securities and bonds are issued to investors,

whereas in secondary market, securities already issued in primary
market are resold to buyers or speculators. As per SEBI, an organ-
isation cannot enter the secondary market without first entering the
primary market. This point can be further explained with the help of
Figure 4.3:

n o t e s
Capital
Market
Secondary Primary
Market Market
Figure 4.3: Relationship between Primary Market and
S
Secondary Market
Let us understand the relationship between primary and secondary

markets with the help of an example. Suppose XYZ Ltd. wants Rs 10
IM
crores for its expansion. Therefore, to raise the required funds from
the capital market, the organisation first needs to seek the permission
of SEBI for an IPO. As we know, IPOs are the characteristics of the
primary market. When an organisation issues an IPO, it has to enter
the primary market. When the organisation receives sufficient funds,
the IPO is closed. The people who purchased the shares of XYZ Ltd.
can either keep the shares to receive dividend or sell them. If they pre-
M
fer to sell the shares, they will have to move to the secondary market,
where already issued shares are resold. Therefore, it is clear from this
example that no new shares are issued in the secondary market.
N
4.2.2 MONEY MARKET
Money market is a part of financial market in which short-term loans

are raised. The maturity period of these loans is one year or less than
one year. In the money market, funds can be raised through treasury
bills, commercial papers, bank loans and asset-backed securities. In
India, the money market is regulated by the Reserve Bank of India
(RBI). Raising funds from the money market is feasible when an or-
ganisation is going to invest in a short-term project. The components
of the money market are explained as follows:
Call Money Market: It is a component of the money market in
which surplus funds of banks are traded. The maturity period of
call money loans is very short and varies from 1 to 15 days. If the
maturity period exceeds even by one day, it is referred to as notice
period. Any amount can be borrowed from this market at an inter-
est rate agreed to by the borrower and the lender.
Treasury Bills: These are government securities that are issued to
raise funds for financing short-term government projects.

n o t e s
Commercial Papers: These are unsecured promissory notes is-

sued at a discount on their face value. Commercial papers are
issued by reputed organisations that carry high credit ratings.
These papers are regulated by the guidelines issued by the RBI
on October 10, 2000. In the money market, a commercial paper is
a negotiable instrument with a fixed maturity of 1 to 270 days. It is
sold and purchased at a discounted price and has a higher interest
payment rate compared to bonds.
Certificate Deposits: These are short-term promissory notes with
a maturity period of not less than three months and not more than
one year.
S
1. In the primary market, fresh securities and bonds are issued
to investors, whereas in the secondary market, securities
already issued in the primary market are resold to buyers or
speculators. (True/False)
IM
2. Treasury bills are___ securities that are issued to raise funds
for financing short-term government projects.
Activity
M
Prepare a small presentation on the Indian capital market.
4.3 LONG-TERM SOURCES OF FINANCE

N
Long-term financing is a mode of financing that is offered for more than

one year. It is required by an organisation during establishment, expan-
sion, technological innovation and research and development. In addi-
tion, long-term financing is required to finance long-term investment
projects. Long-term funds are paid back during the lifetime of an organ-
isation except equity which is paid off during winding up/liquidation.
Various sources of long-term finance are shown in Figure 4.4:
Figure 4.4: Different Sources of Long-Term Finance

n o t e s
4.3.1 SHARES
Shares are a part of stocks that consist of fixed assets and current as-
sets, which may change in different situations. In addition, they can
be issued at discount, par or premium. Discounts and premiums on
shares are calculated on their par value or face value. The value of
shares is calculated according to various principles in different capi-
tal markets. However, the primary basis on which a share is valued is
the price at which it is expected to be sold. The volatility of markets is
a major factor that should be considered to determine the price of a
share in the market at a particular point of time. Tax liability on divi-
dends differs in different zones, states and countries. For example, in
India, dividends are free from tax liability for shareholders; however,
an organisation pays tax on dividend before its distribution at the rate
of 12.5%.
S
Figure 4.5 shows the different types of shares:
IM
Types of Shares
Equity Shares Preference Share

M
Figure 4.5: Different Types of Shares
As shown in Figure 4.5, there are two types of shares, namely equi-
ty and preference, which are issued by an organisation. Each type of
shares has a different set of characteristics, advantages and disadvan-
N
tages.
EQUITY SHARES
Equity shares are one of the most important financial instruments to

raise long-term funds needed for the incorporation, expansion and
growth of an organisation. These shares are treated as the base for
capital formation of the organisation. Equity shareholders are consid-
ered as the real owners of the organisation. They are entitled to receive
dividend out of the profit generated at the end of every financial year.
The amount of dividend may vary from one financial year to another.
The characteristics of equity shares are as follows:

Serve as a source of long-term capital and are repaid during the
lifetime of the organisation; generally, equity shares are repaid at
the time of winding up of an organisation.
Do not require any security from an organisation

n o t e s
Allow shareholders to receive dividend after payment is made to

each and every stakeholder
Provide equity shareholders the right to share profit, assets and
control management
Figure 4.6 shows the different types of equity shares:
Types of Equity Shares
Sweat Equity
Bonus Shares
Shares
S
Figure 4.6: Different Types of Equity Shares
The different types of equity shares are briefly discussed as follows:

IM
Bonus Shares: These shares are issued in place of dividends.
Whenever an organisation has accumulated surplus profit, it may
distribute the profit among its existing shareholders by providing
them bonus shares. In other words, bonus shares are issued when
an organisation has sufficient profit but is in need of more working
capital at that particular time. Issuing bonus shares is beneficial to
both the organisation as well as the shareholders.
M
Sweat Equity Shares: These shares are issued to the employees

of an organisation. Sweat equity shares are always issued at a
discount. These shares are a kind of award for employees for the
work rendered by them to an organisation. This makes employees
N
feel that they are owners of the organisation, motivates them and
increases their productivity.
Equity shares have the following advantages:

Paying dividend on equity shares is not an obligation for an organ-
isation when there is less profit or there is loss.
Equity shares can be used for raising long-term investment, as
these shares are repaid during the lifetime of an organisation.
These shares limit the liability of equity shareholders to the amount
of shares they hold.
Such shares provide higher dividends to equity shareholders
whenever an organisation makes a huge profit.
These shares provide voting rights to the shareholders of an or-
ganisation.

n o t e s
Equity shares have the following disadvantages:

Equity shareholders can interfere in the internal affairs of an or-
ganisation. This may hamper the smooth functioning of an organ-
isation at times.
The cost of capital is high when an organisation raises funds
through equity shares.
If more than the required equity shares are issued, it may lead to
overcapitalisation.
It is difficult to repay funds raised by issuing equity shares during
the lifetime of an organisation, even if these funds are not used.
PREFERENCE SHARES
Preference shares give preferential rights to their holders in comparison
S
to equity shares. These shares carry a fixed percent of dividend, which
is lower than that for equity shareholders. An organisation pays the div-
idend on preference shares before paying dividend to equity sharehold-
IM
ers. Even during the winding up of an organisation, the investment of
preference shareholders is paid before that of equity shareholders.
The characteristics of preference shares are as follows:

They do not allow preference shareholders to act as real owners of
an organisation.
Preference shares are repaid during the existence of an organisation.
M
Preference shareholders receive dividends out of profit earned by

an organisation.
Such shares do not bind an organisation to offer any asset as secu-
rity to shareholders.
N
These shares carry less risk for investors compared to equity shares.
Figure 4.7 shows the types of preference shares:
Cumulative Preference
Shares
Non-Cumulative
Types of Preference Shares
Preference Shares
Convertible Preference
Shares
Non-Convertible
Preference Shares
Redeemable Preference
Shares
Irredeemable Preference
Shares
Figure 4.7: Different Types of Preference Shares

n o t e s
The different types of preference shares are briefly described as fol-

lows:
Cumulative Preference Shares: The dividend on such shares gets
accumulated over a period of time. When an organisation has suffi-
cient profit, the accumulated dividend on these preference shares
is paid.
Non-Cumulative Preference Shares: The dividend on these
shares does not accumulate over a period of time. An organisation
has to pay dividend on these preference shares at the end of a fi-
nancial year.
Convertible Preference Shares: These shares can be converted
into equity shares after a certain time. The holders of convertible
preference shares have to pay conversion price at a given date for
converting their shares into equity shares.
S
Non-Convertible Preference Shares: These shares cannot be
converted into equity shares.
IM
Redeemable Preference Shares: These preference shares are re-
paid by an organisation. Such shares are issued for a fixed time-pe-
riod and are paid during the existence of the organisation.
Irredeemable Preference Shares: These shares are not repaid
during the existence of an organisation but only at the time of liq-
uidation of the organisation. At the time of liquidation, these shares
M
are paid after paying all the liabilities but before Equity Shares
The advantages of preference shares are as follows:

Help in raising more funds as they are less risky
N
Release preference shareholders from any fixed liability at the

time of liquidation of an organisation
Save an organisation from unnecessary interference of preference
shareholders, as they do not enjoy any voting rights
Facilitate trading on equity
Prevent preference shareholders from claiming the assets of an
organisation
The disadvantages of preference shares are as follows:

Provide low returns to preference shareholders
Characterised by fluctuations in returns
Do not provide any voting rights to preference shareholders
4.3.2 DEBENTURES
A debenture is a financial instrument that provides long-term debt

to an organisation. In other words, a debenture is an agreement be-

n o t e s
tween a debenture-holder and an organisation, which acknowledges

that the organisation would repay the debt at a specified date to the
debenture-holder. If an organisation raises funds by issuing deben-
tures, it needs to pay a fixed rate of interest at regular intervals. De-
benture-holders of an organisation are known as creditors. The char-
acteristics of debentures are as follows:
Provide no voting rights to debenture-holders
Allow debenture-holders to receive a fixed rate of interest
Facilitate
debenture-holders to be paid back during the lifetime of
an organisation
Allowthe debenture-holders of an organisation to transfer bearer
debentures to other individuals
Increase the liability of an organisation
S
Figure 4.8 shows the different types of debentures:
IM
Convertible Debentures
Non-Convertible
Debentures
Types of Debentures
Registered Debentures
M
Bearer Debentures
N
Redeemable Debentures
Irredeemable Debentures
Figure 4.8: Different Types of Debentures
The different types of debentures are briefly explained as follows:

Convertible Debentures: The debentures can be converted into
equity shares after a specific period of time.
Non-Convertible Debentures: These debentures cannot be con-
verted into equity shares during their maturity period.
Registered Debentures: These debentures are registered in the
books of an organisation. Registered debenture-holders cannot
transfer their debentures without giving prior information to the
organisation.
Bearer Debentures: These debentures are not registered in the
books of an organisation. Bearer debenture-holders can transfer

n o t e s
their debentures without giving any prior information to the or-

ganisation.
Redeemable Debentures: These debentures are paid back during
the existence of an organisation. These are issued for a fixed peri-
od of time.
Irredeemable Debentures: These debentures are not paid back
during the lifetime of an organisation. An organisation pays inter-
est on the irredeemable debentures till its existence.
The advantages of debentures are as follows:

They involve less cost in raising funds than equity shares.
They help in raising funds from investors who are less likely to
take risks.
S
They provide fixed returns to debenture-holders even if there is
no profit.
They allow debenture-holders to receive payment before equity
IM
and preference shareholders even at the time of liquidation of an
organisation.
The disadvantages of debentures are as follows:

They compel an organisation to pay interest even if there is no
profit or loss.
M
They make it difficult for an organisation to provide security

against debentures if the organisation has insufficient fixed assets.
They do not allow debenture-holders to vote in the official meet-
ings of an organisation and influence decisions.
N
4.3.3 DIFFERENCE BETWEEN SHARES AND DEBENTURES
In an organisation, shares and debentures serve as the sources of rais-

ing funds for long-term projects. However, they have some remarkable
differences in their characteristics. The differences between shares
and debentures are shown in Table 4.1:
Table 4.1: Differences between Shares

and Debentures
Nature Shares Debentures
Ownership Shareholders are the real Debenture-holders are the
owners of an organisation. creditors of an organisation.
Return Shareholders have right to get Debenture-holders get inter-
dividend out of the profit of an est at a fixed rate.
organisation. The amount of
dividend is not fixed.

n o t e s
Nature Shares Debentures

Maturity Shares have no maturity peri- Debentures have fixed matu-
period od. They are paid during the rity period. An organisation
lifetime of an organisation. has to pay regular interest
on debentures till the end of
the maturity period.
Risk and Shares carry high risk and Debentures carry minimum
Return provide high return. risk and provide moderate
return.
Voting Shareholders have voting Debenture-holders have no
rights rights in any decision of an voting rights in any decision
organisation. of an organisation.
4.3.4 TERM LOANS
S
Term loans are long-term loans that are raised for a period of 3 to
10 years from financial institutions. These loans carry a floating rate
of interest and pre-determined maturity period. The main sources of
term loans in India are commercial banks, Industrial Development
IM
Bank of India (IDBI), Industrial Credit and Investment Corporation
of India (ICICI) and Industrial Finance Corporation of India (IFCI).
An organisation uses term loans to purchase fixed assets and fund
projects with long gestation period.
The characteristics of term loans are as follows:

M
Term loan providers are not considered as the owners of an organ-

isation. However, term loan providers are considered as the credi-
tors of the organisation.
These are secured loans. However, sometimes term loans can be
N
unsecured in nature.
These loans allow an organisation to pay interest on a monthly,
quarterly and half-yearly basis at a mutually agreed rate.
An organisation is bound to pay interest for term loans, even if it
is incurring losses.
Term loans carry high risk because they are secured loans, and an
organisation has to repay them even if it is running into losses.
A term-loan agreement is a contract between a borrowing organisa-

tion and a lending financial institution. It includes the following claus-
es and conditions:
Amount and time period of the loan
Security offered against the loan
Rate of interest on the loan

n o t e s
The borrowing organisation has to submit audited annual ac-

counts report to the lender or financial institution
Details of fixed assets purchased from the loan
The advantages of term loans are as follows:

They make raising funds easier.
They help in maintaining good relations with financial institutions.
They help in collecting funds at the right time.

They make organisations more focused on profitable projects, as
they have to pay interest on quarterly, half-yearly or annual basis.
They do not allow the interference of creditors, who have provided
term loans to an organisation, in the internal affairs of the organ-
isation.
S
The disadvantages of term loans are as follows:
They bind an organisation to pay interest even in case of losses.
IM
They carry high risks, as they are secured loans.
They create pressure on an organisation to make profit at any cost,
as the interests on these loans are very high and have to be paid on
a quarterly or a half-yearly basis.
They increase the chances of government interference in the func-
M
tioning of an organisation, as these loans are mainly provided by

financial institutions owned by the government.
4.3.5 MEZZANINE DEBT

N
It is the middle layer of capital between secured senior debt and equi-
ty. Mezzanine debt is generally not secured by assets and is lent judg-
ing an organisation’s ability to repay the debt. It is a good way for new
organisations to fund the deficit between bank loans and the value of
a new project. Mezzanine debt can be considered instead of equity
when a business has stable free cash flow, as this allows obtaining fi-
nance without issuing equity and diluting the ownership of business.
The advantages of mezzanine debt are as follows:

Even though some independence is lost, an owner does not lose
outright control of business.
Lenders of such debt are generally long-term investors.
Lenders can provide strategic help through fresh insights.
It increases the stock value of existing stockholders.
It provides funds to expand a business or acquire new assets.

n o t e s
The disadvantages of mezzanine debt are as follows:

An owner loses some amount of control over the business.
As lenders generally don’t have any direct security interest in a
borrower’s assets, restrictive conditions are included in the terms
of the loan agreement.
Business owners may be imposed restrictions in spending money
on salaries and dividends.
It is more expensive than traditional debt financing.
4.3.6 LOANS FROM FINANCIAL INSTITUTIONS
Financial institution refers to an institution that provides financial

services for its members and caters to their financial requirements.
S
Financial institutions are of two types:
Depository Institution: A depository is a financial institution,
such as a bank, which can legally accept monetary and other de-
posits from the public.
IM
Investment Institution: It is a financial institution that pools large
sums of money and invests them in securities, property and other
commercial avenues that provide or promise to provide substan-
tial returns.
The advantages of borrowing from a financial institution are as fol-

M
lows:
A financial institution issues a large number of loans.
Areliable and experienced lender is able to objectively tell how
N
much a borrower will pay and the conditions of the loan.

Organisations and individuals with good credit history can avail
loans at reasonable interest rates.
The disadvantages of borrowing from a financial institution are as fol-

lows:
Loans form financial institutions are based on strict credit terms.
Penalty is charged on late repayment of loans.
Failure to repay a loan can affect a person or an organisation’s
credit history and lead to the loss of the collateral, such as proper-
ty, provided to obtain loan.
3. Sweat equity shares are awarded to employees for the services

rendered to an organisation. (True/False)
4. A debenture is a financial instrument that provides ___ debt
to an organisation.

n o t e s
Activity
Examine the status of mezzanine debt in India.
4.4 MEDIUM-TERM SOURCES OF FINANCE

Medium-term finance is required by an organisation for a period of
more than 1 year but less than 10 years. The organisation can avail
medium-term finance through various sources, including lease fi-
nance and hire purchase, venture capital finance, public deposits and
retained earnings. An organisation needs medium-term sources of fi-
nance for expansion, replacement of old plant and machinery, writing
off short-term debts and technological upgrade.
S
Figure 4.9 shows the sources of medium-term finance:
IM Lease Finance
Different Sources of Medium-
Hire Purchase
Term Finance
Venture Capital
M
Public Deposits
Retained Earnings
N
Figure 4.9: Different Sources of Medium-Term Finance
4.4.1 LEASE FINANCE
Lease finance has become one of the important sources of medi-

um-term finance in the past few years. It is an agreement between
an owner of assets, called the lessor, and the user of assets, called the
lessee. In lease finance, only the possesion of an asset is transferred
to a lessee and the ownership of the title remains with the lessor. The
lessee makes payment to the lessor for the specified period of time
to use the asset. This periodical payment is called lease rent. A lease
agreement includes the following points:
It gives details, including the cost of the asset to be leased.
It states the starting date of the lease contract.

n o t e s
Itstates the amount, duration and mode of payment of the lease

rent.
It gives guarantee for the payment of the lease rent by a lessee.
Itallows termination of the lease contract due to occurrence of
any uncertainity.
It provides protection of assets from any damage.
Itprohibits a lessee from selling, mortgaging or sub-leasing the
assets without prior permission of the lessor.
Itprohibits a lessee from changing and modifying the assets with-
out prior permission of the lessor.
It gives all the rights to a lessor to inspect the assets.
Figure 4.10 shows the three types of lease:
S
Types of Lease
IM
Sale and Lease
Financial Lease Operating Lease
Back
Figure 4.10: Different Types of Lease

M
The different types of lease are briefly described as follows:

Financial Lease: It is a type of lease in which a lessee has to bear
the cost of repair, maintenance and insurance of the asset. In fi-
nancial lease, the title of an asset can be transferred to the lessee
N
after the payment of the agreed amount. This type of lease is also
called capital lease.
Operating Lease: It is a type of lease in which a lessor has to bear
the cost of repair, maintenance and insurance of the asset. In op-
erating lease, the possession of the assets is taken back from the
lesseee after the date on which the lease expires. The lease can be
cancelled any time by either party after giving a prior notice.
Sale and Lease Back: It is a type of lease in which a lessee pur-
chases assets and sells them to the lessor. After that, the lessor
leases the same assets to the lessee.
The advantages of lease financing are as follows:

The assets are returned to the lessor when they become obsolete.
Itallows the lessee to use costly assets without investing a huge
amount of money.

n o t e s
It helps an organisation to earn moderate profit.

It increases the earnings of the lessor.
The disadvantages of lease financing are as follows:

It does not allow the lessee to own the asset even after paying the
rent for a number of years.
It gives the lessee the opportunity to misuse the leased asset.
It allows the lessee to sell, mortgage and sub-lease the asset of the
lessor.
It gives the lessor the right to inspect, which may affect the bussi-
ness of the lessee.
4.4.2 HIRE PURCHASE
S
In hire purchase, there is an agreement between a hiree (the owner of
the asset) and a hirer (the user of the asset). According to this agree-
ment, the hiree transfers his/her asset to the hirer, keeping ownership
IM
of title with himself/herself and the hirer gets the possesion of the
asset. In hire purchase, the hiree receives periodic payment from the
hirer. The payment made to the hiree is divided into two parts: capital
repayment and interest. In additon, interest and deprication charged
on the asset are treated as revenue expenditure and shown on the
debit side of the profit and loss account. After making the full pay-
M
ment, the hirer may or may not purchase that particular asset. How-
ever, if the hirer fails to make the full payment for the asset, the hiree
can recover the asset without refunding any payments made earlier.
The characteristics, advantages and disadvantages of hire purchase
are more or less similar to lease finance.
N
4.4.3 VENTURE CAPITAL
Venture capital is a significant way of raising medium-term funds in

the 20th century. It is also called risky capital, as it has to be paid even
in case of loss. Venture capital is a form of quasi-equity and is generally
required by new organisations. The capitalist who invests in venture
capital is not similar to bankers and equity shareholders. A venture
capitalist acts as a partner, manager and advisor to an organisation.
Venture capital is needed at the time of incorporation, expansion and
acquisition of an organisation. Raising funds through venture capital
is a common phenomenon in developed nations; however, this con-
cept of financing can also be seen in developing nations today. It is
helpful for developing nations as it the best way to restart sick units.

n o t e s
The different stages of venture capital financing is shown in Table 4.2:
Table 4.2: Different Stages of Venture

Capital Financing
1. Initial stage financing a. Needed for the incorporation of an or-
ganisation
b. Needed for the research and develop-
ment of a new product line
c. Needed for meeting production and
marketing expenses
2. Expansion financing a. Needed for getting additional working
capital
b. Needed for facilitating public issue
3. Acquisition financing a. Needed for acquisition of further growth
S
b. Needed for acquiring and restarting sick
units
IM
Figure 4.11 shows the methods of venture capital financing in India:
Venture Capital
Financing Methods
M
Equity Conditional Loans Income Note
Figure 4.11: Methods of Venture Capital Financing in India

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The methods of venture financing are briefly explained as follows:

Equity: It is the method of raising venture capital in India in which
venture capitalists can own up to 49% equity shares. In this way,
the ownership of an organisation is preserved. The venture capi-
talists that buy shares of an organisation are eligible to share profit
and loss. The main aim of venture capitalists is to sell their shares
to make capital gains.
Conditional Loans: These loans are paid back in the form of roy-
alty. An organisation does not pay interest and dividend for con-
ditional loans. Royalty on conditional loans is paid when an or-
ganisation starts generating revenue. In an organisation, royalty
charged by venture capitalists on conditional loans varies from 2%
to 15%. This royalty depends on the term of the venture, the risk
involved in venture, cash inflow pattern of organisation and other
terms related to the venture agreement.
Income Note: It is the combination of equity and conditional
loans. An income note is an unsecured loan on which a venture

n o t e s
capitalist receives royalty and interest, depending on the revenue

generation of the organisation. In addition, an organisation pays
low interst during its incorporation and growth phase. After the
completion of the growth phase, high interest is paid.
The advantages of venture capital financing are as follows:

It allows a venture capitalist to act as a partner, manager and advi-
sor to an organisation.
It proves helpful to an organisation at each and every stage of the
business cycle.
It allows professionals who have equity in an organisation to act
as guides.
The disadvantages of venture capital financing are as follows:
S
It increases the interference of fund providers in the internal deci-
sion-making process of an organisation.
Venture capitalists generally intend in closing the deal and with-
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drawing investments within three to five years. Thus, venture cap-
ital financing is not ideal for organisations looking for long-term
liquidity. It proves helpful to developed nations only and does not
provide much benefits to developing and underdeveloped nations.
4.4.4 PUBLIC DEPOSITS
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Public deposits are one of the widely–used and important sources of

medium-term finance and are funds and loans raised from general
public, employees and other similar kind of depositors. These are one
of the easiest methods of raising funds during credit crisis, as the pub-
N
lic is always ready to invest in the profitable projects of different or-

ganisations. Public deposits are the most economical source of raising
funds compared to other sources. These are regulated by the Com-
panies Act, 2013 (Amended) and Companies (Acceptance of Deposit)
Rule, 1975.
The advantages of public deposits are as follows:

They make the raising of funds easier and economical.
They save an organisation from paying high interest, as the inter-
est paid on public deposits is lower than bank loans.
They provide more flexibility to an organisation in repaying debt.
They provide no share in the ownership of an organisation to de-
positers. Therefore, depositors cannot interfere in the internal is-
sues of the organisation.

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The limitations of public deposits are as follows:

They affect the solvency of an organisation if the public deposits
are not available at the time of need.
They involve more risk for investors, as these are unsecured loans.
They do not prevent an organisation from investing in non-eco-

nomical areas.
4.4.5 RETAINED EARNINGS
In retained earnings, an organisation uses its accumulated profit for

future investments, which can be short-term or long-term in nature.
After each financial year, some undistributed profit is left. This undis-
tributed profit is transferred to a reserve fund each year and this re-
serve fund is termed as retained earnings. In an organisation, retained
S
earnings are used to meet future uncertainities and growth prospects.
Retained earnings are the best method of raising funds because of the
following advantages:
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They allow an organisation to avoid external liability in raising
funds.
They prevent external interference of any outsider in the internal
decision-making of an organisation.
They do not require any formalities and legal documentation.
M
They allow an organisation to take its own investment decisions.

They increase the total profit of an organisation, as the retained
earnings are not distributed among creditors and shareholders
N
and only invested in future projects.
The disadvantages of retained earnings are as follows:

They reduce the profit of an organisation as a part of the profit is
allocated to retained earnings.
They cannot be used to finance projects requiring huge invest-
ments.
They can lead to opposition from the equity shareholders, who
might feel that retained earnings will reduce their dividends.
They give an opportunity to an organisation to misuse funds, as
there are no legal safeguards to check the misuse of retained earn-
ings.

n o t e s
5. Venture capital is a form of ___.

6. In retained earnings, an organisation uses its accumulated
profit for future investments. (True/False)
Activity
Discuss the role of public deposits in India.
4.5 SHORT-TERM SOURCES OF FINANCE

Short-term financing is aimed to meet the demand of current assets
S
and current liabilities of an organisation. It helps in minimising the
gap between current assets and current liabilities. There are different
means to raise capital from the market for a small duration. Various
IM
agencies, such as commercial banks, co-operative banks, financial in-
stitutions and National Bank for Agriculture and Rural Development
(NABARD), provide financial assistance to organisations. These agen-
cies provide short-term financing in various forms, as shown in Figure
4.12:
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Short-Term Financing
Trade Credit Customer Advances Instalment Credit

N
Figure 4.12: Various Sources of Short-Term Financing
4.5.1 TRADE CREDIT
Trade credit is one of the traditional and common methods of raising

short-term capital from the market. It is an arrangement in which the
supplier allows the buyer to pay for goods and services at a later date.
The decision to provide trade credit depends on the mutual under-
standing of the buyer and supplier. The supplier takes the decision to
extend trade credit after taking into consideration creditworthiness,
goodwill and the record of previous transactions of the buyer. The
trade credit transactions are done in cash and also in kind. For exam-
ple, the supplier may provide raw material, machine, finished goods
and services to the buyer instead of cash.

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The advantages of trade credit are as follows:

Improved cash inflow: Trade credit enhances the cash inflows of
an organisation, which in turn facilitates smoother business oper-
ations.
Reduced capital requirement: If an organisation has trade credit
arrangements with its suppliers, then it would require less short-
term capital to operate its business. In this case, the payments to
the suppliers can be made as per the pre-decided credit terms
after the receipt of payment from customers. Thus, the business
would continue to operate with lower capital requirements. In ad-
dition, the organisation can effectively use the short-term capital
for other activities, such as maintaining inventory.
Increased focus on other business activities: Trade credit allows
an organisation to focus on other business activities, which require
S
immediate funds. Examples of such activities are procurement of
raw materials and payment of salaries and wages.
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The disadvantages of trade credit are as follows:
Increased borrowing: The ease in availability of trade credit often
induces the borrower to raise more credit than required. This re-
sults in accumulation of debt, which may hamper the growth of an
organisation.
Delay or default in the payment of trade credit: This affects the
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goodwill of an organisation. As a result of this, the organisation

may face a problem of poor credit rating, which further reduces its
creditworthiness.
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4.5.2 CUSTOMER ADVANCES
Customer advances may be defined as the part of payment made in

advance by a customer to an organisation for the procurement of
goods and services in the future. It is also called as Cash Before Deliv-
ery (CBD). The customers pay advance when they place the order for
the goods and services required by them. This method of procuring
goods and services depends on the characteristics and value of the
products. Customer advances ease the burden of the customer for the
short term by deferring the remaining payment for some time.
The advantages of customer advances are as follows:

Free from interest burden: An organisation does not need to pay
any interest on customer advances.
No security required: An organisation does not need to present
any security to raise customer advances.
No repayment obligation: An organisation is free to decide wheth-
er to refund money if an order is cancelled by a customer.

n o t e s
The disadvantages of customer advances are as follows:

Limited to selected organisations: The benefits of customer ad-
vances can be availed only by organisations that have goodwill in
the market.
Limited period offer: The customer advances can be availed only
for a limited period of time. The allotted time for the advances and
delivery of goods and services is fixed and cannot be extended.
Limited amount of advance: The payment made by customers
may not fulfil the fund requirement of an organisation. In addition,
the amount of advance is proportional to the value of the product;
therefore, it may vary from product to product.
4.5.3 INSTALMENT CREDIT
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Instalment credit is another source of short-term financing, in which
the borrowed amount is paid in equal instalments with interest. It is
also called instalment plan or hire-purchase plan. Instalment credit is
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granted to an organisation by the suppliers on the assurance that the
repayment would be done in fixed instalments at regular intervals of
time. It is mostly used to acquire long-term assets used in production
processes.
The advantages of instalment credit are as follows:

Convenient mode of payment: Instalment credit is an easy mode
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of payment, as it divides the burden of payment into easy instal-

ments payable at regular intervals.
Protecting blockage of funds: Instalment credit helps an organi-
sation in saving capital, which can be used for other productive ac-
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tivities. In helps the organisation in purchasing goods and services

by making a part of the payment.
Facilitating modernisation: Instalment credit helps an organisa-
tion in acquiring new machines and technology even in the ab-
sence of sufficient funds for the time being.
Quick possession of assets: The instalment method requires very
little paperwork to transfer the ownership of assets from one party
to another.
The disadvantages of instalment credit are as follows:

Influence on liquidity position: The payment of instalments is
considered as an additional burden on the short-term capital of an
organisation.
Extra cost: If an organisation buys goods on instalment credit,
then it needs to pay a higher amount compared to one-time pay-
ment. This happens because the instalments include the amount
of borrowing as well as the interest.

n o t e s
Extra liability: If an organisation fails to pay the instalment

amount in the allotted time, it may seriously affect the image of
the organisation. Therefore, it becomes the liability of the organi-
sation to pay the instalment in time.
7. Short-term finance can be obtained from:

a. Trade credit
b. Customer advances
c. Instalment credit
d. All of the above
8. Customer advances are also known as ___________.
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Activity
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Prepare a PowerPoint presentation comparing the different sourc-
es of short-term capital.
4.6 OVERSEAS SOURCES OF FINANCE

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An organisation operating in the international market requires a large

amount of capital. Funds are raised by MNCs by determining the ideal
capital structure (a mixture of debt and equity) of the organisation. The
capital-structure decision is taken to determine the proportion of the
debt and equity in the capital that has the minimum cost. The capital
N
of an organisation mainly consists of issued shares or stocks, borrowed

funds or debt, retained earnings and undistributed dividends. It is up to
the strategy of the management to determine the proportion of the debt
to be raised by borrowing and the proportion of equity to be raised from
the market. As MNCs operate in domestic and international markets,
they have the advantage of raising capital from either of the markets.
It is the responsibility of the finance manager to explore all the possi-
ble ways of raising capital from the markets, judiciously evaluating the
sources of capital and choosing the one that offers low cost and risk.
MNCs can raise capital from the domestic market by offering equity
shares in the domestic currency. They can also think about sourcing
equity globally by offering shares in foreign countries in the curren-
cies of the respective countries. There is also a means of partially of-
fering the shares in the domestic country and partially in a foreign
country. The advancement and growth of the economy and liberalisa-
tion, coupled with globalisation, have motivated companies to enter
the international market. The international financing of equity pro-
vide a new identity to companies and help in the future expansion and

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diversification of business. The international financing of shares of an

organisation requires the listing of that organisation on the stock ex-
change of the foreign country in which it is offering shares.
The study of international financing trends reveals that the issuance

of equity in the foreign countries has increased significantly over the
years. It shows a sharp increase between 1983 and 1987. Different
organisations from the developed countries have started expanding
their market exposure in the developing and underdeveloped coun-
tries in search of investors. The domestic investors have started tak-
ing an interest in the foreign equity shares because of the high returns
from many international organisations.
The mechanism that is followed for the issue of shares in the interna-
tional market has been depicted in Figure 4.13:
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Organisation
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Figure 4.13: Mechanism of Sourcing Equity Globally
The mechanism of international equity investment as shown in the

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above figure gives an idea of how equity is placed globally. The MNCs
interested in offering equity in a foreign country need to consult the de-
pository bank of that country. The depository bank offers depository re-
ceipts to the investors interested in holding shares in the foreign organ-
isation. The exchange market regulatory body of that country acts as
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the custodian of the shares of the investors and ensures their security.
4.6.1 ADR
ADR stands for American Depositary Receipt. It is a share traded in

the US. financial market by a non-US. organisation. It is an indirect
form of trading in the American market through the depository re-
ceipts. ADRs help the American investors in purchasing shares of the
foreign organisations in the same manner as that of the local organisa-
tions without any problem of cross-country and cross-currency trans-
action. The transactions of ADRs, such as buying, selling and paying
dividends, are denominated in US dollars. ADRs are offered by a de-
pository bank situated in the US holding the shares of the foreign or-
ganisations. It provides the buyer the right of ownership, the authority
to hold it and the power to claim the dividend in the same way as the
general shares but it deprives the right of vote to the owners. ADRs
were introduced in the American market for the first time by J P Mor-
gan in 1927. The major commercial banks acting as the depository
banks for ADRs are J P Morgan, Deutsche Bank, Citibank and the
Bank of New York Mellon.

n o t e s
ADRs issued by the depository bank can be categorised into three dif-
ferent levels:
Level 1: It is the most basic type or the lowest level of ADRs that
do not fulfil the conditions for listing on the US stock exchange.
For foreign organisations, these are the easiest and the most con-
venient means of participating in the US market. Traded through
the OTC market, a level 1 ADR involves minimal obligation as far
as reporting to the US SEC is concerned.
Level 2: These are the depository receipts which are listed on the
US stock exchange and traded through stock exchanges such as
NASDAQ, NYSE and AMEX. These are slightly more complicated
than level-1 receipts and require some formalities, such as regis-
tration under SEC regulation, before trading. The benefit of this
level is the upgrade in the visibility of an organisation by being
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listed on the stock exchange.
Level 3: This is the most prestigious stage of ADRs in the US fi-
nancial market. This is the highest level that can be attained by
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a foreign organisation operating in the US market. At this level,
ADRs of the foreign organisations come under the direct supervi-
sion of SEC and follow the strict guidelines of the regulatory body.
4.6.2 GDR
GDR refers to Global Depositary Receipt. GDRs are the same as ADRs
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but with the right to tap multiple markets by issuing shares. It is a DR

offered by the depository bank of a country to a foreign organisation
to participate in the stock trading of that country. For example, the US
depository banks offer ADRs, European banks offer EDRs and others
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issue GDRs to the foreign organisations. GDR transactions are mostly

denominated in US dollars. These receipts provide an opportunity to
emerging organisations to expand their presence in the foreign coun-
tries by offering shares. The pricing policies of the GDRs are similar to
that of the ordinary shares but differ in trading and settlement of the
shares. Some of the international banks that offer GDRs are J P Morgan
Chase, Deutsche Bank, Citibank and the Bank of New York Mellon.
GDRs are easily available to buyers and allow investors to buy own-
ership in foreign organisations. The investors in the domestic country
can buy the stocks of the organisation denominated in the domestic
currency. Though these shares are traded in the domestic market,
they facilitate the buyer to sell them around the globe through the
branches of that bank. GDRs are treated at par with shares and the
holder enjoys voting and the dividend rights. As per a buyer’s request,
GDRs can be cancelled and transferred into equity shares. With the
consent of the local custodian, the depository bank can convert the
GDRs into equity shares. Generally, 1 GDR is equal to 10 shares.

n o t e s
4.6.3 ECB
ECB or External Commercial Borrowing refers to an instrument used

for raising funds from foreign markets by companies and Public Sec-
tor Undertakings (PSUs). It caters to the financial needs of large com-
panies and PSUs and enables them to access foreign money. Buyer’s
credit, supplier’s credit, commercial bank loans and security instru-
ments are included in ECBs.
RBI has announced guidelines to companies for sourcing equity in

foreign markets. It has highlighted the following points:
The general permission was granted for conversion of ECBs into
equity, subject to certain conditions and prescribed reporting re-
quirements. However, import payables deemed as ECBs would
not be eligible for conversion into equity/preference shares.
S
The requirement of prior approval of RBI for transfer of shares
and convertible debentures (excluding financial services sector)
was dispensed with from October 2004. General permission was
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granted subject to compliance of the terms and conditions and re-
porting requirements for (i) transfer by a person resident in In-
dia to a person resident outside India and (ii) transfer by a person
resident outside India to a person resident in India. The cases of
increase in foreign equity participation by fresh issue of shares as
well as conversion of preference shares into equity capital was put
under general permission, provided such increase falls within the
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sectorial cap in relevant sectors and is within the automatic route.

NGOs engaged in micro finance activities were permitted to raise
ECBs up to $5 million during a financial year for permitted end-
use under the automatic route with effect from 25 April 2005. NGOs
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engaged in micro finance with a satisfactory borrowing relation-

ship of three years with a bank and ‘fit and proper’ board/manage-
ment committee would be eligible to avail ECBs. The designated
AD would have to ensure that (a) the ECB proceeds are utilised for
lending to self-help groups or for micro-credit or for bona fide mi-
cro finance activity including capacity building and (b) at the time
of drawdown, the FOREX exposure of the borrower is hedged.
ECB funds should be routed through normal banking channels
from internationally recognised sources, viz., international banks,
multilateral financial institutions and export credit agencies. Fur-
thermore, overseas organisations and individuals complying with
Know Your Customer (KYC) guidelines and anti-money launder-
ing safeguards may approve ECBs. All other ECB parameters,
such as minimum average maturity, all-in-cost ceilings, issuance
of guarantee, choice of security, parking of proceeds, prepayment,
refinancing and reporting arrangements under the Automatic
Route, should be complied with.
RBI would consider, under the Approval Route, (i) ECBs with min-
imum average maturity of five years by NBFCs from recognised

n o t e s
lenders to finance import of infrastructure equipment for leasing

to infrastructure projects (ii) FCCBs by housing finance organisa-
tions satisfying specific criteria and (iii) application for domestic
rupee-denominated structured obligations to be credit enhanced
by international banks/international financial institutions/joint
venture partners. Furthermore, the limit for allowing prepayment
of ECBs by ADs without prior approval of RBI was raised to $200
million from $100 million, subject to compliance with minimum
average maturity period for the loan.
Source: www.rbi.org.in
9. An ADR is a share traded in the US financial market by a non-

US organisation. (True/False)
S
10. GDR transactions are mostly denominated in ___.
11. One GDR is equal to ____ shares.
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Activity
Discuss the impact of ECBs on the Indian economy.

