FINANCIAL MANAGEMENT

Unit:I

FINANCIAL MANAGEMENT: DEFINITION, AIMS, SCOPE AND FUNCTIONS

As we know finance is the lifeblood of every business, its management requires special attention. Financial management is that activity of management which is concerned with the planning, procuring and controlling of the firm’s financial resources.

The scope and coverage of financial management have undergone fundamental changes over the last half a century. During 1930s and 1940s, it was concerned of raising adequate funds and maintaining liquidity and sound financial structure. This is known as the ‘Traditional Approach’ to procurement and utilization of funds required by a firm. Thus, it was regarded as an art and science of rising and spending of funds. In the words of Paisco, “In a modern money using economy, finance may be defined as the provision of money at the time it is wanted.” The traditional approach emphasized the acquisition of funds and ignored efficient allocation and constructive use of funds. It does not give sufficient attention to the management of working capital.

During 1950s, the need for most profitable allocation of scarce capital resources was recognized. During 1960s and 1970s many analytical tools and concepts like funds flow statement, ratio analysis, cost of capital, earning per share, optimum capital structure, portfolio theory etc. were emphasized. As a result, a broader concept of finance began to be used. Thus, the modern approach to finance emphasizes the proper allocation and utilization of funds in addition to their economical procurement. Thus, business finance, in the words of Authman and Dongall, may broadly be defined as ” the activity concerned with the planning, raising, controlling and administering of funds used in the business.” Modern business finance includes – (i) determining the capital requirements of the firm. (ii) raising of sufficient funds to make an ideal or optimum capital structure, (iii) allocating the funds among various types of assets and (iv) financial control so as to ensure efficient use of funds.

Corporation Finance: The most important area of business finance is the corporation finance because the big business firms require a huge capital which is procured from the market/public. So, an efficient use of funds is very essential. Huge business houses employ expertise to raise and utilize finance from various sources. The corporation finance refers to the planning, raising, administrating and controlling. Thus, it refers to planning, raising, administrating and financing of expansion of business and the financial adjustments.

Definition:

James Van Morne defines Financial Management as follows:

“Planning is an inextricable dimension of financial management. The term financial management connotes that funds flows are directed according to some plan”. Financial managements can be said a good guide for allotment of future resources of an organization.

Preparing and implementation of some plans can be said as financial management. In other words, collection of funds and their effective utilization for efficient running of an organization is called financial management. Financial management has influence on all activities of an organization. Hence it can be said as an important one.

Its main responsibility is to complete the finance function successfully. It also has relations with other business functions. All business decisions also have financial implications. According to Raymond Chambers, Management of finance function is the financial management’.

However, financial management shall not be considered as the profit extracting device. If finance is properly utilized through plans, they lead to profits. Besides, without profits there won’t be finance generation. All these are facts. But this is not complete.

The implication of financial management is not only attaining efficiency and getting profits but also maximizing the value of the firm. It facilitates to protect the interests of various classes of people related to the firm.

Hence, managing a firm for profit maximization is not the meaning for financial management. Financial management is applicable to all kinds of organizations. According to Raymond Chambers, ‘the word financial management is applicable to all kinds of firms irrespective of their objectives’.

SCOPE OF FINANCE FUNCTION/FINANCIAL MANAGEMENT

The main objective of financial management is to arrange sufficient finance for meeting short-term and long-term needs. With these things in mind, a Financial Manager will have to concentrate on the following areas of finance function.

1. Estimating Financial Requirements: The first task of a financial manager is to estimate short-term and long-term financial requirements of his business for this purpose; he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained. The estimations should be based on sound financial principles so that neither there are inadequate nor excess funds with the concern. The inadequacy of funds will adversely affect the day-today working of the concern whereas excess funds may tempt a management to indulge in extravagant spending or speculative activities.

2. Deciding Capital Structure: The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts. Even here if gestation period is longer, then share capital may be most suitable. Long-term funds should be employed to finance working capital also, if not wholly then partially. Entirely depending upon overdrafts and cash credit for meeting working capital needs may not be suitable. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short-term and long-term financial planning of an enterprise.

3. Selecting a Source of Finance: After preparing a capital structure, an appropriate source of finance is selected. Various sources, from which finance may be raised, include: share capital, debentures, financial institutions, commercial banks, public deposits, etc. If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate; on the other hand, if long-term finances are required then share capital and debentures may be useful. If the concern does not want to tie down assets as securities then public deposits may be suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing.

4. Selecting a pattern of investment: When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. Even in various categories of assets, a decision about the type of fixed or other assets will be essential. While selecting a plant and machinery, even different categories of them may be available. The decision-making techniques such as Capital Budgeting, Opportunity Cost Analysis etc. may be applied in making decisions about capital expenditures. While spending or various assets, the principles. One may not like to invest on a project which may be risky even though there may be more profits.

5. Proper Cash Management: Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash maybe required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills; (d) meet day-to-day expenses. The usual sources of cash may be: (a) cash sales, (b) collection of debts, (c) short-term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and nor it is idle An shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the business will mean that it is not properly used. It will be better if Cash Flow Statement is regularly prepared so that one is able to find out various sources and applications. If cash is spent on avoidable expenses then such spending may be curtailed. A proper idea on sources of cash inflow may also enable to assess the utility of various sources. Some sources may not be providing that much cash which we should have thought. All this information will help in efficient management of cash.

6. Implementing Financial Controls: An efficient system of financial management necessitates the use of various control devices. Financial control devices generally used are,: (a) Return on investment, (b) Budgetary Control, (c) Break Even Analysis, (d) Cost Control, (e) Ratio Analysis (f) Cost and Internal Audit. Return on investment is the best control device to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed.

7. Proper Use of Surpluses: The utilization of profits or surpluses also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interest’s shareholders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of shareholders. A balance should be struck in using funds for paying dividend and retaining earnings for financing expansion plans, etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future. A finance manager should consider the influence of various factor, such as: 9a) trends of earning of the enterprises, (b) expected earnings in future, (c) market value of shares, (d) need for funds for financing expansion, etc. A judicious policy for distributing surpluses will be essential for maintaining proper growth of the unit.

OBJECTIVES OF FINANCIAL MANAGEMENT:

Financial management is one of the functional areas of business. Therefore, its objectives must be consistent with the overall objectives of business. The overall objective of financial management is to provide maximum return to the owners on their investment in the long- term.

This is known as wealth maximization. Maximization of owners’ wealth is possible when the capital invested initially increases over a period of time. Wealth maximization means maximizing the market value of investment in shares of the company.

Wealth of shareholders = Number of shares held ×Market price per share.

In order to maximize wealth, financial management must achieve the following specific objectives:

(a) To ensure availability of sufficient funds at reasonable cost (liquidity).

(b) To ensure effective utilization of funds (financial control).

(d) To ensure adequate return on investment (profitability).

(e) To generate and build-up surplus for expansion and growth (growth).

(f) To minimize cost of capital by developing a sound and economical combination of corporate securities (economy).

(g) To coordinate the activities of the finance department with the activities of other departments of the firm (cooperation).

Profit Maximization:

Very often maximization of profits is considered to be the main objective of financial management. Profitability is an operational concept that signifies economic efficiency. Some writers on finance believe that it leads to efficient allocation of resources and optimum use of capital.

It is said that profit maximization is a simple and straightforward objective. It also ensures the survival and growth of a business firm. But modern authors on financial management have criticized the goal of profit maximization.

Ezra Solomon has raised the following objections against the profit maximization objective:

Objections against the Profit Maximization Objectives:

(i) The concept is ambiguous or vague. It is amenable to different interpretations, e.g., long run profits, short run profits, volume of profits, rate of profit, etc.

(ii) It ignores the timing of returns. It is based on the assumption of bigger the better and does not take into account the time value of money. The value of benefits received today and those received a year later are not the same.

(iii) It ignores the quality of the expected benefits or the risk involved in prospective earnings stream. The streams of benefits may have varying degrees of uncertainty. Two projects may have same total expected earnings but if the earnings of one fluctuate less widely than those of the other it will be less risky and more preferable. More uncertain or fluctuating the expected earnings, lower is their quality.

(iv) It does not consider the effect of dividend policy on the market price of the share. The goal of profit maximization implies maximizing earnings per share which is not necessarily the same as maximizing market-price share. According to Solomon, “to the extent payment of dividends can affect the market price of “the stock (or share), the maximization of earnings per share will not be a satisfactory objective by itself.”

(v) Profit maximization objective does not take into consideration the social responsibilities of business. It ignores the interests of workers, consumers, government and the public in general. The exclusive attention on profit maximization may misguide managers to the point where they may endanger the survival of the firm by ignoring research, executive development and other intangible investments.

Wealth Maximization:

Prof. Ezra Solomon has advocated wealth maximization as the goal of financial decision-making. Wealth maximization or net present worth maximization is defined as follows: “The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or as capitalized) at a rate which reflects their certainty or uncertainty.

Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken.

Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken), then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximize wealth or net present worth.”

Wealth maximization is more operationally viable and valid criterion because of the following reasons:

(a) It is a precise and unambiguous concept. The wealth maximization means maximizing the market value of shares.

(b) It takes into account both the quantity and quality of the expected steam of future benefits. Adjustments are made for risk (uncertainty of expected returns) and timing (time value of money) by discounting the cash flows,

(c) As a decision criterion, wealth maximization involves a comparison of value of cost. It is a long-term strategy emphasizing the use of resources to yield economic values higher than joint values of inputs.

(d) Wealth maximization is not in conflict with the other motives like maximization of sales or market share. It rather helps in the achievement of these other objectives. In fact, achievement of wealth maximization also maximizes the achievement of the other objectives. Therefore, maximization of wealth is the operating objective by which financial decisions should be guided.