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4.7 SUMMARY
An organisation requires finance for meeting its various long-term
and short-term needs.
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Long-term finance is a form of finance, which is required to fund the

projects with long-gestation period, while short-term finance is meant
for projects that may need a few months to a year for completion.
A financial market is a place where investors trade securities and
commodities. It is composed of capital market and money market.
In primary market, fresh securities and bonds are issued to in-
vestors, whereas in secondary market, securities already issued in
primary market are resold to buyers or speculators.
Money market is a part of financial market in which short-term
loans are raised.
Shares, debentures and term loans are the sources of long-term
finance.
Financial institution refers to an institution that provides finan-
cial services for its members and caters to their financial require-
ments. They are of two types: depository institution and invest-
ment institution.
Medium-term finance is required by an organisation for a peri-
od of more than 1 year but less than 10 years. The organisation

n o t e s
can avail medium-term finance through various sources, including

lease finance and hire purchase, venture capital finance, public
deposits and retained earnings.
Short-term financing helps in minimising the gap between current
assets and current liabilities.
An organisation operating in the international market requires a large
amount of capital. Funds are raised by MNCs by determining the ide-
al capital structure (a mixture of debt and equity) of the organisation.
The capital-structure decision is taken to determine the proportion of
the debt and equity in the capital that has the minimum cost.
key words
ADR: ADR stands for American Depositary Receipt. It is a share
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traded in the US financial market by a non-US organisation.
Capital Market: It is a type of financial market where debt cap-
ital and equity share capital are raised by different business en-
terprises.
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Debentures: They are financial instruments that provide long-
term debt.
GDR: GDR refers to Global Depositary Receipt. It is similar to an
ADR but with the right to tap multiple markets by issuing shares.
IPO: When an organisation issues shares in the primary market
M
for raising funds, it is known as Initial Public Offer (IPO).

Mezzanine debt: It is the middle layer of capital between secured
senior debt and equity. Mezzanine debt is generally not secured
by assets and is lent judging an organisation’s ability to repay the
N
debt.
Money Market: It is a part of financial market in which short-
term loans are raised.
Retained Earnings: It is the undistributed profit transferred to
a reserve fund. In an organisation, retained earnings are used
to meet future uncertainities and growth prospects.
Shares: They are a part of stocks that consist of fixed assets and
current assets, which may change in different situations.
Trade Credit: It is one of the traditional and common methods of
raising short-term capital from the market. It is an arrangement
in which the supplier allows the buyer to pay for goods and ser-
vices at a later date. The decision to provide trade credit depends
on the mutual understanding of the buyer and supplier.
Venture Capital: It is a form of quasi-equity and is generally re-
quired by new organisations. A venture capitalist acts as a part-
ner, manager and advisor to an organisation. Venture capital is
needed at the time of incorporation, expansion and acquisition
of an organisation.

n o t e s

1. What is a financial market?
2. Differentiate between capital market and money market.
3. What is the relationship between the primary market and the
secondary market?
4. Discuss the different types of shares.
5. What are term loans?
S
Financial Market 1. True
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2. Government
Long-Term Sources of 3. True
Finance
4. Long-term
Medium-Term Sources 5. Quasi equity
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of Finance
6. True
Short-Term Sources of 7. d. All of the above
Finance
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8. Cash before Delivery

Overseas Sources of 9. True
Finance
10. US dollars
11. Ten
1. A financial market is a place where investors trade securities

and commodities. Refer to Section 4.2 Financial Market.
2. Capital market is a type of financial market where debt capital and
equity share capital are raised by different business enterprises,
while money market is a part of the financial market in which
short-term loans are raised. Refer to Section 4.2 Financial
Market.
3. In primary market, fresh securities and bonds are issued to
investors, whereas in secondary market, securities already

n o t e s
issued in primary market are resold to buyers or speculators.

Refer to Section 4.2 Financial Market.
4. Shares are of two types: equity shares and preference shares.
Refer to Section 4.3 Long-Term Sources of Finance.
5. Term loans are long-term loans that are raised for a period of 3
to 10 years from financial institutions. Refer to Section 4.3 Long-
Term Sources of Finance.
Suggested Readings

John Wiley & Sons.
S
Ross, S. (2014). Fundamentals of corporate finance standard edi-
tion. Retrieved 14 November 2014, from http://Fundamentals of
Corporate Finance Standard Edition
IM
E- References
Economywatch.com,. (2014). Sources of Finance (Finance Sourc-

ing) | Economy Watch. Retrieved 14 November 2014, from http://
www.economywatch.com/finance/sources-of-finance.html
M
Sbicaps.com,. (2014). SBI Capital Markets for Capital Markets - Of-

ferings | SBICAP Official Website. Retrieved 14 November 2014,
from http://www.sbicaps.com/index.php/services/capital-markets/
The Economic Times,. (2014). Capital Market Definition | Capital
N
Market Meaning - The Economic Times. Retrieved 14 November

2014, from http://economictimes.indiatimes.com/definition/capi-
tal-market

Ch a
5 p t e r
CAPITAL STRUCTURE MANAGEMENT
CONTENTS
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5.1 Introduction
5.2 Capital Structure Management
5.2.1
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Internal Factors Affecting Capital Structure Management
5.2.2 External Factors Affecting Capital Structure Management
5.2.3 General Factors Affecting Capital Structure Management
Activity
5.3 Capitalisation
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5.3.1 Over-Capitalisation
5.3.2 Under-Capitalisation
Activity
5.4 Theories of Capital Structure Management
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5.4.1 Net Income Approach

5.4.2 Net Operating Income Approach
5.4.3 Modigliani-Miller Approach
5.4.4 Traditional Approach
Activity
5.5 Cost of Capital
5.5.1 Cost of Debt Capital
5.5.2 Cost of Preference Capital
5.5.3 Cost of Equity Capital
5.5.4 Cost of Retained Earnings
5.5.5 Weighted Average Cost of Capital
5.5.6 Marginal Cost of Capital
Activity
5.6 Summary

n o t e s
A STUDY ON CAPITAL STRUCTURE OF INTERNET GIANTS
There are different approaches of capital structure management,

such as net income approach, net operating income approach,
Modigliani-Miller approach, and traditional approach. These ap-
proaches enable an organisation to form a robust capital struc-
ture steering its growth to new heights. In order to form a robust
and fittest capital structure, different sources of funds, such as
debt and equity, are utilised for the overall operation and growth
of the organisation. The modern theory of capital structure came
into existence with the renowned proposal of Modigliani-Miller in
1958. After that, many other theories have been developed, such
as trade-off theory, pecking order theory, flexibility theory, and
lifecycle theory. There was a study done on Internet companies,
S
comparing the use of these theories and approaches in these com-
panies. The study involved almost 71 small and big giants on the
Internet. Out of these 29 were large and 42 were small companies.
The worth of these companies ranged from 40 million to 223.48
IM
billion. With the help of spreadsheet analysis, a robust capital
structure was prepared for these companies. The study showed
that large internet giants, such as Google Inc. are still unlever-
aged with an optimal debt ratio of 16.2% and current debt ratio
8.8%. It was also found that small companies like Ediets.Com Inc.
are overleveraged with 0% optimal debt ratio and 59.54% current
M
debt ratio. A “home bias” was found in the capital structure of

most of the companies. The study suggested that Internet com-
panies can use financing more efficiently globally. This was sup-
ported with some of the reasons like availability of lower interest
rates, flexible regulation, no capitalisation restrictions, etc. It was
N
also recommended that small companies should have less debt

as compared to the large companies that have enough funds to
invest, something that is supported by almost all existing capital
structure theories.

CAPITAL STRUCTURE MANAGEMENT 103
n o t e s
learning objectives

> Explain capital structure management
> Discuss various factors, such as internal, external, and gen-
eral, which affect capital structure management
> Describe capitalisation, over-capitalisation and under-capi-
talisation
> Explain various theories of capital structure management,
such as the net income approach, the Modigliani-Miller ap-
proach, and the traditional approach
> Describe the concept of cost of capital, and cost of prefer-
ence and equity capital
S
> Explain the terms cost of retained earnings, weighted aver-
age cost of capital and marginal cost of capital
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5.1 INTRODUCTION
The need of capital for an organisation is very obvious for investing
in various projects to earn profit. There are various sources to raise
capital for an orgnisation, such as issuing equity shares, preference
shares, or debentures. In order to acquire funds to run a business and
M
invest in future projects, an organisation needs to have a robust cap-

ital structure. Capital structure refers to a combination of different
sources of capital used by the organisation to finance its activities and
future projects. It is important to note that raising capital from any of
the source involves cost. For instance, if an organisation raises debt
N
capital, it needs to pay rate of interest, which can be termed as the cost
of debt capital. Capital structure management is the process to ensure
the most cost efficient blend of sources to generate capital.
Generally, a large portion of the total capital of an organisation con-

sists of debt capital and equity capital. In addition, selection of the
correct proportion of debt and equity capital in the total capital of
an organisation is very important from the perspective of optimising
the overall cost of capital. Therefore, capital structure management
is always taken into consideration while formulating financial man-
agement policies. Effective capital structure management ensures the
availability of adequate amount of finance whenever required by the
organisation.
This chapter begins by explaining the concept of capital structure

management. Further, it describes the factors affecting capital struc-
ture management, which are internal, external, and general. It also
explains capitalisation, over capitalisation, and under capitalisation.
Next, it explains different theories of capital structure management,
such as the net income approach, the net operating income approach,

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the Modigliani-Miller approach, and the traditional approach. In ad-

dition, it explains cost of capital, which includes costs of debt, pref-
erence, equity, and retained earnings. At the end of the chapter, you
learn the concepts of weighted average cost of capital and marginal
cost of capital.
5.2 CAPITAL STRUCTURE MANAGEMENT

A proportion of debt, preference, and equity capital in the overall
capital of an organisation is called capital structure. An ideal capital
structure must maximise the overall value and minimise the cost of
capital of an organisation. However, it is a very challenging task for an
organisation to form a robust and suitable capital structure consider-
ing its needs and objectives. The process of maintaining an optimum
proportion of debt and equity capital is known as capital structure
S
management.
There are numerous factors internal, external, and general factors

IM
that affect the capital structure of an organisation. Internal factors re-
fer to those that affect the organisation by policies and decisions of
management and board of directors. In simple terms, internal factors
arise due to internal policies and decisions of the organisation. These
factors are within the control the management. On the other hand, ex-
ternal factors are not influenced by it management. These factors are
affected by external decisions and environment, such as the taxation
M
policy, EXIM policy, interest rates, and government policies.
The factors that affect capital structure are shown in Figure 5.1:
N
Cost of Capital
Internal
Risk
Factors
Control
Economic Condition
Interest Rates
Factors Affecting External
Policy of Lending Institution
Capital Structure Factors
Taxation Policy
Statutory Restrictions
Constitution of an Organisation
General
Features of an Organisation
Factors
Stability of Earnings
Figure 5.1: Capital Structure of an Organisation

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An explanation of the factors affecting capital structure is provided in

the following sections of the chapter.
5.2.1 INTERNAL FACTORS AFFECTING CAPITAL

STRUCTURE MANAGEMENT
The factors that are regulated and influenced by the internal decisions
of an organisation are known as internal factors. Internal factors, that
affect the capital structure of an organisation are as follows:
Cost of Capital: It refers to the amount paid in the form of divi-
dend and interest. Generally, debt capital and equity capital form
the capital structure of an organisation. Debt capital is believed to
be a cheaper source of capital than equity capital. This happens
because the interest paid on debt capital is treated as an expense,
which is deductible from corporation tax.
S
Control: It involves the decision-making power of equity share-
holders, who are also referred as the owners of the organisation.
In generally an organisation, a major portion of decision-making
IM
power generally remains in the hands of the owners.
Risk: It refers to various uncertainties associated with raising dif-
ferent types of capital. Risk refers to the obligation of an organi-
sation to pay returns to various sources of capital. Therefore, Eq-
uity capital is considered less risky than debt capital because the
organisation needs to pay interest on debt capital even if there is
M
loss.
5.2.2 EXTERNAL FACTORS AFFECTING CAPITAL

N
External factors are those that cannot be controlled by in internal de-

cisions and policies of an organisation. These factors affect the capital
structure of an organisation at the macro level. The external factors,
that affect the capital structure of an organisation are as follows:
Interest Rates: These refer to the rate of interest prevailing in the
capital market. Interest rates keep on fluctuating from one time
period to another depending on the guidelines of generallyRe-
serve bank of India. When interest rates are low, an organisation
prefers to raise debt capital. On the other hand, if interest rates are
high, the organisation prefers to raise equity capital.
Economic Condition: It includes a recession or boom period pre-
vailing in an economy. During recession, the profit of an organisa-
tion decreases. Organisations prefer to raise capital through equi-
ty because it does not need to pay dividend in case of insufficient
profit when the market is down. However, during boom, the re-
turns on equity are high; thus, the organisation would raise more
capital through debt to reduce the cost of capital.

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Policy of Lending Institutions: If the policies of lending institu-

tions are stringent, then it becomes difficult for an organisation to
obtain funds. In such a case, the organisation would avoid raising
debt capital. On the other hand, if the policies of lending institu-
tions are liberal, then it would become easier for it to obtain loans.
In such a case, the organisation would go for debt capital.
Statutory Restrictions: It refers to the restrictions imposed by
a government. An organisation needs to follow various rules and
regulations formulated by the government before planning its cap-
ital structure.
Taxation Policy: It refers to the policy of the government in which
revenue is generated by imposing different policies. The govern-
ment levies various taxes on organisations and individuals through
the taxation policy. The government levies corporate tax on the
S
profit of an organisation. While calculating profit, the organisa-
tion deducts interest paid on debentures from the total profit. This
lowers the amount of the total profit, which in turn reduces the
amount to be paid as corporation tax. If the government raises cor-
IM
porate tax, the organisation would prefer to raise capital through
debt, and vice versa.
5.2.3 GENERAL FACTORS AFFECTING CAPITAL

M
General factors refer are these that affect different organisations in

varied ways. The general factors affecting the capital structure of an
organisation are as follows:
Constitution of an Organisation: It plays a significant role in
N
framing the capital structure. For example, generally, constitu-

tions of private limited companies give importance to the control
factor, whereas the constitutions of public limited companies give
importance to cost and risk factor.
Stability of Earnings: It refers to fluctuations in the earnings of an
organisation. The organisation with more fluctuation in its earn-
ings considers the risk factor while framing its capital structure.
Therefore, there must be stability in the earning pattern of an or-
ganisation.
Features of an Organisation: It refers to the stage, size, and prof-
itability of an organisation. Irrespective of its size, an organisa-
tion needs to keep equity capital in its capital structure as there
is no fixed liability to pay return on this capital. However, if an
organisation decides to raise debt capital to finance its projects
in its initial stage of development in which it realises less profit,
then it may face difficulty in paying interest.

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1. A proportion of debt, preference, and equity capital in the

overall capital of an organisation is called the __________.
2. There are numerous factors, such as internal, external, and
__________ which affect the capital structure of an organisation.
3. Debt capital is considered to be an expensive source of capital
as compared to equity capital. (True/False)
4. Which is considered more risky-debt capital or equity capital?
5. Taxation policy is government policy in which revenue is
generated by imposing different policies on companies and
individuals. (True/False)
S
Activity
Using the Internet, find out how changes in interest rates affect an
IM
organisation’s capital structure.
5.3 CAPITALISATION
The process of determining long-term capital requirements of an or-
M
ganisation is termed as capitalisation. It involves procurement of cap-

ital from various sources including shares, debentures, and reserve
funds. Capital structure deals with the qualitative aspect of finance,
whereas capitalisation deals with the quantitative aspect of finance.
An organisation can come across situations of under-capitalisation
N
and over-capitalisation, as shown in Figure 5.2:
Situations of
Capitalisation
Over- Under-
Capitalisation Capitalisation
Figure 5.2: Situations of Capitalisation
Lets discuss these both these satiations in the sections:
5.3.1 OVER-CAPITALISATION
Over-capitalisation is a situation when an organisation raises more

capital than is required. A major portion of the capital remains un-
utilised in such cases. The main causes of over-capitalisation are as
follows:

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Inadequate Provision for Depreciation: It refers to a situation

where an organisation is unable to provide an appropriate rate of
depreciation. The organisation lacks sufficient funds to replace
obsolete assets in such cases.
High Promotion Cost: It refers to high promotional expenses in-
curred on making contracts, underwriting commission, and draft-
ing documents at the time of incorporation of an organisation. If
the organisation does not earn sufficient returns in proportion to
high expenses, it may face a situation of over-capitalisation.
Purchase of Assets at Higher Prices: It implies acquiring assets
at an inflated price. In such a situation, the book value of assets
becomes more than their actual value. This results in over-capital-
isation for the organisation.
Liberal Dividend Policy: It refers to a situation where are direc-
S
tors of an organisation generously distribute the dividends to their
shareholders. Consequently, the organisation may suffer deficien-
cy of capital. Therefore, to overcome this deficiency, fresh capital
IM
is raised, resulting in over- capitalisation.
The effects of over-capitalisation are as follows:

It results in decline in goodwill due to decreased rate of dividend.
It reduces the number of customers as the products are sold aqt
higher prices.
M
It forces the organisation to borrow at higher rate of interest.

It leads to a fall in the value of shares, which causes dissatisfaction
among shareholders.
N
The remedies to correct over-capitalisation are as follows:

Keeping a part of the profit as retained earnings for further invest-
ments
Re-organising the capital structure by increasing the proportion
of retained earnings in it
Maintaining adequate depreciation fund
Writing-off all fictitious assets
Reducing the rate of dividend on preference shares and interest
on debentures
5.3.2 UNDER-CAPITALISATION
Under-capitalisation refers to the situation where an organisation

does not have sufficient capital to carry out its normal business op-
erations and repay its creditors. This situation generally occurs when
an organisation does not generate enough cash flows or is not able to
access financing options such as debt or equity. When an organisation
cannot generate sufficient capital over time, it increases its chances of

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becoming bankrupt by losing its ability to repay debts. The reasons of

under-capitalisation are as follows:
Purchasing fixed assets when their market price is low
Raising less funds due to underestimation of capital needs
Undervaluing assets and setting a high rate of depreciation
Employing inefficient and incompetent professionals in manage-
ment.
The effects of under-capitalisation are as follows:

It bears heavy tax burden as undercapitalised organisations
earn more profit.
It discourages growth and expansion of the organisation. This
happens because the organisation is earning more profit with-
S
out expansion. Therefore, it does not find the investment in
long-term projects worthwhile.
It creates a situation of speculation and uncertainty in the cap-
ital market.
IM
The remedies to rectify under-capitalisation are as follows:
Issuing bonus shares for the shareholders of the organisation
Issuing more equity and preference shares
Revaluing fixed assets and reducing the rate of depreciation
M
charged on them

N
6. The process of determining long-term capital requirements of

an organisation is termed as ___________.
7. Capital structure deals with the qualitative aspect of finance,
whereas capitalisation deals with the quantitative aspect of
finance. (True/False)
8. There are two types of capitalisation: over-capitalisation and
____________.
9. Over-capitalisation leads to fall in the value of shares, which
causes dissatisfaction among shareholders. (True/False)
10. Over-capitalisation does not force an organisation to borrow
at higher rate of interest. (True/False)
11. Under-capitalisation results in bears a heavy tax burden as
under capitalised organisations earn more profit. (True/False)
Activity
Using the Internet, search for a case where an organisation was

faced with an under-capitalisation situation.

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THEORIES OF CAPITAL STRUCTURE

5.4
MANAGEMENT
Capital structure management is the need of a business at each and
every phase of its life cycle. It is very important in calculating the cost,
risk, control, flexibility, and timing associated with various sources
of capital. In order to help in deciding an efficient capital structure,
there are various theories of capital structure management. There are
certain basic assumptions, which are common for all the theories to
understand various relationships. These assumptions are as follows:
An organisation uses only two types of capital, that is, debt capital
and equity capital.
Corporation tax does not exist and there is no bankruptcy cost.
S
The organisation distributes its 100% earnings through dividends.
The organisation has no retained earnings.

The operating earnings of an organisation are given for a particu-
IM
lar date and expected to increase further.
The total assets of an organisation remain constant.
The organisation would continue its businesses perpetually.
Business risk is independent of capital structure and financial
risks.
M
The organisation can bring changes in the capital structure with-

out any transaction cost.
There are various theories the managing the capital structure of an

N
organisation, as shown in Figure 5.3:
Theories of Capital
Structure Management
Net Operating Modigliani-

Net Income Traditional
Income Miller
Approach Approach
Approch Approch
Figure 5.3: Theories of Capital Structure Management
These theories are explained in the follwong sections:
5.4.1 NET INCOME APPROACH
According to per the net income approach, given by David Durand,

the valuation of an organisation can be increased and cost of capital
can be decreased by introducing additional debt capital in the capital
structure. David Durand proposed in this theory that, “there exists a

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direct relationship between the capital structure and valuation of the

firm and cost of capital.”
According to income approach, when the degree of financial leverage

increases, the cost of capital decreases. This theory is based on certain
assumptions, which are as follows:
The cost of debt is less than the cost of equity.
The risk associated with debt does not affect the perception of in-
vestors.
The cost of debt and equity remains constant.
Hidden costs do not exist when more debt is introduced.
The net income approach can be mathematically calculated by using

the following formulae:
S
Total market value of an organisation = Market value of equity
shares + Market value of debt
IM
Overall cost of capital = Earnings before interests and tax/Total
market value of an organisation
The net income approach is explained in Figure 5.4:
Y
M
Ke (cost of equity capital)

Cost of capital
Ko (overall cost of capital)

N
Kd (cost of debt capital)
X
0 Percent of debt in financing mix
Figure 5.4: Net Income Approach
It can be clearly seen in Figure 5.4 that the X-axis shows the percent
of debt in financing mix, while cost of capital is shown on the Y-axis. It
can be observed that the overall cost of debt capital is lower than the
cost of equity as line Kd is below line KE. Both the cost of equity and
debt is kept constant according to the assumption. In a total financing
mix or capital structure, when debt capital is increased, the overall
cost of capital declines. This decline in the overall cost of capital would
continue to a certain, limit, and after that the cost of capital would be-
come constant. Therefore, it can be concluded that in the net income
approach, increase in debt capital reduces the cost of capital and en-
hances the value of an organisation.

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Let us take up an example to understand the net income approach.

Assume that we have an organisation ABC, which uses both bebt and
equity for its capital structure. Its net operating income (NOI) is `2000.
The organisation has to give `400 as interest payment. Let the cost of
equity ke be 9.5% and the cost of debt kd be 5%. Since the value of the
firm is the sum total of the market value of the equity and debt com-
bined we can calculate the vale of the firm as follows:
Net Income (NI) = NOI – Interest = 2000 – 400 = `1600
Therefore,
Value of Equity (E) = Net Income/ Cost of Equity = NI/ ke
E = 1600 / (.095) = 16842.10
In a similar fashion, value of debt (D) is calculated as:
S
Value of Equity (D) = Interest/ Cost of Debt = NI/ kd
D = 400/0.05 = 8000
IM
Therefore the value of the firm:
V=E+D
V = 16842.10 + 8000 = 24,842.10
Now, let us calculate the cost of capital of ABC:

Cost of capital of the organisation = NOI / value of the firm
M
Ko = 2000/24,842.10
Ko = 0.0805 =8.05%
N
The overall cost of capital of the organisation is weighted average cost

of capital (WACC) or (ko).
WACC = Cost of Equity X Weight of Equity + Cost of Debt X
Weight of Debt
Ko = Ke X (E/V)+ Kd X (D/V)
Ko = 0.095 X (16842.10/24842.10)+ 0.05 X (8000/24842.10)
Ko = 0.095 X 0.677 + 0.05 X 0.3220
Ko = 0.064315 + 0.0161
Ko = 0.080415 =~ 8.05%
Now, according to this approach, the cost of capital can be decreased

by introducing additional debt capital in the capital structure. Let us
examine this with the help of an example. In the above example, ap-
proximately 2/3rd equity and 1/3rd debt was used. Let us assume that
100% financing is done through debt. Then,
Ko = 0.0933 X 0+ 0.05 X 1

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Ko = 0.05 = 5%
Let us assume another case where 80% debt is used, and the rest is
financed by equity. Then,
Ko = 0.0933 X 0.2 + 0.05 X 0.8
Ko = 0.01866 + 0.04
Ko = 0.05866 = 5.8%
5.4.2 NET OPERATING INCOME APPROACH
The net operating income approach, given by David Durand, states

that “the valuation of the firm and its cost of capital are independent
of its capital structure”. According to this approach, the market value
S
of an organisation depends on its net operating income rather than
its pattern of financing. In this approach, if an organisation increases
debt capital in its capital structure then, its cost of capital decreas-
IM
es. As a result, the profit of the organisation increases, which in turn
raises the expectations of the equity shareholders. If the organisation
pays more dividends to, equity shareholders the the cost of equity cap-
ital increases. Therefore, the aggregate cost of capital would remain
unchanged even after introducing more debt capital. This theory is
based on certain assumptions, which are as follows:
M
The overall cost of capital remains constant for any financing mix.
The market value of an organisation depends on its net operating
income and not on pattern of financing.
The advantage of debt is reversed by an increase in the cost of
N
equity capital.
The cost of debt is constant.
Figure 5.5 explains the concept of net operating income approach:
Y
Ke Cost of equity capital
Cost of capital (%)
Ko Total cost of capital
Kd Cost of debt capital
X
Figure 5.5: Net Operating Income Approach

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In Figure 5.5, the X-axis shows the percent of debt in the financing mix,
while the Y-axis shows the cost of capital. In the figure, the cost of to-
tal capital and the cost of debt capital are constant according to the
assumption. Therefore, the lines showing the total cost of capital and
cost of debt capital (Ko + Kd) are drawn parallel to X-axis. It can be
observed that with the increase in percent of debt capital in the capital
structure, the cost of equity capital increases. In addition, total cost does
not change with the increase in debt capital in the total financing mix.
Therefore, the total cost of capital of an organisation remains the same
irrespective of proportion of debt and equity in the capital structure.
Assume that there is a company ABC. The financial statistics of the

company is as follows:
Particulars `
S
Earnings before Interest Tax (EBIT) 200,000
Debt 500,000
Cost of Debt 10%
IM
WACC 13%
Now, let us calculate the value of ABC:
Particulars `
(EBIT) 200,000
WACC 13%
M
Market value of the company EBIT/WACC

200,000/13%
15,38,461.53
Total Debt 500,000
N
Total Equity Total market value-total debt

15,38,461.53 - 500,000
1038461.53
Shareholders’ earnings EBIT-interest on debt
200,000-10% of 500,000
1,50,000
Cost of equity 1,50,000/1038461.53
0.1444 = 14.4%
Now, let us assume a case where debt decreases from 500000 to 400000.
In that case:
Particulars `
(EBIT) 200,000
WACC 13%
Market value of the company EBIT/WACC
200,000/13%
15,38,461.53

n o t e s
Particulars `
Total Debt 400,000
Total Equity Total market value-total debt
15,38,461.53 - 400,000
1138461.53
Shareholders’ earnings EBIT-interest on debt
200,000-10% of 400,000
1,60,000
Cost of equity 1,60,000/1138461.53
0.1405 = 14.05%
Therefore, the in case of the net Operating income approach, with

the decrease/increase in debt proportion, the total market value of the
S
company remains unchanged; however, the cost of equity decreases/
increases.
5.4.3 MODIGLIANI-MILLER APPROACH

IM
The Modigliani-Miller approach is similar to the net operating income
approach. Modigliani-Miller approach also takes the risk factor into
consideration while determining the capital structure. According to
this approach, the value of an organisation and cost of capital are in-
dependent from its capital structure. As per according to the Modigli-
M
ani-Miller approach, if on organisation raises more debt capital as

compared then equity capital, it implies that the organisation is run-
ning on high risk. However, at the same time, the organisation is also
earning high profit. In such a situation, the equity shareholders would
demand a higher rate of dividend on their holdings. If the organisa-
N
tion pays higher dividends to the equity shareholders, the overall cost
of capital increases. It is important to note raises that the organisa-
tion raised more debt capital to reduce the cost of capital. However,
the cost of capital would not decrease because the organisation would
pay higher dividends to the equity shareholders. If the cost of capital
would increase, it defeats the purpose of raising more debt capital. In
such a situation, the overall cost of capital would not change, which in
turn keeps the value of the organisation constant. Therefore, it can be
stated that the organisation’s value and cost of capital are not related
to the capital structure. In short, the MM approach advocates the ir-
relevancy of the capital structure on the value of the organisation. An
organisation’s leverage has no impact on its market value. On the con-
trary, the market value of an organisation depends on the operating
profits of the company.
The assumptions of the Modigliani-Miller approach are as follows:

No taxes
No transaction cost for buying and selling securities

n o t e s
No bankruptcy cost
Information is available freely and in a symmetric pattern
Cost of borrowing is the same for investors and the organisations
alike
EBIT of the organisation does not get affected by the debt financ-
ing
According to the MM approach, the value of a leveraged organisation

will be the same as the value of an unleveraged organisation, provid-
ed the operating profits and future prospects are kept unchanged for
both. For an investor, it would mean that the cost of buying shares of
an unleveraged organisation is the same as buying the shares of a lev-
eraged organisation.
S
The original propositions of the MM approach are:
MM-Proposition I (MM 1958): A firm’s total market value is inde-
pendent of its capital structure.
IM
MM-Proposition II (MM 1958): A firm’s cost of equity increases
with its debt-equity ratio.
Dividend Irrelevance (MM 1961): A firm’s total market value is
independent of its dividend policy.
Investor Indifference (Stiglitz 1969): Individual investors are in-
M
different to all firms’ financial policies.
Modigliani and Miller have put forward two propositions with the “no
taxes” assumption. They are described below:
Proposition 1: As mentioned earlier, the assumption of “no taxes”
N
is valid here. The financing mix or the capital structure has no

bearing on the valuation of a firm. It means that increasing the
portion of the debt does not increase the value of the organisation.
Additionally, according to this proposition, the earnings are split
equally among the equity and the debt holders.
Value of a Levered Organisation = Value of a Unlevered Organi-
sation
VL = VU
Let us consider two organisations. One have is unlevered and the
other is levered. Let the organisation have 500 shares and the price
per share is `10. Therefore, the market value of the organisation
is `5,000. The operating incomes on a perpetual basis are given
below, and the earnings are paid to the shareholders in form of
dividend. The expected income and expected return are `1500 and
20% respectively.

n o t e s
Possible Outcomes
Operating income 500 1000 1500 2000
Earnings Per Share (EPS) (Oper- 1 2 3 4
ating Income/ no. of shares)
Return on Equity 10% 20% 30% 40%
Now, assume that the organisation borrows `2000 at 10% interest
and buys back 200 shares of its own . Now, the following case de-
velops:
No. of shares = 500 – 200 = 300
D= 300 X 10 = 3000
E = 2000
Price per share = `10
S
Annual Interest payment = `300 (10% of 3000)
Operating Income 500 1000 1500 2000
Interest
IM 300 300 300 300
Equity Earnings 200 700 1200 1700
Earnings Per Share (Operating 1.66 3.33 5 6.66
Income/ no. of shares)
Return On Equity 16.6% 33.3% 50% 66.6%
When the operating income is more than `1000, the expected re-
M
turn on equity increases. Now, when we expect an operating in-

come of `1500, then the shareholders expect 30% ROE. Assume
that the investor borrows `10 and already has `10 with him; using
`20, he buys two shares of the organisation that is unlevered. Un-
N
der such a condition, the benefit derived by him is the same as he

would have got by investing in the levered organisation.
Proposition 2: According to this hypothesis, the financial leverage
is directly proportional to cost of equity. It states that as the debt
component increases, the risk perception of the equity sharehold-
ers of the organisation also increases. That is, the shareholders
expect a higher return, which increases the cost of equity. This
proposition also assumes that the debt holders have a lead while
presenting a claim over the earnings of the organisation. This de-
creases the cost of debt, as follows:
WACC = Ke = Ka + (Ka – Kd) (D/E)
Where,
Ke = Cost of equity or required rate of return on equity
Ka = Cost of capital to the organisation assuming that there is no
leverage

n o t e s
Kd = Cost of debt or the required rate of return on borrowings

D/E = Debt-to-equity ratio
According to this proposition, as the leverage increases, WACC re-
mains constant. But a higher debt-to-equity ratio leads to a high
Ke or the required return on equity as more risk is involved for the
shareholders of the company where debt is included in the capital
structure.
Following the example above, we proceed as follows:
WACC = Ke = Ka + (Ka – Kd) (D/E)
Assume that ka is 10% and kd is 5%. The value of Debt (D) = `1000,
and the value of equity (E) is `9000.
Therefore,
S
ke = 10 + (10 – 5) (1000/9000)
ke = 10 + (5/9)
IM
ke = 10.55%
Another approach: Modigliani and Miller also proposed an approach

that takes into account taxes. In practice, tax is a reality of the corpo-
rate world. This approach takes into account the fact that the interest
paid on the debt is tax deductible. On the other hand, the dividend
paid to the shareholders is not tax deductible. It means that the actual
M
cost of debt to the organisation is less than the nominal cost of debt.
According to this approach, the organisation can fulfill its require-
ments with debt till the point where the cost of bankruptcy exceeds
the value of the tax benefits. In other words, the debt portions can
be increased till a point where it adds value to the company. This ap-
N
proach advocates that the change in the financing mix impacts WACC.
It means that as the debt part of the financing mix increases, WACC
decreases.
Proposition 1: It states that for two organisations that have the
same business risk, the optimal debt ratio that will lead to maxi-
mum value of the organisation will be fully financed by debt or will
be 100% levered Therefore:
VL = VU + TCD
Where,
VL = Value of a levered firm.
VU = Value of an unlevered firm.
TC = Tax rate
D = Value of debt
Also, assume that the debt is perpetual.

n o t e s
Therefore, according to this approach, it is advantageous for an or-

ganisation to be levered as the interest payments are tax-deduct-
ible.
Proposition 2: It states that there is a positive relationship between
the required return on equity in a levered firm and the debt-equity
(D/E) ratio Therefore.
Ke = Ka + (D/E) (Ka – Kd) (1- TC)
Where,
Ke = Cost of levered equity or required rate of return on equity
Ka = Cost of capital to the organisation assuming that there is no
leverage
Kd = Cost of debt or the required rate of return on borrowings
S
D/E = Debt-to-equity ratio
TC = Tax rate
IM
Let us now look at an example for understanding the propositions I
and II under the tax conditions as shown here.
Assume that the cost of capital for an unlevered firm is ka = 10% and
the rate of corporate tax TC is 33%.
Cash Flows Unlevered Organisa- Levered Organisation

M
tion (in lacs) (in lacs)

EBIT 10000 10000
Less: Interest 500
EBT 10000 9500
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Less: Tax 3.300 3135

Net Income 6,700 6365
Cash Flow (Debt +Eq- 6,700 6865
uity)
Note here, the differ-
ence = 165 = 33% of
500
Income tax savings = Interest expense * Tc

= 500 X .33 = `165 lacs
PV tax savings = Income tax savings / market rate (5%)
= 165 / .05 = 3300.

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Proposition I: VL = VU + TCD
Vu = EBIT (1 – TC ) / ka
Vu = NOI (1 – TC ) / ka
Vu = 6700 (1 – .33 ) / .1
Vu = 44890
VL = VU + TC B
VL = 44890 + 3300
VL = 48190
E = VL - D
E = 48,190 – 10,000 E = 38,190
Proposition II: Ke = Ka + (D/E) (Ka – Kd) (1- TC)
S
In case of unlevered firm, Ke = Ka = .10 + (0 / 10,000) (1–.33)
(.10 – .05) = 10%
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In case of levered firm, Ke = .10 + (10,000 / 38,190) (1 – .33)
(.10 – .05)
Ke = .10 +(0.2618) (0.0335) = 10.0087%
WACC = (D / VL ) (1 – Tc ) kd + (E / VL ) ke
= (10000 / 48190) (1 – .33) (.05) + (38,190/ 48190) (.100087)
M
= (0.0275) (0.67) (.05) + (0.7924) (.100087)

= 0.0009 + 0.0793
= 0.0802 = 8.02%
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5.4.4 TRADITIONAL APPROACH
The traditional approach falls between the net income approach and
the net operating income approach. It is also called intermediate
approach. In this approach, when debt capital is introduced up to a
certain limit, it is assumed that debt capital would increase EPS by
decreasing the overall cost of capital and increasing the value of an
organisation. However, when the debt capital is raised beyond a cer-
tain limit, the overall cost of capital increases, and the value of the
organisation decreases.
Figure 5.6 shows the graphical representation of the traditional ap-

proach:

n o t e s
Ko (Total cost of
Cost of capital
capital)
Kd (Cost of
debt capital)
X
Figure 5.6: Traditional Approach
S
In Figure 5.6, the X-axis shows the percentage of debt in the financing
mix, while the Y-axis shows the cost of capital. In the figure, we can
see that an increase in debt capital is followed by a decline in the total
cost of capital as Ko is moving downward. Further increase in debt
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capital in the capital structure will bring the total cost of the capital to
its minimum point. The optimal capital structure is a point where the
overall cost of capital decreases to its minimum point while total value
of the organisation increases to its maximum point. It can be seen in
Figure 5.6 that when an organisation increases its capital beyond the
minimum point, the total cost of capital increases and the value of the
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organisation decreases.
12. Capital structure management is the need of a business at

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each and every phase of its life cycle. (True/False)

13. It is very important to calculate the cost, risk, control, flexibility,
and timing associated with various sources of ______.
14. Who formulated the net income approach and the net
operating income approach?
15. The Modigliani-Miller approach does not consider the
risk factor while determining the capital structure of an
organisation. (True/False)
16. Which approach is also called the intermediate approach?
Activity
Which approach do you find the best for capital structure manage-
ment? Support your answer with explanation.

n o t e s
5.5 COST OF CAPITAL

Cost of capital can be defined both from organisation’s and investor’s
point of view. From an organisation’s point of view, cost of capital is a
rate at which an organisation raises capital to invest in various proj-
ects. The basic motive of an organisation is to raise any kind of capital
to invest in its various projects for earning profit. Further, out of that
profit, the organisation pays interest and dividend as a return on the
sources of capital. The amount paid as interest and dividend is consid-
ered as cost of capital. From the investors’ point of view, cost of capital
is the rate of return, which investors expect from the capital invested
by them in the organisation. The calculation of cost of capital is very
significant for the management of an organisation. The significance of
cost of capital is as follows:
S
Capital Budgeting Decision: It refers to the decision, which helps
in calculating profitability of various investment proposals.
Capital Requirement: It refers to the extent to which fund is re-

IM
quired by an organisation at different stages, such as incorporation
stage, growth stage, and maturity stage. When an organisation is
in its incorporation stage or growth stage, it raises more of equity
capital as compared to debt capital. The evaluation of cost of capi-
tal increases the profitability and solvency of an organisation as it
helps in analysing cost efficient financing mix.
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Optimum Capital Structure: It refers to an appropriate capital

structure in which total cost of capital would be least. Optimal cap-
ital structure suggests the limit of debt capital raised to reduce the
cost of capital and enhance the value of an organisation.
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Resource Mobilisation: It enables an organisation to mobilise its

fund from non-profitable to profitable areas. The resource mobil-
isation helps in reducing risk factor as an organisation can shut
down its unproductive projects and move the resources to produc-
tive ones to earn profit.
Determination of Method of Financing: When an organisation

requires additional finance, the finance manager opts for a capital
source, which bears the minimum cost of capital. Although cost of
capital is important in determining the methods of financing, it is
equally important to consider the risks involved.
Cost of capital can be measured by using various methods, as


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Cost of Debt Capital
Cost of Preference Capital
Methods for Cost of Equity Capital

Measuring
Cost of Capital Cost of Retained Earnings
Weighted Average Cost of Capital
Marginal Cost of Capital
Figure 5.7: Methods of Measuring Cost of Capital
S
An explanation of the methods measuring cost of capital (as shown in
Figure 5.7) is given in the following sections.
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5.5.1 COST OF DEBT CAPITAL
Cost of debt capital refers to the total cost or the rate of interest paid
by an organisation in raising debt capital. However, in a real life sit-
uation, the total interest paid for raising debt capital is not consid-
ered as cost of debt because the total interest is treated as an expense
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and deducted from tax. This reduces the tax liability of an organisa-
tion. Therefore, to calculate the cost of debt, the organisation needs
to make some adjustments. Let us understand the calculation of cost
of debt with the help of an example. Suppose an organisation raised
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debt capital of `10000 and paid 10% interest on it. The organisation is
paying corporation tax at the rate of 50%. In this case, the total 10% of
interest rate would not be deducted from tax and the deduction would
be 50% of 10%. Therefore, the cost of debt would be only 5%. While
calculating the cost of debt capital, discount allowed, underwriting
commission, and cost of advertisement are also considered. These ex-
penses are added to the amount of interest paid, which is considered
as the total cost of debt capital. For example, when an organisation
increases its proportion of debt capital more than the optimum level,
then it increases its risk factor. Therefore, investors feel insecure and
their expectations of EPS start increasing, which is the hidden cost
related to debt capital.
The formulae to calculate the cost of debt are as follows:

n o t e s
1. When the debt is issued at par (it includes both redeemable and
irredeemable cases)
KD = [(1 – T) * R] * 100
Where,
KD = Cost of debt
T = Tax rate
R = Rate of interest on debt capital
KD = Cost of debt capital
For example, if the cost of debt before tax is 6.5% and the rate of
corporate tax is 33%. In that case the effective cost of debt will
be:
KD = [(1 – .33) * 0.065] X 100
S
KD = [(1 – .33) * 0.065] X 100
KD = 0.04355 X 100 = 4.3%
IM
Let us see another example. A company issues its 5-year bonds
(debt) at 20% interest rate at par. Bond value is `100 each. If the
organisation realises the full face value of the bonds, i.e., `100
and pays `100 to the bondholders after 5 years. Then the cost of
debt before tax will be equal to the rate of interest, i.e., `20. That
is,
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KD = i = Int/Bo
Here, KD = Cost of debt before tax
i = Coupon rate of interest
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Bo = Issue price of the bond

Int = Interest amount and it
Interest amount is equal to the product of issue price of debt and
interest rate., i.e,
Int = Issue price of debt X interest rate
The cost of debt (bond) in above example is:
KD = 20/100 = 20%
2. Debt issued at premium or discount when debt is irredeemable
KD = [ ((1 – T) X I) / (NP) 100]
KD = [I/NP * (1 – T) * 100]
Where,
I = Annual Interest Payments
NP = Net proceeds of debt
KD = Cost of debt capital

n o t e s
T = Tax rate
For example, if a company issues bonds (15%) at par for
`5, 00,000, calculate the after-tax cost of bonds if the tax rate at 33%.
KD = [I/NP * (1 – T) * 100]
I = 15 % of 5,00,000 = 75000
NP = `5,00,000
KD = (75000/5,00,000) (1-0.33)
KD = (0.15) (0.67) = 0.1005 = 10.05%
Let us take up another example. A company issues bonds
worth `2,00,000 at a coupon rate of interest of 10%. The tax rate
applicable is 30%. Let us calculate the cost of debt when the
bonds are issued at par, at a discount of 10% and a premium of
S
10%.
Here, I = 10% of 2,00,000 =20,000

T = 0.3
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Now, we calculate the cost of debt for each case.
a. When the bonds are issued at par, the cost of debt will be:
NP = 2,00,000 and therefore, KD = [(1 – 0.3) X 0.1] X 100 = 7%
b. When the bonds are issued at discount, the cost of debt will
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be:
NP = 2,00,000 – 10% of 2,00,000 = 1,80,000
Therefore, KD = [(20,000/1,80,000) X (1 – 0.3) X 100] = 7.7%
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c. When the bonds are issued at premium, the cost of debt will
be:
NP = 2,00,000 + 10% of 2,00,000 = 2,20,000
Therefore, KD = [(20,000/2,20,000) X (1 – 0.3) X 100] = 6.3%
3. Cost of redeemable debt
KD (Before Tax) = {I + [(P-NP)/n]} / {(P + NP) / 2}
Where,
I = Annual Interest Payments
P = Redeemable value of debt
T = Tax rate
n = Numbers of years of maturity
The cost of debt after taxes is calculated as:
KD (After Tax) = (1-T) X KD (Before Tax)

n o t e s
Let us now look at an example. Assume that a company issues

bonds worth `1,50,000 but due to brokerage charges at the rate of
3%, it realises only `1,45,500. The time of maturity is 5 years and
the coupon rate is 10%. Tax rate is 30%.
Here,
I = 10% of 1, 50,000 = `15000
P = 1,50,000
NP = 1,45,500
n=5
Therefore, KD (Before Tax) = {15000 + [(4500)/5]} / {(2,95,500) / 2}
KD (before tax) = 15,900 / 1,47,750
= 10.76%
S
And now, we calculate the cost of debt after tax:
KD (After Tax) = (1-0.3) X 0.1076
KD (After Tax) = 0.07532 = 7.53%
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5.5.2 COST OF PREFERENCE CAPITAL
Cost of preference capital is the sum of amount of dividend paid and

expenses incurred for raising preference shares. The dividend paid on
preference shares is not deducted from tax, as dividend is an appro-
M
priation of profit and not considered as an expense. Cost of preference

share can be calculated by using the following formulae:
1. Cost of redeemable preference shares:
Kp = {D + (P-NP) / n} / {(P+NP) / 2}
N
Where,
KP = Cost of preference share
D = Annual preference dividend
P = Redeemable value of debt
n = Numbers of years of maturity
Let us now, look at an example. A company issues 10,000
preference shares at a coupon rate of 15%. The face value of each
is `100. They are issued at a premium of 6%. 2.5% of the issue
price is spent on underwriting fees, legal fees and registration
fees, etc. The shares are redeemable after 6 years and at a
premium of 5%. Then, we can calculate the cost of preference
share capital as follows:
Kp = {D + (P-NP) / n} / {(P+NP) / 2}
Here,
D = 15% of 100 = `15

n o t e s
NP = 106% of 100 – 2.5% of 100 X 106% = 103.35

n=6
P = 105% of 100 = 105
Kp = {15 + (105-103.35) / 6} / {(208.35) / 2}
Kp = 15.275 / 104.175 = 14.66%
2. Cost of irredeemable preference shares:
KP = (D/NP) * 100
Where,
D = Preference dividend to be given
NP = Net proceeds generated by the firm
Let us now, look at an example. A company issues 1000 preference
S
shares at an issue price of `10 per share. The rate of dividend to
be paid is 11%. Calculate the cost of preference shares at par, at
10% discount and at 10% premium.
IM
a. At par, D = 11% of 10000 = `1100, NP = 10000 and therefore,
KP = (1100/10000) * 100 = 11%
b. At discount, D = 11% of 10000 = `1100, NP = 90,000 and
therefore, KP = (1100/90000) * 100 = 12.22%
c. At discount, D = 11% of 10000 = `1100, NP = 1,10,000 and
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therefore, KP = (1100/1,10,000) * 100 = 10.00%
5.5.3 COST OF EQUITY CAPITAL
It is very difficult to calculate the cost of equity capital as compared to

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debt capital and preference capital. The main reason is that the equity
shareholders do not receive fixed interest or dividend. The dividend
on equity shares varies depending upon the profit earned by an organ-
isation. Risk factor also plays an important role in deciding the rate
of dividend to be paid on equity capital. Therefore, there are various
approaches to calculate cost of equity capital, as shown in Figure 5.8:
Dividend Price Approach
Earning Price Ration Approach
Approaches Dividend Price Plus Growth Approach

to Calculate
Realised Yield Approach
Cost of Equity
Capital Capital Asset Price Model
Bond Yield Plus Risk Premium Approach
Gordon Model
Figure 5.8: Approaches to Calculate Cost of Equity Capital

n o t e s
An explanation of these approaches (as shown in Figure 5.8) is cov-

ered in the following sections:
Dividend Price Approach
The dividend price approach describes the investors’ view before in-
vesting in equity shares. According to this approach, investors have
certain minimum expectations of receiving dividend even before pur-
chasing equity shares. An investor calculates the present market price
of the equity shares and their rate of dividend. The dividend price
approach can be mathematically calculated by using the following for-
mula:
KE = (D /P) * 100
Where,
S
D = Dividend per share
P = Market price per share and
IM
KE = Cost of equity capital
However, the dividend price approach is criticised on certain grounds,

which are as follows:
It does not take into consideration the appreciation in the value of
capital. The dividend price approach is based on the assumption
that investors expect some dividend on their shares. It completely
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ignores the fact that some investors also consider the chances of
capital appreciation, which increases the value of their shares.
It ignores the impact of retained earnings, which affect both the
market price of shares and the amount of dividend paid. For exam-
N
ple, suppose if an organisation keeps a major portion of its profit as

retained earnings. In that case, it would pay low dividend, which
may decrease the market price of its shares.
Let us look at an example. Assume that a company pays dividend at

a constant rate on a perpetual basis. Let the price of a share be `10/-
and its market price be `30. If the company pays a dividend of `3 per
share, then the cost of equity capital as per the dividend price model is:
Ke= 3/30 = 0.1 or 10%
Earnings Price Ratio Approach
The earnings price ratio approach suggests that the cost of equity cap-
ital depends upon the amount of fixed earnings of an organisation.
According to the earnings price ratio approach, an investor expects
that a certain amount of profit must be generated by an organisation.
Investors do not always expect that the organisation distribute divi-
dends on a regular basis. Sometimes, they prefer that the organisation
invests the amount of dividend in further projects to earn profit. In

n o t e s
this way, the organisation’s profit would increase, which in turn would
increase the value of its shares in the market.
The formula to calculate cost of capital through the earnings price

ratio approach is as follows:
KE = E/MP
where,
E = Earnings per share
MP = Market price of share
However, this approach is criticised on the following grounds:

Assumes that EPS would remain constant
Assumes that market price per share would remain constant
S
Ignores the fact that all the earnings of an organisation are not dis-
tributed in the form of dividend. However, some part of earnings
may be kept in form of retained earnings.
IM
Let us look at an example. Assume that a company has an earnings
of `2,00,000. The shares of this company are trading at the market
price of `120. It has 40,000 outstanding shares. Assuming that the
company has zero debt and that it is expected to remain stable, let
us calculate the cost of equity.
E= 200000 / 40000 = 5
M
KE = E/MP = 5/120 =1/24 = 0.0416 = 4.16%
Dividend Price Plus Growth Approach

N
The dividend price plus growth approach refers to an approach in

which the rate of dividend grows with the passage of time. In the divi-
dend price plus growth approach, investors not only expect dividends
but regular growth in the rate of dividend. The growth rate of dividend
is assumed to be equal to the growth rate in EPS and market price per
share. In the dividend price plus growth approach, the cost of capital
can be calculated mathematically by using the following formula:
KE = [(D/MP) + G] * 100
where,
D = Expected dividend per share, at the end of period
G = Growth rate in expected dividends
MP=Market Price of Share
This approach is considered as the best approach to evaluate the ex-

pectations of investors and calculate the cost of equity capital.

n o t e s
Let us look at an example. Assume that the dividend per share is `5

and the growth rate of dividends is 7% and the market price of the
share is `80. Then,
KE = [(D/MP) + G] * 100
KE = [(5/80) + 0.07] * 100
KE = 0.1325 = 13.25%
In practice, analysts nowadays also include adjustments for inflation

and growth while calculating the cost of equity capital with the divi-
dend price approach. Let us look at an example to include the adjust-
ments for both the parameters. Assume that the growth rate is 5% and
the inflation rate is 6%. Then, Ke = D (1+ growth rate/100) (1+inflation
rate/100) / Price of per share + (growth rate + inflation rate) Ke = (3
X 1.05 X 1.06 ) / 30 + ( 0.05 + 0.06 ) = 0.1113 + 0.11 = 0.2213 = 22.13%.
S
RealiSed Yield Approach
In the realised yield approach, an investor expects to earn the same

IM
amount of dividend, that the organisation has paid in the past few
years. In this approach, the growth in dividend is not considered as
major factors for deciding the cost of capital. This approach is based
on the following assumptions:
Risk factor remains constant in an organisation. Returns in the
given risk remain the same as per the expectations of sharehold-
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ers.
Realised yield is equivalent to the reinvestment opportunity rate
for shareholders.
N
According to the realised yield approach, the cost of capital can be

calculated mathematically by using the following formula:
KE = [(P+D)/p] - 1
Where,
P = Price at the end of the period
p = Price per share today
For example, assume that the price of a company’s share last year was
`200 and this year the price is `250. The last dividend paid by the com-
pany is `10. The return shareholder realised and the cost of equity to
the company is:
KE = [(P+D)/p] - 1
KE = [(250+10)/200] – 1
KE = 1.3 - 1
KE = 0.3 = 30%

n o t e s
Let us now look at an example. Assume that an investor, Mr. A, pur-

chased an equity share of a company at a rate of `200 on 1st Jan 2000.
He held the share for a period of 5 years before selling it in Jan 2005.
He sold it at `310. He received a dividend of `20, `21, `21, `22 and `23
during these years. If the discounting factor is 12%, the cost of equity
will be calculated as:
Year (A) Cash Inflows (`) (B) DF (12%) (C) PV of (B) = (B) X (C)
2000 20 0.893 17.86
2001 21 0.797 16.73
2002 21 0.712 14.95
2003 22 0.636 13.99
2004 23 0.567 13.04
2005 310 0.507 157.17
S
Sum of PV of (B) 233.74
Purchase Price 200
IM
As, the purchase price was 200 and the value realised is 233.74, the
cost of equity would be less than 12%.
Capital Asset Price Model (CAPM)
CAPM helps in calculating the expected rate of return from a share of

equivalent risk in the capital market. The cost of shares that carry risk
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would be equal to the cost of lost opportunity. For example, an inves-

tor has two investment options— to buy the shares of either X Ltd. or
Y Ltd. If the investor decides to buy the shares of X Ltd., then the cost
of shares of Y Ltd. would be the cost of lost opportunity.
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CAPM is based on the following assumptions:

A rational investor would always avoid risk.
A rational investor would always wish to maximise the expected
yield.
All investors would have similar expectations.
All investors can lend freely on the riskless rates of return.
Capital market is in good condition and there is no existence of tax
Capital market is competitive in nature.

Securities are completely divisible, and there is no transaction cost.
The computation of cost of capital using CAPM is based on the con-

dition that the required rate of return on any share should be equal
to the sum of risk less rate of interest and premium for the risk. Ac-
cording to CAPM, cost of capital can be calculated mathematically by
using the following formulae:
E = R1 + β {E (R2) – R1}

n o t e s
Where,
E = Expected rate of return on asset
β = Beta coefficient of assets
R1 = Risk free rate of return
E (R2) = Expected return from market portfolio
This value can be calculated by analysing data of usually five years.

The formula used to calculate beta value is as follows:
β = PIM (SD1) (SDM)/SD2M
Where,
β = Beta of stock
PIM = Correlation coefficient between the returns on stock, I and
S
the returns on market portfolio, M.
SD1 = Standard deviation of returns on assets
IM
SDM = Standard deviation of returns on the market portfolio
SD2M = Variance of market returns
Let us look at an example. Assume that a company has a beta value of

0.87 and the expected market return is 20%, lkand the e=risk-free rate
of return is 9%,. In this case, the cost of capital using CAPM is:
M
E = 0.09 + 0.87 {0.20 – 0.09}

E = 0.09 + 0.87 {0.20 – 0.09}
E = 0.09 + 0.0957
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E = 0.1857 = 18.57%
Bond Yield Plus Risk Premium Approach
The bond yield plus risk premium approach states that the cost on eq-
uity capital should be equal to the sum of returns on long-term bonds
of an organisation and risk premium given on equity shares. The risk
premium is paid on equity shares because they carry high risk. Math-
ematically, the cost of capital is calculated as:
Cost of equity capital= Returns on long-term bonds + Risk pre-
mium or
Ke = Kd + RP
The bond yield plus risk premium approach is based on the fact that
a risky organisation would have high financial leverage. As a result
of this, it would be earning higher profit. Therefore, the equity share-
holders due to higher risks on their investments expect higher returns
in the form of risk premium.

n o t e s
Let us now look at an example. Assuming that the market return is

22%, the risk free rate of return is 12% and the rate of return on long
term bonds is 14%, the cost of equity capital is:
Ke = 14 + (22-12) = 24%
Gordon Model
Myron Gordon developed the Gordon model to calculate the cost of eq-
uity capital. As per this model, an investor always prefers less risky in-
vestment as compared to more risky investment. Therefore, an organi-
sation should pay risk premium only on risky investments. The Gordon
model also suggests that an investors would always prefer more of those
investments, which would provide them the current income.
The Gordon model is based on the following assumptions:
S
The rate of return on the investments of an organisation is con-
stant.
The cost of equity capital is more than the growth rate.
IM
Corporation tax does not exist in the economy.
The organisation has perpetual existence.
The growth rate of the organisation is a part of the retention ratio
and its rate of return.
M
According to the Gordon model, cost of capital can be calculated math-

ematically by using the following formula:
P = E (1 – b)/K – br
Where,
N
P = Price per share at the beginning of the year

E = Earnings per share at the end of the year
b = Fraction of retained earnings
K = Rate of return required by shareholders
r = Rate of return earned on investments made by the organisation
g = br
Let us look at an example. Assume that a company has an EPS of `20

and the DPS is `15. The cost of equity is 22% and the rate of return
earned on investments made by the organisation is 27%, and the re-
tention ratio is 40%. Therefore, we calculate the price per share as
follows:
P = 20 (1 – .4) / 0.22 – (0.4X0.27)
P = 12 / 0.112
P = `107.14

n o t e s
5.5.4 COST OF RETAINED EARNINGS
Retained earnings refer to the part of the profit that is kept as a re-
serve. Though it is a part of the profit, it is not distributed as divi-
dend. These are kept to finance long-term as well as short-term proj-
ects of the organisation. It is argued that retained earnings do not cost
anything to the organisation. It is debated that there is no obligation
either formal or implied, to earn any profit by investing on retained
earnings. However, This is not correct because investors expect that
if the organisation is not distributing dividend and keeping a part of
the profit as reserves, then it should invest the retained earnings in
profitable projects. Further, investors expect the organisation should
distribute the profit earned by investing retained earnings in the form
of dividend. Cost of retained earnings can be calculated with the help
of various approaches, which are as follows:
S
KE= KR Approach: It assumes that if the profit earned by an or-
ganisation is not retained but distributed as dividend, the share-
holders would invest this dividend in other projects to earn fur-
IM
ther profit. If an organisation retains the dividend, it prohibits the
shareholders from earning more profit. Therefore, for retaining
the dividend, the organisation should earn profit, which the share-
holders would have earned by investing the dividend in other proj-
ects. Therefore, the amount of profit expected from the organisa-
tion on retained earnings is the cost of retained earnings.
M
Here, Kr = Ke = D/NP+g
Soloman Erza Approach: It includes the two options that an or-
ganisation has, that is, whether to retain earnings to meet future
uncertainties or to invest in its or other organisation’s projects.
N
Here, Kr = Ke (1-t) (1-b)

Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Rate of tax
b = Cost of purchasing new securities or brokerage cost.
Let us look at an example. Assume that a company has Ke = 20%,
tax rate is 35% and the brokerage cost is 3%. Now, we can calculate
the cost of retained earnings as follows:
Kr = .20 (1-0.35) (1-0.03)
Kr = 12.61%
5.5.5 WEIGHTED AVERAGE COST OF CAPITAL
Weighted average cost of capital is determined by multiplying the cost

of each source of capital with its respective proportion in the total

n o t e s
capital. For instance, an organisation raises capital by issuing deben-

tures and equity shares. It pays interest on debt capital and dividend
on equity capital. When the organisation adds the total interest paid
on debt capital to the total dividend paid on equity capital, it obtains
weighted average cost of capital. An organisation requires to generate
the profit on its various investments equal to the weighted average
cost of capital.
Weighted average cost of capital can be calculated mathematically by

using the following formula:
Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D)
+ (KR * R)
Where
E = Proportion of equity capital in capital structure
S
P = Proportion of preference capital in capital structure
D = Proportion of debt capital in capital structure
IM
KR = Cost of proportion of retained earnings in capital structure
R = Proportion of retained earnings in capital structure
Let us look at an example. Assume that a company has equity, pre-

ferred stock, debt and retained earnings in the proportion of 20%,
30%, 40% and 10%. The cost of equity, preferred stock, debt and re-
M
tained earnings are 22%, 12%, 10% and 14% respectively. The weight-
ed average cost of capital will be calculated as follows: WACC = (.20 X
.22) + (.30 X .12) + (.40 X .10) + ( 0.10 X 0.14) = 0.458 = 45.8 %.
5.5.6 MARGINAL COST OF CAPITAL

N
Marginal cost of capital refers to the cost of additional capital required

by an organisation to finance investment proposals. It is calculated by
first estimating the cost of each source of capital based on the market
value of the capital. Further, it is identified which source of capital
would be more appropriate for financing a project. The marginal cost
of capital is determined by taking into consideration the effect of addi-
tional cost of capital on the overall profit.
In simpler terms, the marginal cost of capital is calculated in the same

manner as the weighted average cost of capital, adding additional cap-
ital to the total cost of capital.
Marginal cost of capital can be calculated mathematically by using the

following formula:
Marginal Cost of Capital = KE {E/(E + D + P + R)} + KD {D/(E
+D + P + R)} + KP {P/(E + D + P R)} + KR {R/(E + D + P + R)}

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17. Cost of capital the a rate at which an organisation raises capital

to invest in various projects. (True/False)
18. Total interest paid for raising ________ is not considered as
cost of debt because the total interest is treated as an expense
and deducted from tax.
19. Cost of preference capital is the sum the of amount of dividend
paid and the expenses incurred for raising preference shares.
(True/False)
20. The earnings price ratio approach suggests that the cost of
equity capital depends on the amount of ___________ of an
organisation.
S
21. Marginal cost is not calculated by estimating the cost of each
source of capital based on the market value of the capital.
(True/False)
IM
Activity
Using the Internet, explain the CAPM method.

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5.6 SUMMARY
A proportion of debt, preference, and equity capital in the overall
capital of an organisation is called the capital structure.
There are numerous factors, such as internal, external, and gener-
N
al factors that affect the capital structure of an organisation.

External factors refer to the factors which cannot be controlled by
internal decisions and policies of an organisation.
The process of determining long-term capital requirements of an
organisation is termed as capitalisation.
Under-capitalisation refers to a situation in which an organisation
earns exceptionally high profits as compared to the other organi-
sations operating in the same industry.
Capital structure management is the need of a business at each
and every phase of its life cycle.
Modigliani-Miller approach takes risk factor into consideration
while determining the capital structure.

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The traditional approach falls between the net income approach

and the net operating income approach.
key words
Capitalisation: It refers to the process of determining long-term

capital requirements of an organisation.
Cost of Capital: It refers to the rate at which an organisation
raises its capital to invest in various projects.
Capital Structure: Capital structure refers to a proportion of
debt, preference, and equity capital in the overall capital of an
organisation.
Internal Factors: It refers to the factors that are regulated and
influenced by the internal decisions of an organisation.
S
Over-capitalisation: Over-capitalisation refers to a situation
when an organisation raises more capital than its requirements.
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1. Explain the internal factors affecting capital structure management.
2. Explain the external factors affecting structure management.
3. Explain over capitalisation.
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4. Explain the concept of under capitalisation.

5. Explain net income approach of capital structure management.
6. Explain the Modigliani-Miller approach of capital structure
N
management.
7. Explain Cost of capital.
8. Explain the term Cost of retained earnings.
9. Explain weighted average cost of capital.
10. Find the cost of debt capital issued at par if the cost of debt before
tax is 5% and the rate of corporate tax is 30%.
11. What is the earnings price ratio approach, which is used to
calculate the cost of equity? Using this method and assuming
that the company has zero debt, find the cost of equity if the
earning of the company is `3,00,000 and the market price of
shares is `200. The number of outstanding shares is 20,000.

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Topic Q.No. Answers

Capital Structure 1. Capital structure
Management
2. General factors
3. False
4. Equity capital
5. True
Capitalisation 6. Capitalisation
S
7. True
8. Under capitalisation
IM
9. True
10. False
11. True
Theories of Capital 12. True
Structure Management
M
13. Capital
14. David Durand
15. False
16. Traditional approach
N
Cost of Capital 17. True

18. Debt Capital
19. True
20. Fixed Earnings
21. False

1. The factors which are regulated and influenced by the internal
decisions of an organisation are known as internal factors. Refer
to Section 5.2 Capital Structure Management.
2. External factors refer to the factors which cannot be controlled
by internal decisions and policies of an organisation. Refer to
Section 5.2 Capital Structure Management.
3. Over-capitalisation is a situation when an organisation
raises more capital than its requirements. Refer to Section
5.3 Capitalisation.

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4. Under-capitalisation refers to a situation in which an organisation

earns exceptionally high profits as compared to the other
organisations operating in the same industry. Refer to Section
5.3 Capitalisation.
5. As per the net income approach, given by David Durand, the
valuation of an organisation can be increased and cost of capital
can be decreased by introducing additional debt capital in
the capital structure. Refer to Section 5.4 Theories of Capital
Structure Management.
6. Like net operating income approach, the Modigliani-Miller
approach is more or less similar to it; it also takes risk factor into
consideration while determining the capital structure. Refer to
Section 5.4 Theories of Capital Structure Management.
7. Cost of capital is a rate at which an organisation raises capital to
S
invest in various projects. Refer to Section 5.5 Cost of Capital.
8. Retained earnings refer to the part of the profit that is kept as a
reserve. Though it is a part of the profit, but it is not distributed
IM
as dividend. Refer to Section 5.5 Cost of Capital.
9. Weighted average cost of capital is determined by multiplying
the cost of each source of capital with its respective proportion
in the total capital. Refer to Section 5.5 Cost of Capital.
10. The effective cost of debt will be:
M
KD = [(1 – T) * R] * 100
KD = [(1 – .3) * 0.05] X 100
KD = 0.035 X 100 = 3.5%
N
Refer to Section 5.5 Cost of Capital.

11. The cost of equity will be:
KE = E/MP
E= 300000 / 20000 = 15
MP = 200
KE = 15/200 = 0.075 = 7.5%
Refer to Section 5.5 Cost of Capital.
Suggested Readings
Baker,H., & Martin, G. (2011). Capital structure & corporate fi-
nancing decisions. Hoboken, N.J.: John Wiley & Sons.
Bhat, S. (2008). Financial management. New Delhi: Excel Books.

n o t e s
Keown, A., Martin, J., & Petty, J. (2008). Foundations of finance.

Upper Saddle River, N.J.: Pearson Prentice Hall.
Pandey, I. (2010). Management accounting ; planning and control
approach. Noida: Vikas Pub. House Pvt. Ltd.
Pratt,S., & Grabowski, R. (2008). Cost of capital. Hoboken, N.J.:
John Wiley & Sons.
E-REFERENCES
(2014). Retrieved 14 November 2014, from http://facultyfp.salis-
bury.edu/dmervin/htdocs/Lectures/Fin440/Capital%20Struc-
ture%20Lecture%20R2.pdf
Defining the Cost of Capital. (2014). Boundless. Retrieved
from https://www.boundless.com/finance/textbooks/bound-
S
less-finance-textbook/introduction-to-the-cost-of-capital-10/
the-concept-of-the-cost-of-capital-87/defining-the-cost-of-capi-
tal-372-8286/
IM
Inc.com,. (2014). Capital Structure. Retrieved 14 November 2014,
from http://www.inc.com/encyclopedia/capital-structure.html
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N

Ch a
6 p t e r
LEVERAGES
CONTENTS
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6.1 Introduction
6.2 Concept of Leverage in Finance
IM
6.2.1 EBIT-EPS Analysis
6.2.2 Break-even Analysis
Activity
6.3 Financial Leverage
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Activity
6.4 Operating Leverage
Activity
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6.5 Combined Leverage

Activity
6.6 Summary

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MUL RAISES DEBT CAPITAL
Maruti Suzuki India Ltd (formerly Maruti Udyog Ltd) is India’s

largest passenger car company, accounting for over 50 per cent of
the domestic car market. The company offers a full range of cars
from the entry level Maruti 800 and Alto to the stylish hatchback
Ritz, A-star, Swift, Wagon R, Estillo and sedans DZire, SX4 and
Sports Utility Vehicle Grand Vitara. The company is a subsidiary
of Suzuki Motor Corporation of Japan. The company is engaged
in the business of manufacturing, purchase and sale of motor ve-
hicles and spare parts (automobiles). The other activities of the
company include facilitation of pre-owned car sales, fleet man-
agement and car financing. In April 2009, the company revealed
the new Ritz K12M engine at the Gurgaon plant. The company
S
plans to modernise a part of the Gurgaon plant, expand the K-se-
ries capacity, invest further in new model development and take
over new projects. The capital structure policy of MUL is to in-
crease the net worth by plugging back profit to reduce cost of eq-
IM
uity and raise funds through debt capital. The company increased
its capital from `3363.3 crore to `10043.8 crore. Long-term debts
went up from `656 crore to `698.9 crore. Both excess capital and
increase in the use of debt were proportionated by the reserve
and surplus instead of making additional issue of equity shares.
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LEVERAGES 143
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learning objectives

>> Explain the concept of leverage in finance
>> Describe financial leverage ratios
>> Discuss operating leverage
>> Explain the concept of combined leverage
6.1 INTRODUCTION
Organisations require capital for carrying out their business activities,
projects, and operations. An organisation can arrange for capital from
two major sources, which are debt capital and equity capital. Debt capi-
S
tal refers to that part of a firm’s total capital, which commonly compris-
es loan-capital and short-term bank loans such as overdraft. Organisa-
tions pay fixed interest on these borrowings. On the other hand, equity
capital is that part of a firm’s capital, which is raised by issuing equity
IM
shares to the public and distributing dividends on these shares. The
interest on debt capital and dividends on equity capital are paid out of
the organisation’s profit. If the organisation is mostly funded through
debt, the profit available to equity share holders is higher. This is be-
cause the rate of interest on debt capital is fixed, and often lower than
the dividend payout on equity capital. When profits are increased, the
M
amount of dividend that an organisation could pay to its shareholders

automatically increases. Therefore, in financial terms, it can be said
that if an organisation generates higher profits from its projects using
debt capital, then the dividend available to the equity shareholders may
also increase. In simple words, leverage measures the ability of an or-
N
ganisation to earn profit on debt capital so that the returns to equity

shareholders could be increased. Such a relationship between the debt
capital and dividend payout to equity shareholders is studied under the
concept of leverage. Leverage involves the use of fixed costs to magnify
the returns. Leverage and capital structure are closely related and form
the basis of capital budgeting decisions of a firm.
The concept of leverage forms an important part of financial manage-

ment as it helps in determining the framework for a firm’s financial
decisions. It is also the basis for determining an optimal proportion of
debt and equity in a firm’s capital structure, so that the cost of capital
can be reduced. A finance manager needs to be very careful while
determining the optimum capital structure for a firm. For instance,
during periods of recession, the proportion of debt capital should be
reduced while increasing the equity capital to avoid the payment of in-
terests on debt capital in case the firm experiences a loss. The efficient
usage of leverage enhances the goodwill and value of an organisation
by increasing returns on equity capital.
In this chapter, you will study about financial leverages in detail.

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6.2 CONCEPT OF LEVERAGE IN FINANCE

In finance, leverage can be defined as the use of an optimal combi-
nation of debt capital to increase the return on equity capital, that is,
Earning per Share (EPS). In simple words, leverage depicts the rela-
tionship between two financial variables: debt capital and EPS. EPS
is the portion of a firm’s profit allocated to each outstanding share of
common stock. It is an indicator of a firm’s profitability. Let us un-
derstand the concept of leverage with the help of an example. Organ-
isations could raise funds from various sources. In return, they are
required to pay a fixed rate of interest on sources, such as loans and
debentures. For raising capital through other sources such as equity
shares; it pays variable rates of return. It is important to note that vari-
able rates of return are dependent on the profit of the organisation. If
the organisation earns higher profit, the variable rate of returns in-
S
creases, and viceversa. Capital raised through loans and debentures
is a part of debt capital, whereas the capital raised through shares
form a part of equity capital. As the rate of interest on debt capital is
IM
fixed, the ratio of debt capital in the total capital affects the return on
equity capital. An increase in debt capital may increase the profit of
an organisation. As EPS (dividend) is a part of organisation’s profit,
it would also increase. This relationship between the EPS and debt
capital is explained through the concept of leverage.
In finance, there are three types of leverages, as shown in Figure 6.1:

M
Types of Leverages
N
Financial Operational Combined

Leverage Leverage Leverage
Figure 6.1: Types of Leverages
You will study about these three leverages later in this chapter.
6.2.1 EBIT-EPS ANALYSIS
Earnings before Interest and Tax (EBIT), is an indicator of an organi-

sation’s profitability. It is calculated as revenue minus expenses, elim-
inating tax and interest charges. EBIT is also referred to as operating
earnings/operating profit/operating income. The formula to calculate
EBIT is as follows:
EBIT = Revenue – COGS – Operating Expenses
EBIT can be calculated by adding back interest and taxes to the net
income.

LEVERAGES 145
n o t e s
EBIT-EPS analysis is used to study the impact of the leverage on an

organisation’s profit/earnings. Increased use of debt leads to higher fi-
nancial risks while also a high return of equity. On the other hand, de-
crease in the use of debt for raising capital reduces the financial risks
but also decreases the EPS or return on equity. Therefore, organisa-
tions require a method to derive an optimal amount of fixed cost of
financing. This method is known as EBIT-EPS analysis. EBIT-EPS
analysis helps organisations to understand the effect on EPS resulting
due to changes in EBIT under different financial combinations. EBIT
is a firm’s operating profit while EPS is the earnings per share, which
can be calculated as follows:
EPS = Profit after Tax (PAT)/ Number of shares outstanding
PAT = EBIT – interest – taxes
S
The EPS would be as follows:
( EBIT − I )(1 − t )
EPS =
n
IM
Where EBIT = Earnings before Interest and Tax
I= Interest
t = Tax rate
n = Number of shares outstanding
M
EBIT-EPS analysis helps organisations in selecting a capital structure

(financial plan) that maximises EPS over a specified range of EBIT.
Illustration: Suppose an organisation wants to raise a total capital of

` 10,00,000. The organisation wants to use 75% debt and 25% equity
N
capital. In order to raise the equity capital of ` 2,50,000 the organisa-

tion wants to issue 25,000 equity shares. The EBIT of the company is
`2,40,000The interest on debt is 15% per annum. Calcuate the EPS.
Assume that the tax rate is 0.5%.
Solution: Total interest paid will be (10,00,000-2,50,000)*15/100 =

`1,12,500.
( EBIT − I )(1 − t )
EPS =
n
EBIT = `2,40,000
I = 1,12,500
T = 0.05
n = 25,000.
(2, 40, 000 − 1,12,500)(1 − 0.05)
EPS = 25, 000 =`4.85.

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6.2.2 BREAK-EVEN ANALYSIS
Break-even point is the level of sales at which a firm’s total revenues

are exactly equal to total operating costs. Break-even analysis is used
by an organisation by a company to assess how much it needs to sell in
order to pay for an investment, or at what point expenses and revenue
are equal. Operating costs are divided into three categories, as shown
in Figure 6.2:
Fixed Costs
Variable Costs
S
IM Semi-Fixed/Semi-Variable Costs
Figure 6.2: Types of Operating Costs
Let us discuss each of these costs in detail:

Fixed Operating Costs: These are costs such as depreciation and
insurance, which do not vary with level of production. These costs
do not depend on the number of units produced within a given
M
range of production/plant capacity.

Variable Operating Costs: These are the expenses that vary di-
rectly with the level of production and sales.
Semi-Fixed/Semi-Variable Costs: These are costs that include
N
both fixed and variable costs. The fixed element of the cost is
incurred recurrently over time, while the variable element is in-
curred as a function of activity/volume.
The break-even point is calculated as follows:
F
Q* =
P −V
Where Q* = break-even quantity,
F = Fixed costs
P = Price
V = Variable costs
P-V in the denominator is referred to as the contribution margin per

unit (CM) and denotes the amount that each unit sold contributes to
meeting the fixed costs.

LEVERAGES 147
n o t e s
An organisation that has high fixed costs should generate more reve-
nues in order to break-even. Therefore, more capital-intensive organ-
isations, which requires substantial amount of capital for the produc-
tion of goods must produce and sell more only to survive.
An important point regarding break-even analysis is that the impact

of a change in unit volume has on profits, is increased as operating
leverage increases. In simple words, when an organisation with high
operating leverage is above the break-even point, another unit of sales
makes a greater contribution on profit compared to an organisation
with less operating leverage.
Illustration: ABC company is involved in manufacturing a single

product. The company has invested `9, 00,000 as fixed cost. The vari-
able cost is ` 450/unit. The company sells its products at `900/unit.
Calculate the break-even production level.
S
Solution:
At break-even point: Sp * Q = Vp*Q + FC

IM
900 × Q = 450× Q + 9,00,000
900 Q = 450Q + 9,00,000
450Q = 9, 00,000
Q = 2000 units.
M
Therefore, the company will achieve breakeven at 2000 units.

N
1. ________ is the portion of a firm’s profit allocated to each

outstanding share of common stock.
2. Capital raised through loans and debentures is a part of debt
capital; whereas, the capital raised through shares form a part
of equity capital. (True/False)
3. The formula for EBIT = _________________.
4. __________ analysis helps organisations to understand the
effect on EPS resulting due to changes in EBIT under different
financial combinations.
5. Break-even point is the level of sales at which a firm’s total
revenues are higher than total operating costs.
6. ___________ are costs such as depreciation and insurance,
which do not vary with level of production.
7. The break-even point is calculated as _____________.
8. An organisation that has high fixed costs should generate
more revenues in order to break-even. (True/False)

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Activity
Using the Internet, show the graphical representation of the break-

even point and explain its significance.
6.3 FINANCIAL LEVERAGE

Financial leverage refers to a situation in which an organisation earns
higher profit compared to the rate of interest it pays on the debt cap-
ital. The rate of interest on debt capital is also termed as the cost of
debt capital. Let us understand the concept of financial leverage with
the help of an example. Say, an organisation generates debt capital of
`10,000 at an interest rate of 10 per cent, paid annually to invest in a
garment manufacturing project. If the organisation gets `3000 on first
S
year from the sale of garments and pays `1000 as interest, then the
project earns a profit of `2000. In this case, the organisation is said to
be financially leveraged because it earns profit on its debt capital. As
IM
discussed, the profit earned on debt capital increases the overall earn-
ings of an organisation. Also, as returns on equity are paid from profit,
they would also increase.
L.J. Gitman defines financial leverage as “the firms’ ability to use fixed
financial charges to magnify the effects of changes in EBIT on the
firms’ EPS.”
M
Financial leverage is represented through different financial ratios,

such as debt to equity ratio, and interest coverage ratio. Let us discus
the calculation of financial leverage using debt to equity ratio. The fol-
lowing steps need to be performed to calculate the debt to equity ratio:
N
1. Compute the debt capital of the organisation by adding total

long-term and short-term debt.
2. Compute the equity capital of the organisation by multiplying the
total number of equity shares with the book value of the shares.
3. Compute the debt to equity ratio by dividing the total debt capital
with the total equity capital.
This debt to equity ratio represents the financial leverage of the or-
ganisation.
The formula to calculate debt to equity ratio is as follows:

Debt to Equity Ratio (D/E) = Total Debt/Shareholders’ Equity
Let us now learn how to calculate financial leverage with the help of
debt to value ratio. The following steps need to be performed for cal-
culating the debt to value ratio:
1. Add the long-term and short-term debts to calculate the total
debt of the organisation.