The above description reveals that wealth maximization is more useful if objective than profit maximization. It views profits from the long-term perspective. The true index of the value of a firm is the market price of its shares as it reflects the influence of all such factors as earnings per share, timing of earnings, risk involved, etc.

Thus, the wealth maximization objective implies that the objective of financial management should be to maximize the market price of the company’s shares in the long-term. It is a true indicator of the company’s progress and the shareholder’s wealth.

However, “profit maximization can be part of a wealth maximization strategy. Quite often the two objectives can be pursued simultaneously but the maximization of profits should never be permitted to overshadow the broader objectives of wealth maximization.

ORGANIZATION OF FINANCE FUNCTION

The vital importance of the financial decisions to a firm makes it imperative to set up a sound and efficient organization for the finance functions. The ultimate responsibility of carrying out the finance functions lies with the top management. Thus, a department to organize financial activities may be created under the direct control of the board of directors.

The reason for placing the finance functions in the hands of top management may be attributed to the following factors:

· Financial decisions are crucial for the survival of the firm. The growth and development of the firm is directly influenced by the financial policies.

· The financial actions determine solvency of the firm. Because solvency of the firm is affected by the flow of firm which is a result of the various financial activities, top management being in a position to coordinate these activities retain finance functions in its control.

· Centralization of the finance functions can result in a number of economies to the firm. For example, the firm can save in terms of interest on the borrowed funds, can purchase fixed assets economically or issue shares or debenture efficiently.

ROLE OF FINANCE MANAGER

Board Of directors

Managing Director

Production Director

Personnel Director

Finance Director

Marketing Director

Controller/ Chief Accountant

Treasure

· Financial Accounting ● Auditing

· Management Accounting ● Credit Management

· Planning and Budgeting ● Retirement Benefits

· Costing ● Cash Manager

· Inventory Management ● Capital Expenditure Mgmt.

· Performance Evaluation ● Portfolio Management

· Data Processing Manager ● Foreign Exchange Mgmt.

· Tax Manager ● Risk Management

● Intercepting new opportunities

The exact organization structure for financial management will differ across firms. It will depend on factors such as size of the firm, nature of business, financing operations, capabilities of the firm’s financial officers and most importantly on the financial philosophy of the firm. The designation of the chief financial officer would also differ within the firm. In some firms, the financial officer may be known as the financial manager, while in others as the vice president of finance or the director of finance or the financial controller. Two more officers-Treasure and controller may be appointed under the direct supervision of chief financial officer to assist him or her. In larger companies, with modern management, there may be vice president or director of finance usually with both controller and treasurer reporting to him.

The function of controller is related mainly to accounting and control. The financial controller does not control finances: he or she develops uses and interprets information some of which will be financial in nature- for management control and planning. For this reason, the financial controller may simply be called as the controller. Management of finance or money is a separate and important activity. Traditionally the accountants have been involved in managing money in India. But the difference in managing money resources should be appreciated.

In the American business, the management of finance is treated as a separate activity and is being performed by the treasurer. The title of the treasurer has not found favor in India to the extent the controller has. The company secretary in India discharges some of the functions performed by the treasurer, in the American context. Insurance coverage is an example in this regard. The functions of maintaining relations with investors (particularly shareholders) may now assume significance in India because of the development in the Indian Capital markets and the increasing awareness among investors.

The general title, financial manager or finance director seems to be more popular in India. This title is also better than the title of treasurer since it conveys the function involved. the main function of financial manger in India should be the management of the company’s fund. The financial duties may often be combined with others. But the significance of not combining the financial manager’s duties with others should be released. The managing of funds - a very valuable resources is a business activity requiring extraordinary skill on the part of the financial manager. He or she should ensure the optimum use of money under various constraints. He or she should therefore be allowed to devote his or her full energy and time in managing the money resources only.

TIME VALUE OF MONEY

A finance manager is required to make decisions on investment, financing and dividend in view of the company's objectives. The decisions as purchase of assets or procurement of funds i.e. the investment/financing decisions affect the cash flow in different time periods. Cash outflows would be at one point of time and inflow at some other point of time, hence, they are not comparable due to the change in rupee value of money. They can be made comparable by introducing the interest factor. In the theory of finance, the interest factor is one of the crucial and exclusive concept, known as the time value of money.

Time value of money means that worth of a rupee received today is different from the same received in future. The preference for money now as compared to future is known as time preference of money. The concept is applicable to both individuals and business houses.

Reasons of time preference of money :

1) Risk :

There is uncertainty about the receipt of money in future.

2) Preference for present consumption :

Most of the persons and companies have a preference for present consumption may be due to urgency of need.

3) Investment opportunities :

Most of the persons and companies have preference for present money because of availabilities of opportunities of investment for earning additional cash flows.

Importance of time value of money :

The concept of time value of money helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent values of a particular point of time, present or future. The cash flows arising at different points of time can be made comparable by using any one of the following :

- By compounding the present money to a future date i.e. by finding out the value of present money.

- By discounting the future money to present date i.e. by finding out the present value(PV) of future money.

1) Techniques of compounding :

i) Future value (FV) of a single cash flow :

The future value of a single cash flow is defined as :

FV = PV (1 + r)ⁿ

Where, FV = future value

PV = Present value

r = rate of interest per annum

n = number of years for which compounding is done.

If, any variable i.e. PV, r, n varies, then FV also varies. It is very tedious to calculate the value of

(1 + r)ⁿso different combinations are published in the form of tables. These may be referred for computation; otherwise one should use the knowledge of logarithms.

ii) Future value of an annuity :

An annuity is a series of periodic cash flows, payments or receipts, of equal amount. The premium payments of a life insurance policy, for instance are an annuity. In general terms the future value of an annuity is given as:

FVA_n = A * ([(1 + r)ⁿ- 1]/r)

Where,

FVA_n⁼Future value of an annuity which has duration of n years.

A = Constant periodic flow

r = Interest rate per period

n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, and rate of interest and the time period, if any of these variable changes it will change the future value of the annuity. A published table is available for various combination of the rate of interest 'r' and the time period 'n'.

iii) Future value of an annuity due : A payment that must be made at the beginning, rather than at the end, of a period. For example, an annuity due mayrequire payment at the beginning of the month instead of at the end.

Annuity_Due = Annuity_Ordinary x (1 + i)

2) Techniques of discounting :

i) Present value of a single cash flow :

The present value of a single cash flow is given as :

PV = FV_n ( 1 )ⁿ

1 + r

Where,

FV_n
=Future value n years hence

r = rate of interest per annum

n = number of years for which discounting is done.

From above, it is clear that present value of a future money depends upon 3 variables i.e. FV, the rate of interest and time period. The published tables for various combinations of ( 1 )n

^{1
+ r}

are available.

ii) Present value of an annuity :

Sometimes instead of a single cash flow, cash flows of same amount is received for a number of years. The present value of an annuity may be expressed as below :

PVA_n = A/(1 + r)¹ + A/(1 + r)² + ................ + A/(1 + r)^n-1 + A/(1 + r)ⁿ

= A [1/(1 + r)¹ + 1/(1 + r)² + ................ + 1/(1 + r)^n-1 + 1/(1 + r)ⁿ ]

= A [ (1 + r)ⁿ - 1]

r(1 + r)ⁿ

Where,

PVA_n= Present value of annuity which has duration of n years

A = Constant periodic flow

r = Discount rate.

Unit:II

CAPITALIZATION

The objective of every business is to maximize the value of the business. In this respect the finance manager, as well as individual investors, want to know the value created by the business. The value of business relates to the capitalization of the business.

The need for capitalization arises in all the phases of a firm’s business cycle. Virtually capitalization is one of the most important areas of financial management. In this article we will discuss various aspects relating to capitalization.

Meaning of Capitalization:

Capitalization is one of the most important constituents of financial plan. The term “Capitalization” has been derived from the word capital and in common practice it refers to the total amount of capital employed in a business. However, financial scholars are not unanimous regarding the concept of capital.

As a matter of fact, they have defined ‘Capitalization’ in a number of ways. If the definitions are properly studied, we can classify them into two ways, viz.; a broad interpretation and a narrow interpretation.

Broad Interpretation of Capitalization:

Many authors regard Capitalizations as synonymous with financial planning. Broadly speaking, the term ‘Capitalization’ refers to the process of determining the plan of financing. It includes not merely the determination of the quantity of finance required for a company but also the decision about the quality of financing. A financial plan is a statement estimating the amount of capital and determining its composition.

Used in this sense, capitalization includes:

(i) Estimating the total amount of capital to be raised;

(ii) Determining the type of securities to be issued; and

(iii) Determining the composition or proportion of the various securities to be issued.

Narrow Interpretation of Capitalization:

In its narrow sense, the term ‘Capitalization’ is used in its quantitative sense and refers to the process of determining the quantum of funds that a firm needs to run its business. According to the scholars holding this view, the decisions regarding the form or composition of capital fall under the term “Capital Structure”.

Some of the important definitions of traditional experts, in this regard, are given below:

According to Guthman and Dougall, “Capitalization is the sum of the par value of stocks and bonds outstanding.”

The above definition considers and includes in capitalization only the par value of share capital and debentures. It does not include reserves and surpluses which, usually, form part of the long-term funds of a firm.

Bonneville and Deway refer to capitalization as, “The balance sheet values of stocks and bonds outstanding.”

Arthur S. Dewing defines it as, “The sum total of the par value of all shares.”

According to Gerstenberg, “Capitalization comprises of a company’s ownership capital which includes capital stock and surplus in whatever form it may appear and borrowed capital which consists of bonds or similar evidences of long-term debt.”

Gilbert Harold refers to capitalization as any of the following concepts:

(i) The total par value of all the securities -shares and debentures outstanding at a given time.