LEVERAGES 149
n o t e s
2. Add the total debt and total equity to calculate the value of the
organisation.
3. Divide the amount of the total debt with the sum of total debt
and equity.
This gives the debt to value ratio, which represents the financial lever-
age of the organisation. The formula to calculate debt to value ratio is
as follows:
Debt to Value Ratio = Debt/ (Debt + Equity)
Another way to compute financial leverage is through the interest

coverage ratio. The following steps need to be performed for calculat-
ing the interest coverage ratio:
1. Find out the profit or earning of the organisation before charging
S
any interest on debt and paying tax to the government that is
Earnings before Interest and Tax (EBIT).
2. Compute the total interest paid by the organisation on total debt.
IM
3. Divide EBIT with interest on debt to calculate interest coverage
ratio.
This ratio represents financial leverage of the organisation.
The formula to calculate interest coverage ratio is as follows:

M
Interest Coverage Ratio = EBIT/Interest on Debt or Interest
A financial leverage ratio of 2:1 is said to be favourable for an organi-

sation. However, a higher ratio signifies that the organisation is highly
leveraged, which is not a favourable situation. A highly leveraged or-
N
ganisation is prone to high risks as it has a bigger liability to pay inter-

est on the debt capital. On the other hand, a lower financial leverage
ratio signifies that the organisation is weakly leveraged, which is also
an unfavourable situation. Low financial leverage ratio implies that
the organisation is not able to secure enough debt to fund its projects
and increases the pressue on raising equity
In an organisation, the intensity or extent of financial leverage is mea-

sured by the Degree of Financial Leverage (DFL) establishes a rela-
tionship between EBIT and EPS. The organisation initially computes
its EBIT and deducts the corporation tax and interest on debt capital
from EBIT, to arrive at EPS. Usually, the corporate taxes remain con-
stant; therefore, the change in EPS mainly occurs due to change in
interest on debt capital.
Consider that the EBIT of an organisation increases due to increase

in debt capital. The organisation may face two situations. In the first
case, the amount of EPS increases, which would indicate a positive
relationship between EPS and EBIT. In the second scenario, the
amount of EPS decreases, which would indicate an inverse relation-

n o t e s
ship between EPS and EBIT. The positive relationship between EPS
and EBIT signifies that financial leverage is favourable for the organ-
isation, whereas inverse relationship between the two variables de-
picts that financial leverage is unfavourable for the organisation.
DFL can be calculated by using the following formula:

DFL = Operating Profit or EBIT/ (EBIT – Interest)
= Operating profit/Profit before tax
Therefore, DFL = Percentage change in EPS/Percentage change in

EBIT
If DFL is greater than 1, it shows that the organisation enjoys high fi-
nancial leverage. However, high financial leverage also indicates high-
er risk, and vice versa.
S
Benefits and Limitations of Financial Leverage
Financial leverage refers to the ability of an organisation to use debt

IM
capital for investing in various projects or acquiring fixed assets. It has
various benefits and drawbacks, which are discussed in this section.
The benefits of financial leverage are as follows:

Helps in increasing EPS when interest on debts is low
M
Reduces tax liability, as interest paid on debt is treated as expense,

which is deducted from profit
Reduces cost of capital, if the debt capital is raised on low rate of
interest
N
Preserves the control of an organisation. As already discussed, the

debt capital is mainly raised by issuing debentures and raising
long term loan from Financial Institutions. The debenture holders
do not have voting rights; therefore, they cannot interfere in the
internal decisions of the organisation. In this way, the control of
the organisation remains with the owners.
The limitations of financial leverage are as follows:

Decreases return on equity in conditions when interest rates are
high
Increases the liability to pay interest when profits fluctuates
Involves a high risk as debts are raised by mortgaging the assets
of an organisation
Let us look at few illustrations to understand the concept of financial

leveraging:

LEVERAGES 151
n o t e s
Illustration : XYZ Ltd. has come up with three financial plans as fol-
lows:
Particulars A (`) B (`) C (`)

Equity capital 4000 3000 2000
Debt 2000 2000 2000
EBIT or operating profit 1200 800 500
Calculate the degree of financial leverage for each plan.
Working notes: Interest @20% on debt in all cases.
Solution: The degree of financial leverage in case of each financial

plan is calculated as follows:
S
Particulars A (`) B (`) C (`)
EBIT 1200 800 500
Less: Interest @ 20% 400 400 400
Profit before tax (PBT) 800
IM 400 100
Financial leverage 1200/800 = 1.5 800/400 = 2 500/100 = 5
(EBIT/EBIT – Interest)
Note: Profit before tax refers to profit before paying any kind of divi-
dend (equity as well as preference).
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Illustration : The capital structure of ABC Ltd. has the following se-
curities:
10% preference share = `10,000
Equity shares @ `20 each = `20,000
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The amount of operating profit = `6000 and the tax rate is 50%.
a. Calculate the financial leverage of ABC Ltd.
b. What will be the financial leverage when EBIT increases to
`9000?
Solution: The computation of the present financial leverage is shown

as follows:
Particulars Amount (`)

EBIT 6000
Less: Dividend paid on preference shares(earnings before 2000
tax = Dividend/(1 – Tax rate) = 1000/(1 – 0.50) = 2000)
Profit before tax (PBT) 4000
Present financial leverage (EBIT/PBT = 6000/4000 = 1.5) 1.5

n o t e s
The financial leverage when EBIT increases to `9000 would be calcu-

lated as follows:

EBIT 9000
Less: Dividend paid on preference shares 2000
PBT 7000
New financial leverage (EBIT/PBT = 9000/7000 = 1.28) 1.28
Illustration : PQR Ltd. has the following capital structure:

Equity share capital = `2,00,000
20% preference share capital = `2,00,000
10% debentures = `1,50,000
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The present EBIT is `1, 00,000 and tax rate is 50%. Calculate PQR’s
financial leverage.
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Solution: PQR’s financial leverage is calculated as follows:
Particulars Amounts (`)

EBIT 1,00,000
Less: Interest on debentures 15,000
Less: Dividend on preference shares (Earnings before 40,000
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tax = 20000/(1 – 0.50) = 40000)

PBT 45,000
Financial leverage (EBIT/PBT = 1,00,000/45,000 = 2.22) 2.22
Illustration : An organisation has the following capital structure:

N
1000 equity shares of `100 each = `1,00,000

1000 10% preference shares of `20 each = `20,000
1000 20% debentures of `100 each = `1,00,000
Calculate EPS for each case of the following levels of EBIT:

1. `2, 00,000
2. `1, 50,000
3. `1, 20,000
Tax rate is 50%.
Also, calculate the financial leverage considering `2,00,000 (Case-1) as

the base.

LEVERAGES 153
n o t e s
Solution: The solution to the given problem is as follows:
Particulars Case-1 Case-2 Case-3

(`) (`) (`)
EBIT 2,00,000 1,50,000 1,20,000
Less: Interest on debentures 20,000 20,000 20,000
PBT 1,80,000 1,30,000 1,00,000
Less: Tax 90,000 65,000 50,000
Profit after tax (PAT) 90,000 65,000 50,000
Less: Preference dividend 40,000 40,000 40,000
Earnings available for equity shareholders 50,000 25,000 10,000
EPS 50 25 10
This shows that in Case-2 the EBIT has decreased by 25%, while the
S
EPS has decreased by 50%. In Case-3, the EBIT has decreased by 40%
and EPS has decreased by 80%.
Therefore, DFL can be calculated as follows:

IM
DFL = Percentage change in EBIT/Percentage change in EPS
DFL for Case-1 and Case-2 = 25/50 = 0.50
DFL for Case-1 and Case-3 = 40/80 = 0.50
M
9. Debt to Equity Ratio (D/E) = _____________________.

10. ______________ = Operating Profit or EBIT/ (EBIT – Interest)
N
Activity
Discuss how rate of interest on debt capital affects the financial

leverage of a firm.
6.4 OPERATING LEVERAGE

Operating leverage measures the effect of change in the sales volume
and operating capacity on EBIT. It indicates the variation in operat-
ing profit (or simply profit), which is directly proportional to sales vol-
ume. This implies that if the sales volume increase, profits would also
increase. As discussed, there are two main costs in an organisation,
fixed cost and variable cost. Fixed cost remains unchanged with the
change in the volume of sales; while variable cost changes with the
increase in volume of sales. For instance, a firm’s fixed cost is `1 crore.
Its sales figures may be less than, more than, or equal to `1 crore. If
the sales volume is equal to total cost (fixed cost + variable cost), it

n o t e s
shows a no profit and no loss situation (break-even point). If the sales

volume is greater than the total cost then it shows a profitable situa-
tion for the organisation, and vice versa. Therefore, changes in sales
may affect a firm’s profit levels.
Significance of Operating Leverage
Operating leverage illustrates the effect of change in a firm’s sales on

its EBIT. When there is high operating leverage, even a small rise in
sales results in significant increase in the EBIT. Similarly, a minute
drop in sales would result in dramatic fall in EBIT. Therefore, exis-
tence of high operating leverage reflects a high-risk situation. As the
operating leverage reaches its maximum (near break-even point), an
organisation may protect itself from the dangers of high operating
leverage and the consequent operating risk by operating above the
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break-even point.
Operating leverage arises when an organisation invests in fixed assets

to increase the sales volume and generate sufficient revenue for meet-
IM
ing its fixed and variable costs. Suppose an iron rods manufacturing
organisation invests in an additional piece of machinery to increase
the production of iron rods. When the production of rods increases,
the sales volume would also increase. In such a case, if the organisa-
tion generates additional revenue and covers the cost of additional
piece of machinery and other variable cost incurred in the production,
M
it is said to have operational leverage.
As discussed, operating leverage indicates variations in operating

profit. Therefore, operating profit is calculated using the following
formula:
N
Operating Profit = [N (SP – VC)]/ [N (SP – VC) – FC]

where, N = Number of units sold
SP = Selling price
VC = Variable cost
FC = Fixed Cost
Degree of Operating Leverage (DOL) establishes a relationship be-

tween changes in operating profit and changes in sales volume. In
other words, DOL measures the change in operating profit for a given
change in sales volume. A value of greater than 1 is estimated to be
favourable for DOL. This implies a profitable situation for an organi-
sation. If the value of DOL is equal to one, it represents a situation of
no profit and no loss (break-even). When the value of DOL is less than
one, it means that the organisation is incurring losses. A high degree
of operating leverage indicates that the investment in fixed asset is
high, due to which the sales volume and operating profit are also high-
er and vice versa.

LEVERAGES 155
n o t e s
DOL can be calculated by using the following formula:

DOL = Percentage change in operating profit/Percentage change
in sales
DOL can also be calculated using break-even analysis with the
help of the following formula:
DOL = (SP – VC)/ (SP – VC – FC)
Where SP= Sales Price
VC = Variable Costs
FC = Fixed Costs
or DOL = Contribution/Operating Profit
Benefits and limitations of Operating Leverage:
S
An organisation with a high operating leverage generates more reve-
nue as compared to the organisation with low operating leverage. The
benefits of operating leverage are as follows:
IM
Helps in increasing the profit of an organisation by increasing
sales volume.
Reduces dependency on variable cost. Suppose an organisation
hires cabs to provide pick and drop services to its employees. It
pays a fixed amount of rent for hiring the cabs, which is a part of
M
variable cost. If the organisation buys its own cabs, it does not re-
quire paying rent for hiring taxis. Thus, the organisation’s depen-
dency on variable cost decreases.
Reduces the overall cost of production, if the sales figure increases
N
and covers the entire fixed cost.
The limitations of operating leverage are as follows:

Helps only large-sized organisations as the concept of operating
leverage is not applicable to new and small-sized organisations
with insufficient fixed assets.
Involves high risks when sales start declining. In such a case, an
organisation finds it difficult to pay interest on debt capital raised
to acquire fixed assets.
Let us look at a few illustrations:
Illustration : Calculate DOL from the following information:

Sales = `1,00,000
Fixed cost = `70,000
Variable cost = `20,000

n o t e s
Solution: The calculation of DOL is as follows:

DOL = (SP –VC)/ (SP – VC – FC)
= (100000 – 70000)/ (100000 – 70000 – 20000) = 3
Therefore, DOL is three times greater than sales.
Illustration : Calculate operating leverage in Case-1, Case-2, and

Case-3 from the following information:
Installed capacity = 1600 units
Actual production and sales = 1200 units
Selling price per unit = `20
Variable cost per unit = `10
S
Fixed cost in case-1 = `2000
IM
Solution: Operating leverage would be calculated as follows:
Particulars Case-1 Case-2 Case-3

Amount Amount Amount
(`) (`) (`)
Sales (units sold * (selling price per 36000 36000 36000
M
unit + variable cost per unit))

Less: Variable cost 12000 12000 12000
Contribution 24000 24000 24000
Less: Fixed cost 2000 4000 6000
N
Operating profit 22000 20000 18000

Operating leverage (contribution/ 1.09 1.2 1.33
operating profit)
Illustration: The following table provides information about organi-

sations A and B:
Sales Variable cost Fixed cost

(` in lakhs) (` in lakhs) (` in lakhs)
Organisation A 180 45 90
Organisation B 150 75 37
By using the above data, calculate the following:

a. Profit to Sales ratio
b. DOL for both organisations A and B

LEVERAGES 157
n o t e s
Solution:
a. The calculation of profit to sales ratio is as follows:
Contribution ratio = Contribution/Sales
Organisation A = (180 – 45)/180 = 0.75
Organisation B = (150 – 75)/150 = 0.50
Profit margin ratio = Profit/Sales
Organisation A = (135 – 90)/180 = 0.25
Organisation B = (75 – 37)/150 = 0.25
b. The calculation of DOL is as follows:
DOL = Contribution/EBIT
S
Organisation A = 135/45 = 3
Organisation B = 75/38 = 1.97
IM
11. Operating leverage arises when an organisation invests

in fixed assets to increase the sales volume and generate
sufficient revenue for meeting its fixed and variable costs.
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(True/False)
12. DOL = _________________.
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Activity
Discuss how different degree of operating leverages affects an or-

ganisation’s capital decisions.
6.5 COMBINED LEVERAGE

As the name suggests, combined leverage refers to the combination of
both operating and financial leverages. You have studied by far that
in an organisation, operating leverage measures the relationship be-
tween percentage change in EBIT and percentage change in sales.
Contrary to this, financial leverage evaluates the relationship between
percentage change in EPS and percentage change in EBIT.
Combined leverage can be calculated by using the following formula:
Combined leverage = {(Sales – VC)/EBIT} × {EBIT/ (EBIT – Interest)}
= (Sales – VC)/ (EBIT – Interest)

= Operating leverage × Financial leverage

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Degree of Combined Leverage (DCL) measures the relationship be-

tween percentage changes in sales to percentage change in EPS. This
relationship can be represented by using the following formula:
DCL = % change in EPS / % change in sales
Or DCL = Contribution / (EBIT-I)
The advantage of DCL is that it shows the effect of changes in sales

on EPS. It proves useful when an organisation needs to choose a new
project between various alternatives. The organisation can compare
the DCL of different projects before arriving at a decision. If the DCL
of a project is equal to one, that project is exposed to constant risk. In
such a case, the profitability of the organisation would not be affected.
Thus, the project may prove to be favourable.
Let us look at a few illustrations:
S
Illustration: In ABC Ltd., the operating leverage and combined lever-
age are 2 and 4, respectively at a sales level of 1, 00,000 units. The sell-
ing price per unit is `20 and variable cost is `10. Corporate income tax
IM
rate is 50% and the rate of interest on debt capital is 10%. Calculate
the amount of debt in the capital structure of the ABC Ltd.

Sales = 1,00,000 × 20 = `20,00,000
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Variable cost = 1,00,000 × 10 = `10,00,000

Contribution = Sales – VC = 20,00,000 – 10,00,000 = `10,00,000
Operating leverage = Contribution/EBIT
N
Therefore, 2 = 1000000/EBIT
EBIT = 1000000/2 = `5,00,000
Combined leverage = Contribution/ (EBIT – Interest)
Therefore, 4 = 10, 00,000/ (5,00,000 – Interest)

Interest = (20,00,000 – 10,00,000)/4 = `2,50,000
Rate of interest is 10%. Therefore, amount of debt in capital struc-
ture = 2,50,000/ (10 ×100) = `25,00,000
Illustration : The capital structure of PQRS Ltd. is as follows:

Equity share capital (each share of `10) = `6000
10% debentures = `8000
Retained earnings = `2000
Sales volume of the organisation is `60,000. Its variable operating cost

is 4% of sales, fixed operating cost is `10000, and the income tax rate
is 50%.

LEVERAGES 159
n o t e s
The profitability structure of the organisation is as follows:

Sales = `60,000
VC = `24,000
Contribution = `36,000
FC = `10,000
EBIT = `26,000
Interest = `800
EBT = `25,200
Taxes = `12,600
Profit after tax = `12,600
1. Calculate different types of leverages
S
2. Determine the likely level of EBIT if EPS in case-1 = `1, case-2 =
`2, and case-3 = `3
IM
Solution: The calculation of leverages is as follows:
Operating leverage = Contribution/EBIT = 36,000/26,000 = 1.38
Financial leverage = EBIT/EBT = 26,000/25,200 = 1.03
Combined leverage = Contribution/EBT = 36,000/25,200 = 1.43
M
The calculation of EBIT is as follows:

EPS = 50% of (EBIT – Interest)/Numbers of equity shares
Case-1: EPS = 50% of (EBIT – Interest)/Number of equity shares
N
1 = 50% (EBIT – 800)/600 = 2000

Case-2: EPS = 50% of (EBIT – Interest)/Number of equity shares
2 = 50% (EBIT – 800)/600 = 3200
Case-3: EPS = 50% of (EBIT – Interest)/ Number of equity shares
3 = 50% (EBIT – 800)/600 = 4400
Illustration: From the following information, calculate the percent-

age change in earnings per shares if sales is increased by 10%:
Particulars ` (in lakhs)

EBIT 112
PBT 32
FC 70

DOL = Contribution/EBIT
= (EBIT + FC)/EBIT = (112 + 70)/112 = 1.625

n o t e s
DFL = EBIT/PBT = 112/32 = 3.5

DCL = DOL × DFL = 1.625 × 3.5 = 5.6875
DCL = Percentage change in EPS/Percentage change in Sales
5.6875 = Percentage change in EPS/10 = 56.875
Therefore, percentage change in EPS = 56.875
13. _____________ measures the relationship between percentage

changes in sales to percentage change in EPS.
14. If the DCL of a project is more than one, that project is exposed
to constant risk. (True/False)
S
Activity
IM
Discuss how DCL helps organisations in selecting from among a
gamut of projects.
6.6 SUMMARY
Leverage can be defined as the use of an optimal combination of
M
debt capital to increase the return on equity capital; that is, Earn-
ing per Share (EPS).
EPS is the portion of a firm’s profit allocated to each outstanding
share of common stock. It is an indicator of a firm’s profitability.
N
In finance, there are three types of leverages; financial leverage,

operational leverage, and combined leverage.
Earnings before Interest and Tax (EBIT), is an indicator of an or-
ganisation’s profitability. EBIT = Revenue – COGS – Operating
Expenses.
EBIT-EPS analysis helps organisations to understand the effect
on EPS resulting due to changes in EBIT under different financial
combinations.
Break-even point is the level of sales at which a firm’s total reve-
nues are exactly equal to total operating costs.
Operating costs are divided into three categories; fixed costs, vari-
able costs, and semi-fixed/semi-variable costs.
F
The break-even point is given as Q* = ; where Q* = break-
P −V
even quantity, F = fixed costs, P = price, and V = variable costs.

LEVERAGES 161
n o t e s
Financial leverage refers to a situation in which an organisation

earns higher profit compared to the rate of interest it pays on the
debt capital.
Degree of Financial Leverage (DFL) establishes a relationship be-
tween EBIT and EPS.
DFL = Operating Profit or EBIT/(EBIT – Interest)
Operating leverage measures the effect of change in sales volume
and operating capacity on EBIT.
Operating Profit = [N (SP – VC)]/ [N (SP – VC) – FC]
Degree of Operating Leverage (DOL) establishes a relationship
between changes in operating profit and changes in sales volume.
Combined leverage refers to the combination of both operating
S
and financial leverages.
Combined leverage = {(Sales – VC)/EBIT} × {EBIT/ (EBIT – In-
terest)}
IM
Degree of Combined Leverage (DCL) measures the relationship
between percentage changes in sales to percentage change in EPS.
key words
Capital Structure: It is the relative proportions of debt, equity,

M
and other securities used to finance a firm’s fixed assets.

Corporate Tax: These are taxes on business profits and other
forms of income levied by the State and Central governments
on corporate bodies.
N
Degree of Leverage: It is the percentage change in operating

income (or EBIT) that results from a change in sales.
Financial Break-even Point: It is a level of EBIT to cover the
fixed financial liabilities of a firm.
Shareholders’ Equity: It is the portion of the balance sheet that
represents the capital received from investors in exchange for
stock (paid-in capital).

1. Explain the concept of leverage in finance.
2. Describe EBIT-EPS analysis for leveraging decisions.
3. Explain the concept of break-even analysis.
4. Discuss the ratios for calculating financial leverage.
5. The following table provides some information about
organisations A and B:

n o t e s
Sales Variable Cost| Fixed Cost

(` in lakhs) (` in lakhs) (` in lakhs)
Organisation A 200 50 80
Organisation B 175 65 47
By using the above data, calculate the following:
a. Profit to Sales ratio
b. DOL for both organisations A and B
6. Suppose the following information is available about an
organisation:
` in lakhs
Earnings before Interest and Tax (EBIT) 2,240
Profit before Tax (PBT) 640
S
Fixed Cost 1,400
Calculate the percentage change in earning per share in case of
10% change in sales.
IM

M

Concept of Leverage 1. EPS
in Finance
2. True
N
3. Revenue – COGS – Operat-

ing Expenses
4. EBIT-EPS Analysis
5. False
6. Fixed costs
7. F
Q* =
P −V
8. True
Financial Leverage 9. Total Liabilities/Sharehold-
ers’ Equity
10. Degree of Financial Leverage
(DFL)
Operating Leverage 11. True
12. Percentage change in op-
erating profit/Percentage
change in sales

LEVERAGES 163
n o t e s

Combined Leverage 13. Degree of Combined Lever-
age (DCL)
14. False

1. Leverage can be defined as the use of an optimal combination
of debt capital to increase the return on equity capital; that
is, Earning per Share (EPS). Refer to Section 6.2 Concept of
Leverage in Finance.
2. EBIT-EPS analysis helps organisations to understand the
effect on EPS resulting due to changes in EBIT under different
financial combinations. Refer to Section 6.2 Concept of Leverage
S
in Finance.
3. Break-even point is the level of sales at which a firm’s total
revenues are exactly equal to total operating costs. Refer to
IM
Section 6.2 Concept of Leverage in Finance.
4. Financial leverage is represented through different financial
ratios, such as debt to equity ratio, debt to value ratio, and
interest coverage ratio. Refer to Section 6.3 Financial Leverage.
5. Calculate the profit to sales ratio by computing Contribution
ratio, Profit margin ratio. Calculate DOL as Contribution/EBIT.
M
Refer to Section 6.4 Operating Leverage.

( EBIT + Fixed Cost ) 3640
6. DOL = = = 1.625.
EBIT 2240
EBIT 2240
N
DFL = = = 3.5
PBT 640
DCL = DOL*DFL = 1.625*3.5 = 5.6875
% change in EPS % change in EPS
We know that DCL = % change in sales =
5
% change in EPS = 5 *5.6875 = 28.4375.
Refer to Section 6.4 Operating Leverage.
SUGGESTED READINGS
Kapil, S. (2010). Financial management. Pearson.
Khan, M., & Jain, P. (1985). Management accounting and financial
Pandey, I. (1979). Financial management. New Delhi: Vikas Pub.
House.

n o t e s
E-REFERENCES
Elearning.sol.du.ac.in,.
(2014). Study Material-1. Retrieved 14 No-
vember 2014, from http://elearning.sol.du.ac.in/mod/book/view.
php?id=883&chapterid=785
Evans, M. (2014). Operating Leverage. Exinfm.com. Retrieved 14
November 2014, from http://www.exinfm.com/board/operating_
leverage.htm
Inkling.com,. (2014). Inkling. Retrieved 14 November 2014,
from https://www.inkling.com/read/fundamentals-corporate-fi-
nance-brealey-7th/chapter-4/4-6measuring-financial-leverage
S
IM
M
N

C h a
7 p t e r
DIVIDEND POLICY
CONTENTS
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7.1 Introduction
7.2 Dividend Policy
IM
Activity
7.3 Factors Determining Dividend Policy
Activity
7.4 Types of Dividend Policy
M

Activity
7.5 Approaches to Dividend Policy
7.5.1 Irrelevance Approach (Modigliani and Miller)
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7.5.2 Relevance Approach (Walter and Gordon)

Activity
7.6 Forms of Dividend Payment
Activity
7.7 Summary

n o t e s
NALCO DIVIDEND FOR FY 2013-14
National Aluminium Company Limited or NALCO, a navratna

company has declared a dividend to the tune of `386.59 crore for
the FY 2013-14. It roughly forms 30% of its paid up capital. Gov-
ernment of India is a major stakeholder in NALCO and its share
of dividend is estimated at `313.23 crore. As we know that the div-
idend can be paid once or more in a year, in March 2014 the organ-
isation had already paid the central government a sum of `229.80
crores as interim dividend. From the day the company started its
operation it has paid a total of `4,905.77 crores as dividend, which
includes `4,233.96 crores that has been paid to the Government of
India. The analysis of the dividends that NALCO has been giving
out over the years suggests that the organisation follows a stable,
S
regular and extra dividend policy.
IM
M
N

DIVIDEND POLICY 167
n o t e s
learning objectives

> Summarise the concept of dividend and dividend policy
> Explain the factors that determine a dividend policy
> Classify and explain the different types of dividend policy
> Explain and exemplify the different forms of dividend pay-
ment
7.1 INTRODUCTION
In the last chapter you have studied the concept of leverage in terms
of corporate finance. We studied the relation between debt capital and
S
returns to equity shareholders. We can say that leverage measures the
ability of an organisation to earn profit on the debt capital it has taken
from the market so as to increase the returns to equity shareholders.
IM
We know that an organisation needs capital to finance for its various
activities and operations. Capital is basically raised from, one, the debt
sources on which the company has to pay a fixed interest amount and
two, from the equity sources on which variable rate of interest has to
be paid. The returns that are paid to the equity holders is in form of
dividends. The dividend that is paid out to the equity holders is vari-
M
able and depends on the profits that are earned by the organisation. In
case the organisation derives high profits, it gives more dividend and
in case it incurs losses, it does not pay dividend. The role of dividend
policy is to decide the rate and type of dividend payment. Devising the
N
dividend policy is a top management function. A good dividend policy

serves as a very important function that is to motivate the existing
investors to invest further in the organisation and also motivate the
new investors to invest in the organisation. The organisation always
endeavors to maintain and strengthen its reputation in the market for
which it is important to have a sound financial management policy
and a consistent and increasing dividend record.
This chapter begins by elaborating on dividend policy of an organisa-

tion. It explains the irrelevance and relevance approaches of dividend
policy at length. Further, it provides information about internal and
external factors determining dividend policy. In addition, the chapter
sheds light on different types of dividend policy, including stable divi-
dend policy, long-term dividend policy, regular and extra dividend pol-
icy, irregular dividend policy, and regular stock dividend policy. Final-
ly, it makes you familiarise with the two forms of dividend payment,
namely cash dividend and stock dividend.

n o t e s
7.2 DIVIDEND POLICY

Dividend policy refers to a policy under which the decisions related to
the distribution of profit in the form of dividends to the shareholders
is made. All financial policies play a crucial role in determining the
value of the organisation on a long term basis and the dividend policy
plays a key role in it. As mentioned earlier, formulating a dividend pol-
icy is a function of the top management or the board of directors. The
decision is made in the annual general meeting of the organisation. In
this meeting, the directors take into consideration the profit, corpo-
rate taxes, and the rate of interest that is to be paid to the debenture
holders and then decide the rate at which the dividend must be paid
to the shareholders. The dividend is usually in the form of cash but it
may be in the form of shares as well. In this case the company gives
the shareholders shares of the value of the dividend instead of cash.
S
The dividends are paid out of the profits of the organisation and never
from the capital of the company.
The following factors are considered before devising a dividend

IM
policy:
Fund Availability: It means that the organisation must have suffi-
cient funds to distribute the dividends.
Shareholders Expectations: The board of directors while decid-
ing the dividend policy must take into consideration the expec-
M
tations of the shareholders also. In cases, when the organisation

generates huge profits, the shareholders expect high dividends.
The shareholders also expect that they receive a steady level of
dividend payments over the years.
N
Status Quo Factor: It refers to various factors that the organisa-

tion must consider while framing a dividend policy. Usually, the
rate of dividend is proportional to the level of profits that is the
rate of dividend increases when the profits increase and decreases
when the profits drop. There are no general guidelines relating to
the formulation of the dividend policy. But, according to professor
I.M. Pandey, organisations need to answer a few questions before
devising dividend policy:
What are the preferences of shareholders—dividend income or
capital gain?
What are the levels of financial needs of the company?
What are the constraints on paying dividends?
Should the company follow a stable dividend policy?
What should be the form of dividend (i.e., cash or bonus
shares)?

DIVIDEND POLICY 169
n o t e s
1. Formulating a dividend policy is a function of the____________.

2. Shareholders generally prefer cash dividends. (True/False)
3. When an organisation generates good profits, the shareholders
expect _____dividends.
Activity
Using the Internet or journals, find out the cases when the organisa-
tions dividend decision was influenced by the availability of funds.
S
FACTORS DETERMINING DIVIDEND
7.3
POLICY
There are various factors that influence the dividend policy of the or-
IM
ganisation. They are grouped under two categories which are internal
factors and the external factors. Internal factors are the factors which
are internal to an organisation and can be controlled to a large extent.
On the contrary, there are external factors that are external to an or-
ganisation and are not under the control of the organisation.
M
Let us now look at the internal factors that influence the dividend pol-
icy, which are explained as follows:
Stability of Earnings: Stability of the earnings refers to regular
profit generation. Ideally the profits should show a stable and in-
N
creasing trend. For an organisation having stable earnings the divi-

dend policy will also be consistent. For an organisation whose earn-
ings are not consistent, the dividend policy will also be inconsistent.
Life Stage of the Organisation: An organisation goes through
three stages in its entire life cycle, viz. introduction, growth and
maturity. If the organisation is in the introduction stage then it fol-
lows a conservative dividend policy because it has to keep a giant
share of the profit for further investment in the organisation. If
the organisation is in the mature phase then it can follow a liberal
policy for its dividend. For an organisation in the growth phase,
the dividend policy should ideally be a good combination of quality
dividend payout to the shareholder along with a good amount to
be kept for further investment in the company.
Liquidity of Funds: Since the dividend to the shareholders goes in
the form of cash, it is important to look at the cash available with
the organisation and also the assets that the organisation holds
and their convertibility to cash. The more the liquidity of funds
available, the better will be the ability of the organisation to pay
the shareholders dividend.

n o t e s
Retained Earnings: The organisation has to retain a part of the

profit that needs to be reinvested in the organisation to enhance
its base i.e., for expansion and consolidation reasons and to en-
hance its financial position. The organisations of small size have
a hard time finding sources of funds and therefore they follow a
conservative dividend policy and keep a good share of the profit
for reinvesting in the company.
Information on Previous Dividend Rates: It is a general practice
to keep the share dividends at a rate that shows a consistent trend
and they must be near to the average dividend returns paid by the
organisation in the past. Therefore while deciding the rate of div-
idends the board of directors must keep in mind the trend of the
dividends paid in the past. If the dividend rates are set at a very
high or a very low level then the shares of the organisation would
come under speculation. Speculative shares are supposed to be
S
risky shares thereby putting the goodwill of the company at stake.
Consistency of Dividend Payout: The dividend payments to the
shareholders must be consistent and preferably in an increasing
IM
pattern over the years. It serves to motivate the investors to invest
further in the organisation and thereby help in strengthening the
goodwill of the organisation in the market.
Shareholder’s Tax Situation: Stock holders prefer lower cash div-
idend because of higher tax to be paid on the dividend income
M
Let us now look at the external factors influencing dividend policy,

which are explained as follows:
Business Cycles: Every business organisation goes through stages
where they go through a boom period or period of low profits due
N
to various reasons. The organisation follows generous policy and

gives higher dividends in periods of boom. On the contrary an or-
ganisation follows a restrictive dividend policy during periods of
low profits.
Government Policies: Government policies include the fiscal pol-
icy that relates to the taxes and subsidies, industrial, and labor
policies. Any change in these policies has a direct impact on the
organisation and its earnings. For instance, if the tax rates applica-
ble for organisation increases then, the net profit after deducting
the taxes which is available to be distributed as dividend decreases
and the shareholders get lesser dividends. Or consider a case in
which the organisation gets some subsidies from the government,
due to policy changes the subsidies are reduced or are cut off en-
tirely then the organisation will have more expenditure thereby
decreasing the net profits.
Statutory and Legal Requirements: For the organisations to func-
tion there are a set of established statutory and legal requirements
which also play a significant role in deciding the dividend policy of

DIVIDEND POLICY 171
n o t e s
the organisation. For instance, Companies Act 1956 has prescribed

certain guidelines for the distribution and payment of dividend.
An organisation is required to provide for depreciation on its fixed
and tangible assets before declaring dividend on shares. Also, the
dividend should not be distributed out of the capital.
External Obligations: When the organisation borrows funds from
the external sources, it needs to pay the interest and/or the princi-
pal amount. On the other hand, if the organisation does not borrow
funds and uses its retained earnings in business, the organisation
does not need to pay interest and principal liabilities.
4. An organisation that has stable earnings will follow a dividend
S
policy that is _________
5. The changes in business cycles, government policies, etc., can
be controlled by an organisation. (true/false)
IM
6. Organisations of small size follow a _____________dividend
policy
Activity
With the help of secondary sources find an example where an or-

M
ganisation has started giving good dividends in the very initial stag-
es of its establishment.
N
7.4 TYPES OF DIVIDEND POLICY

The dividend policy of the organisation is decided based on various
factors and differs from organisation to organisation. There are five
basic types of dividend policies, as shown in Figure 7.1:
Types of
Dividend
Policy
Regular Regular
Stable Long-term Irregular
and Extra Stock
Dividend Dividend Dividend
Dividend Dividend
Policy Policy Policy
Policy Policy
Figure 7.1: Types of Dividend Policy

n o t e s
The five types of dividend policies are explained here as follows:

Stable Dividend Policy: Also called the constant-payout-ratio, un-
der this policy the organisation gives dividend to shareholders on
a regular basis.
Long-Term Dividend Policy: Under this policy, the dividend is
paid to the shareholders on a long term basis. Irrespective of the
fact whether the organisation makes huge profits or losses the
dividend is not paid regularly. The organisation retains these un-
distributed earnings for the future for reinvestment purpose. This
type of payout is favored by the Investors looking for long-term
capital gains. It is not favorable for the investors who look up for a
constant payout of dividends.
Regular and Extra Dividend Policy: Under this dividend policy,
the organisation pays a fixed amount of dividend on a regular ba-
S
sis. In addition to this, an extra amount of dividend is paid to the
shareholders in case the organisation earns abnormal profits. The
advantage of this policy is that it encourages the prospective in-
IM
vestors to invest in the organisation and encourage the existing
shareholders to invest further and thereby helps in raising capital
in the future.
Irregular Dividend Policy: Under this dividend policy the divi-
dend payout ratio keeps on changing and is not constant. The divi-
dend per share depends on the profits earned by the organisation.
M
High profits lead to high DPS and low profits lead to low DPS.
This type of dividend policy is pursued by the organisations which
have instable profits. This is the least preferred dividend policy
from the perspective of the shareholders.
N
Regular Stock Dividend Policy: Under this dividend policy the

organisation gives dividend in the form of stocks instead of cash. It
is a very strong method of maintaining the liquidity position of the
organisation as the cash is not distributed as dividend. The organ-
isation issues bonus shares instead of dividend in cash form. Since
the shareholders prefer getting cash dividend, regular stock divi-
dend policy is not considered a very good strategy as it adversely
affects share prices and credit standing of the organisation.
7. A stable dividend policy is also called __________________.

8. Under a regular and extra dividend policy, an organisation
gives additional dividends only if there are abnormal profits.
(True/False)
9. Regular stock dividend policy adversely affects the ___________
and _________________of an organisation.

DIVIDEND POLICY 173
n o t e s
Activity
List the names of companies that you know about and try to search
the type of dividend policy they follow. You may take the help of the
Internet in this.
7.5 APPROACHES TO DIVIDEND POLICY

There are two approaches that describe the relation between the divi-
dend policy of an organisation and the value of the organisation. First-
ly, there is the irrelevance model supported by a section of economists
who believe that the dividend policy has no impact on the value of
the organisation. This model suggests that whether the organisation
distributes a part of profit as dividend or it retains that part of profits
S
as retained earnings, it has no effect on the value of the organisation.
Secondly, there is the relevance model supported by a section of econ-
omists who believe that the decision regarding dividends, i.e. whether
IM
to distribute the dividend or to retain them has an impact on the value
The two approaches of dividend policy are shown in Figure 7.2:
Approaches
M
of Dividend
Policy
N
Irrelevance Relevance
Approach Approach
Figure 7.2: Approaches of Dividend Policy
Let us now discuss these approaches in detail.
7.5.1 IRRELEVANCE APPROACH (MODIGLIANI

AND MILLER)
According to the irrelevance approach, there is no relation between

the dividend policy and the value of an organisation. This approach
advocates that dividend is residual in nature and paid after paying
debt liabilities, corporate tax and other liabilities out of profit. The
economists who support the irrelevance approach argue that the
decision to pay the dividend depends upon the availability of invest-
ment opportunities. In case there are some investment opportunities
available to the organisation, the profit is not distributed as dividends
and reinvested in business. In the counter case, when there are no

n o t e s
investment opportunities available, then the dividend is distributed.

The decision to invest the earnings or distribute them is based on two
parameters, namely the return on the investment (r) and the cost of
the capital (k).
Two conditions may arise:

1. When r > k. In this case, the profit is reinvested back in the
business.
2. When r < k. In this case, profit is not invested further in the
organisation.
This approach is based on the assumption that the shareholders pre-

fer appreciation in the capital rather than regular dividends. In case
the shareholders are convinced that the organisation would generate
more profit by investing the profits back into the business, then they
S
do not demand dividend. Shareholders have good faith in the organ-
isation and believe that more profits result in the capital apprecia-
tion, thereby increasing the market value of their shares. There may
IM
be cases when the organisation starts incurring losses. In such cases
shareholders prefer to get back their dividends.
Now, let us study a famous theory in support of the irrelevance ap-

proach.
There is a theory given by Modigliani and Miller, also known as the

M
MM model. According to the MM model, the dividend policy has no

impact on the value of an organisation or market price of shares. The
value of an organisation depends upon the investment decisions only.
According to Modigliani and Miller’s hypothesis, “under condition of
perfect capital market, rational investors, absence of tax discrimination
N
between dividend income and capital appreciation, given the firm’s in-
vestment policy, its dividend policy may have no influence on market
price of shares.”
The assumptions of the MM model are as follows:

Perfect market condition
Investors are rational and the securities are infinitely divisible
Absence of transaction and flotation cost
Corporate taxes do not exist.
No floatation costs
Investment policy would not change
Investors’ future earnings can be predicted with perfect certainty.
The MM model is based on the arbitrage process. In the arbitrage

process, the organisation enters into two transactions simultaneously
which completely offset each other. These two transactions are pay-

DIVIDEND POLICY 175
n o t e s
ing dividend and raising external loans. It has been assumed that the
organisation distributes dividend among the shareholders, and raises
the same amount of capital from the market. The arbitrage condition
involved in these transaction states that the payment of the dividend
would be offset by external borrowing of the fund. When the organi-
sation pays dividend, the market value of its shares decreases. There-
fore, the gain of the shareholders in the form of dividend would be
neutralised by decrease in the value of shares due to dividend dis-
tribution. As a result of this, the position of the shareholders would
remain unchanged. Therefore, the decision to distribute dividend is
irrelevant, as it does not affect the value of an organisation.
The irrelevance approach can be represented mathematically as fol-

lows:
Po = (D1 + P1) / (1+Ke)
S
Where,
Po = Current Market Price
IM
Ke = Cost of Equity Capital
D1= Dividend received at the end of period 1
P1= Market price of a share at the end of period 1
This approach has some shortfalls and is criticised because of the fol-
lowing reasons:
M
This theory assumes perfect market conditions, which are practi-

cally impossible. In practice, no perfect markets exist.
This theory assumes that there are no taxes and transaction cost.
In practice no such conditions exist.
N
No differentiation between retained earnings and cost of capital.