(ii) The total par value of all the securities outstanding at a given time plus the valuation of all other long-term obligations.

(iii) The total amount of capital and liabilities of corporation, i.e. amount of capital stock plus bonds.

Thus, the essence of the above definitions is that capitalization is the sum total of long-term securities issued by a company and the surplus not meant for distribution.

Modern Concept of Capitalization:

Though the narrower interpretation of capitalization is more popular because of its being very specific in the meaning, the modern thinkers consider that even short-term creditors should be included in capitalization.

In the words of Walker and Baughn, “The use of capitalization refers to only long-term debt and capital stock; and short-term creditors do not constitute suppliers of capital is erroneous. In reality total capital is furnished by short-term creditors and long-term creditors.”

They further opine that the sum of capital stock and long-term debt-refers to capital rather than the capitalization.

Thus, according to modern concept, capitalization includes:

(i) Share Capital

(ii) Long-term Debt.

(iii) Reserves and Surplus.

(iv) Short-term Debt.

(v) Creditors.

NEED OF CAPITALIZATION:

The need of capitalization arises not only at the time of incorporation or promotion of a company but may also arise as a going concern after promotion and during the life time of a corporation.

Generally, the problem of capitalization arises in the following circumstance:

i. At the time of promotion/incorporation of a company.

ii. At the time of expansion of an existing company.

iii. At the time of amalgamation and absorption of two or more companies.

iv. At the time of re-organisation of capital of a company.

The study of capitalization involves an analysis of three aspects:

i) amount of capital

ii) composition or form of capital

iii) changes in capitalization.

CLASSIFICATION OF CAPITALIZATION

Capitalization may be of 3 types. They are over capitalization, under capitalization and fair capitalization. Among these three over capitalization is likely to be of frequent occurrence and practical interest.

· Over Capitalization:

Many have confused the term ‘over-capitalization’ with abundance of capital and ‘under-capitalization’ with shortage of capital. It becomes necessary to discuss these terms in detail. An enterprise becomes over-capitalized when its earning capacity does not justify the amount of capitalization.

Over-capitalization has nothing to do with redundancy of capital in an enterprise. On the other hand, there is a greater possibility that the over-capitalized concern will be short of capital. The abstract reasoning can be explained by applying certain objective tests. These tests require the comparison between the different values of the equity shares in a corporation. When we speak in terms of over-capitalization we always have the interest of equity holders in mind.

There are various standards of valuing corporation or its equity shares:

Par value:

It is not the face value of a share at which it is normally issued, i.e., at premium nor at discount, it is static and not affected by business oscillations. Thus it fails to reflect the various business changes.

Market Value:

It is determined by factors of demand and supply in a stock market. It is dependent on a number of considerations, affecting demand as well as supply side.

Book Value:

It is calculated by dividing the aggregate of the proprietary items – like share capital, surplus and proprietary reserves – by the number of outstanding shares.

Real Value:

It is found out by dividing the capitalized value of earnings by the number of outstanding shares. Before the earnings are capitalized, they should be calculated on an average basis. It may be pointed out at this place that longer the period cover by the study, the more representative the average will be the period should normally cover all the phase of business cycle, i.e., good, bad, and indifferent years. Some authors compare the par value of the share with the market value and if par value is greater than the market value they regard it as a sign of over-capitalization.

Par value > Market value

The comparison of book and real values of shares is a better test in the sense that the book value gives an idea about the company’s past career i.e., how it had fared during the last few years, and its strength is determined by its reserves and surplus.

Real value is a study of the working of company in the light of the earning capacity in the particular line of business. It takes into account not only the previous earnings or earning capacity of a concern but relates the earnings to the general earning capacity of other units of the same nature. It is a scientific and logical test.

Book Value = Real Value (Fair capitalization)

Book Value > Real Value (Over-capitalization)

Book Value < Real Value (Under capitalization)

Causes of over-capitalization:

The following are the cases for over-capitalization:

i) Promotion with inflated asset:

The promotion of a company may entail the conversion of a partnership firm or a private company into a public limited company and the transfer of assets may be at inflated prices which do not bear any relation to the earning capacity of the concern. Under these circumstances, the book value of the corporation will be more than its real value.

ii) The incurring of high establishment or promotion expenses (ex: good will, patent rights) is a potent cause of over-capitalization. If the earnings later on do not justify the amount of capital employed, the company will be over-capitalized.

iii) Inflationary conditions:

Boom is a significant factor for making the business enterprises over-capitalized. The newly started concern during the boom period is likely to be capitalized at a high figure because of the rise in general price level and payment of high prices for the property assembled. These newly floated concerns as well as the reorganized and expanded ones find themselves over-capitalized after the boom conditions subside.

iv) Shortage of capital:

The shortage of capital is also a contributory factor of over-capitalization, the inadequacy of capital may be due to faulty drafting of the financial plan. Thus a major part of the earnings will not be available for the shareholders which will bring down the real value of the shares.

v) Defective depreciation policy:

It is not uncommon to find that many concerns are over-capitalized due to insufficient provision for depreciation/replacement or obsolescence of assets. The efficiency of the company is adversely affected and it is reflected in its reduced profit yielding capacity.

vi) Liberal Dividend Policy:

If corporations follow liberal dividend policy by neglecting essential provisions, they discover themselves to be overcapitalized after a few years when book value of their shares will be higher than the real value?

vii) Taxation Policy:

Over-capitalization of an enterprise may also be caused due to excessive taxation by the Government and also their basis of calculation may leave the corporations with meagre funds.

EFFECTS OF OVER CAPITALIZATION:

Over-capitalization affects the company, the shareholders and the society as a whole. The confidence of Investors in an over-capitalized company is injured on account of its reduced earning capacity and the market price of the shares which falls consequently. The credit-standing of a corporation is relatively poor.

Consequently, the credit-standing of a corporation is relatively poor. Consequently, the company may be forced to incur unwieldy debts and bear the heavy loss of its goodwill In a subsequent reorganization. The Shareholders bear the brunt of over capitalization doubly. Not only is their capital depreciated but the income is also uncertain and mostly irregular. Their holdings have little value as collateral security.

An over-capitalized company tries to increase the prices and reduce the quality of products, and as a result such a company may liquidate. In that case the creditors and the Laborers will be affected. Thus it leads to the misapplication and wastage of the resources of society.

Corrections for over-capitalization:

Overcapitalization can be rectified if the following steps are taken:

1. Reorganization of the company by selling shares at a high rate of discount.

2. Issuing less interested new debentures on premium in place of old debentures.

3. Redeeming preference shares carrying high dividend

4. Reducing the face value (par value) of shares.

UNDER-CAPITALIZATION:

Generally, under-capitalization is regarded equivalent to the inadequacy of capital but it should be considered as the reverse of over-capitalization i.e. it is a condition when the real value of the corporation is more than the book value.

Causes for under-capitalization:

1. Underestimation of earnings:

Sometimes while drafting the financial plan, the earnings are anticipated at a lower figure and the capitalization may be based on that estimate; if the earnings prove to be higher the concern shall become under-capitalized.

2. Unforeseeable increase in earnings:

Many corporations started during depression find themselves to be under-capitalized in the period of recovery or boom due to unforeseeable increase in earnings.

3. Conservative dividend policy:

By following conservative dividend policy some corporations create adequate reserves for depreciation, renewals and replacements and plough back the earnings which increase the real value of the shares of those corporations.

4. High efficiency maintained:

By adopting ‘latest techniques of production many companies improve their efficiency. The profits being dependent on the efficiency of the concern will increase and, accordingly, the real value of the corporation may exceed its ‘book value’.

Effects of under-capitalization:

The following are the effects of under-capitalization:

1. Causes wide fluctuations in the market value of shares.

2. Provoke the management to create secret reserves.

3. Employees demand high share in the increased prosperity of the company.

CAPITAL STRUCTURE: CONCEPT, DEFINITION AND IMPORTANCE

“Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders”-P. Chandra.

Concept of Capital Structure:

The relative proportion of various sources of funds used in a business is termed as financial structure. Capital structure is a part of the financial structure and refers to the proportion of the various long-term sources of financing. It is concerned with making the array of the sources of the funds in a proper manner, which is in relative magnitude and proportion.

The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

Again, each component of capital structure has a different cost to the firm. In case of companies, it is financed from various sources. In proprietary concerns, usually, the capital employed, is wholly contributed by its owners. In this context, capital refers to the total of funds supplied by both—owners and long-term creditors.

The question arises: What should be the appropriate proportion between owned and debt capital? It depends on the financial policy of individual firms. In one company debt capital may be nil while in another such capital may even be greater than the owned capital. The proportion between the two, usually expressed in terms of a ratio, denotes the capital structure of a company.

Definition of Capital Structure:

Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share capital and shareholders’ funds.

Various authors have defined capital structure in different ways.

Some of the important definitions are presented below:

According to Gerestenberg, ‘capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and bonds’. Keown et al. defined capital structure as, ‘balancing the array of funds sources in a proper manner, i.e. in relative magnitude or in proportions’.

In the words of P. Chandra, ‘capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders’.

Hence capital structure implies the composition of funds raised from various sources broadly classified as debt and equity. It may be defined as the proportion of debt and equity in the total capital that will remain invested in a business over a long period of time. Capital structure is concerned with the quantitative aspect. A decision about the proportion among these types of securities refers to the capital structure decision of an enterprise.

Importance of Capital Structure:

Decisions relating to financing the assets of a firm are very crucial in every business and the finance manager is often caught in the dilemma of what the optimum proportion of debt and equity should be. As a general rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Capital structure is usually designed to serve the interest of the equity shareholders.

Therefore instead of collecting the entire fund from shareholders a portion of long term fund may be raised as loan in the form of debenture or bond by paying a fixed annual charge. Though these payments are considered as expenses to an entity, such method of financing is adopted to serve the interest of the ordinary shareholders in a better way.