This theory also assumes that information regarding all the trans-
actions is freely available which is not possible in practice.
Ignores the risk involved in the future investments.
Let us now look at an example. Let the current market price of a share
of a company be `200 and the cost of equity capital be 15%. The divi-
dend received at the end of period 1 is `7. Let us calculate the market
price of a share at the end of period 1, as follows:
Po = (D1 + P1) / (1+Ke)
200 = (7 + P1) / (1+0.15)
200 X 1.15 = (7 + P1)
P1 = 223

n o t e s
7.5.2 RELEVANCE APPROACH (WALTER AND GORDON)
According to the relevance approach the dividend policy plays an im-

portant role in the determination of the value of an organisation. This
approach assumes that the shareholders have preference for current
consumption rather than future earnings which are quite uncertain
and highly risky. Many economists support the relevance model. Wal-
ter model and Gordon model are two such models that advocate in
favor of relevance approach, given by economists Professor James E.
Walterargues and Myron Gordon respectively.
This model states that the dividend policy and the investment policy
of an organisation are interrelated. It also suggests that the dividend
policy can be determined by finding the relation between return on
organisations investment denoted by r and the cost of capital denoted
by k as explained below:
S
r > k: In a situation when the rate of return on investment is great-
er than the cost of capital, the organisation would retain the earn-
ing for reinvestment rather than distributing them in form of div-
IM
idend.
r < k: In a situation when the rate of return on investment is lesser
than the cost of capital the organisation would not retain its profit
for reinvestment and may distribute it in the form of dividend.
r = k: In such cases the rate of return on investment is equal to
M
the cost of capital. In such a situation, the organisation would not

generate either profit or loss from the project. Therefore, the or-
ganisation would be indifferent whether to retain the earnings or
distribute the dividend.
N
Assumptions of the Walter Model:

This model assumes that only the retained earnings are used to
finance a project or to distribute the dividends.
The value of return on investments and the cost of capital remain
constant.
An organisation exists for a long period.
Earning Per Share (EPS) remains constant in a given period of time.
The formula used to make dividend decision is as follows:

P = D/ (Key –g)
Alternatively, the Walter’s formula can also be written as:

 r 
D+  ( E − D)
 Ke 
Ke

DIVIDEND POLICY 177
n o t e s
Where,
P = Price of Equity Shares
D = Initial Dividend
E = Earnings per share
R = Rate of return on the company’s investments.
Ke = Cost of Capital
g = Expected growth rate of the earnings
Let us look at an example. Assume that we are given the following

information of a company. We need to calculate and show the effect of
the dividend policy on the market price of the shares, given that r is
equal to (i) 8% (ii) 12% and (iii) 15%.
S
Ke = 12%
E = 15
D = 10
IM
i. R = 8%
 0.08 
10 +   (15 − 10)
 0.12 
P=
0.12
10 + ( 0.66 ) (5)
M
P=
0.12
10 + 3.3
P=
0.12
N
P = 110.83
ii. R = 12%
 0.12 
10 +   (15 − 10)
 0.12 
P=
0.12
10 + 5
P=
0.12
P = 125
iii. R = 15%
 0.15 
10 +   (15 − 10)
 0.12 
P=
0.12
10 + (1.25 ) (5)
P=
0.12

n o t e s
10 + 6.25 )
P=
0.12
P = 135.41
The Walter model suffers from some limitations, which are as follows:
This model assumes that only retained earnings are used for the
investment, which is purely a hypothetical situation.
This theory also assumes that the value of return on investment
remains constant which is not possible in practice.
This theory also assumes that the EPS is constant thereby neglect-
ing the risk of fluctuation in the earnings.
Another model given by Gordon also supports the relevance model
S
and suggests that there is relation between the dividend policy and
the value of the organisation. This model is also called as the bird in
hand argument as it assumes that the shareholders prefer to receive
dividends in present or near future because the future dividends are
IM
uncertain and risky. If the organisation wants to or needs to reinvest its
retained earnings, then the organisation must ensure that the share-
holders get the premium for bearing risk of reinvesting their dividend
share in projects.
The assumptions of the Gordon model are as follows:

M
The organisation exists for a long period.

Increase in investment would not affect the value of r and k.
No external fund, such as debt or equity, would be used to finance
various investments.
N
Retention ratio (br) and retained earnings (g) are constant and
that g = br.
The formula used for the determination of the dividend decision is as

follows:
P = D/(Ke – g)
When the organisation invests its retained earnings in new projects

and earns more profit, then it may pay more dividend to its sharehold-
ers. This increase in dividend is calculated with the help of following
formula:
P = [E (1 – b)]/ (ke – br)
Where,
P = Price of the share
E = EPS
B = Retention ratio or the percentage of earnings retained

DIVIDEND POLICY 179
n o t e s
(1-b) = Dividend pay-out ratio or the percentage earnings distrib-

uted as dividends
Ke = Cost of capital
br= g = Growth Rate or the rate of return on investment of an
all-equity company
Let us look at an example. Assume that we are given the following

information of a company. We need to calculate the price of the shares
under each case using the Gordon model:
i. b = 30%, r = 15%, E = 25 and ke = 14%
ii. b = 40%, r = 15%, E = 25 and ke = 15%
iii. b = 50%, r = 15%, E = 25 and ke = 16%
iv. b = 60%, r = 15%, E = 25 and ke = 17%
S
Let us solve each case now, as following
i. b = 30%, r = 15%, E = 25 and ke = 14%
IM
E (1 − b)
P=
Ke − br
25 (1 − 0.3)
P=
0.14 − 0.045
17.5
M
P=
0.095
P = 184.21
ii. b = 40%, r = 15%, E = 25 and ke = 15%
N
25 (1 − 0.4)
P=
0.15 − 0.06
15
P=
0.09
P = 166.66
iii. b = 50%, r = 15%, E = 25 and ke = 16%
25 (1 − 0.5)
P=
0.16 − 0.075
12.5
P=
0.085
P = 147.05
iv. b = 60%, r = 15%, E = 25 and ke = 17%
25 (1 − 0.6)
P=
0.17 − 0.09

n o t e s
10
P=
0.08
P = 125
10. The irrelevance approach argues that the decision to pay

dividend depends upon the _________.
11. Economists Professor James E. Walterargues and Myron
Gordon supported the _______________ model of dividend
policy.
12. Retained earnings are symbolised as _________ under the
Gordon model.
S
Activity
IM
Search the names of the economists that support the relevance and
irrelevance models other than those given in this chapter. Try and
study their assumptions and the model.
7.6 FORMS OF DIVIDEND PAYMENT

M
An organisation has the option to pay dividend to its shareholders in

the form of either cash or in form of bonus shares. The decision to
pay either in cash or stock depends on the dividend policy and the
existing economic conditions. For instance, the organisation prefers to
N
pay in the form of bonus shares when the organisation or the industry
of which organisation is a part or the economy at the national or in-
ternational level is going through recession. At other times when the
economy is in good condition and the organisation is in its boom phase
then it prefers to give cash dividends.
Figure 7.3 shows the different forms of dividend payment:
Dividend
Cash Stock
Dividend Dividend
Figure 7.3: Forms of Dividend Payment

DIVIDEND POLICY 181
n o t e s
Let us define the two types of dividends:

Cash Dividend: It is a type of dividend payment where the profits
are distributed among the shareholders in form of cash or through
cheque. This is the simplest and commonly used method for div-
idend payment. The dividend rate is decided by the top manage-
ment. An organisation is bound to fulfill all legal formalities of
Companies Act, while making any dividend declaration. It should
declare dividend as per Companies (Declaration of Dividend out of
Reserves) Rules, 1975.
Stock Dividend: It is a type of dividend that is paid in the form of
bonus shares. It is also known as bonus issue. When an organisa-
tion wants to use the retain earnings for the purpose of reinvest-
ment instead of paying cash dividend then this type of dividend
is issued. An organisation opting for bonus issue must fulfill the
S
following conditions:
The articles of association must have a clause for it. In case it is
not in the articles, a special resolution has to be passed.
IM
Guidelines issued by Securities and Exchange Board of India
(SEBI) must be strictly adhered to.
13. An organisation prefers to pay bonus shares when it is going

M
through recession. (True/False)

14. Dividend is declared as per _______________________.
N
Activity
Using the Internet, find at least two organisations that have issued
the dividends in the financial year 2013-14 in the form of cash and
bonus shares respectively.
7.7 Summary
Dividend policy refers to a policy under which the decisions re-
lated to the distribution of profit in the form of dividends to the
shareholders are taken
Various factors to be considered before devising a dividend poli-
cy are fund availability, shareholders expectations and status quo
factors.
Formulating a dividend policy is a function of the top management.
Stabilityof earnings, life stage of the organisation, life stage of the

organisation, retained earnings, information on previous dividend

n o t e s
rates, consistency of dividend payout and Shareholder’s tax situa-

tion are the internal factors that affect dividend policy.
Business cycles, government policies, statutory and legal require-
ments and external obligations are the external factors that affect
dividend policy.
Shareholders usually prefer a Stable Dividend Policy.
Two approaches that describe the relation between the dividend
policy of the organisation and the value of the organisation are the
irrelevance model and the relevance model.
The economists who support the irrelevance approach argue that
the decision to pay the dividend depends upon the availability of
investment opportunities.
An organisation has the option to pay divided to its shareholders
S
in the form of either cash or in form of bonus shares.
The decision to invest the earnings or to distribute them is based
on two parameters namely the return on the investment (r) and
IM
the cost of the capital (k).
When r > k, in this case the profit is reinvested back in the busi-
ness.
When r < k, then the profit is not invested further in the organi-
sation.
M
key words
Bonus Issues: These are the bonus shares that are issued when
an organisation decides to pay dividend in the form of stock.
N
Business Cycles: These are the changes in the economic activi-

ties of an organisation over a period of time.
Dividend: This is the part of an organisation’s profit, which is
distributed by board of directors to the shareholders of an or-
ganisation.
Dividend Payout Ratio: This is the ratio used to find out what
fraction of profits is paid out as dividend.
Retained Earnings: This is the part of an organisation’s profit,
which is ploughed back in the organisation for further invest-
ments.
Retention Ratio: It is the part of an organisation’s profit, which
is reserved by the organisation as retained earnings.

DIVIDEND POLICY 183
n o t e s

1. What do you mean by the term dividend? What is a dividend policy?
2. Discuss any two factors that determine the divided policy.
3. Explain the five types of dividend policy.
4. State the assumptions of Modigliani and Miller and explain the
model.
5. State the assumptions of Walter and explain the model.
6. State the assumptions of Gordon and explain the model.
7. You are given the following information of a company. You need
to calculate the price of equity shares according to the Walter
model. Given that r is equal to 15%, Ke = 12%, E = 20, and D = 15.
S
8. Calculate the market price of a share at the end of period 1 if the
current market price of a share of the company is `150 and the
cost of equity capital is 12%. The dividend received at the end of
IM
period 1 is `10.

M
Topic Q.No. Answers

Dividend Policy 1. Top management
2. True
N
3. High
Factors Determining 4. Consistent
Dividend Policy
5. False
6. Conservative
Types of Dividend Policy 7. Constant-payout-ratio
8. True
9. Share prices, Credit standing
Approaches to Dividend 10. Availability of investment oppor-
Policy tunities
11. Relevance
12. g
Forms of Dividend 13. True
Payment
14. Companies (Declaration of Divi-
dend out of Reserves) Rules, 1975

n o t e s

1. The returns that are paid to the equity holders is in form of
dividends. Refer to Section 7.2 Dividend Policy.
2. Factors to be considered before devising a dividend policy. Refer
to Section 7.3 Factors Determining Dividend Policy.
3. Five types of dividend policies viz. stable, long term, regular and
extra, irregular dividend and regular stock dividend policies.
Refer to Section 7.4 Types of Dividend Policy.
4. Assumptions and explanation of Modigliani and Miller model.
Refer to Section 7.5 Approaches to Dividend Policy.
5. Assumptions and explanation of Walter model. Refer to Section
7.5 Approaches to Dividend Policy.
S
6. Assumptions and explanation of Gordon model. Refer to Section
7.5 Approaches to Dividend Policy.
7. Price of Equity Shares according to the Walter model is as
IMfollows:
 r 
D+  ( E − D)
 Ke 
P=
Ke
r = 15%
M
 0.15 
15 +   (20 − 15)
 0.12 
P=
0.12
N
15 + (1.25 ) (5)
P=
0.12
21.25
P=
0.12
P = `177.08
8. Market price of a share at the end of period 1is as follows:
Po = (D1 + P1) / (1+Ke)
150 = (10 + P1) / (1+0.12)
200 X 1.12 = (10 + P1)
P1 = `214

DIVIDEND POLICY 185
n o t e s
Suggested Readings
John Wiley & Sons.
Ross, s. (2014). Fundamentals of corporate finance standard edition.
Retrieved 14 November 2014, from http://Fundamentals of Corpo-
rate Finance Standard Edition
E-refernces
Reporter, B. (2014). Nalco declares `386 cry dividend for 2013-14.
Business-standard.com. Retrieved 14 November 2014, from http://
www.business-standard.com/article/companies/nalco-declares-rs-
S
386-cr-dividend-for-2013-14-114111301784_1.html
(2014).
Retrieved 14 November 2014, from http://www.icaiknowl-
edgegateway.org/littledms/folder1/chapter-4-dividend-decisions.
IM
pdf
Dividends, T. (2014). Types of Dividends - For Dummies. Dummies.
com. Retrieved 14 November 2014, from http://www.dummies.com/
how-to/content/types-of-dividends.html
M
N

N
M
IM
S
8
Working Capital Management
CONTENTS
S
8.1 Introduction
8.2 Concept of Working Capital Management
8.2.1
IM
Need of Adequate Working Capital
8.2.2 Working Capital and Cash Management
Activity
8.3 Principles of Working Capital Management
M
Activity
8.4 Factors Affecting Working Capital Management
Activity
8.5 Methods for Assessing Working Capital
N
8.5.1 Operating Cycle Method

8.5.2 Maximum Permissible Bank Finance (MPBF) Method
8.5.3 Other Methods
Activity
8.6 Financing of Working Capital Requirement
Activity
8.7 Asset Securitisation (Way for Raising the Working Capital)
Activity
8.8 Working Capital Factoring
Activity
8.9 Summary

n o t e s
Dabur India - working capital management
In the late 1990s, the management of Dabur India was handed

over to a team of professional managers. The new management
was faced with a huge challenge of improving the performance
in several areas of the organisation. This involved in particular,
the working capital and cost management functions. The man-
agement argued that the prevailing current ratio of 3.2 and quick
ratio of 2.4 were too high and indicated unnecessary investments
in working capital creating a negative impact on Dabur India’s
profitability. The team brought about significant changes in the
approach and strategy of managing the working capital in the
company. The management concluded that most of the compa-
ny’s investment was blocked in inventories and debtors, pulling
S
down the overall returns. The company focused on reducing the
working capital needed for the operations. It set a target of achiev-
ing zero net working capital by year 2000-01, and aimed at further
reducing it to negative levels in the long-term. A number of initia-
IM
tives were taken to reduce the cost of different components of the
working capital. These involved inventory management, debtors
management, cash management, supplier management, etc. The
whole process was met with stiff resistance from various quarters,
before finally yielding results.
M
N

Working Capital Management 189
n o t e s
learning objectives

> Describe the concept of working capital management
> Discuss the principles of working capital management
> Explain the factors affecting working capital management
> Elaborate on financing of working capital requirement
> Explain asset securitisation
> Discuss working capital factoring
8.1 INTRODUCTION
S
The previous chapter discussed the dividend policy, which aims to de-
termine the amount of profit that would be distributed among share-
holders. This chapter focuses on working capital management, which
essential for an organisation to maintain liquidity.
IM
Working capital is needed to allocate a part of an organisation’s funds
as liquid assets for meeting its regular expenses, such as purchasing
raw materials and paying wages to laborers. It is needed to perform
the day-to-day operations and activities of the organisation. The pro-
cess of managing the working capital plays a crucial role in the overall
M
financial management of the organisation.
Working capital management includes managing stock, cash balanc-

es, short-term debtors and creditors, and bills receivables and pay-
ables. It helps the organisation in identifying the scarcity and surplus
N
of short-term funds in advance so that it can plan its operations ac-

cordingly.
In this chapter, you will learn the concept of working capital man-
agement and the principles of working capital management in detail.
The chapter also provides information about factors affecting working
capital management. In addition, it elaborates on financing of work-
ing capital requirement and asset securitisation. Toward the end, you
will learn about working capital factoring.
Concept of Working Capital

8.2
Management
Working capital management implies the process of controlling the
flow of working capital in an organisation. There are two types of
working capital, namely gross working capital and net working capi-
tal. Gross working capital refers to the current assets of an organisa-
tion. Current assets are those assets that can be converted into cash
within one year or less. These include bills receivables, stocks, sun-

n o t e s
dry debtors, and cash in hand and at bank. The difference between
current assets and current liabilities is called the net working capital.
Current liabilities are those liabilities that are to be paid within one
year or less. These include sundry creditors, bills payables, bank over-
drafts, salaries, and outstanding expenses. Different organisations
need different types of working capital at different points of time. The
timely payment of current liabilities out of current assets increases
the goodwill of an organisation.
The different types of working capital are shown in Figure 8.1:
Types of Working Capital
S
Temporary Permanent Seasonal Special
Working Capital Working Capital Working Capital Working Capital
IM
Figure 8.1: Types of Working Capital
Let us discuss the types of working capital in brief:

Temporary Working Capital: The working capital that is required
to produce extra units of products in case of excess demand is
called temporary working capital. This is also known as fluctuat-
M
ing working capital. When the demand of the product increases,

extra working capital is raised from short-term sources.
Permanent Working Capital: The working capital that is needed
for the smooth running of the business is called permanent work-
N
ing capital. This capital is required on a daily basis for production

and payment of current liabilities. If an organisation fails to main-
tain permanent capital, it will cease to exist in the long run.
Seasonal Working Capital: This is the capital required by organi-
sations in seasonal industries that operate in a specific season and
shut down or slow down their activities by the end of the season.
Examples of seasonal industries are the umbrella and raincoat in-
dustries.
Special Working Capital: This is the capital requirement of differ-
ent sectors, such as primary, secondary, and tertiary, of an econ-
omy. The working capital requirement of the primary sector is
seasonal in nature. The secondary sector requires a huge working
capital for maintaining stock and paying salaries. The tertiary sec-
tor requires less working capital as compared to secondary sector
as it renders services to conduct its business on the basis of cash.

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8.2.1 Need of adequate working capital
The main aim of maintaining working capital is to ensure business

liquidity but not up to that level which reduces the profitability. There
is a need of adequate working capital because of the following reasons:
Working capital is needed for long-term success and run of a busi-
ness.
Investment in current assets represents a substantial portion of
total investment.
Working capital helps an organisation to meet its current liabilities
Working capital helps in taking advantage of financial opportuni-

ties.
Working capital ensures the smooth operating cycle of the busi-
S
ness.
Working capital speeds up the flow of funds for meeting the capi-
tal needs of existing operations and thus, avoids the stagnation of
funds.
IM
Working capital strikes a balance between twin objectives namely
liquidity and profitability.
8.2.2 Working capital and cash management
Cash management is an integral part of the working capital manage-

M
ment. We cannot take working capital management and cash manage-

ment in isolation. Working capital ensures that an organisation has
an enough cash flow for meeting the debt obligation and operating
expenses. Cash is the king of any business and the most liquid asset.
N
However, the funds in the form of cash do not earn any interest. An
effective management is to keep the hard cash at the level at which
adequate liquidity is maintained at the lowest possible cost. The func-
tions of cash management are as follows:
Establishes a reliable forecasting and reporting system
Streamlines the system of cash collection
Achieves optimum savings
Cash budget is the tool that is used for effective cash management.
This tool helps in holding adequate cash balances by avoiding exces-
sive balances. Cash budget shows the estimated cash inflows and cash
outflows over the planning horizon. It highlights the net cash position
of an organisation.
Working capital is managed with the help of cash budget in the follow-
ing ways:
Coordinate the Timings of Cash Needs: With the cash budget, it is
easy to identify the period when there may be shortage of cash or
excessive cash requirement.

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Plan the Discounts: With the knowledge of excess cash, an organi-

sation can plan for dividend discounts (assessing the present value
of a stock based on the growth rate of dividends), payment of debts
and finance capital expansion.
Prevents Accumulation of Funds: Excess cash can result in un-
der-employed organisations due to improper use of cash inflows
generated from business activities. Cash budget provides advance
knowledge of the cash that has not been employed in operating ac-
tivities. This helps the management to invest surplus cash in long-
term investments.
1. Working capital that is required to produce extra units of

products in case of excess demand is called ___________________
S
2. Which of following is a current liability?
a. Sundry creditors b. Debentures
c. Cash d. Term-loans
IM
3. The working capital requirement of the primary sector is
seasonal in nature. (True/False)
4. The type of working capital required by the food processing
industry is________________.
M
Activity
Visit any organisation and learn the importance of working capital

in it.
N
Principles of Working Capital

8.3
Management
There are four principles of working capital management that deter-
mine the relationship between profitability and risk, cost of capital
and risk, cash inflow and cash outflow, and the contribution of current
assets and net worth of an organisation.
The principles of working capital management are shown in
Figure 8.2:
Principles of Working Capital

Management
Principle of Principle of Principle of Principle of

Risk Variation Cost of Capital Equity Position Maturity Payment
Figure 8.2: Principles of Working Capital Management

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Let us discuss these principles of working capital management in

brief:
Principle of Risk Variation: This principle helps in determining
the relationship between risk and profitability associated with
working capital management. (Risk here refers to the ability of
an organisation to write-off its current liabilities.) The risk for the
organisation may increase and profitability may decrease if the
working capital increases by raising short-term loans. The organ-
isation can increase its profitability by paying short-term loans. In
such a case, its working capital and risk would decrease. There-
fore, it can be stated that there is an inverse relationship between
the risk and profitability of an organisation.
Principle of Cost of Capital: According to this principle, there is
an inverse relationship between the cost of capital and degree of
S
risk. For example, if the debt capital increases, the cost of capital
goes down, but the risk of paying return at the time of loss increas-
es. This happens because the organisation does not pay dividends
on equity at the time of loss.
IM
Principle of Equity Position: According to this principle, the
amount of working capital employed in a current asset should pos-
itively influence the returns on equity and value of the organisa-
tion. The investment in current assets would increase the working
capital of the organisation. The optimum amount, which should
be invested in current assets to raise the equity position of the or-
M
ganisation, is calculated with the help of the following two ratios:

Level of Current Assets = Current assets/Percentage of total
assets
N
Level of Current Assets = Current assets/Percentage of total

sales
Principle of Maturity Payment: This principle states that an organ-

isation should frame its policies in such a way that its cash inflow
would be sufficient to meet cash outflow. This facilitates the timely
payment of short-term debts, which in turn enhances the goodwill and
creditworthiness of an organisation.
5. There is a positive relationship between risk and profitability

in an organisation. (True/False)
6. There is an inverse relationship between cost of capital and
degree of risk. (True/False)
7. ___________ helps in determining the relationship between
risk and profitability associated with working capital
management.

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Activity
Analyse how there is an inverse relationship between risk and prof-

itability in an organisation.
Factors affecting Working

8.4
Capital Management
The requirement of working capital varies from organisation to organ-
isation. The need of capital requirement depends on various factors
that influence different organisations in different ways. Let us discuss
the factors affecting working capital management:
Characteristics of Business: If the organisation is in a public util-
S
ity business then it requires more working capital as most of the
transactions are carried on a cash basis. However, a manufactur-
ing organisation would require less working capital as majority of
transactions would require credit.
IM
Labour Requirement: It is the amount of labour required in the
mode of production adopted by an organisation. There are two
modes of production, such as labour intensive and capital inten-
sive. If an organisation adopts labour intensive mode of production
then it requires more working capital for wage payment. Howev-
er, if an organisation adopts capital intensive mode of production
M
then it requires less working capital.

Cost of Raw Material: If an organisation requires expensive raw
materials, then more working capital is needed to carry out pro-
duction. On the other hand, if an organisation needs low-priced
N
raw materials, then it requires less working capital. For example,

iron and steel industries need more working capital as they re-
quire expensive raw materials as compared to the plastic industry,
which requires low-priced raw materials.
Credit Policy: The agreement between an organisation and its
suppliers for the purchase of raw materials. An organisation would
require less working capital if the suppliers agree to provide raw
materials on a credit basis. However, if the suppliers provide raw
materials on a cash basis, then the organisation would require
more working capital.
Seasonal Variation: Some products may have high demand in
a particular season and moderate demand in other seasons. The
working capital requirement of the organisation producing sea-
sonal products is more in the peak season and less in other sea-
sons. For example, an organisation manufacturing refrigerator
needs more working capital during summer season and less work-
ing capital in other seasons.

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Sales Turnover: One of the most important factors affecting the

requirement of working capital is an organisation’s sales turnover.
A firm maintains current assets because they are needed to sup-
port operational activation, which result in sales. The volume of
sale and the size of the working capital are directly related to each
other. As the volume of sales increases, the working capital invest-
ment increases and vice versa.
Dividend Policy: A shortage of working capital often acts as pow-
erful reason for reducing a cash dividend.
Profitability of the Organisation: Adequate profit contributes to
the generation of cash. High profitability allows organisations to
plough back a part of the earnings into the business and build up
on financial resources to internally fund the working capital needs.
S
8. The working capital requirement of an organisation producing

seasonal products is more in the peak season and less in other
IM
seasons. (True/False)
9. ___________is the amount of labour required in the mode of
production adopted by an organisation.
10. The working capital requirement of an organisation producing
seasonal products is ________in the peak season.
M
Activity
Visit an organisation and list the factors that affect its working cap-
N
ital.
Methods for assessing working

8.5
capital
Assessing the working capital requirement is one of the major part
of short-term planning in an organisation. It needs to be done very
effectively for avoiding over- or under-estimation. The methods used
to determine working capital are discussed in the following sections.
8.5.1 Operating Cycle Method
The operating cycle is the time duration starting from the procure-
ment of raw materials and ending with sales realisation. The length
and nature of the operating cycle may differ according to the size and
nature of an organisation. For instance, in a trading concern, there is
a series of activities that starts with the procurement of finished goods

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and ends with the realisation of sales revenue. Similarly, in case of the
manufacturing industry, the series starts with the procurement of raw
materials and ends with the sales realisation of finished goods. If we
see, in both the cases, there is a time gap between the occurrence of
the first and last activity. This time gap is known as operating cycle.
Thus, we can define the operating cycle as time needed to convert
raw material into finished goods, finished goods into sale and account
receivable into cash.
At different stages of operating cycle, the need of working capital var-

ies. Thus, operating activities create the necessity of working capital,
which is neither synchronised nor certain. For example, a manufac-
turing organisation is in its initial stage of operating cycle in which it
procures raw material. In such a situation, the organisation requires
more working capital for making payment to suppliers. However, if the
S
organisation is in the last stage of operating cycle in which it sells its
finished goods on cash then it requires less working capital. It should
be noted that if the organisation sells its goods on credit then it would
require more working capital. Also, the longer the cycle, the greater is
IM
the need for the operating cycle.
Calculation of operating cycle involves the following:

a. Procurement of Raw Material
b. Conversion/Process Time
M
c. Average Time for Holding Finished Goods

d. Average Collection Period
e. Operating Cycle (a+b+c+d)
N
Operating cycles per year = 365/e
For example
a. Procurement of Raw Material = 30 days
b. Conversion/Process time = 15 days
c. Average Time for Holding Finished Goods = 15 days
d. Average Collection Period = 30 days
e. Operating Cycle (a+b+c+d) = (30+15+15+30) = 90 days
Operating cycles per year = 365/90 = 4
Working Capital Requirement =
Operating expenses per annum

Number of operating cycles per annum
For example, if the total operating expenses in the current year are
`60 lakhs, then the working capital would be calculated as follows:

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60,00,000/ 4 = `15,00,000
note
Net operating cycle is the length of time it takes for an organisa-

tion’s investment in inventory to generate cash, considering that
some or the entire inventory is purchased using credit. It is also
called the cash conversion cycle.
Number of days Number of days Number of days
S
Net operating cycle = + −
of inventory of receivables of payables
Where:
IM
Accounts payable 365
Number of=
days of payables =
Average day's Accounts payables turnover
purchases
8.5.2 Maximum Permissible Bank Finance (MPBF)

M
method
The MPBF method was suggested by the Tandon Committee and re-
lates to the banking sector. This method indicates the maximum level
for holding the inventory and receivables in each industry. As per the
N
Tandon Committee, organisations are discouraged from accumula-

tion of stocks of current assets and required to move towards the lean
inventories and receivable levels. There are three methods for deter-
mining MPBF:
First Method: Finance a maximum of 75% of the working capital
gap.
The formulas is:
MPBF =.75 X (TCA-OCL)
Where,
TCA = Total Current Asset
OCL = Other Current Liabilities
note
Other current liabilities reported in the balance sheet include sales

tax, income tax, payroll, and customer advances (deferred revenue).

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Second Method: Borrower is required to provide a minimum of

25% of the total current asset out of the long term funds. Liabil-
ities will be available to finance a part of the remaining amount
the of current assets with banks financing the remaining portion.
Therefore:
MPBF = (.75 X TCA)-OCL
Where,
Third Method:
MPBF = 0.75 (TCA - CCA) – OCL
Where,
S
CCA = Core Current Assets or permanent current assets
IM
Let us now take up an example to understand the three methods. We
are given the following data.
Current Assets (`Lakhs) Amount Amount

Raw Material 20
Work in Progress 5
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Finished Goods 10
Receivables 10
Other Current Assets 7
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(CCA = 27) 52
Current Liabilities (`Lakhs)
Creditors 10
Other Current Liabilities 6
Bank Borrowings 11
27
Now, we calculate the MPBF according to the three methods as follows:

Method 1: MPBF = .75 × (TCA-OCL) = 0.75 × (52 – 16) = `27 lakhs
Method 2: MPBF = (.75 × TCA)-OCL = 0.75 × 50 – 16 = `23 lakhs

Method 3: MPBF = 0.75 (TCA - CCA) – OCL = 0.75 (52 - 27) – 16
= `2.75 lakhs
8.5.3 Other methods
Other methods include:

Drawing Power Method: Drawing power implies the amount of
funds that a borrower is allowed to draw from the working capital

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limit allocated to him/her. Thus, working capital is analysed with

the help of percentage allocated by the banks.
Let us now look up at an example. Assume that we are given the
following statistics about a company:
Particulars Stock Value Margin DP
Paid Stock 10 25% 7.5
Semi-Finished Goods 12 50% 6
Finished Goods 8 25% 6
Book Debts 8 50% 4
Total 23.5
Turnover Method: The Nayak Committee suggested the Project-

ed Annual Turnover (PAT) method. In this method, the working
S
capital requirements are estimated at 25%. The banks can finance
up to 20% of the projected turnover. Balance 5% is the net work-
ing, capital, which is brought in by the borrower as his/her margin.
For example:
IM
S. No. Particulars Amount (in
crores)
A Projected Annual Turnover 160
B WC Required (25% of A) 40
C Minimum Margin from Borrower (20% of B) 8
M
D Minimum Bank Borrowing (80% of B) 32

E Actual NWC Available 7
F Stipulated Margin (Maximum of C or E) 8
G Permissible Limit (B – F) 32
N
Therefore, the ratio of bank borrowing : net working capital = 32

:8=4:1
Cash Budget Method: In this method, the borrower submits the
cash budget for a future period and then the working capital is
calculated. The profitability statement and balance sheet for the
future period is taken into account for preparing the cash budget:
CASH BUDGET (amount in ` lakhs)

Particulars Apr. May June July Aug Sep Oct Nov Dec Jan Feb Mar
Sales 500 700 350 350 120 200 310 350 350 250 250 440
Cash Flow from

Operations
Receipts
1. Cash Sales 50 70 35 35 12 20 31 35 35 25 25 44
2. Collection from 350 530 365 445 208 120 159 255 310 350 245 256
Debtors

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3. Total Receipts 400 600 400 480 220 140 190 290 345 375 270 300
Payments
1. Payment to 300 450 300 200 160 80 120 180 260 280 190 200
Trade Creditors
2. Wages 100 150 100 125 40 20 30 45 60 70 45 50
3. Office Expenses 50 70 45 60 15 5 15 20 30 35 20 25
4. Taxes 30 30 30 30
5. Total Payments 450 670 475 385 215 135 165 245 380 385 255 275
Cash from Operat- -50 -70 -75 95 5 5 25 45 -35 -10 -15 25

ing Activities (A-B)
Cash at Start of 30 -20 -90 -165 -70 -65 -60 -35 10 -25 -35 -50
Month
S
Cumulative Cash -20 -90 -165 -70 -65 -60 -35 10 -25 -35 -50 -25
(C+D)
Target Cash Balance 5 5 5 5 5 5 5 5 5 5 5 5
Cumulative Surplus -25 -95 -170 -75 -70 -65 -40 5 -30 -40 -55 -30
IM
or Loan Required
(E-F)
Here, the maximum cash deficit is 170 lakhs. The borrower or the com-
pany can borrow according to the cash budget. For example, here he/she
may be permitted to draw 25 lakhs, 95 lakhs for the months of April and
May, and he/she will not be permitted to draw any amount in November.
M
Exhibit
Tandon Committee
N
The Tandon Committee was set up in 1974 to come up with guide-

lines for follow-up of bank credit. This was headed by P.L. Tandon.
The committee submitted its report in 1975 and it had the following
terms of reference:
1. Recommend directions for commercial banks to follow up and
supervise credit to ensure proper end-use of funds and keep a
watch on the safety of the advances and to suggest the type of
operational data and other information that could be obtained
by banks periodically from such borrowers and by the RBI
from the lending banks.
2. Make recommendations to get periodical forecasts from
borrowers of (a) business/production plans and (b) credit
needs.
3. Make suggestions to prescribe inventory norms for different
industries both in the private and public sectors and to indicate
the broad criteria for deviating from these norms.
4. Make suggestions regarding criteria for satisfactory capital
structure and sound financial basis with relation to borrowing.

n o t e s
5. Recommend guidelines about the sources of financing the

minimum working capital requirements.
6. Make recommendations to the existing pattern of financing
the working capital requirements by cash credit/overdraft
system etc., in case they need to be modified and suggest the
modifications.
7. Make recommendations on any other matter related to the
subject of enquiry or any other allied matter which may be
specifically referred to the committee by the RBI.
11. _____________is the time duration starting from the procurement
S
of raw materials and ending with the sales realisation.
12. At different stages of the operating cycle, the need of working
capital remains the same. (True/False)
IM
Number of days
13. Operating cycle = + ____________________
of inventory
14. ____________is the average time it takes to pay its suppliers
15. MPFB stands for ______________
M
16. _______________implies the amount of funds that a borrower

is allowed to draw from the working capital limit allocated to
him/her.
N
Activity
Find out the difference between the MPBF method and the operat-
ing cycle method.
Financing of Working Capital

8.6
Requirement
The decision to finance the working capital of an organisation is taken
by the management after considering all the sources and applications
of funds. The sources to finance working capital are as follows:
Bank Credit: This refers to a short-term source of financing work-
ing capital. The bank credit can take the forms of cash credit,
bank overdrafts, and discounting of bill. In addition, bank credit
is used to raise low amount of working capital for meeting daily
needs. Generally, small organisations use bank credit to finance
their working capital as their requirements are low. Bank credit is
a type of secured loans (organisation has to mortgage their assets

n o t e s
against these loans) and interest has to be paid on them till the
time of maturity.
Loans from Financial Institutions: This refers to a long-term
source of financing the working capital. Generally, large organi-
sations need large amounts of loans for long term. Such loans are
provided by major financial institutions, such as ICICI and IDBI.
Large organisations undertake huge projects for which bank cred-
its are not sufficient; therefore, they prefer these loans to finance
their projects. These loans are not preferred by small organisa-
tions as their turnover is insufficient to pay back these loans.
Public Deposits: Apart from the issue of shares and debentures,
organisations may accept deposits from the public to finance its
medium and short-term capital needs. This source is very popular
among the public as organisations often offer interests at rates,
S
which are higher than those offered by banks. Under this method,
organisations can obtain funds directly from the public eliminating
the financial intermediaries. The maturity period of a public de-
posit is more than one year and less than three years. This source
IM
is useful for an organisation in meeting working capital needs of
medium-term projects.
Prepaid Income: This refers to the income that is received in the
form of advance payments from distributors. Prepaid income is
the most economical source to finance the working capital as the
organisation does not need to pay interest to distributors on pre-
M
paid income.
Retained Earnings: These are reserve funds that are maintained
by an organisation. Retained earnings are the most reliable source
of financing working capital as they can be raised at the time of
N
need without any delay. The organisation has no obligation to

mortgage its assets for using these funds.

17. ______________ are reserve funds maintained by an
organisation.
18. What are the different forms of bank credit?
Activity
Apart from the sources mentioned in the chapter, what can be the
other sources of working capital?

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Asset Securitisation (Way for

8.7
raising the working capital)
The unstable environment in financial markets emphasises on the im-
portance of asset securitisation to the organisations. Securitisation is
the most important financial innovation to occur in the last few years.
As per Pennacchi (1988), “securitisation was going to be a fundamen-
tal change in the commercial banking business.”
Asset securitisation is the process of combining several individual as-

sets and pooling them together so that investors may buy interests in
the pool rather than in the individual assets. For example, mortgage
backed securities are asset-backed securities secured by a collection
of mortgages. Owing to the high degree of predictability inherent in
large groups, asset securitisation increases predictability of invest-
S
ments, lowers risks, and increases asset value.
Securitisation of assets helps in funding and liquidity for wide range

of consumer and business credit needs. This involves securitisation
IM
of residential and commercial mortgages, automobile loans, student’s
loans, credit card financing and business trade receivables.
Asset securitisation enhances liquidity in the market and acts as an

important tool for raising funds. The salient features are as follows:
Asset backed security is issued through a special purpose entity.
M
Issuingan asset backed security is asset sale rather than debt fi-
nancing.
The credit of asset backed security is derived from credit of under-
lying assets.
N
The benefits of securitisation for the organisations are as follows:

Provides liquidity to organisation by covering illiquid assets into
cash
Provides better asset liability management
Helps in recycling the assets easily
Improves transparency of the assets
19. _______________is the process of creating securities by pooling

together various cash flow producing financial assets, which
are sold further to investors.
20. Asset securitisation blocks the liquidity in the market. (True/
False)

n o t e s
Activity
From the Internet, search and write a note on the increasing use of
asset securitisation.
8.8 Working Capital Factoring

Factoring can be defined as a way to convert the accounts receivables
(illiquid receivables) into money which can be further invested in the
working capital. This is done by using factors such as banks, financial
institutions that are ready to purchase these assets. As this helps in
getting direct cash, this is also called working capital factoring. This
helps in growing the business by ensuring the capital needed as steady
flow of cash is ensured.
S
The process of working capital factoring involves a factor ( bank, leas-
ing company) and a client (with receivables). Working capital factor-
ing gives an unlimited access to capital as the amount to be borrowed
IM
with this method increases with increase in sales. Thus it provides
financial freedom to the business. The factoring involves the following
parties:
The Client: An organisation with receivables
A Factor: A financial service organisation/ bank
M
Debtor: One who is creating the receivables
The benefits of factoring are as follows:

Increases liquidity by raising cash
N
Provides access to capital at lower rate of cost

Enhances the working capital of the organisation
Transfer the credit risk of receivables to the factor from the firm
Reduces the firm’s burden in setting up collection centers
21. Who is considered as a factor in working capital factoring?
Activity
Visit a bank and learn about the process of working capital factor-
ing.

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8.9 SUMMARY
Working capital management implies the process of controlling the
flow of working capital in the organisation. There are two types of
working capital namely gross working capital or net working cap-
ital.
An effective management is to keep the hard cash at the level at
which adequate liquidity is maintained at the lowest possible cost.
The operating cycle is time duration starting from the procure-
ment of raw materials and ending with the sales realisation.
MPBF method indicates the maximum level for holding the inven-
tory and receivables in each industry.
The principles are principle of risk variation, principle of cost of
S
capital, principle of equity position, and principle of maturity pay-
ment.
Asset securitisation is the process of creating securities by pooling
IM
together various cash flow producing financial assets, which are
sold further to investors
Factoring can be defined as way to convert the accounts receiv-
ables (illiquid receivables) into money which can be further in-
vested in the working capital. This is done by using factors such
as banks, financial institutions that are ready to purchase these
M
assets.
key words
Current Assets: These are the assets that can be converted into
N
cash within a short period of time.

Current Liabilities: These are the liabilities that need to be
paid within one year.
Goodwill: It refers to an intangible asset, which an organisation
obtains by performing well, making profit and distributing div-
idend on a regular basis.
Working Capital: It refers to the part of capital that is required
to finance the day-to-day activities of an organisation.

1. Explain the concept of working capital management.
2. Discuss the need of working capital management.
3. Explain the principles of working capital management.
4. Discuss the factors affecting working capital management.
5. Explain the method for assessing working capital management.

n o t e s
6. Discuss working capital and cash management.

7. Write a note on working capital factoring
8. Write a short note on asset securitisation.
9. What are the types of working capital?
10. You are given the following information of a company. Calculate
the working capital requirement according to the operating cycle
method.
S
e. Total operating expenses in the current year are `3 crores
11. Calculate the bank borrowing : net working capital ratio if you
are given the following information:
IM
Projected Annual Turnover = 200 and
Actual NWC available = 10

M
Topic Q.No. Answers

Concept of Working Capi- 1. Temporary working capital
N
tal Management
2. Sundry creditors
3. True
4. Seasonal working capital
Principles of Working Cap- 5. False
ital Management
6. True
7. Principle of Risk Variation
Factors Affecting Working 8. True
Capital Management
9. Labor Requirement
10. More
Methods for Assessing 11. Operating cycle
Working Capital
12. False
13. Number of days of receivables

n o t e s
Topic Q.No. Answers

14. Number of days of payables
15. Maximum Permissible Bank Fi-
nance
16. Drawing power
Financing of Working Cap- 17. Retained Earnings
ital Requirement
18. The bank credit can take the forms
of cash credit, bank overdrafts,
and discounting of bill.
Asset Securitisation (Way 19. Asset securitisation
for Raising the Working
Capital)
S
20. False
Working Capital Factoring 21. Financial service organisation/
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bank

1. Working capital management implies the process of controlling
the flow of working capital in the organisation. Refer to Section
8.2 Concept of Working Capital Management.
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2. The main aim of maintaining working capital is to ensure the

business liquidity but not up to that level which reduces the
profitability. Refer to Section 8.2 Concept of Working Capital
Management.
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3. The principles are Principle of Risk Variation, Principle of Cost

of Capital, Principle of Equity Position, and Principle of Maturity
Payment. Refer to Section 8.3 Principles of Working Capital
Management.
4. The need of capital requirement depends on various factors that
influence different organisations in different ways such as nature
of business, labour requirement and cost of raw material. Refer
to Section 8.4 Factors Affecting Working Capital Management.
5. Methods for assessing working capital are operating cycle
method, MPBF method and drawing power method. Refer to
Section 8.5 Methods for Assessing Working Capital.
6. Cash management is the integral part of the working capital
management. Refer to Section 8.2 Concept of Working Capital
Management.
7. Working capital factoring gives an unlimited access to capital
as the amount to be borrowed with this method increases with
increase in sales. Refer to Section 8.8 Working Capital Factoring.

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8. Asset securitisation is the process of creating securities by

pooling together various cash flow producing financial assets,
which are sold further to investors. Refer to Section 8.7 Asset
Securitisation (Way for Raising the Working Capital)
9. Temporary Working Capital, Permanent Working Capital,
Seasonal Working Capital, Special Working Capital are the types
of working capital. Refer to Section 8.2 Concept of Working
Capital Management.
10. Working Capital Requirement according to the operating cycle
method is calculated as follows:
S
e. Operating Cycle (a+b+c+d) = (20+10+10+20) = 60 days
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f. Operating cycles per year = 365/60 = 6

Working Capital Requirement = `50,00,000
M
Refer to Section 8.2 Concept of Working Capital Management.

11. Bank borrowing : net working capital ratio is calculated as
follows:
N
S. No. Particulars Amount (in

crores)
A Projected Annual Turnover 200
B WC Required (25% of A) 50
C Minimum Margin from Borrower (20% of B) 10
D Minimum Bank Borrowing (80% of B) 40
E Actual NWC Available 10
F Stipulated Margin (Maximum of C or E) 10
G Permissible Limit (B – F) 40
Bank Borrowing : net working capital = 40 :
10 = 4 : 1
Refer to Section 8.2 Concept of Working Capital Management.

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Suggested Readings
John Wiley & Sons.
Ross, s. (2014). Fundamentals of Corporate Finance Standard Edi-
tion. Retrieved 14 November 2014, from http://Fundamentals of
Corporate Finance Standard Edition
E-references
Investinginbonds.com,.(2014). Securitization: An Overview. Re-
trieved 14 November 2014, from http://www.investinginbonds.
com/learnmore.asp?catid=11&subcatid=56&id=130
S
The Economic Times,. (2014). Capital Market Definition | Capital
Market Meaning - The Economic Times. Retrieved 14 November
2014, from http://economictimes.indiatimes.com/definition/capi-
IM
tal-market
The Economic Times,. (2014). Securitization Definition | Securi-
tization Meaning - The Economic Times. Retrieved 14 November
2014, from http://economictimes.indiatimes.com/definition/securi-
tization
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N

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9
RECEIVABLES AND INVENTORY MANAGEMENT
CONTENTS
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9.1 Introduction
9.2 Concept of Receivables Management
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9.2.1 Objectives of Receivables Management
Activity
9.3 Credit Policies and Credit Terms
9.3.1 Credit Period
9.3.2 Cash Discount
M

Activity
9.4 Collection Policies
N
Activity
9.5 Concept of Inventory Management
9.5.1 Objectives of Inventory Management
Activity
9.6 Tools and Techniques of Inventory Management
9.6.1 Stock Levels
9.6.2 VED Analysis
9.6.3 FSN Analysis
9.6.4 Just in Time (JIT) Inventory Management
9.6.5 ABC System
9.6.6 Economic Order Quantity (EOQ) Model
Activity
9.7 Reorder Point
Activity

CONTENTS
9.8 Safety Stock

Activity
9.9 Summary
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N

RECEIVABLES AND INVENTORY MANAGEMENT 213
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DELL COMPUTERS’ ZERO TIME INVENTORY
Dell Computers pioneered the use of the direct marketing chan-

nel for selling and distributing its personal computer systems.
The company follows a strategy of manufacturing a system based
on the specifications of the customer popularly known as the
build-to-order approach for selling its personal computers. This
approach offered Dell numerous advantages over its competitors
such as low inventory costs, zero dealer costs and use of latest
technology in each manufactured computer. The traditional ap-
proach of inventory management would emphasise on maintain-
ing adequate inventories of computer systems for providing cus-
tomers with more variety, selling computers through middlemen
who could explain the complexities of the systems to potential
S
customers. On the contrary, Dell developed its own strategy and
offered customers a chance to select the features they desired in
their systems apart from the regular computers available in the
market. Dell manufactured systems only after they were ordered
IM
by a customer, which, according to the traditional approach,
looked extremely costly and time consuming. Dell guaranteed the
delivery of computers within five to seven days of order. Dell re-
alised that personal computers were becoming a commodity, and
it no longer required the use of middlemen to give details about
the systems to computers in the conventional way. This result-
M
ed in a winning situation for both Dell and its customers. Facto-

ry inventory was approximately three days, supported by strict
alliances with suppliers to deliver smaller loads more frequent-
ly than traditional manufacturing systems. Dell’s inventory was
zero as systems were directly shipped to customers, which saved
N
the company’s cost on warehousing. In comparison to traditional

supply chains of about 60 days of inventory of parts and 30 days of
inventory of systems, Dell now managed to maintain an inventory
of not more than 7 days.

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learning objectives

> Explain the concept of receivables management
> List credit policies and credit terms
> Discuss collection policies
> Describe the concept of inventory management
> List various tools and techniques of inventory management
9.1 INTRODUCTION
An organisation does not conduct all of its transactions in terms of
S
cash because all clients cannot make cash payment. In such a situa-
tion, if it wants to increase its client base, it needs to sell its products
on a credit basis. When the organisation sells its products on credit, it
receives a document stating that the clients would make the payment
IM
at a future date. This document is referred to as bills receivable or re-
ceivable note. In an organisation, maintaining receivables involve cost
as well as benefits. The cost of maintaining receivables is expenses
incurred on collecting and maintaining receivables, whereas benefit
includes an increase in the client base of an organisation. The process
of keeping the level of receivables at an optimum level is known as
M
receivables management.
An organisation always wishes to keep its production flow smooth

to maintain a timely supply of goods to customers. This can be done
by retaining an adequate level of raw material, semi-finished goods
N
and finished goods, which can also be termed as inventory. Howev-

er, maintaining inventory involves cost as well as benefits. The cost
of maintaining inventory are the expenses incurred on ordering and
storing inventory. If the sufficient level of inventory is maintained, the
organisation can benefit from increase in sales by meeting the unex-
pected rise in demand at a very short notice. In addition, when the or-
ganisation procures a large quantity of inventory, it may benefit from
discounted prices. The process of minimising the cost and maximising
the benefits of inventory is known as inventory management.
If the organisation fails to manage its receivables and inventory in an

efficient manner, it may face cash crunch or shortage of stock. This
may further hamper the day-to-day activities, operations and projects
of the organisation. Therefore, receivables and inventory manage-
ment form an important part of financial management as they may
influence the financial position of an organisation.
The chapter begins by explaining the concept and objectives of receiv-

ables management. Further, it discusses credit policies, credit terms,

n o t e s
and collection policies. In addition, the chapter explains inventory

management and its objectives. You will also study about the concepts
of reorder point and safety stock.
CONCEPT OF RECEIVABLES
9.2
MANAGEMENT
Receivables include the amount of money to be received by an or-
ganisation from its debtors. In other words, receivables encompass
all debts (even if they are not currently due), unsettled transactions,
or various other monetary obligations owed to an organisation by its
debtors or customers. Receivables are recorded in the balance sheet
of an organisation. They provide a number of benefits to an organisa-
tion, such as enhanced sales volume and increased profits. An organi-
S
sation invests in receivables through a trade credit policy with an aim
to expand the customer base and survive in the competitive business
environment.
IM
When an organisation sells goods on credit, it needs to raise funds
from different sources in order to meet its day-to-day expenses (this
is because the liquidity of the organisation goes down). Raising funds
from different sources incurs a certain cost, called the cost of receiv-
ables, to an organisation. There are three types of costs associated with
receivables: collection cost (administrative cost incurred on maintain-
ing a credit department and acquiring credit information); capital cost
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(incurred on procuring additional capital for meeting daily expenses);

delinquency cost (arises when payments on credit sales remain due
after the expiry of the credit period); and default cost (arises when an
organisation is unable to recover receivables because of the inability
N
of debtors).
Thus, there is always a degree of risk and uncertainty associated with

receivables as it cannot be ensured that an organisation would get
back its returns. In such a situation, receivables are treated as bad
debts and bring losses for an organisation. This happens due to var-
ious factors, such as type of industry, economic conditions, seasonal
factors and level of competition. To avoid such a situation, an organ-
isation needs to manage its receivables. Here, the role of receivables
management comes into the picture.
Receivables management, also called credit management, is a tech-

nique of reducing and mitigating bad debt risks by having insight
into creditworthiness of debtors and customers. It involves streamlin-
ing collections and managing late payments proactively. Receivables
management is not only confined to increased sales volume but also
includes maximisation of overall returns on investment. Let us now
discuss the objectives of receivables management in the next section.

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9.2.1 OBJECTIVES OF RECEIVABLES MANAGEMENT
The primary objective of receivables management is to maximise the

returns on investments and minimise the risk of bad debts. Apart
from this, the following are some other objectives of receivables man-
agement:
To maintain a proper balance between profitability and risk asso-
ciated with receivables.
To sell goods on credit by issuing receivables when an organisa-
tion has sufficient money to meet daily expenses without any con-
straints.
To survive in the competitive market by increasing credit sales.
Although receivables involves a high degree of risk, an organisation
S
can manage its receivables through appropriate credit policies, cred-
it terms, credit standards, and collection procedures. Let us discuss
about credit policies in the next sections.
IM
1. _________ include the amount of money received by an

organisation from its debtors.
2. The primary objective of receivables management is to
maximise the returns on investments and minimise the risk of
M
bad debts. (True/False)
Activity
N
Hold a discussion with the head of the credit department of a retail

organisation. Discuss the objectives that the organisation has be-
hind managing receivables.
9.3 Credit Policies and Credit Terms

The credit policy of an organisation encompasses a set of written
guidelines that state the terms and conditions related to offering
goods on credit; credit criteria for customers; procedure to be adopted
for the collection; actions to be taken in case of debtors’ inability. The
credit policy of any organisation has two important elements: credit
standards and credit analysis.
Credit standards state the basic criteria for extending credit for cus-
tomers. These standards can be restrictive or liberal. While setting
credit standards, an organisation need to take into consideration var-
ious factors, such as collection cost, average collection period, level of
bad debts, sales volume, etc. After formulating credit standards, an

n o t e s
organisation needs to perform credit analysis to evaluate credit appli-

cants.
In credit analysis, the organisation evaluates the creditworthiness of

debtors. For this, it needs adequate credit data. This data can be col-
lected from various internal (available at the organisational level) or
external (bank references or trade references) sources. After that, this
data need to be analysed by the organisation in order to formulate an
effective credit policy.
After establishing credit standards and creditworthiness of custom-

ers, the organisation needs to define terms and conditions called
credit terms based on which the trade credit would be extended.
Credit terms have two important components, which are shown in
Figure 9.1:
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Components of Credit Terms
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Credit Period Cash Discount
Figure : Components of Credit Terms

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Let us discuss these components in the subsequent sections.
9.3.1 CREDIT PERIOD
Credit period refers to a time span within which debtors or customers
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are allowed to pay for their purchases. This period generally varies
from 15-60 days. Organisations enhance the credit period to attract
new customers and retain existing ones; thereby increasing sales vol-
ume. If the credit period is short, it tends to low sales volume. How-
ever, at the same time, it reduces the incidences of bad debts due to
prompt realisation of the debt tied up in debtors. An organisation
generally extends the credit period for a client if it has relaxed credit
standards for that client. However, extending the credit period has a
significant impact on the residual income of the organisation. Thus,
it is important for the organisation to measure this impact before ex-
tending the credit period for any client. The following is the formula
for calculating the effect of the credit period on the residual income:
ΔRI = [ΔS (1 – V) - ΔSbn] (1 – t) – k ΔI
ΔI here is calculated as follows:

ΔI = (ACPn – ACPo) [So/360] + V (ACPn) ΔS/360
Where,
ΔRI = Changes in residual income

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ΔS = Increase in sales
V = Ratio of variable costs to sales
bn = Bad debts loss ratio on new sales
t = Corporate tax rate
k = Post-tax cost of capital
ΔI = Increase in receivables investment
ACPn = New average collection period (after enhancing the
credit period)
ACPo = Old average collection period
9.3.2 CASH DISCOUNT
S
Organisations provide cash discounts to customers in order to induce
them to make prompt payments. However, the percentage of discount
and the period during which it is available are reflected in credit terms.
IM
For example, credit terms of 2/10, net 30 means that a discount of 2%
would be offered if the payment is made by the 10th day; otherwise
the full payment is due on the 30th day. The effect of cash discount on
residual income may be estimated by the following formula:
ΔRI = [ΔS (1 – V) - ΔDIS] (1 – t) + k ΔI
Where,
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ΔS = Increase in sales
V = Ratio of variable
k = Cost of capital
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ΔI = Savings in receivables investment

ΔDIS = Increase in discount cost
Illustration: XYZ Corporation is a manufacturer of mobile phones.

It sells a mobile phone for Rs. 10000 and the cost of producing per unit
of mobile phone is Rs. 8000. In the year ended 31st March 2010, the
organisation sold on an average 5000 mobile phones per month. The
organisation had a credit policy according to which one-month credit
is provided to its customers. However, this policy did not suit most of
its customers. Consequently, many of its customers stopped dealing
with the organisation.
Owing to the current situation, XYZ decided to extend the credit pe-
riod up to two months on account of which the following is expected:
Increase in sales 25%

Increase in stock 200000
Increase in creditors 1000000

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Additional Information:
All customers avail the credit period of two months.
The new credit policy is given to only new customers.
The entire increase in sales is attributable to new customers.
The organisation expects a minimum return of 40% on investments.
Analyse the new credit policy of the organisation.
Solution:
Particulars All New Cus-

Customers tomers Only
Incremental Sales:
Sales at proposed 2 months credit period 7,50,00,000 7,50,00,000
S
(5000 units * 12 months * 10000 per unit) *
1.25
Less: Sales at existing 1 month credit period 6,00,00,000 6,00,00,000
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(5000 units * 12 months * 10000 per unit)
Increase in sales 1,50,00,000 1,50,00,000
Less: Increase in variable costs @ 80% of 1,20,00,000 1,20,00,000
sales
Incremental contribution 30,00,000 30,00,000
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Less: Cost of additional capital required 28,00,000 12,00,000

Incremental profit 2,00,000 1,80,000
Working Note:
Existinginvestment in debtors at variable cost with credit period
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of one month (60000000 * 0.80/12 = 4000000)

When all customers are extended 2 months credit period, then the
increase in sale would be (75000000 * 0.80)/6 = 10000000
When credit period is extended to new customers only; then the
increase in sale would be (15000000 * 0.80)/6 = 2000000
Additional investment in working capital required and its cost is
as follows:
Particulars All Customers New Customers

Only
Incremental investments in debtors 6000000 2000000
(10000000 – 4000000 = 6000000)
Increase in stock 2000000 2000000
Less: Increase in creditors 1000000 1000000
Increase in working capital 7000000 3000000
Cost of additional working capital @ 2800000 1200000
40%

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3. Credit standards state the basic criteria for shortening credit

for customers. (True/False)
4. Organisations provide ___________ to customers in order to
induce them to make prompt payments.
Activity
Using the Internet, conduct a research to find out the credit policies
of at least three Indian manufacturing organisations.
9.4 COLLECTION POLICIES
S
In the previous section, you have studied about the credit period with-
in which a client needs to make payments to the organisation. How-
IM
ever, some clients fail to make payments within that period. For this,
the organisation needs to make a sound collection policy that involves
procedures to be followed to collect receivables after the expiry of the
credit period. An effective collection policy leads to short average col-
lection period, reduction in the percentage of bad debts and increase
in collection expenses. On the contrary, a relaxed collection policy re-
sults in extended average collection period, increased bad debt per-
M
centage, and perhaps reduce the collection expenses.
After the credit period is over and the payment is due, every organisa-
tion first takes polite measures to collect receivables. However, if polite
measures go in vain, an organisation needs to adopt strict measures
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with the passage of time. The collection policy of an organisation aims

at timely collection of receivables. It has a provision for the following:
Monitoring the state of receivables
Giving reminders to customers whose due date is approaching
Reminding customers about the legal action that can be taken
against overdue payments
Taking a legal action against overdue accounts
In most cases, an organisation opts for a legal action which is the last
resort. This is because legal actions involve a huge cost and spoil the
relationship with customers. In addition, the organisation should give
due consideration to the genuine difficulties of customers.
5. After the credit period is over and the payment is due, every
organisation first takes __________ to collect receivables.

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Activity
Using the Internet, find the collection policy of an insurance organisa-

tion.
CONCEPT OF INVENTORY
9.5
MANAGEMENT
The word inventory refers to the stock possessed by an organisation.
It is broadly classified into three types, namely raw materials, work-in-
progress and finished goods. Raw materials are the components used
for manufacturing final products. Work-in-progress represents goods
that are required at the intermediate stages of production. Finished
goods are final products that are ready for sale. Manufacturing or-
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ganisations usually hold all the three types of inventories while dis-
tribution organisations hold only finished goods. As inventory is an
important asset of an organisation, it is essential for an organisation to
IM
manage its inventory effectively. This is because excessive inventory
levels may lead to extra cost for an organisation, while lower inventory
levels can hamper the production process.
Inventory management is a process of monitoring and controlling the

level of stock available in an organisation. It prevents situations like
excessive inventory or shortage of inventory by taking into consider-
M
ation the factors that influence inventory levels. Some of these factors
are discussed as follows:
Rate of Inventory Turnover: It is the rate at which inventory is
used in the production cycle. When the inventory turnover rate
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rises, investment in inventories is likely to be low and vice versa.

Characteristics of Products: The nature of products stored in-
fluences the inventory level to a large extent. For example, if the
products are durable in nature, the level of inventory would be
high. This is because the chances of perishability and obsolescence
would be less. However, in case of perishable products, the level of
inventory would be low.
Structure of the Market: If the market is imperfect and the de-
mand is unpredictable, the organisation should keep large inven-
tories to realise profitable opportunities.
9.5.1 OBJECTIVES OF INVENTORY MANAGEMENT

The main objective of inventory management is to ensure a smooth
flow of production process in the organisation. Apart from this, the
following are the other objectives of inventory management:
To meet a sudden rise in demand
To optimise investments in inventory

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To organise and schedule production activities

To manage replenishment orders
6. Inventory is broadly classified into three types, namely

_______, work-in-progress and finished goods.
Activity
Using the Internet, find the main objective of inventory manage-

ment of an IT organisation.
TOOLS AND TECHNIQUES OF
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9.6
INVENTORY MANAGEMENT
An organised approach should be followed to inventory management
IM
for balancing out the anticipated costs and benefits of holding inven-
tories. The finance manager may be required to answer the following
questions to ensure competent management of inventories:
1. Are all inventory items equally important, or are some items to
be given more attention?
2. What should be the size of each order or replacement?
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3. At what level should the order for replenishment be placed?
There are various techniques practiced by the finance manager to

manage inventories. These techniques are discussed in detail in the
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following section.
9.6.1 STOCK LEVELS
Having too much or too little inventory is unfavourable for any busi-
ness. If the inventory is too little, the organisation would face regular
stock-outs, which would in turn involve high ordering costs. On the
other hand, a large investment in inventory can also be disadvanta-
geous. Therefore, an organisation should ideally keep an optimum
level of inventory where the inventory cost is the lowest. The various
stock levels maintained by an organisation can be discussed as fol-
lows:
Minimum Stock Level: Represents the rate of inventory that must
be maintained at all the times. If the inventory is less than the min-
imum level, the production of goods may hamper due to shortage
of materials. The formula to calculate the minimum stock level is
as follows:
Minimum Stock Level = Reordering level – (Normal consumption
× Normal reorder period)

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Reordering Level: Refers to the level of inventory at which an

organisation reorders raw material. In other words, when the
amount of raw material reaches a certain level, a new order for
the same is forwarded. The order is forwarded before the amount
of raw material depletes to a minimum stock level. The reordering
level is fixed somewhere between the minimum level and maxi-
mum level of inventory. The formula to calculate reordering level
is as follows:
Reordering Level = Maximum consumption × Maximum reorder
point
Maximum Stock Level: Refers to the maximum amount of inven-
tory that an organisation should keep with itself. The organisation
should not go beyond the maximum stock level because it would
unnecessarily increase the cost of holding the inventory. In addi-
S
tion, over-stocking would block working capital, which would in
turn result in wastage of material. The formula to calculate the
maximum stock level is as follows:
IM
Maximum Stock Level = (Reordering level + Reordering quanti-
ty) – (Minimum consumption × Minimum reordering period)
Danger Level: Refers to the level beyond which the inventory
should not fall in any case. If the danger level is reached, immedi-
ate steps should be taken to replenish the stocks, even if it means
incurring additional costs in arranging the materials. The danger
M
level is determined by the following formula:

Danger Level = Average consumption × Maximum reordering
point for emergency purchases
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9.6.2 VED ANALYSIS
VED analysis is used to segregate inventories into three categories

in the decreasing order of their criticality. VED analysis can be very
valuable for capital-intensive industries. As VED analysis scrutinises
items based on their criticality, it can be used for raw materials that
are difficult to procure. VED analysis is a technique that is used to
control and manage inventory based on the impact of the items on
production. In the VED technique, inventory items are divided into
three groups, which are:
Vital items (Group V): These items are required for machines
and equipment having high criticality. The termination of such
machines would lead to high downtime, decline in production ef-
ficiency, and unacceptable decrease in product quality. As vital
items directly affect the production process; thus, their availability
needs to be assured continuously.
Essential items (Group E): These items are required for machines
and equipment whose termination may have significant impact on
production but does not put the entire production process on halt.

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Therefore, essential items require moderate control and regular

purchases.
Desirable items (Group D): These items are required for ma-
chines and equipment whose termination does not have signifi-
cant impact on the quantity or quality of manufactured products.
Thus, they are purchased as and when needed and require mini-
mum control.
9.6.3 FSN ANALYSIS
FSN analysis segregates the items into three categories in the decreas-
ing order of their usage rate. In FSN analysis, F stands for fast-mov-
ing items, that is, items that are exhausted within a short period of
time. S signifies slow-moving items whose usage rate is low. General-
ly, the existing stock of S items lasts for two years or more. N stands
S
for non-moving items, that is, stock whose usage rate is negligible
because the organisation does not foresee any additional demand of
such products.
IM
The FSN analysis is based on the frequency of using inventory for the
production process in an organisation. The groups identified in this
analysis are as follows:
Fast Moving (F) Items: These items are required more than once
a month. Thus, they are purchased and stocked in bulk.
M
Slow Moving (S) Items: These items are required once in two or
three months; thus, these parts are purchased less frequently.
Non-Moving (N) Items: These items are required occasionally
once in two years and are purchased only when needed and usu-
N
ally not stocked in inventory.
Stock of fast-moving items must be taken care of constantly, and re-

plenishment orders must be forwarded in time to prevent stock-outs.
Slow-moving stocks must be evaluated very cautiously before any
replenishment orders are placed. The reorder amount of such items
must be decided after taking the future demand into consideration.
Dead stock of inventory signifies the money spent that cannot be real-
ised. Therefore, once such items are recognised, effort must be made
to find the use of such items, or they must be must be disposed off.
9.6.4 JUST IN TIME (JIT) INVENTORY MANAGEMENT
JIT inventory management, as the name suggests, means all inven-

tories, including raw materials, work in progress, and finished goods.
In other words, raw materials are expected just in time to be used to
manufacture finished products, and finished products are manufac-

n o t e s
tured in time to be supplied to the consumers. In this approach, the

flow of goods is restricted by what is called the pull approach to pro-
duce the products. The pull approach ends at the final assembly stage
of the production process. After that, the concerned department is no-
tified to deliver the precise quantum of parts and materials required
for further assembly of products. In this way, a smooth flow of parts
and materials is maintained with no inventory build-up at any point.
The successful operation of JIT inventory system has the following
requirements:
The organisation must have limited suppliers.
The suppliers must be bound under long-term agreements and
prepared to make repeated deliveries in small lots.
The organisation must develop a system of total quality control.
S
Poor quality of raw material or parts cannot be accepted.
Workers must be multi-skilled in the JIT environment.
In JIT inventory control, the inventory is obtained and introduced into

IM
the production process at the right time. This involves proficient pur-
chasing, dependable suppliers, and a well-organised inventory-han-
dling system.
9.6.5 ABC SYSTEM
M
The ABC system is a widely used classification technique to identify

various items of inventory for the purposes of inventory control. This
technique is based on the assumption that an organisation should
not exercise the same degree of control on all items of inventory. An
organisation should keep a rigorous control on items that are costly
N
while less expensive items need not be controlled to the same degree.
On the basis of cost, various inventory items are categorised into three
groups—A, B, and C. The items included in group A require a large
amount of investment. Therefore, inventory control should be made
stringent by adopting advanced techniques. Group C consists of a
large number of items that involve comparatively small investments.
Therefore, the items of group C require the minimum level of control.
The investment incurred in the items of group B is moderate; thus, it
deserves less attention than A, but more than C.
The ABC analysis divides the total inventory into three classes using
their percentage values. For example, class A constitutes 15%, class B
includes 35%, and class C contains 50% of the total inventory. How-
ever, the actual break-up of the inventory may vary from situation to
situation. The preceding categorisation is represented in Table 9.1:

n o t e s
Table 9.1: ABC Analysis of Inventory Items

Category Percent of Items Percent of Value
A 15 80
B 35 15
C 50 5
Total 100 100
Class A is made up of items that are either very expensive or used in

massive quantities. Thus, these items, though few in number, contrib-
ute a high proportion of the value of inventories (80%). Class B items
are neither too few nor too many in number. These items are neither
very expensive nor very cheap and constitute only 15% of the total val-
ue of the inventory. Class C contains a relatively large number of items
used in very small quantities. Therefore, such items do not constitute
S
more than a negligible fraction of the total value of the inventory.
Class A items merit a tightly-controlled inventory system with constant

purchase and store management. Class B items merit a formalised in-
IM
ventory system and periodic purchase and store management. Organ-
isations use relaxed inventory procedures for class C items.
Illustration: ABC company is planning to use ABC system to control

inventory. Following is the inventory data of the company:
Items Unit Unit Cost

M
1 3,000 8.00
2 31,100 0.10
3 8,400 4.20
4 1,500 12.00
N
5 27,900 0.40
6 11,340 1.00
7 13,320 1.30
8 7,380 0.80
9 10,260 0.80
10 45,000 0.20
11 14,970 0.60
12 12,330 1.00
Solution:
Item Units % of Total Unit Total %Total

Units Cost (`) Cost (`) Cost
A 3 8,400 4.52 4.20 35,280 21.43
1 3,000 1.61 8.00 24,000 14.58
4 1,500 0.81 12.00 18,000 10.94
7 13,320 7.16 1.30 17,316 10.52

n o t e s
Item Units % of Total Unit Total %Total

Units Cost (`) Cost (`) Cost
14.10% 57.47%
B 12 12,330 6.63 1.00 12,330 7.49
6 11,340 6.10 1.00 11,340 6.89
5 27,900 15.00 0.40 11,160 6.78
10 45,000 24.19 0.20 9,000 5.47
11 14,970 8.05 0.60 8,982 5.46
9 10,260 5.51 0.80 8,208 4.99
65.48%
C 8 7380 9.97% 0.80 5,904 3.59
2 31,100 16.45% 0.10 3,060 1.86
20.42% 5.45%
S
9.6.6 ECONOMIC ORDER QUANTITY (EOQ) MODEL
IM
The Economic Order Quantity (EOQ) model provides answers to two
basic questions related to inventory management. These questions
are:
What should be the size of an order?
At what level should the order be placed?
M
EOQ is a common tool for inventory management. It is the order

quantity of inventory items that optimises the total cost of spare parts
inventory management. To understand the concept of EOQ, let us first
study about the two major costs involved in inventory management,
as shown in Figure 9.2:
N
Ordering Cost
Carrying Cost
Figure 9.2: Costs Involved in EOQ Analysis
Let us study about these two costs in detail:

Ordering cost: These are costs incurred on obtaining inventory
items from vendors and include costs incurred on order place-
ment, transportation cost, etc.
Carrying cost: These costs are incurred on holding items in the
inventory. Carrying costs include opportunity costs, storage costs,
spoilage costs, etc.

n o t e s
Ordering costs and carrying costs are contrary to each other. This im-
plies that in order to minimise carrying costs, a small order need to be
placed which results in higher ordering costs. On the contrary, in or-
der to minimise ordering costs, fewer orders need to be placed which
results in higher carrying costs.
Let us derive the equation to calculate the optimum level of inventory

through EOQ:
D = Annual demand (units)
C = Cost per unit
Q =Order quantity (units)
S =Cost per order
H =Holding cost
S
Total inventory cost = Ordering cost + Carrying cost
Number of orders = D / Q
IM
Ordering costs = S × (D / Q)
Average inventory (units) = Q / 2
Average inventory (cost) = (Q / 2) × C
Therefore, cost to carry average inventory = (Q / 2) × H
Total cost = (Q/2) × H+S × (D/Q)…………………… (Equation 1)
M
Taking the derivative of Equation (1)

d(TC)/d(Q) = H / 2 – (D × S) / Q² ……………………. (Equation 2)
To optimize Equation (2), let us put the value of d(TC)/d(Q) as
N
zero
Therefore, DS/ Q² = H / 2
or Q²/DS = 2 / H
or Q²= (DS × 2)/ H
Therefore Q = √ (2DS / H)
2DS
The derived formula for EOQ =√
H
Illustration: ABC Ltd. is a manufacturer of plastic chairs. The cost
per order is `400 and its carrying cost is `10 per unit. The organisation
has a demand for 20,000 units of plastic chairs per year. Calculate the
order size, total orders required in a year, total carrying cost, and total
ordering cost for the year.
2 × 20000 × 400
Solution: EOQ =√ = 1,265 units of plastic chairs
10

n o t e s
20000
Therefore, total orders per year = = 16 approximately
1265
Total ordering cost = 400 × 16 = 6,400
0 + 1265
Average inventory = = 632.5
2
Therefore, total carrying cost = 632.5 × 10 = `6,325
7. What do we call the level beyond which the inventory should

not fall in any case?
S
Activity
Using the Internet, find the major inventory management tech-

niques used by a FMCG organisation like HUL.
IM
9.7 REORDER POINT
Reorder point refers to the level of inventory that triggers an order for
replenishing the current inventory. In simple words, a reorder point
can be defined as the level of inventory when a fresh order should be
M
placed with suppliers for procuring additional inventory. The reorder

point is based on the following assumptions:
The usage inventory is constant on a daily basis.
N
The lead-time to procure inventory is fixed.
The formula for determining the reorder point is as follows:

Reorder point = Lead time in days * Average daily usage of
inventory
For example, if the lead time is 15 days and the average daily usage of
inventory is 120 units, then the reorder point will be = 15*120 = 1800
units.
The lead time refers to the time taken in receiving the delivery after
placing orders with suppliers. It covers the span of time from the point
when a decision to place the order for the procurement of inventory is
taken to the actual receipt of inventory by the organisation. The lead
time may also be called the procurement time of inventory. Therefore,
we can say that the reorder point is the point where inventory level of
an organisation is equal to the consumption during the lead time. For
instance, the average inventory consumption of an organisation is 500
units per day. The number of days required to receive the delivery of
inventory after placing order is 15 days. The reorder point = 500 units

n o t e s
* 15 days = 7500 units. The implication is that the organisation should

place an order for replenishing the stock of inventory as soon as the
inventory level reaches 7500 units. The size of reorder would be equal
to EOQ.
Illustration: A manufacturing plant has estimated that 1,20,000 units

of its products will be sold in the next year. The processing cost of an
order is `10 and the plant incurs `0.6 as carrying cost for oen unit.
The lead time for an order is 3 days. Calculate the (a) Economic Order
Quantity (EOQ) and Reorder point.(Assume 300-day year).
Solution:
2 ×1, 20, 000 ×10

EOQ = =√ =2,000 units
0.6
(b) Reorder point = Daily usage* Lead time
S
Daily usage = 1,20,000/300 = 400 units
Reorder point = 400*3 = 1,200 units.
IM
8. Reorder point = __________ * Average daily usage of inventory

M
Activity
Hold a discussion with the production manager of a manufacturing

plant and discuss the significance of reorder point.
N
9.8 SAFETY STOCK

Safety stock can be defined as the minimum additional inventory to
serve as a safety margin or buffer to meet an unanticipated increase in
demand. The formula to calculate the level of safety stock is as follows:
(Maximum usage rate – Average usage rate) * Lead time
Where,
The usage rate is the rate at which inventory is used in the organisa-
tion. For example, if an organisation uses 300 units of inventory every
day, the usage rate would be 300 units.
The safety stock is maintained to avoid the situations of shortage of

stock, which is also known as stock out. If the lead time and usage rate
change frequently, the organisation may face a situation of stock out.
In such a situation, complete protection against stock-out is required
by maintaining a large safety stock. An organisation also maintains
the safety stocks to deal with the situations of unexpected delays in

n o t e s
delivery. Thus, in the situation of uncertainties when the safety stock

is maintained, the reorder point can be determined as follows:
Reorder point = (Lead time * Average usage) + Safety stock
Illustration: A manufacturing plant uses 120 units of raw material on

an average. It has been observed that the maximum usage rate on a
given day can move upto 180 units. The organisation maintains a lead
time of 5 days. Calculate the safety stock.
Solution:
Safety Stock: (Maximum usage rate – Average usage rate) * Lead
time
= (180-120)*5
= 60*5
S
= 300 units.

IM
9. The safety stock is maintained to avoid the situations of
shortage of stock, which is also known as stock out. (True)
Activity
M
Hold a discussion with the production manager of a manufacturing

plant and discuss the significance of safety point.
9.9 SUMMARY
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Receivables include the amount of money to be received by an or-

ganisation from its customers.
Receivables management, also called credit management, is a
technique of reducing and mitigating bad debt risks by having in-
sight into creditworthiness of debtors and customers.
The primary objective of receivables management is to maximise
the returns on investments and minimise the risk of bad debts.
The credit policy of an organisation encompasses a set of written
guidelines that state the terms and conditions related to offering
goods on credit; credit criteria for customers; procedure to be ad-
opted for the collection; actions to be taken in case of debtors’ in-
ability.
Credit terms have two important components, namely credit peri-
od and cash discounts. A credit period refers to a time span within
which debtors/customers are allowed to pay for their purchases,
while cash discounts are concessions that organisations provide
to customers in order to induce them to make prompt payments.

n o t e s
The word inventory refers to the stock possessed by an organisa-

tion. It is broadly classified into three types, namely raw materials,
work-in-progress and finished goods.
Inventory management is a process of monitoring and controlling
the level of stock available in an organisation. An organised ap-
proach should be followed to inventory management for balancing
out the anticipated costs and benefits of holding inventories.
Reorder point refers to the level of inventory that triggers an order
for replenishing the current inventory.
Safety stock can be defined as the minimum additional inventory
to serve as a safety margin or buffer to meet an unanticipated in-
crease in demand.
S
key words
Credit Policy: A policy that helps in determining credit stan-

dards and credit analysis.
IM
Ordering Cost: The fixed cost of placing and receiving an in-
ventory order.
Carrying Cost: It is a variable cost for holding an item in inven-
tory for a particular period of time.
Lead Time: It is the time taken in receiving delivery after plac-
ing orders with suppliers.
M

1. Write a short note on receivables.
N
2. What are the two components of credit terms?

3. What are the objectives of inventory management?
4. What do you understand by the term minimum stock level?
5. Parag Enterprise deals in wooden furniture. The cost per order
is estimated to be `600 and the carrying cost is `20 per unit per
annum. Suppose the organisation received an order of 15,000
units of furniture. Calculate the order size, total orders required
in a year, total carrying cost and total ordering cost for the year.

n o t e s
Topic Q.No. Answers

Concept of Receivables 1. Receivables
Management
2. True
Credit Policies and Credit 3. False
Terms
4. Cash discounts
Collection Policies 5. Polite measures
S
Concept of Inventory Man- 6. Raw materials
agement
Tools and Techniques of 7. Danger level
Inventory Management
IM
Reorder Point 8. Lead time in days
Safety Stock 9. True

1. Receivables encompass all debts (even if they are not currently
M
due), unsettled transactions, or various other monetary

obligations owed to an organisation by its debtors or customers.
Refer to Section 9.2 Concept of Receivables Management.
2. There are two components of credit terms, namely credit period
N
and cash discount. Refer to Section 9.3 Credit Policies and

Credit Terms.
3. The objectives of inventory management are to meet a sudden
rise in demand, optimise investments in inventory, organise
and schedule production activities, and manage replenishment
orders. Refer to Section 9.5 Concept of Inventory Management.
4. Minimum stock level represents the rate of inventory that must
be maintained all the times. Refer to Section 9.6 Tools and
Techniques of Inventory Management.
2 ×15, 000 × 600

5. EOQ =√ = 949 units.
20
15000
Therefore, total orders per year = = 16 approximately
949
Total ordering cost = 600 × 16 = 9,600

n o t e s
0 + 949
Average inventory = = 475 Approx.
2
Therefore, total carrying cost = 475 × 20 = `9500 Approx.
Refer to Section 9.6 Tools and Techniques of Inventory
Management.
SUGGESTED READINGS
Brealey, R., & Myers, S. (1984). Principles of corporate finance.
New York: McGraw-Hill.
Coleman, A. (2004). Collection management handbook. Hoboken,
S
NJ: Wiley.
Fogarty, D., Blackstone, J., Hoffmann, T., & Fogarty, D. (1991). Pro-
duction & inventory management. Cincinnati, OH: South-Western
IM
Pub. Co.
E-REFERENCES
BusinessDictionary.com,. (2014). What is credit policy? definition
and meaning. Retrieved 14 November 2014, from http://www.busi-
nessdictionary.com/definition/credit-policy.html
M
Investopedia,. (2009). Inventory Definition | Investopedia. Re-

trieved 14 November 2014, from http://www.investopedia.com/
terms/i/inventory.asp
Slideshare.net,.(2014). Management of Receivables. Retrieved 14
N
November 2014, from http://www.slideshare.net/neerajchitkara/

management-of-receivables-13919925

Ch
10 a p t e r
BUDGET AND BUDGETING
CONTENTS
S
10.1 Introduction
10.2 Concept of Budget
IM
Activity
10.3 Types of Budget
10.3.1 Performance Budget
10.3.2 Fixed Budget
10.3.3 Flexible Budget
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10.3.4 Incremental Budget

Activity
10.4 Budgeting as Tool of Cost Control
N

Activity
10.5 Advantages and Limitations of Budgeting
Activity
10.6 Zero-Based Budgeting (ZBB)
Activity
10.7 Rolling Budget
Activity
10.8 Cash Budget
Activity
10.9 Summary

n o t e s
FAILURE OF ASHES DUE TO INADEQUATE BUDGETING
Ashes football club, India was struggling to survive due to lack

of funds. The club formed a new committee and called a special
meeting at the head office to look for the ways to save the club.
The new committee hired a new team of volunteers from within
the club and assigned it the responsibility to examine the finan-
cial affairs of the club.
After analysing the financial records and history of the club, the
team of volunteers discovered that the financial reports produced
to the committee were complicated to understand. It was also
found that the former committee lacked expertise in financial
management. Due to this, no formal budgets were formed for the
S
years that passed under former committee’s supervision. Moreo-
ver, during this time major financial decisions were made in the
absence of any budget which had no mention in the records.
IM
As a result of the lack of budgets, the club had debts of around
$120,000 including unpaid taxes needed to be cleared in a short
period of time. The new committee was not able to raise the funds
situation in such a short time. As a result, Ashes was declared
bankrupt.
M
N

BUDGET AND BUDGETING 237
n o t e s
learning objectives

> Discuss the concept of budget
> Describe different types of budget
> State advantages and limitations of budgeting
> Define zero-based budgeting
> Explain rolling budget
> Describe cash budget
10.1 INTRODUCTION
S
In the previous chapter, you have studied about receivables and in-
ventory management. Apart from that, an important technique used
for maintaining and organising all the resources is budgeting. In an
organisation, budget is a financial statement enlisting different sourc-
IM
es of planned income and expenditure in a given period of time. Bud-
gets are used to receive information about the allocation of specific
funds in various activities in an organisation to maximise profit and
minimise cost. The budgeted performance is compared with actual
performance of the organisation.. This comparison helps in identify-
ing the gaps and problem areas so that the organisation can take time-
M
ly corrective actions.
The data provided by budget statements is also used for preparing

various financial plans and policies of the organisation. In addition,
it facilitates the comparison between the current and previous year’s
N
performance of the organisation. It helps in the efficient utilisation of

funds by setting a maximum limit of funds for all the activities.
Budget serves as a crucial tool of financial management as it aids in

forecasting the profit of the organisation. It assists the organisation
in determining feasible financial goals and objectives by taking into
consideration all the sources of finance. Budget helps in maintaining
co-ordination among the activities of different departments of the or-
ganisation. For example, if the purchase department has sufficient
fund then it can easily co-ordinate with production department. In
this chapter you will study about the importance of budgets in organ-
isations.
10.2 CONCEPT OF BUDGET

Budget can be defined as a quantitative statement developed to as-
certain the funds required for various projects and the income that
would be generated from them. In simple words, budget helps in allo-
cating the income to various expenses. According to Chartered Insti-

n o t e s
tute of Management Accountants (CIMA), “A budget is a financial and/

or quantitative statement prepared prior to a defined period of time, of
the policy to be pursued during that period for the purpose of attaining
a given objective”.
The main objectives behind preparing budget in organisations are:

Ensuring better co-ordination among the activities of various de-
partments
Spotting and correcting deviations by periodically comparing the
actual performance with budgeted performance
Maintaining a two-way communication in all the levels of manage-
ment to reduce the gap between actual and budgeted performance
The process of preparing the budget of an organisation is known as
S
budgeting. It is used to assess overall funds required to finance var-
ious projects of the organisation. It also helps in eliminating the fu-
ture situations of excess or scarcity of funds. The essential elements to
make budgeting effective are shown in Figure 10.1:
IM
Constant
Checks
Statistical
M
Flexibility
Information
Essentials
of Effective
N
Budgeting Accepted
Realistic
Accounting
Targets
Standards
Adequate Defined
Cost Business
Information Policies
Figure10.1: Essentials of Effective Budgeting
Let us discuss each of these elements in detail

Constant Checks: It implies that periodic reports must be main-
tained to compare the budget with the actual performance. Con-
stant check helps in identifying any deviation in the budget plan-
ning for taking immediate corrective actions. This ensures smooth
management of projects by identifying barriers on a periodic basis.

n o t e s
Flexibility:It enables an organisation to prepare itself for future

uncertainties and contingencies, such as inflation, deflation, reces-
sion, and other unforeseen circumstances.
Accepted Accounting Standards: It refers to the accounting stan-
dards that are sanctioned by Institute of Chartered Accountants of
India (ICAI). These include the standard framework of guidelines
for financial accounting used in a given jurisdiction.
Defined Business Policies: It refers to a set of policies followed by
a business unit. Examples of business policies include level of in-
ventory maintained, nature of purchase (credit or cash purchase),
and nature of sales (credit or cash sales).
Adequate Cost Information: It supports the management of an
organisation in forecasting costs of various projects. The manage-
ment considers inflation rate and other factors, such as market
S
condition, while forecasting costs of various projects.
Realistic Targets: It refers to the feasible and achievable targets
fixed in the budget by the management.
IM
Statistical Information: It is the information gathered from the
past financial records of an organisation.
Even though a little forecasting is always needed in budgeting, there

is marked difference between the two terms. Table 10.1 explains the
differences between budgeting and forecasting:
M
Table 10.1: Difference between Budgeting and

Forecasting
Budgeting Forecasting
N
Budget is a detailed representa- Forecast is limited to major reve-

tion of the future results, financial nue and expense line items. There
position, and cash flows that man- is usually no forecast for financial
agement wants to achieve during a position, though cash flows may be
certain period of time. forecasted.
Budget may be updated only once a Forecast is updated at regular inter-
year depending on how frequently vals, perhaps monthly or quarterly.
the senior management wants to
revise information.
Budget is compared to actual re- Forecast may be used for short-term
sults to determine variances from operational considerations, such as
expected performance. adjustments to staffing, inventory
levels, and the production plan.
Management takes remedial steps There is variance analysis that com-
to bring actual results back into line pares the forecast to actual results.
with the budget.
Budget to actual comparison Changes in the forecast do not
can trigger changes in perfor- impact performance-based compen-
mance-based compensation paid to sation paid to employees.
employees.

n o t e s
1. Which of the following element implies that periodic reports

must be maintained to compare the budget with the actual
income and expenditure?
a. Constant check
b. Flexibility
c. Defined business policies
d. Realistic targets
Activity
Using the Internet, list the points to consider while preparing the
S
yearly budget.
IM
10.3 TYPES OF BUDGET
As discussed earlier, budget is a financial statement that provides de-
tailed information about the revenue and expenditure of a particular
year. However, there is no single rule or proforma available to pre-
pare budget, as in case of balance sheet and profit and loss account.
For example, government organisations usually go for zero-based
M
budgeting; on the other hand, a large-scale organisation prepares

performance budget. Apart from different rules, the budget of an or-
ganisation depends on various factors, such as size, sales, purchases,
and market situations. Budget is generally divided into four types, as
N
Performance
Budget
Incremental Types of Fixed

Budget Budgets Budget
Flexible
Budget
Figure 10.2: Types of Budget

n o t e s
The different types of budgets are discussed in detail in subsequent

sections.
10.3.1 PERFORMANCE BUDGET
Performance budget is the collection of all the activities carried out

in the organisation along with their outcomes. It includes a set of per-
formance targets to be achieved at a given level of expenses. In an
organisation, right to approve, modify, disapprove, and revise the per-
formance budget is reserved with the top-level management. The top
management decides about the approval of the proposed budget after
taking into consideration the profitability of various activities, proj-
ects, and operations. Performance budget is prepared after taking into
account various budgets formulated by different departments, which
are shown in Figure 10.3:
S
Sales Budget
IM
Production Budget
Cash Budget
M
Selling and Distribution Cost Budget

Constituents of
Performance Budget
N
Purchase Budget
Research and Development Budget
Plant Utilisation Budget
Capital Expenditure Budget
Figure 10.3: Constituents of Performance Budget
These constituents are discussed as follows:

Sales Budget: It is the assessment of past sales, general business
conditions, plant capacity, seasonal fluctuations, availability of
stock, and market research by the marketing manager.

n o t e s
Production Budget: It helps in the analysis of availability of fin-

ished goods required by the sales department. Production budget
is used to manage and control the overall production activities of
an organisation. Therefore, it is also termed as operating budget
prepared to forecast the current expenses of an organisation and
the anticipated sources of funds. It focuses on ensuring the ade-
quate amount of funds required for paying salaries, interest, and
depreciation charges.
Cash Budget: It defines the need of funds by taking into account
cash and credit sales and payments made to creditors.
Selling and Distribution Cost Budget: It estimates the cost to be
incurred on selling and distribution during a period of time. This
budget is prepared by the marketing manager after considering
direct selling, sales office, distribution, and advertising expenses.
S
Purchase Budget: It gives information associated with purchases
during the budgeted period. It is prepared by considering opening
and closing stocks, work in progress, and the maximum and mini-
IM
mum level of inventory to be maintained by an organisation. Pur-
chase budget helps an organisation in reducing the cost of produc-
tion by minimising unnecessary purchase by planning in advance.
Research and Development Budget: It helps in forecasting the
cost to be incurred on research and development during the bud-
geted period. It is prepared on the basis of existing and potential
M
market of the product along with the new product and demand in
the market
Plant Utilisation Budget: It forecasts the production capacity of
the plant for the future production. It considers the cost of pur-
N
chasing a new plant during the budget period. In addition, the

plant utilisation budget is based on cost of utilisation of machine
per hour. It also considers that whether the plant is operating more
or less than its optimum capacity.
Capital Expenditure Budget: It forecasts the cost to be incurred
in purchasing assets for an organisation. It is prepared by consid-
ering the long-term and short-term requirement of assets. Capital
expenditure budget also forecasts the need of asset replacement,
delays in purchasing new assets, and alternative means to satisfy
the production requirement.
Illustration: Use the following details to prepare the following:

a. Purchase budget for direct materials for the three products,
namely A, B, and C
b. Production budget for products A, B, and C

n o t e s
Products Budgeted Materials Rate Labour Rate per di-

units for consumption per kg hour per rect labour
the year per unit (`) unit hour (`)
A 40,000 10 kg 5 8 4
B 45,000 20 kg 10 12 8
C 50,000 30 kg 15 16 12
Additional Information: Packing cost is 5% of the direct material
cost. The expenses have been forecast as follows:
Particulars Amount
(`)
Indirect wages 2,00,000
Other employment cost 1,00,000
S
Repairs and maintenance 60,000
Power and fuel 1,20,000
Rent and rates 1,60,000
Insurance
IM 40,000
Depreciation 40,000
Miscellaneous factory expenses 1,20,000
The following additional information is also given:
Particulars Product A Product B Product C

M
Finished goods:
Opening stock (unit) 10,000 20,000 30,000
Closing stock required (in units) 4,000 6,000 8,000
N
Raw materials:
Opening stock (kg) 20,000 40,000 60,000
Closing stock required (in kg) 10,000 20,000 30,000
Solution: The preparation of production budget (quantity in units) is

shown in the following table:

Sales 40,000 45,000 50,000
Add: Closing stock of finished 4,000 6,000 8,000
goods
Less: Opening stock of finished 10,000 20,000 30,000
goods
Production budget (A) 34,000 31,000 28,000

n o t e s
The preparation of material consumption budget is shown in the fol-

lowing table:

Material required per product in 10 20 30
kg (B)
Total quantity (C) = (A * B) 3,40,000 6,20,000 8,40,000
Price per kg (D) 5 10 15
Value of material for production 17,00,000 62,00,000 126,00,000
budget
The preparation of direct labour budget is shown in the following ta-

ble:
S
Production units (from A) 34,000 31,000 28,000
Labour hours per units (E) 8 12 16
Total labour hours (F) 2,72,000 3,72,000 4,48,000
IM
Rate per hour (G) 4 8 12
Total (F * G) 10,88,000 29,76,000 53,76,000
The preparation of purchase budget is shown in the following table:

M
Total quantity required as per 3,40,000 6,20,000 8,40,000

(C) above in kg
Add: Closing stock 10,000 20,000 30,000
Less: Opening stock 20,000 40,000 60,000
N
Purchase quantity in kg 3,30,000 6,00,000 8,10,000

Price per kg 5 10 15
Value for purchase budget in ` 16,50,000 60,00,000 1,21,50,000
10.3.2 FIXED BUDGET
To prepare a fixed budget, funds required to complete various tar-

gets in the budgeted period are rigidly fixed. It is usually a short-term
budget as it does not consider variations that may occur in the long
run. An organisation having a low percentage of variable cost in the
total cost of production can make fixed budget as it does not affect the
working of the organisation. On other hand, an organisation having
a high percentage of variable cost in the total cost of production can-
not rely on fixed budget. For example, an aluminium manufacturing
organisation requires more of sophisticated machinery and less of la-
bours. The purchase of sophisticated machinery is a part of fixed cost;

n o t e s
whereas, the wages of labours are a part of variable cost. Thus, the
contribution of fixed cost in the total cost of the organisation is more
as compared to variable cost. In such a situation, the organisation can
prepare fixed budget. Fixed budget offers following advantages:
Requires less time and money for preparing as there are no or less
changes in different situations
Eliminates complexities as it is made on an assumption that all
types of cost are fixed
Facilitates
better comparison between different periods as it re-
mains unchanged
The disadvantages of fixed budget are:

Based on unrealistic assumptions, such as market situation and
economic condition would not change
S
Does not provide useful information as fixed budget does not con-
sider variable cost while calculating profit
IM
Makes it difficult to take into considerations the impact of inflation
on cost of production
10.3.3 FLEXIBLE BUDGET
Flexible budget is the one that can be altered depending upon differ-
ent activity levels of the organisation. In flexible budget both the fixed
M
and variable costs are considered. While preparing flexible budget,

variation in variable cost at different levels of output need to be con-
sidered. The advantages of a flexible budget are as follows:
It helps in controlling the cost of production as variable cost for
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different production level is considered.

Itsupports in maintaining a greater level of accuracy by consider-
ing different situations, such as recession and inflation.
Ithelps in comparing the actual performance with the budgeted
targets to find the gap between the two.
Ithelps in making financial plans and forecasts about future fund
requirement.
The disadvantages of a flexible budget are as follows:

Itconsumes a lot of time in preparation as segregating fixed and
variable costs, is a difficult task.
It enhances complexities as different budgets are prepared for dif-
ferent levels of output.

n o t e s
Illustration: The following data relate to the working of an organisa-

tion for the current year:
Particulars Amount Amount
(`) (`)
Capacity worked, 50%
Fixed costs:
Salaries 16,800
Rent and rates 11,200
Depreciation 14,000
Other administrative expenses 16,000 58,000
Variable costs:
Materials 48,000
Labour 51,200
S
Other expenses 7,600 1,06,800
Possible sales at various levels of working are as follows:

IM
Capacity (%) Sales
60 1,90,000
75 2,30,000
90 2,75,000
100 3,05,000
M
Prepare a flexible budget and show the forecast of profit at 60, 75, 90,
and 100% capacity operations.
Solution: Flexible Budget

N
Percentage of Capacity Worked 60% 75% 90% 100%

Sales revenue 1,90,000 2,30,000 2,75,500 3,05,000
Less: Total costs
Variable costs:
Materials 57,600 72,450 86,400 96,000
Labour 61,440 76,800 92,160 1,02,400
Other expenses 9120 11,400 13,680 15,200
A. Total variable costs 1,28,160 1,60,650 192,240 2,13,600
Fixed costs:
Salaries 16,800 16,800 16,800 16,800
Rent and rates 11,200 11,200 11,200 11,200
Depreciation 14,000 14,000 14,000 14,000
Other administrative expenses 16,000 16,000 16,000 16,000
B. Total fixed cost 58,000 58,000 58,000 58,000
Total cost (A + B) 1,86,160 2,18,650 2,50,240 2,71,600
Forecast profit 3,840 11,350 25,260 33,400

n o t e s
10.3.4 INCREMENTAL BUDGET
In an incremental budget, an extra amount is summed up to the pre-

vious budget on an yearly basis. Incremental budget is prepared by
keeping the actual performance of the preceding year as a base. In
incremental budget, funds are allocated to different activities in the
pattern similar to the preceding year. For example, if an organisation
allocates `1 lakhs to various activities in the current year, the same
amount would be increased in the next year’s budget too. Incremental
budget is mainly criticised for ignoring changes in business, economy,
and fiscal and monetary policies. Following are the advantages of an
incremental budget:
Covers the increase in cost by allocating more funds to each activ-
ity as compared to previous year.
S
Helps in maintaining consistency in business operations as funds
are always sufficient and do not get affected by inflation rate.
Simplifies the process of framing and analysing the budget.
IM
Allocates separate amount of funds for each and every department
of an organisation. Therefore, there are fewer chances of clashes
between different departments.
Evaluates the effect of changes in cost on a regular basis.
The disadvantages of an incremental budget are as follows:

M
It is assumed that the cost of each and every activity is increased

at a constant rate
The cost of production is increased in every new budget
More spending habit is encouraged even if it is not required. This
N
happens because the funds for different activities are increased

without any cost analysis.
2. Apart from different rules, the budget of an organisation

depends on various factors, such as size, sales, purchases, and
market situations. (True/False)
Activity
Discuss the basis of categorisation of different types of budgets.

n o t e s
BUDGETING AS TOOL OF COST

10.4
CONTROL
By providing a quantitative statement, budgeting helps an organisa-
tion not just in arranging resources and funds, but also in cost con-
trolling too. Generally, a budget comprises profit planning, cash bud-
geting, and balance sheet forecasting. These terms can be explained
as follows:
Profit Planning (Pro-forma Income Statement): While develop-
ing profit plans, an organisation needs to take into consideration
sales forecast and corresponding costs and expenses. The profit
plans enable an organisation to view the complete picture and
evaluate the behaviour of costs and expenses in relation to chang-
es in the level of sales.
S
Cash Budgeting: A cash budget helps an organisation to antici-
pate cash inflows and outflows to maintain the optimum level of
cash. It further helps the organisation to determine whether or not
IM
additional financing is required to address cash shortfalls. For this,
the organisation must list down all transactions having cash flow
implications. This results in a net cash balance which is then car-
ried over to the next period
Balance Sheet Forecasting (Pro-forma Balance Sheet): This is
used to determine asset levels to support the estimated sales tar-
M
gets. For example, to meet the higher sales targets a retail compa-
ny may have to open more outlets, resulting in more, investments
in fixed assets and current assets
N
3. While developing ____________, an organisation needs to take

into consideration sales forecast and corresponding costs and
expenses.
Activity
Using the Internet, list the major tools that are used for cost con-
trolling in organisations.
ADVANTAGES AND LIMITATIONS OF

10.5
BUDGETING
Other than helping an organisation in controlling overall costs, bud-
geting helps in various other ways. The following points explain the
advantages of budgeting:
It helps in problem-solving in a disciplined manner.

n o t e s
Ithelps an organisation in planning and arranging resources, so

that goals can be achieved in time.
It ensures the availability of funds at the time of need.
It enhances the goodwill of an organisation.
It helps in spreading cost-consciousness throughout the organisa-
tion.
However, budgeting is not free from faults. There are some limitations
of budgeting, which are described as follows:
Forecasts only quantitative data; however, most of the time an or-
ganisation needs non-quantitative data, such as research and de-
velopment.
Budgeting is also impacted by external factors, which are beyond
S
the control of an organisation.
Requires high cost that makes budgeting difficult for small organ-
isations.
IM
Gives very complex results that cannot be easily understood by
every individual.
4. Budgeting forecasts only quantitative data, but most of the

M
time an organisation needs non-quantitative data, such as

research and development. (True/False)
N
Activity
Discuss the budgeting process of Tata Motors.
10.6 ZERO-BASED BUDGETING (ZBB)

Zero-Based Budgeting (ZBB) is a process of production planning that
requires each departmental head to justify their entire budget in a
detailed form. In ZBB, every cost element of various activities is anal-
ysed and justified every time when a new budget is prepared. In ZBB,
no base budget is considered or referred for preparing a new budget.
Moreover, various activities are arranged according to their priority
and the cost of each activity is forecasted on the basis of certain facts.
The cost involved in all the activities is subjected to verification. Be-
fore including an activity in the budget, the following questions should
be answered:
Should the activity be undertaken?
How would we perform the activity?

n o t e s
How much would various alternatives cost?
The process pursued to frame ZBB is:

1. Determine the activities to be performed in a budgeted period
and the responsibility of managers regarding those activities.
2. Request concerned managers to find all the alternatives to
perform an activity.
3. Rank the alternatives according to priority.
4. Arrange the funds required to carry out the activities smoothly.
ZBB is prepared by organisations to achieve the following objectives:

Forecasting the resource requirement for prevailing and new ac-
tivities in a budgeted period
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Assigning responsibilities to various levels of management to cal-
culate expenditure on several activities during the budgeted period
Evaluating the various alternatives to perform an activity
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Emphasising on giving higher priority to the alternatives that are
more profitable
5. _______________ is a process of production planning that

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requires each departmental head to justify his/her entire

budget in a detailed form.
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Activity
List down the main advantages of zero-based budgeting.
10.7 ROLLING BUDGET

Rolling budget is prepared by making changes in a given budget at a
fixed interval of time. The changes can be made on monthly, quarterly,
half yearly or annual basis. Thus, it can be stated that rolling budget
has a scope of amendments at any period of time. The rolling budget is
prepared for a very short period of time. It is very useful for industries
that are facing swift changes and require forecasting for a short inter-
val of time. For example, in most of the cases, an IT organisation faces
swift changes due to frequent enhancements in technology. Another
term used for rolling budgets is continuous budget as it never ends
and the management keeps on incorporating changes in the same
budget as per the organisational needs.

n o t e s
6. The rolling budget is prepared for a very long period of time.

(True/False)
Activity
Using the Internet, find the challenges in preparing a rolling budget.
10.8 CASH BUDGET

Cash budgets are generally prepared by analysing cash inflow and
outflow of an organisation. These budgets help in ensuring a sound
S
liquid position of an organisation for the payment of short-term lia-
bilities. It also helps the organisation in avoiding situations in which
there is idle cash or shortage of cash. The cash budget is generally di-
vided into four sections. These four sections are discussed as follows:
IM
Receipts Section: This section is used to maintain the records of
the cash receipts obtained from customers and other sources.
Payment Section: This section is used to keep the records of all
the payments or expenditure incurred by the organisation.
Cash Flow Section: This section is used to maintain the record of
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difference between cash inflow and outflow to determine surplus

or shortage of cash.
Financing Section: In case the cash budget is deficient, the financ-
ing section shows the amount of funds that need to be borrowed.
N
The financing section of cash budget consists of borrowings and

repayments.
7. ________________ are generally prepared by analysing cash

inflow and outflow of an organisation.
Activity
Discuss the limitations of a cash budget.

n o t e s
10.9 SUMMARY
Budget can be defined as a quantitative statement developed to
ascertain the funds required for various projects and the income
that would be generated from them.
The process of preparing the budget of an organisation is known
as budgeting. It is used to assess overall funds required to finance
various projects of the organisation.
The process of preparing the budget of an organisation is known
as budgeting. It is used to assess overall funds required to finance
various projects of the organisation.
There is no single rule or pro forma available to prepare budget, as
in case of balance sheet and profit and loss account.
S
Performance budget is the collection of all the activities carried
out in the organisation along with their outcomes. It includes a set
of performance targets to be achieved at a given level of expenses.
IM
To prepare fixed budget, funds required to complete various tar-
gets in the budgeted period are fixed. It is usually a short-term
budget as it does not consider variations that may occur in the long
run.
Flexible budget is the one that can be altered with the different
activity levels of the organisation. In flexible budget both the fixed
M
and variable costs are considered.

In Incremental budget, extra amount is summed up to the pre-
vious budget on yearly basis. Incremental budget is prepared by
keeping actual performance of preceding year as a base.
N
By providing quantitative statement, budgeting helps an organi-

sation not just in arranging resources and funds, but also helps in
cost controlling too.
Budgeting helps an organisation in problem-solving, planning and
arranging resources, spreading cost-consciousness, etc.
Zero-Based Budgeting (ZBB) is a process of production planning
that requires each departmental head to justify their entire budget
in a detailed form.
Rolling budget is prepared by making changes in a given budget
at a fixed interval of time. The changes can be made on monthly,
quarterly, half yearly or annual basis.
Cash budgets are generally prepared by analysing cash inflow and
outflow of an organisation. These budgets help in ensuring the
sound liquid position of an organisation for the payment of short-
term liabilities.

n o t e s
key words
Budget: It is the financial and quantitative statement prepared

before a specific period to show the details of activities to be
performed within pre-decided standards.
Fixed Budget: It is the budget in which standards for different
activity level are fixed and cannot be changed at any point of
time.
Flexible Budget: It is the budget in which standards for various
activity levels can be changed according to the situation.
Zero-Based Budgeting: It is the process of budgeting in which
managers of various departments are required to justify the en-
tire budgeted amount in detail.
S
Cash Budget: It forecasts the cash inflow and outflow of an or-
ganisation.
IM
1. Explain the concept of budget.
2. Discuss the various types of budget.
3. ABC organisation manufactures two products: X and Y. Following
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is the forecast of the finance department of the sales of the two

products in the first seven months of a given year:
Month Product X Product Y

(`) (`)
N
January 20000 56000

February 24000 56000
March 32000 48000
April 40000 40000
May 48000 32000
June 48000 32000
July 40000 36000
The following are anticipated by the company:

No work-in-progress will be there at the end of any month.
Finished products equal to the half of next month’s demand will be
there in the stock at the end of each month (including the previous
year’s December month).
Budgeted production and production cost for the whole year are
as follows:

n o t e s
Particulars Product X Product Y

Product (units) 1,10,000 1,20,000
Direct Material Cost Per Unit 241 380
Direct Labour Cost Per Unit 20.25 35
Total factory overhead (apportioned) 3,30,000 4,80,000
Prepare for the six months period ending 30th June; production bud-
get for each month and a summarized production cost budget.
S
Topic Q.No. Answers
Concept of Budget 1. a. Constant check
Types of Budget 2. True
IM
Budgeting as Tool of Cost 3. Profit plans
Control
Advantages and Limita- 4. True
tions of Budgeting
Zero-Based Budgeting 5. Zero-based budgeting
(ZBB)
M
Rolling Budget 6. False

Cash Budget 7. Cash budgets
N

1. Budget can be defined as a quantitative statement developed
to ascertain the funds required for various projects and the
income that would be generated from them. Refer to Section
10.2 Concept of Budget.
2. Budget is generally divided into four types; namely performance
budget, fixed budget, flexible budget, and incremental budget.
Refer to Section 10.3 Types of Budget.
3. The solution to the given problem is as follows:
Production Budget of Products X and Y (units) for the Six
Months (January to June)

n o t e s
Month Sales Planned Inventory Budget Production

Closing Opening (Column (Column
2 + 4 - 6) 3 + 5 - 7)
X Y X Y X Y X Y
1 2 3 4 5 6 7 8 9
January 20000 56000 12,000 28,000 10,000 28,000 22,000 56,000
February 24000 56000 16,000 24,000 12,000 28,000 28,000 52,000
March 32000 48000 20,000 20000 16,000 24,000 36,000 44,000
April 40000 40000 24,000 16,000 20,000 20,000 44,000 36,000
May 48000 32000 24,000 16,000 24,000 16,000 48,000 32,000
June 48000 32000 20,000 18,000 24,000 16,000 44,000 34,000
Refer to Section 10.3 Types of Budget.
S
Suggested Readings
IM
Pandey, I. (1979). Financial management. New Delhi: Vikas Pub.
House.
M
E-REFERENCES
Fmlink.com,.(2014). Budgeting and Cost Control. Retrieved
14 November 2014, from http://www.fmlink.com/article.cgi?-
N
type=How%20To&pub=BOMI%20International&id=31187&-
mode=source
Small Business - Chron.com,. (2014). Five Types of Budgets in
Managerial Accounting. Retrieved 14 November 2014, from http://
smallbusiness.chron.com/five-types-budgets-managerial-account-
ing-50928.html
Smetoolkit.org,.(2014). Budgeting as a Control Tool. Retrieved 14
November 2014, from http://www.smetoolkit.org/smetoolkit/en/
content/en/543/Budgeting-as-a-Control-Tool

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C h
11 a p t e r
CASE STUDIES
CONTENTS
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Case Study 1 Analysis of Financial Decisions at Taneja Exporters Ltd.
Case Study 2 Functions of a Finance Manager
Case Study 3 Application of Time Value of Money
Case Study 4
IM
NPV at Aryan Ltd.
Case Study 5 Funds Sourcing at Global Enterprises
Case Study 6 Nike, Inc. - Cost of Capital
Case Study 7 High Level of Corporate Debts in India is a Matter of Concern: Imf
Case Study 8 Relationship between Stock Price Volatility and Dividend Policy: A
Case Study of Karachi Stock Market
M
Case Study 9 Working Capital Management in Cytec Industries

Case Study 10 Working Capital Management at Dabur
Case Study 11 Receivable Management in a Public Limited Company
Case Study 12 Meeting Business Objectives through Budgeting: A Case Study
of Kraft
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Case study 1
n o t e s
Analysis of Financial Decisions at Taneja

Exporters Ltd.
This Case Study explains the analysis of financial decisions in an

organisation. It is with respect to Chapter 1 of the book.
Taneja Exporters Ltd. is the manufacturer and seller of industrial

containers and packing cases. The organisation has a significant
market share in the industry. However, due to an increase in the
level of competition in the last few years, Taneja Exporters felt the
need to take steps for retaining its position in the market.
Consequently, a meeting of Board of Directors is called by the

Chairman of the organisation, Mr. Shashi Chakravarty. In the
meeting, it is decided that the organisation should reduce the
S
prices of the products in order to attract more customers and in-
crease profits. However, a sudden and high reduction in the prices
of products can also lead to heavy loss for the organisation. So, it
is decided that this reduction will be done in three phases. Firstly,
IM
the prices will be reduced by 5% and its effect on the overall prof-
its of the organisation will be analysed. After that, the prices may
further be reduced by 10% and then by 15%. Along with the reduc-
tion in prices, the organisation also needs to increase its sales for
maintaining the profit level. So, it is necessary to assess the impact
of this reduction on the sales and profit of the organisation.
M
The finance manager of Taneja Exporters is assigned the task of

determining the profitability of the organisation, if the prices of
the product are reduced to 5%, 10% and 15%. The finance man-
ager starts his analysis using the following information:
N

Present sales turnover (300000 units) 3000000
Less: Variable cost (300000 units) 1800000
Less: Fixed cost 700000
Net profit 500000
Based on the above information and the current price of prod-

uct (which is `10), the finance manager conducted an analysis to
check whether the decision of reduction in prices is feasible or
not. The results of the analysis are shown in the following table:

Case study 1: Analysis of Financial Decisions at Taneja Exporters Ltd. 259
Case study 1
n o t e s
Particulars Present Price at Price at Price at

price reduction reduction reduction
of 5% (`) of 10% (`) of 15% (`)
Price 10 9.50 9.00 8.50
Less: Variable cost 6.00 6.00 6.00 6.00
Contribution per unit 4.00 3.50 3.00 2.50
Total contribution required = Fixed cost + Profit
= `700000 + `500000 = `1200000
Therefore, the units required to meet the total contribution are

calculated as follows:
Particulars Calculation Units to be
S
produced
At the present price `1200000 /4.00 300000
When price is reduced by 5% `1200000 /3.50 342860
IM
From the above table, it can be said that the decision of reducing
the prices of product is feasible for the organisation. It will enable
the organisation to retain its position in the market and increase
its customer base.
M
questions
1. Which method of financial decision analysis is used by

N
Taneja Exporters?
(Hint: Cost-Volume-Profit analysis)
2. How the CVP analysis is different from the BEP analysis?
(Hint: Cost-Volume-Profit (CVP) analysis determines the
change in profit with respect to changes in sales volume
and costs while the BEP analysis is used to check whether
the given level of production would be profitable for an
organisation or not.)

N
M
IM
S
Case study 2
n o t e s
FUNCTIONS OF A FINANCE MANAGER
This Case Study shows the functions that need to be performed by

a financial manager during the expansion of an organisation. It is
with respect to Chapter 1 of the book.
Madhu Ltd. is a manufacturer of dairy products that caters to the

needs of local markets of India. It has become one of the top or-
ganisations in the dairy industry of India and is working in collab-
oration with some reputed international organisations. It mainly
focuses on manufacturing dairy products, like milk, curd, khoya,
cheese, etc. The organisation wants to expand its business opera-
tions in international markets. The main objective of the organi-
sation is value maximisation, i.e. increasing the value of its shares
in the market.
S
For doing so, the organisation appoints Mr. Rajendra Pal as Chief
Financial Officer (CFO). His tasks include identifying investment
opportunities and taking financial decisions for the expansion of
IM
the organisation in other countries. In order to do so, Mr. Rajen-
dra performs the following investment functions:
Determining the expected return and profitability from new
investments
Comparing the required rate of return against the prospective
M
return of new investments

Identifying the risk and uncertainty involved in the expansion
projects
N
The financial functions performed by Mr. Rajendra Pal are as

follows:
Identifying the amount of capital required for the business ex-
pansion program.
Selecting the source of capital to be used for expansion pur-
pose. These sources of capital will include short term and long
term financing.
Deciding the capital structure, that is, the debt-equity ratio for
the investment
After performing the above functions, Mr. Rajendra decides that

Madhu Ltd. should start its expansion in USA as it is one of the
biggest dairy products manufacturer as well as consumer and
then move on to other countries.

Case study 2
n o t e s
questions
1. What are the recurring functions that should be performed

by Mr. Rajendra Pal?
(Hint: The recurring duties of finance manager include
the estimation of financial needs, sourcing the required
funds and allocation of these funds. Along with this the
risk-return assessment and other economic factors, which
impact the long term success of the organisation should
be evaluated on a continuous basis.)
2. List the methods used by the CFO to analyse the financial
decisions of Madhu Ltd.
(Hint: Cost-Volume-Profit analysis, Break-Even analysis,
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IM and marginal costing)
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N

Case study 3
n o t e s
Application of Time Value of Money
This Case Study explains the application of the time value of money
in determining retirement savings of an individual. It is with re-
spect to Chapter 2 of the book.
Mr. Raman Shrivastava, a 35 years old man, has planned to take

retirement from his current job at the age of 65 (i.e. 30 years from
now). His objective is to have atleast an income of `75,000 every
year in his retirement account starting from his day of retirement
(i.e. 31 years from now) and this should continue up to 25 years.
The current balance that he is saving for the retirement purpose
is `10,000. To increase this amount, he started saving `5,000 every
year. He is not able to increase this saving amount further as he
is a single parent with two children, who will be starting their col-
S
lege in the next five years. He can only increase this amount after
his children complete their graduation, which will be around 10
years from now. Mr. Raman wants to determine the amount that
IM
he should save after his children complete their graduation (i.e.
after 10 years) to meet his ultimate goals. For this purpose, he
meets a financial consultant.
The financial consultant goes through the problem of Mr. Ra-

man and summarise the main points of his problem, which are as
follows:
M
Current amount of money in the retirement account, i.e. the

first cash inflow
Amount of money to be saved in the next 10 years, i.e. the sec-
ond cash inflow
N
Amount of money to be saved between 11 to 30 years, i.e. the

third cash inflow
Amount of money taken as income from 31 to 50 years, i.e. the
one cash outflow
In the abovementioned amounts, the first and second cash in-

flows are given while we need to determine the third cash inflow.
The financial consultant identified that the amount of three cash
inflows should be equal to the one cash outflow in order to meet
the objective of Mr. Raman Shrivastava. In addition, the analyst
has assumed an average of 8% annual return in the retirement
account.
The financial manager performed the following calculations in or-

der to get the third cash inflow:
All the three cash inflows are indexed at t = 30 First cash inflow:
FV (single sum) = PV *(1 + r)N

Case study 3
n o t e s
= (`10,000)*(1.08)30
= `100,627
Second cash inflow:

FV annuity factor = [(1 + r)N – 1]/r
= ((1.08)10 - 1)/.08
= 14.48656
FV (annuity) with a `5000 payment = (`5000)*(14.48656)
= `72,433
The above amount is accumulated at t = 10, and we need to index

it to t = 30, which can be calculated as follows
S
FV (single sum) = PV *(1 + r)N
= (`72,433)*(1.08)20
IM
= `337,606
Cash PV annuity factor = (1 - (1/(1 + r)N)/r
= (1 - (1/(1.08)25/0.08
= 10.674776.outflow
PV (annuity) with payment of `75,000= (`75,000)*(10.674776)
M
=`800,608
As the three cash inflows should be equal to cash outflow at

t=30, so:
N
(`100,627) + (`337,606) + X = `800,608

X = `362,375
Thus, Mr. Raman should have a total of `362,375 amount in his

retirement account from 11 to 30 years after the completion of his
children graduation in order to meet his retirement goals. Thus,
the amount he should save every year starting from 11 years to 30
years is as follows:
FV annuity factor = ((1 + r)N - 1)/r
= ((1.08)20 - 1)/.08 = 45.76196
A = FV/FV annuity factor = (362,375)/45.76196 = `7919
So, Mr. Raman Shrivastava should increase his saving from `5,000
to `7,919.

Case study 3: Application of Time Value of Money 265
Case study 3
n o t e s
questions
1. Identify some other applications of time value of money in

real life.
(Hint: The concept of time value of money can be applied
for determining mortgages payments and selecting
projects.)
2. Why a person values the money available at present?
(Hint: Investment options currently available in the
market and the risk associated with the money to be
received in future are the two reasons why people value
the money available at present.)
S
IM
M
N

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IM
S
Case study 4
n o t e s
NPV at Aryan Ltd.
This Case Study shows the application of the NPV method for
project selection in an organisation. It is with respect to Chapter 3
of the book.
Aryan Ltd. is one of the renowned publishers of school books. It

is well known for its good quality books. The sales force of the or-
ganisation is highly dedicated and is thus able to bring good proj-
ects for the organisation. Although the organisation takes only
one project at a time due to lack of resources, it completes the
project with full enthusiasm along with proper checks on quality.
Like always, the sales team of the organisation has come up with
two new projects and the organisation needs to select one of them.
S
For this purpose, both the projects are analysed qualitatively and
quantitatively by the management of the organisation. The quali-
tative analysis includes the brand image and equity of the projects
and how they will help Aryan Ltd. to get new opportunities in the
IM
near future. The results of the qualitative analysis show that both
the projects are equally profitable for the organisation. After that,
quantitative analysis of the projects is conducted by the finance
manager of the organisation.
The finance manager found that the weighted average cost of

M
capital (WACC) of the company is 8%. Among the two projects,

the first project costs $7 million to the company while the income
generated annually will be $3 million after three years from when
the project is taken to five years (i.e. 3 to 7 years). However, the
second project will cost around $2.5 million for the company
N
and generate $2 million in the next three years (i.e. 1 to 3 years).

Based on the above information, the financial manager has used
the NPV method for the selection of the project. The formula used
by him is as follows:
NPV = (PV inflows) - (PV outflows)
NPV for the first project is calculated as follows by the finance

manager:
PV outflows for the first project = cost of the project = $7 million

PV inflows of the first project are viewed as an annuity in which
the first payment will be received by the organisation after three
years. Thus, the annuity factor can be calculated as follows:
PV annuity factor for r = .08
N=5
PV factor of annuity = (1 - (1/(1 + r)N)/r
= (1 - (1/(1.08)5)/.08

Case study 4
n o t e s
= (1 - (1/(1.469328)/.08
= 3.99271
When t=2, then

PV of annuity = ($3 million)*(3.99271) = $11.978 million
When discounting back two periods, we get:
PV inflows for the first project = ($11.978)/(1.08)2 = $10.269 million

Thus, NPV for the first project is calculated as follows:
NPV of first project= $10.269 million - $7 million
= $3.269 million
Now, the manager determines the NPV of the second project as
S
follows:
PV annuity factor for r = .08, N = 3
IM
PV factor of annuity = (1 - (1/(1.08)3)/.08
= (1 - (1/(1.259712)/.08
= 2.577097
PV of the annuity = ($2 million)×(2.577097)
= $ 5.154 million (PV inflows for second project)
M
NPV of the second project is calculated as follows:

NPV of second project = ($5.154million) - ($2.5 million)
= $2.654 million.
N
From the above calculations, it can be seen that NPV of the first
project, i.e. $3.269 million is more than NPV of the second project,
i.e. $2.654 million. So, the finance manager selects the first project
and communicates the same to the top management of the organ-
isation.
questions
1. What is the benefit of using the NPV method for the

selection of a project by Aryan Ltd.?
(Hint: NPV helps in getting accurate measurements of
profitability by determining the cash flows generated by
a project throughout its life cycle.)
2. What are the other methods of the project selection that
can be used by Aryan Ltd.?
(Hint: Internal Rate of Return (IRR) and Profitability Index)

Case study 5
n o t e s
Funds Sourcing at Global Enterprises
This Case Study shows how funds are sourced by an organisation. It

is with respect to Chapter 4 of the book.
Global Enterprises is a manufacturer of a wide variety of leather

accessories. It not only caters to the needs of Indian customers
but also exports its products to other countries. The organisation
is also expanding in countries like the USA, UK and Australia.
In addition, the organisation is also planning to introduce a new
range of products specifically for the youth. Global Enterprises
is primarily focusing on the expansion of its business in the USA
and UK as the demand for its products is increasing in the mar-
kets of these countries. However, the organisation is concerned
about the exposure to exchange rate risk during its expansion.
S
In order to avoid such situation, the organisation has decided to
work in joint venture with the leading organisations in the same
industry of the USA and UK for producing and selling its prod-
IM
ucts in these markets. In return of this service, Global Enterprises
is ready to pay the organisations in the USA and UK in dollars
and pounds, respectively. Thus, the organisation requires a good
amount of funds to enter these new markets.
As a result, the management of the organisation has decided to

raise funds through external short-term financing. It takes the fol-
M
lowing steps in this respect:

Global Enterprises has a strong goodwill; thus, it gets the
short-term loans sanctioned very easily and at low interest
rates as the interest rate prevalent in the USA and UK mar-
N
kets are one-third and half of the Indian market, respectively.

Global Enterprises has shifted its excess funds, i.e. cash sur-
plus units to cash deficit units in order to raise funds. This has
lowered down the cost of external borrowing of the organisa-
tion and also reduced the market risk of exposure.
The internal financing is done by the subsidiary of the
organisation. This increases the liquidity and efficiency of the
organisation.
Thus, Global Enterprises is able to enter the markets of USA and

UK in order to earn huge profits.

Case study 5
n o t e s
questions
1. Do you think the external sources of short-term funding

used by Global Enterprises are justified? Discuss.
(Hint: The organisation opted for short-term funds from
external sources as the organisation could take loans
at low interest rates compared to India’s interest rates.
However, the organisation would have benefitted from
long term financing as short-term loans need to be repaid
within a tenure of 1-3 years and the Indian organisation,
which would be in its growth stage during these years
cannot afford to take the risk of destabilising its working
capital.
S
2. How will the liquidity and efficiency of the organisation
improve through internal financing?
(Hint: In case the organisation arranges finances
IM
internally, its liquidity and efficiency increases as the
finances can be arranged relatively faster internally than
by obtaining funds from external sources, it also improves
the profitability, which in turn results in enhancing the
value of its shares.)
M
N

Case study 6
n o t e s
NIKE, INC. - COST OF CAPITAL
This Case Study discusses the use of Weighted Average Cost of Cap-
ital (WACC) for evaluating investment opportunities at Nike Inc. It
is with respect to Chapter 5 of the book.
Nike, Inc. is a US based multinational organisation engaged in

the design, development, manufacture, and sale of footwear, ap-
parel, accessories, etc. In June, 2001, Kim Ford, a portfolio man-
ager at North Point Group, a mutual-fund management firm,
went through the reviews of the shoe manufacturer posted on the
Internet by other financial analysts. She concluded that Nike’s
share price had fallen sharply since the beginning of the year.
Kim wondered if she should purchase some shares of Nike for
the mutual fund she was managing. The mutual fund contained
S
shares of mostly Fortune 500 companies. Some of the other com-
panies in the mutual fund managed at North Point Group, includ-
ed big names like ExxonMobil, General Motors, McDonald’s, 3M,
IM
and other large-cap economy stocks. In spite of the severe decline
in the US markets over the last 18 months, the North Point Large-
Cap Fund had performed exceptionally well.
Earlier in the week, a meeting had been held at Nike’s headquar-

ters for disclosing its results for the fiscal-year 2001. However, the
other intention of holding the meeting was that management at
M
Nike Inc. wanted to communicate a strategy for revitalising the

organisation’s performance. Right from the beginning of 1997, the
company’s revenues had plateaued at around $9 billion; its net
income had dropped to $580 million (from almost $800 million).
In addition, the shoe maker’s market share had fallen from 48%,
N
in 1997 to 42% in 2000. Nonetheless, recent supply-chain issues in

the company had a strong negative effect on the revenue.
Kim Ford read the report on the meeting held at Nike headquar-
ters but the reports gave her no clear guidance about buying,
holding or giving away with Nike’s shares. Finally, Kim decided
to develop her own discounted cash flow forecast to come to a
clearer conclusion. Her forecast indicated that at a discount rate
of 12%, Nike was overvalued at its current share price of $42.09.
Performing a quick sensitivity analysis, Kim also found out that
Nike was undervalued at discount rates below 11.2 per cent. Kim
wanted to perform further research on Nike’s share but had to
leave for another meeting. So she requested her assistant, Joanna
Cohen, to estimate Nike’s cost of capital. Joanna collected all the
data she needed and started with her analysis. At the end of the
day, she submitted her cost of capital estimate to Kim Ford.
Since Nike is funded with both debt and equity, Joanne used the
Weighted Average Cost of Capital (WACC) method for estimating

Case study 6
n o t e s
its cost of capital. Weighted average cost of capital (WACC) is the

average after-tax cost of an organisation’s capital sources, includ-
ing common stock, preferred stock, bonds and any other long-
term debt. It represents the minimum rate of return at which a
company offers value to its investors. Based on the latest available
balance sheet, debt makes up 27.0 per cent and equity accounts
for 73.0 per cent of the total capital..In addition, it is given in the
company records of Nike that its cost of debt (Kd) is 4.3% with tax
and it is 2.7 % after adjusting taxes. On the other hand, its cost of
equity (Ke) is 10.5 %.
Later, Joanne put all the values in the WACC formula for compu-
tation of Nike’s cost of capital:
WACC = 2.7 × 27 + 10.5 × 73
S
WACC = 8.4 %
questions
IM
1. What should Kim Ford recommend regarding an
investment in Nike?
(Hint: Since WACC indicates the minimum returns the
company needs to generate for creating value for its
customers, a lower WACC is preferable. Since Nike’s
M
performance in the last few years is low, generating

returns at this rate would be challenging. Nonetheless,
Kim could project future cash flows and discount them
using WACC (WACC is used as discount rate for NPV
calculations) and divide the resulting figure by number of
N
equity share holders. This would give the share value of

the company, which could be compared with the current
market price to decide whether to invest in Nike or not.)
2. Why do you think it is important to estimate a firm’s cost
of capital?
(Hint: The cost of capital is the rate of return required by a
capital provider in exchange for foregoing an investment
in another project, it is the minimum return required
by investors, it represents the discount rate for NPV
calculations, helps in evaluating the capital structure of a
company, etc.)

Case study 7
n o t e s
HIGH LEVEL OF CORPORATE DEBTS IN INDIA IS A

MATTER OF CONCERN: IMF
This Case Study discusses the threat posed by highly leveraged firms
on the Indian economy. It is with respect to Chapter 6 of the book.
S
The International Monetary Fund (IMF) has recently warned that
IM
the high level of debts in Indian companies is posing a threat to
the economic stability of the country. According to IMF, the debt-
equity ratio of almost one third of the corporates in the country
exceeds 3. According to IMF, this is the highest degree of leverage
in the Asia-Pacific region. In the Asia Pacific Economic Outlook,
IMF announced that “In some countries, even though aggregate
M
measures are not excessive, a large share of corporate debt is con-

centrated in only a few, highly leveraged firms. The distribution
of leverage does matter and Asia clearly has ‘pockets’ of highly le-
veraged firms- including in China, Japan, India, and Korea – they
may pose a risk to macroeconomic stability.”
N
A high debt-equity ratio is indicative of the fact that the company

is relying on borrowing rather than raising funds from the market
to fund its expansion. Therefore, a high debt-to-equity ratio can
adversely affect the financial health of a firm in the case of a rise
in interest rates and a slowdown in the economy.
In case, the global liquidity tightens and interest rate rises, the
cost of borrowing funds will rise, which, in turn, will put further
strain on the corporate sector. The slowdown of the economy, rise
in interest rates, fall in demands, and delay in project approvals
adversely affect the ability of many firms to repay debts. The IMF
projected the Indian economy to grow by 5.4% in 2014-15 as com-
pared to 4.5% in the year ending 31 March 2014. The IMF also
observed that out of the total borrowing of USD 400 billion by
3,500 Indian companies, almost 34% was with the firms having
low interest cover, in comparison with 31% in the previous year.
High financial leverage in firms poses systematic risks in various

sectors, such as infrastructure, power, road, textiles, and jewelry.

Case study 7
n o t e s
This systematic risk can have negative effects on exports as well

as employment.
In India, more than 50% of the corporate debt is held by firms hav-
ing less than 5% return on assets. In addition, some of these com-
panies are even incurring losses. Moreover, more than one fifth
of the debt is held by firms having less than one profit-to-interest
expense ratio. The lower is the profit-to-interest expense ratio,
the greater burden of debt the company has. According to K.C.
Chakrabarty, the previous deputy governor of Reserve Bank of
India (RBI), Indian banks are over-burdened by highly leveraged
firms in India. RBI’s Outgoing Deputy Governor K.C. Chakra-
barty said in a recent interview that bad loans originate from non-
-performing administration. According to him, “If NPAs (non-per-
forming assets) are high, everybody is responsible including the
S
central and state governments, policymakers and regulators.”
In December 2013, the gross bad debt of 40 listed banks of India

IM
jumped to `2.43 trillion: a 36% increase over the previous year.
According to said Shinjini Kumar, the executive director at Price-
waterhouseCoopers India, a leading consultancy, “I think the con-
centration of debt due to the small base of large enterprises does
pose its challenges and is a worrying phenomenon across emerg-
ing markets, including India. We could see a turnaround depend-
ing on post-election policy scenarios, but in the meanwhile, banks
M
will have to deal with challenges of provisioning and allocating

capital for risk,” He also added “The downside is that even if pol-
icy climate is set right, capital to fund growth will be scarce, slow-
ing recovery.”
N
Raghuram Rajan, the Governor of RBI also warned bankers to

avoid cleaning up of books by delaying the classification of assets
turning into bad loans. He also added that banks need to speed up
recovery to clean up their books.
questions
1. How does high financial leverage in firms affect an

economy?
(Hint: Financial leverage poses systematic risk and
financial threat in the case of interest rate hike.)
2. How does profit-to-interest expense ratio reflect the
financial health of a firm?
(Hint: Low profit-to-interest expense ratio indicates that
the company is not making sufficient profits to meet its
interest payment obligations.)

Case study 8
n o t e s
Relationship between Stock Price Volatility

and Dividend Policy: A Case Study of Karachi
Stock Market
This Case Study discusses the correlation between stock price vol-
atility and dividend policies in non-financial firms in the Karachi
stock market. It is with respect to Chapter 7 of the book.
S
IM
The case deals with the analysis of stock price volatility in the
non-financial firms on Karachi Stock Exchange to find out its re-
lationship with the dividend policy. The study was conducted on
35 firms over a decade (2001-2011). The dividend yield was taken
M
as the main variable in the case. Firm size, growth, EPS and stock
price volatility were the other explanatory variables. The study
concluded that there is an inverse relationship between dividend
yields.
N
In simple words, stock price volatility refers to fluctuations in the

stock prices during a particular period. Stock price volatility is
very commonly observed in the equity market. Investors would
have no interest in investing in the stock market without volatil-
ity. Stock price volatility depends on a number of factors, such as
earnings of the firm, leverage position, bonds yields and dividend
yields.
Studying the relationship between the stock price volatility and

dividend yields is very crucial as it can influence the dividend pol-
icy decisions of companies. A number of studies have been con-
ducted previously to determine as to how the dividend policy of a
firm affects its stock prices. This case focuses on stock price vola-
tility because of changes in the dividend policy.
Research Methodology
The financial data of 35 non-financial companies is listed on the

Karachi Stock Exchange (KSE) for a decade 2001-2011. The sam-

Case study 8
n o t e s
ple of companies was randomly picked from a list of the compa-

nies in Hundred Index on October 19, 2011. The research team
calculated six variables of the 35 companies for 11 years. Data was
collected from the annual reports of the companies. The 35 com-
panies in the sample consisted of companies from various sectors,
such as automobile, communication and technology, cement, en-
ergy, sugar, textile, jute, chemical and fertilizer, pharmaceuticals,
and foods and beverages.
Following model was used in the study:

1. P_VOL = α +β1P_OUT + β2D_YIELD + β3E_VOL + β4SIZE
+ β5 GROWTH + β6 EPS+ε
In which:
S
1. α refers to intercept.
2. β refers to regression coefficient.
3. ε is the error term.
IM
The correlation of the variables shows that there is a high
level of correlation (0.88) between the dividend yield and
payout ratio.
The following partial regression models were used in the
study:
M
2. P_VOL = α +β1D_YIELD + ε
3. P_VOL = α +β1D_YIELD + β2SIZE+ ε
4. P_VOL = α +β1D_YIELD + β3GROWTH+ε
N
5. P_VOL =α+β1D_YIELD+ β3GROWTH + ε

6. P_VOL =α+β1D_YIELD + β5E_VOL + ε
Following is the calculation of the summary statistics of the vari-

ables:
Table 1: Descriptive Statistics
Mean Max. Min. Std. Skewness Kurtosis J-bera
Dev.
D-YIELD 0.056 0.904 0.000 0.074 8.245 90.587 64,540.563
EPS 5.50 159.15 .0013 13.617 7,304 73,118 51,512.291
E-VOL .213 1.093 .015 165 1.745 7.775 332.374
GROWTH .275 1.382 0.005 .254 1.618 5.509 139.018
P_OUT .348 5.531 .013 .463 7.994 84.750 56087.241
P_VOL .599 3.568 .001 .557 2.078 9.293 566.355
SIZE 17,272.21 187,302 272.300 27.853 3.514 17.101 2,534,155

Case study 8: Relationship between Stock Price Volatility and Dividend
Policy: A Case Study of Karachi Stock Market 277
Case study 8
n o t e s
The correlation between the variables used in the study is shown

in the following table:
D_
YIELD EPS E_VOL GROWTH P_OUT P_VOL SIZE
D_YIELD 1
EPS 0.12 1
E_VOL .20 0.15 1
GROWTH -.017 -0.03 -0.11 1
P_OUT 0.88 0.11 0.07 0.22 1
P_VOL -0.13 -0.01 0.00 0.14 -0.15 1
SIZE -0.02 -0.15 -0.36 0.01 0.02 -0.2 1
As it can be seen in the table, the highest positive correlation
S
(0.88) is between dividend yield and payout ratio.
Conclusion
IM
The study used partial regression models to analyse the relation-
ship between the dependent variable and various independent
variables. The results show that there is a negative correlation
between price volatility and dividend yields.
M
questions
1. How can the study, discussed in this case, help companies

in devising dividend policy decisions?
(Hint: There is a negative correlation between price
N
volatility and dividend yields.)

2. Why is it important to study the correlation between the
stock price volatility and dividend yield?
(Hint: It can influence the dividend policy decisions of
companies.)

N
M
IM
S
Case study 9
n o t e s
Working Capital Management in Cytec

Industries
This Case Study discusses how Cytec Industries managed its work-
ing capital in a time of economic downturn. It is with respect to
Chapter 8 of the book.
The case deals with working capital management in Cytec Indus-
S
tries, a chemical and material company, headquartered in New
Jersey that develops, manufactures and sells value-added prod-
ucts. It supplies various materials to a wide range of industries,
IM
such as aerospace, adhesive, automotive, industrial coatings,
chemical intermediates, inks, mining and plastics. Cytec Indus-
tries operate in more than 35 countries.
Challenges
Towards the end of 2008, there has been a major slowdown in the
M
global economy and the business activities of Cytec have been

likewise affected. Therefore, it became obvious to the manage-
ment that managing cash would be very crucial in dealing with
the business slowdown. The stock price of the company also went
N
down. Therefore, the company was required to amend its bank

facility covenants and refinance the senior debts cue in 2010. In
order to refinance debt, the company had to demonstrate to the
capital market that it was in a position to generate cash even in
the downturn and manage the operations effectively.
The working capital requirements had been showing an incre-

mental trend because of growth rate and a number of acquisitions
made by the company. The working capital requirement was sig-
nificantly higher than that of the competitors. The financial anal-
ysis of the company showed excess working capital of more than
USD 200 million. Working capital management was not an issue
as long as the business was running strong. However, the down-
trend made the management realise that effective working capital
management was very crucial for generating cash. According to
David Drillock, Vice President of Cytec, “We recognised the op-
portunity to tap excess working capital to invest in the businesses
that will shape our future.” He also added “When the economy
began to deteriorate in 2008, we decided to accelerate this effort.”

Case study 9
n o t e s
However, reducing the working capital requirements was not an

easy job as it would require better metrics and reporting system.
In addition, it would also require a change in the culture of the
company to inculcate the habit of focusing on working capital in
organisational decision-making. According to Scott Hain, Vice
President, Global Supply Chain, “We want our people to under-
stand how their day-to-day activities affect working capital”. He
also adds “Anytime an individual makes a decision/ he or she
should ask, ‘what impact will this have on working capital?”
Plan of Action
The company hired REL as a financial consultant to devise a plan

for improving working capital conditions without compromising
S
in customer services. Drillock notes that “Just about anyone can
take steps to address working capital, but we wanted to make sure
our results were sustainable. He added that “We wanted a part-
ner who understands this and working capital is REL’s business.”
IM
After analysing the business functions of the company, REL iden-
tified the key functional areas that affect working capital manage-
ment. Every key functional area was assigned with a project team
to identify the opportunities of improving working capital condi-
tions. In addition, REL analysed the operations of two operating
units of Cytec in two continents, took personal interviews with the
M
front-line personnel, and examined the transactional level activi-

ties to identify the drivers of working capital. On the basis of the
analysis, REL concluded that the working capital goal of Cytec
Industries could be improved by taking the following actions:
Following a standard practice of collection in all operating
N
locations
Differentiating credit policies on the basis of the characteris-
tics of customers
Implementing an escalation process in order to avoid overdue
of receivables
Evaluating the inventory parameters to create an economic
balance between cost and service levels of different categories
of products
Improving the payment terms with key suppliers
Using a payment clock to ensure that bills are not paid before
they become due
Prior to the intervention by REL, Cytec’s management expected

to reduce working capital requirements by reducing inventory
level. The analysis revealed that there was scope of improvement
in payables and receivables. According to Hain, “We knew that we

Case study 9: Working Capital Management in Cytec Industries 281
Case study 9
n o t e s
are on the right track, but the analysis provided the evidence and
specificity that enabled us to refocus priorities across functions
and gain support for moving forward.” REL and Cytec teamed up
to utilise the findings of the analysis to create a comprehensive
action plan to improve working capital conditions.
Implementation
Cytec adopted the project management approach of REL by in-

corporating proper reporting structure and building close coordi-
nation among multinational teams and initiated a five-month long
implementation project.
Within a few weeks of the implementation process, it was observed

that the employees were taking the action plan very seriously. A
S
number of quick wins were made in the area of receivables and
payables. Once people saw the new concept succeed, they wanted
to put more dedication towards the goals.
IM
REL assisted Cytec in defining various important metrics and key
performance indicators to measure the progress of the project.
Results
Within a year of starting the project, Cytec achieved its working

M
capital improvement goals through a number of modifications in

receivables, payables and inventory processes. In each process,
the company made significant progress against the key metrics.
For example, Cytec reduced the number of days of holding in-
ventory on hand, number of days of sales outstanding, and the
N
number of days to pay. In addition, by improving working capital

condition, Cytec was better able to manage cash and focus on its
future goals and invest in critical businesses in spite of a challeng-
ing economic and business environment.
questions
1. Explain the importance of working capital management

in adverse economic situations in context of the given
case.
(Hint: Every organisation needs an adequate amount of
working capital to overcome financial crisis. In addition,
excessive working capital acts adversely for organisations.)
2. What were the crucial factors in improving the working
capital condition of Cytec?
(Hint: Accounts payable, receivable, credit policy,
inventory management etc.)

N
M
IM
S
Case study 10
n o t e s
Working Capital Management at Dabur
This Case Study discusses the working capital management in

Dabur. It is with respect to Chapter 8 of the book.
S
IM
Dabur was set up in 1884 by Dr. S. K. Burman in West Bengal. The
company was run as a family business for more than 100 years.
However, towards the end of 1990s, the management of the com-
pany was handed over to a team of professionals. It was quite chal-
lenging for the new management to deal with various important ar-
M
eas, such as working capital management and cash management.

The prevailing current and quick ratios of the company were 3.2
and 2.4, respectively. The ratios were considered too high and in-
dicated that the company had high working capital requirements.
N
Naturally, the new management put efforts to improve the work-

ing capital situation. However, these efforts faced a high level of
resistance from different sectors of the company. In spite of the re-
sistance, the new management was successful in bringing a dras-
tic improvement in the working capital condition of the company.
Approach of the New Management
The new management came with a renewed approach of man-

aging the company. Earlier, the major focus of the company was
on improving profitability. The new management emphasised on
improving performance and efficiency in all areas of the com-
pany. It took help of the consulting giant McKinsey & Company
to restructure the organisational structure in order to ensure bet-
ter responsibility accounting. In addition, the management in-
troduced and restructured various departments, such as supply
chain, sales/marketing and procurement. Moreover, the planning
and budgeting activities in the company were streamlined, and

Case study 10
n o t e s
the finance department was entrusted with continuously evalu-

ating the performance of the company with other FMCG majors
with the help of ratio analysis. The old management completely
ignored these aspects of operations and management. In short,
the idea behind introducing such organisation-wide changes was
to ensure efficiency in all areas of the business.
Managing and improving the working capital condition was a spe-

cial area of interest of the new management. A lot of funds were
blocked in inventories and debtors. This resulted in decline in the
overall Return on Capital Employed (ROCE). Therefore, there
was a significant opportunity in cutting down investment in these
areas. The main focus of the management was to bring down
working capital requirements. The goal was set to bring down net
working capital to zero by 2000-01 and negative in the long term.
S
In order to achieve this goal, the management took several initia-
tives to reduce the cost of the components of the working capital.
However, the management efforts faced stiff resistance from the
IM
stockists, suppliers of materials and the major customers.
Inventory Management to Control Cost
The new management identified that effective forecasting of in-

ventory was most important for effective working capital manage-
ment. This is because the company manufactured and marketed
M
a wide variety of products that required hundreds of different raw

materials. In such cases, any inefficiency in forecasting inventory
would lead to excess inventory and unwanted blockage of funds
in addition to the risk of damage of perishable goods.
N
The new management introduced a new inventory management

system that would encompass all related departments, such as
procurement, manufacturing, marketing, sales and supply chain.
Every year, the annual planning starts in November-December to

develop the annual budget of the company before the beginning
of the next financial year. In addition, the management commit-
tee, consisting of the heads of various departments, also sets the
sales target for the forthcoming year.
The sales department finalises the product requirements on the

basis of the sales target of the forthcoming year. Next, the infor-
mation regarding the product requirement is passed on to the
production department, which prepares a production plan and
determines the raw material requirements. Determination of ma-
terial requirements by the production department helped in pre-
venting excess raw material purchase, reducing the storage cost
and reducing the cost of fund blocked in inventories.

Case study 10: Working Capital Management at Dabur 285
Case study 10
n o t e s
Managing Debtors
Products of the company are purchased mainly by three types

of customers: stockists, institutions and international/export cus-
tomers. The old management did not have any standard credit
policy that could be applied to all the customer types. Under the
old management, the stockists were given a 5-day credit period.
However, the new management decreased the credit time to 1
day. In addition, the company offered relatively flexible payment
terms to institutions, such as malls, large stores and hotels. The
credit terms for the international customers were decided to be
set on the basis of international competition and product pricing.
Cash Management
S
The new management started maintaining bank accounts at all
depot towns. This helped in sending the cheques/drafts collected
from customers in nearby places for local clearing; thereby, re-
IM
ducing the average collection period and increasing the velocity
of cash inflows. Funds, thus collected in the depot towns, were
transferred to the corporate bank account of the company. The
sweeping arrangement of the company with the bank ensured
that the funds transferred from the depot towns were automat-
ically credited towards the settlement of the cash credit loan.
These steps reduced the amount of interest payment.
M
In case some amount of surplus funds was available to the com-

pany, it invested the same in various short-term investment tools,
such as mutual funds and government securities.
N
Financing Working Capital
The underlying principle followed by the company to finance

working capital is to increase the velocity of cash inflows from the
customers and slow down the velocity of cash outflows to cred-
itors. Therefore, negotiation with the debtors and creditors for
favourable terms was very crucial. The management trained the
debtors and creditors in modern ways of financing, such as fac-
toring or bills discounting. In addition, the management also en-
sured transparency in discussion of terms and conditions with the
suppliers and debtors.
Improvement in Supply Chain
The management recognised that efficiency in the supply chain

was very crucial for improving sales and profitability and reduc-
ing working capital requirements. The management restructured
the supply chain as follows:

Case study 10
n o t e s
Raw Material Raw Material

Suppliers- Suppliers-
Imported Domestic C & FAs
Manufacturing Mother
C & FAs
Location Depots
Intermediate
Products
Institutions Distributors
Export
Customers Retailers
The restricted supply chain had positive impact on sales by im-
S
proving service level. In addition, it reduced investment in inven-
tories and increased account payables. Moreover, the new supply
chain optimally used the fixed assets and infrastructure of the
IM
firm by increasing inventory turnover.
Improved Financial Department
The finance department was entrusted with all the aspects of

financial planning and control. The quarterly score cards main-
tained by the departments were used to evaluate the employee
M
performance vis-à-vis Cost to Company (CTC). The management

also implemented an effective incentive system based on the per-
formance of employees. Some other roles of the finance depart-
ment included monitoring and managing inventories, debtors and
N
creditors to ensure that the net working capital remained within

the budget. For example, in case the funds invested in inventory
was in excess of the planned limits, it must be compensated ei-
ther by increasing the amount due to creditors or by reducing the
amount due from debtors.
questions
1. Outline the major activities of the new management to

reduce working capital.
(Hint: Organisational restructuring, streamlining
operations, working capital management etc.)
2. On the basis of the case, discuss the role of inventory
management in reducing working capital requirements.
(Hint: Inefficient inventory management may lead to
unwanted blockage of funds in excess inventory; thereby,
increasing working capital requirements.)

Case study 11
n o t e s
Receivable Management in a Public Limited

Company
This Case Study discusses the receivable management practices in

an Indian public limited company. It is with respect to Chapter 9 of
the book.
Introduction
One of the most crucial objectives of any firm is to make regu-

lar profits. This can happen when the goods and services of the
firms are sufficiently and profitably sold in the market. In order
to supply adequate goods and services in the market, a firm needs
effective production and operation systems, which require suffi-
cient amounts of working capital. Therefore, the growth of a firm
S
is directly linked to its working capital management. Steady sup-
ply of working capital depends on the efficiency of the receivable
management in the firm. Receivables originate from credit sales,
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which is an essential part of the business. This case studies the
efficiency of receivable management in a public limited company.
The following are the major objectives of the study:

Evaluating the credit policy of the company
Evaluating financial performance in terms of sales and
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profitability
Identifying financial parameters crucial for receivable
management
Improving receivable management
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Research Methodology
The study was conducted on a major Indian public limited com-

pany. The study was conducted entirely on secondary data col-
lected from the annual reports of the company for a period of five
years (1999 to 2003). The data, in turn, was analysed with the help
of ratio analysis and other tools, such as t-test, correlation, mean,
standard deviation and percentage analysis.
The performance of the company was evaluated on the basis of a

number of parameters. The following table shows the receivable
management ratios and descriptive statistics:

Case study 11
n o t e s
Year CR LR WTR CSTS DTR ACP CTR APP

1999 1.156 0.940 18.26 0.75 30.71 12 2.915 125
2000 1.189 0.824 24.55 0.75 20.41 18 2.344 155
2001 1.396 0.875 13.32 0.80 10.92 33 2.607 140
2002 1.533 0.992 9.16 0.80 6.69 55 2.484 146
2003 1.287 0.814 15.23 0.85 6.00 57 2.231 163
Mean 1.312 0.889 16.104 0.79 14.945 35 2.516 146
SD 0.155 0.076 5.760 0.042 10.521 20.652 0.264 15.55
CV 11.805 8.577 35.768 5.295 70.39 59.001 10.502 9.979
The following ratios were evaluated to measure the efficiency of

receivable management:
S
Current Ratio: It measures the short-term solvency of a firm.
2:1 is considered to be a healthy current ratio. The table shows
an increasing trend in the current ratio of the company even
IM
though it is below the norms. The solvency of the firm was
considered satisfactory and the firm was in a position to meet
its current liabilities.
Quick Ratio: It is the ratio of the liquid assets and current
liabilities. As norms, a quick ratio of 1:1 is adequate for a firm.
Over the study period, the firm maintained a satisfactory
M
quick ratio.
Working Capital Turnover Ratio (WTR): It is the ratio of the
net current assets and sales. The higher the WTR, the more
efficient is the use of working capital. The table shows that the
WTR of the firm varied between 9.16 and 24.55 with high fluc-
N
tuations. The average WTR of the firm was 16.104, which was
below the satisfactory level. There was a positive correlation
coefficient between working capital and sales of the company.
This indicates that the sales of the company increased with
the increase in the working capital.
Credit Sales to Total Sales (CSTS): Generally, 50:50 CSTS
is considered to be safe for a company. A higher CSTS than
the norms indicates improper credit management. The table
shows that the credit sales of the company range from 75% to
85% of total sales.
Debtors Turnover Ratio (DTR): A high DTR indicates more
efficiency in managing debtors. The DTR of this company
shows a decreasing trend. However, the DTR of the company
is still in the satisfactory level.
Average Collection Period (ACP): The table shows an in-
creasing trend in the ACP of the firm. On an average, the com-
pany was extending 35 days of credit period.

Case study 11: Receivable Management in a Public Limited Company 289
Case study 11
n o t e s
Creditors Turnover Ratio (CTR): A low CTR indicates liberal

credit policies extended by the suppliers. CTR is a very critical
ratio as it can reduce the dependence of a firm on its current
assets. The table shows a decreasing trend in the CTR.
Average Payable Period (APP): The table shows that the APP
of the company varies from 125 to 163 days. As a rule of thumb,
the APP of a company should be greater than the average col-
lection period; which is observed in the case of the company.
Results
The following are the key findings of the study:

The firm has a satisfactory liquidity position. The current ra-
tio position of the company does not differ much from the in-
S
dustry standard.
The WTR of the company is below the desired level.
IM
There is an increasing trend in the credit sales of the com-
pany. It maintains a satisfactory DTR.
The company was extending an average of 35 days of the credit
period. The collection of the company was quite satisfactory.
M
questions
1. On the basis of the study, provide suggestions to the

company for improving financial performance.
(Hint: Sales level should be increased, average collection
N
period should be maintained, and credit sales should be

reduced, etc.)
2. Was the receivable management of the company
satisfactory? Explain with the help of ratios.
(Hint: ACP and WTR of the company were satisfactory.)

N
M
IM
S
Case study 12
n o t e s
Meeting Business Objectives through

Budgeting: A Case Study of Kraft
This Case Study discusses how Kraft takes a flexible budgeting ap-
proach to accommodate opportunities and meet business objectives.
It is with respect to Chapter 10 of the book.
Kraft Foods Group Inc. is an American grocery manufacturing

and processing company based in Illinois. This case shows how
S
the company strives to achieve its vision of becoming the undis-
puted global food leader with the help of effective budgeting. The
world food industry is a highly competitive and dynamic market.
To succeed in such a business environment, Kraft incorporates
IM
flexibility in every aspect of the organisation so that it can incor-
porate business opportunities to its business operations. This phi-
losophy is also reflected in the budgeting process of the company,
which is highly flexible and is based on the consensus and shared
understandings. The company uses a flexible budgeting approach
so that the various components of the company can contribute to
M
achieve its strategic objectives.
The following are the major objectives of the company:

Being an employer where employees wish to work
N
Being a high performing food company

Serving customers effectively
Being a responsible organisation and a positive force in the
community in which Kraft employees live, work and make its
products
Kraft meets all these objectives with the help of effective budget-
ing. In Kraft, budgets are prepared after consultations with dif-
ferent business functions to achieve a shared vision. The finance
department ensures to secure support from other business func-
tions. The company follows the philosophy that a budget should
be challenging as well as realistic. A challenging and realistic bud-
get would motivate people to work towards its achievement. The
company inculcates cost saving in the organisational culture. In
the food industry, significant amount of funds can be saved by
eliminating wastes.
The company recognises that the budget needs to be developed
and approved in advance of the period to which it relates to. The
budget reflects the expected income and expenditure.

Case study 12
n o t e s
The finance department in the company collates different costs in

relevant cost centers to manage expenses. Cost centers also pro-
vide a better means to analyse the cost data. The cost centers in
Kraft are related to particular factories and production units. The
manager of a particular cost center is responsible to govern the
costs of the cost centers.
The budgeting process of Kraft involves making precise plans for

each cost center, which in turn, sums up to making the entire bud-
get of the organisation. This process is crucial for quantifying the
future costs of the operation of the company. Preparation of bud-
get of each cost center is a part of the overall strategic planning of
the company. While developing the individual budget of each cost
center, various factors, such as company objectives, income and
expense projections are considered.
S
The wide portfolio of goods of Kraft is sold to a varied group of
customers. The customers include small shops, cash and carry
IM
shops as well as international supermarket chains.
The company incurs the following types of costs in its business

operations:
Raw material costs
Production and manufacturing costs
M
Marketing, promotional and selling costs to sell the products

Distribution costs
The starting point of developing budget at Kraft is forecasting the

N
probable sales figures on the basis of historical data and analys-

ing the business environment. This sales figure help in determin-
ing the quantity of products to be produced. After determining
these figures, the company could easily allocate costs to different
departments, such as marketing, sales, administration, etc. Next,
the figure for the likely capital expenses is determined. Finally,
the budgeted profit and loss account and the balance sheet are
constructed. After the management of the company approves the
budget, it works as the benchmark for the performance of differ-
ent business components.
The entire budget process includes continuous review and moni-

toring. The company uses variance analysis to check whether any
deviation occurs in the monthly financial results. Monthly perfor-
mance monitoring helps the company in alerting the cost centers
of the variances so that managers can take suitable actions.
The budget accountant conducts periodic reviews so that the em-

ployees can provide feedback regarding current actual spend vs.
plan so that the plan can be reforecast or the current activities can

Case study 12: Meeting Business Objectives through
Budgeting: A Case Study of Kraft 293
Case study 12
n o t e s
be altered. There are two types of feedbacks: single loop feedback

and double loop feedback. The first one helps in making altera-
tion to current activities; whereas, the double loop feedback in-
volves amending the plan to accommodate the current activities.
One very significant factor in the financial management of Kraft

is that the budget can be amended. The company operates in a
rapidly changing business environment in which consumer de-
mand patterns and production technology go through rapid and
sudden changes. Therefore, the company needs to take a flexible
approach and be always ready to respond to challenges. This is
the reason the company has a policy of considering budget altera-
tion in case there is a valid reason.
Kraft takes help of budgetary control to remain focused and con-
S
trol costs. The company takes appropriate cautions to ensure that
short-term focus on financial results does not affect the long-term
goals of the company. In addition, the company ensures that em-
IM
ployees participate in the process of developing budget. This is
because if managers are unhappy with the budget, they may not
co-operate towards its fulfillment. This is the reason the company
follows a cooperative and consultative approach towards devel-
oping budgets.
There are a number of budgeting types to choose from. Kraft uses

M
a mix of the following. It has been empirically observed that in a

dynamic business environment, it is more effective to start from
the beginning while developing a budget rather than basing the
plans on past performances. This rule of thumb applies to Kraft
as well as the company operates in a very dynamic business envi-
N
ronment. Therefore, the budgeting process in the company helps

in identifying new opportunities and inculcating those within the
budget. This concept is related to zero-based budgeting that helps
in gaining competitive advantage.
questions
1. How does flexibility help the company in the budgeting

process?
(Hint: The Company operates in a highly dynamic
business environment that demands a flexible approach.)
2. How does Kraft ensure employee participation in the
budgeting process?
(Hint: By incorporating the consultative approach and
taking appropriate feedback)

N
M
IM
S
Corporate Finance
Corporate Finance
IM
M
N

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TOC Reviewer Content Reviewer

Author: Preeti Marwah

Reviewed By: Chetan Jain

NMIMS Global Access - School for Continuing Education

CHAPTER NO. CHAPTER NAME PAGE NO.

2 Time Value of Money 27

5 Capital Structure Management 101

7 Dividend Policy 165

8 Working Capital Management 187

9 Receivables and Inventory Management 211

10 Budget and Budgeting 235

11 Case Studies 257

NMIMS Global Access - School for Continuing Education

An Introduction to Finance: Concept of Finance, Scope of Finance, Functions of Finance, Con-

Capital Structure Management: Capital Structure Management, Capitalisation, Theories of Cap-

Leverages: Concept of Leverages in Finance, Financial Leverage, Operating Leverage, Combined

Working Capital Management: Concept of Working Capital Management, Principles of Work-

NMIMS Global Access - School for Continuing Education

NMIMS Global Access - School for Continuing Education

1.4.1 Functions of a Finance Manager

NMIMS Global Access - School for Continuing Education

1.7.4 Margin of Safety

NMIMS Global Access - School for Continuing Education

Brew & Bite’s Financial Decision

Of these options, Jessy chooses the option of taking a bank loan

NMIMS Global Access - School for Continuing Education

After studying the chapter, you will be able to:

in its products. The process of managing the funds of an organisation

Financial management aims to achieve three major objectives in an

organisation. Firstly, it ensures that there is enough finance available

This chapter starts by explaining the concept of finance. It also ex-

1.2 CONCEPT OF FINANCE

NMIMS Global Access - School for Continuing Education

Finance can be defined from the corporate and business point of

 The third approach, also called the modern/managerial approach

self assessment Questions

1. __________ involves the financial decisions that an organisation

Suppose you have to explain the concept of finance to a non-finan-

1.3 SCOPE OF FINANCE

NMIMS Global Access - School for Continuing Education

 Production: It refers to the process of converting raw material into

self assessment Questions

2. In the advertising function, an organisation needs finance

to promote its products via sales promotion activities. (True/

1.4 FUNCTIONS OF FINANCE

NMIMS Global Access - School for Continuing Education

 It need to compare the required rate of return against the pro-

1.4.1 FUNCTIONS OF A FINANCE MANAGER

A finance manager aims to efficiently allocate and use the resources

of on organisation. He/She is responsible for procuring funds from

for both short-term (working capital requirements) and long-term

NMIMS Global Access - School for Continuing Education

 Cash management: It includes providing cash supply on time to

A controller is a person responsible for establishing and executing in-

A treasurer has a regulatory role over all aspects of financial man-

 General financial oversight: These responsibilities involve over-

NMIMS Global Access - School for Continuing Education

 Banking, book-keeping and record-keeping: These responsibil-

It can be concluded that a treasurer is responsible for ensuring that

self assessment Questions

3. A controller is the chief accounting manager of an organisation.

1.5 CONCEPT OF FINANCIAL MANAGEMENT

The third approach, also called the modern/managerial approach

Production: It refers to the process of converting raw material into

It need to compare the required rate of return against the pro-

Cash management: It includes providing cash supply on time to

General financial oversight: These responsibilities involve over-

Banking, book-keeping and record-keeping: These responsibil-

Measuring efficiency: It refers to estimating the capability of an or-

1.6.3 DIFFERENCE BETWEEN PROFIT MAXIMISATION

It helps in budget preparation to determine sales, costs, and prof-

It cannot differentiate between fixed and variable costs in some