The importance of designing a proper capital structure is explained below:

· Value Maximization:

Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.

· Cost Minimization:

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.

· Increase in Share Price:

Capital structure maximizes the company’s market price of share by increasing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.

· Investment Opportunity:

Capital structure increases the ability of the company to find new wealth- creating investment opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.

· Growth of the Country:

Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.

PATTERNS OF CAPITAL STRUCTURE:

There are usually two sources of funds used by a firm: Debt and equity. A new company cannot collect sufficient funds as per their requirements as it has yet to establish its creditworthiness in the market; consequently they have to depend only on equity shares, which is the simple type of capital structure. After establishing its creditworthiness in the market, its capital structure gradually becomes complex.

A complex capital structure pattern may be of following forms:

i. Equity Shares and Debentures (i.e. long term debt including Bonds etc.),

ii. Equity Shares and Preference Shares,

iii. Equity Shares, Preference Shares and Debentures (i.e. long term debt including Bonds etc.).

However, irrespective of the pattern of the capital structure, a firm must try to maximize the earnings per share for the equity shareholders and also the value of the firm.

FACTORS DETERMINING CAPITAL STRUCTURE

Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.
Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
Flexibility of financial plan- In an enterprise, the capital structure should be such that there are both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
Choice of investors- The Company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital should consist of share capital generally equity shares.
Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.
Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

CAPITAL STRUCTURE THEORIES

A corporate can finance its business mainly by 2 means i.e. debts and equity. However, the proportion of each of these could vary from business to business. A company can choose to have a structure which has 50% each of debt and equity or more of one and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company.

Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest obligations etc.

For finding the optimum capital structure in order to maximize shareholder’s wealth or value of the firm, different theories (approaches) have evolved. Let us now look at the first approach

· NET INCOME APPROACH

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having a higher proportion of debt, which is a cheaper source of finance compared to equity finance.

According to Net Income Approach, change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

The total market value of a firm on the basis of Net income approach can be ascertained as below:

V = E +D

Where,

V= Total market value of firm

E= Market value of Equity

D=Market value of Debt

Market value of Equity can be calculated as follows:

E = NI/Ke

Where,

NI= Net income ( Income after interest and tax)

Ke= Equity Capitalization Rate or Cost of Equity

and, Overall cost of capital can be calculated as follows:

Ko = EBIT/V

Where,

Ko= Overall cost of capital

EBIT= Earnings before interest and tax

V= Value of the firm

Assumptions of net income approach

Net Income Approach makes certain assumptions which are as follows.

The increase in debt will not affect the confidence levels of the investors.
The cost of debt is less than the cost of equity.
There are no taxes levied.

§ NET OPERATING INCOME APPROACH (NOI APPROACH)

This approach was put forth by Durand and totally differs from the Net Income Approach. Also famous as traditional approach, Net Operating Income Approach suggests that change in debt of the firm/company or the change in leverage fails to affect the total value of the firm/company. As per this approach, the WACC and the total value of a company are independent of the capital structure decision or financial leverage of a company.

As per this approach, the market value is dependent on the operating income and the associated business risk of the firm. Both these factors cannot be impacted by the financial leverage. Financial leverage can only impact the share of income earned by debt holders and equity holders but cannot impact the operating incomes of the firm. Therefore, change in debt to equity ratio cannot make any change in the value of the firm.

It further says that with the increase in the debt component of a company, the company is faced with higher risk. To compensate that, the equity shareholders expect more returns. Thus, with an increase in financial leverage, the cost of equity increases.

The value of a firm on the basis of Net Operating Income Approach can be determined as below:

V= EBIT/Ko

Where,

V= Value of the firm

EBIT= Earning before interest and tax

Ko=Overall cost of capital

To test the validity of Net Operating Income Approach:

Ko= Kd(D/V) + Ke(E/V)

Where,

Ko=Overall cost of capital

Kd=Cost of Debt

Ke=Cost of Equity

D=Market Value of Debt

E=Market value of Equity

V= Value of Firm

Assumptions / features of net operating income approach:

The overall capitalization rate remains constant irrespective of the degree of leverage. At a given level of EBIT, value of the firm would be “EBIT/Overall capitalization rate”
Value of equity is the difference between total firm value less value of debt i.e. Value of Equity = Total Value of the Firm – Value of Debt
WACC (Weighted Average Cost of Capital) remains constant; and with the increase in debt, the cost of equity increases. An increase in debt in the capital structure results in increased risk for shareholders. As a compensation of investing in the highly leveraged company, the shareholders expect higher return resulting in higher cost of equity capital.

· TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium. The risk premium which is expected by the investors will enhance the overall cost of capital. The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity

· MODIGLIANI - MILLER APPROACH

Modigliani - Miller thesis of capital structure is akin to the Net Operating Income Approach. But, NOI approach is purely definitional; it Jacks behavioral significance. The NOI approach does not provide operational justification for the irrelevance of capital structure. M.M. Thesis does support the NOI approach relating to the independence of the cost of capital of the degree of leverage at any level of debt equity ratio. It provides behavioral justification for constant overall cost of capital and therefore total value of the firm. In other words, the M.M. approach maintains that the weighted average cost of capital does not change with changes in the degree of leverage.

The M.M. theory is based on three basic propositions. They are :

1. Market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its class. The average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class.

2. The expected yield of a share stock is equal to the appropriate capitalization rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt equity ratio times the spread between capitalization rate and yield on debt.

3. The cut off point for investment in the firm in all the cases will be the capitalization rate and will be unaffected by the type of security used to finance the investment.

These propositions are based on a simple switching mechanism called arbitrage. Arbitrage refers to an act of buying asset-security in one market (at lower prices) and selling it in another (at a higher price). M.M. contend that market value of those firms which are identical except for the difference in the pattern of financing will not vary because arbitrage process will drive the total values of the two firms together, Rational investors, according to them, will employ arbitrage in the market to prevent the existence of two assets in the same risk class and with same expected returns from selling at different prices.

The theoretical validity of the M.M. proposition (as many authors agreed) is difficult to counter. However, they have been criticized bitterly by numerous experts questioning the very assumptions on which the edifice of the theory is founded. The basic assumption of M.M. is that individuals through use of leverage can alter corporate leverage. This argument cannot be supported in a practical context for it is extremely doubtful whether personal investor would substitute personal leverage for corporate leverage since they do not have the same risk characteristics.

Another assumption of M.M. is that there is no corporate tax. Nowhere in the world has corporate income remained untaxed. Further, taxation laws have provided for deductibility of interest payments on debt for calculating taxable income. If this is so, debt becomes relatively a much cheaper means of financing and the firm is naturally encouraged to employ leverage. In view of this controversy, Modigliani and Miller in their subsequent article in 1963 admitted that, given the tax factor, the overall cost of capital can be lowered as more debt is inducted in the capital structure of the firm. In spite of these limitations, M.M. Thesis serves as an aid in understanding the capital structure theories.

Long-Term Sources of Fund

The following points highlight the five long-term sources of fund of a company. The long-term sources are: 1. Equity Shares 2. Preference Shares 3. Debentures 4. Loans from Financial Institutions and 5. Retained Earnings.

Source of Fund # 1. Equity Shares:

It represents the ownership capital of a firm. A public limited company may raise funds from public or promoters as equity share capital by issuing ordinary equity shares.

Ordinary shareholders are those the owners of which receive their dividend and return of capital after the payment to preference shareholders.

They undertake the risk of the company. They elect directors and have total control over the management of the company. These shareholders are paid dividends only when there are distributable profits. As equity shares are paid only on liquidation, this source has the minimum risk.

The liability of equity shareholders is limited up to the face value of the shares. Further, equity share capital provides a security to other investors of funds. Hence, it will be easier to raise further funds for companies having adequate equity share capital.

Advantages and Disadvantages:

Advantages:

The equity share capital offers the following advantages:

1. It is one of the most important long-term source of funds.

2. There are no fixed charges attached to ordinary shares. If a company earns enough divisible profits it will be able to pay a dividend but there is no legal obligation to pay dividends.

3. Equity share capital has no maturity date and hence the company has no obligation to redeem.

4. The firm with the longer equity base will have greater ability to raise debt finance on favourable terms. Thus issue of equity share increases the creditworthiness of the firm.

5. Dividend earnings are exempted from tax in the hands of investors. However, the company paying equity dividend will have to pay tax on it.

6. The equity shareholders enjoy full voting right and participate in the management of the company.

7. The company can issue further share capital by making right issue or bonus issue etc.

8. If the company earns more profit, more dividend is paid. So the value of goodwill of the company increases, It ultimately leads to appreciate the market value of equity shares of the company.

9. In India, returns from the sale of ordinary shares in the form of capital gains are subject to capital gains tax rather than corporate tax.

Disadvantages:

The following are the disadvantages in raising finance by issue of ordinary shares:

1. Dividends payable to ordinary shareholders are not deductible as an expense for the purpose of computation of tax but debenture interest is tax deductible. So, the cost of equity capital is usually higher than other source of funds. Further, the rate of return required by equity shareholders are higher than the rate of return required by other investors.

2. The company has no statutory obligation for the payment of dividend on equity shares. So, the risk of getting the dividend by the equity shareholders is very high. They may get higher rate of dividend or lower rate of dividend or no dividend at all.

3. The issue of new equity shares to outsiders dilutes the control of existing owners. So small firms normally avoid equity financing as they may not like to share control with outsiders.

4. The problem of over-capitalisation may arise because of excess issue of equity shares.

5. Trading on equity is not possible, if the entire capital structure is composed of equity shares.

6. Unlike debenture holders, equity shareholders do not get fixed rate of return on their investment. So the investors expecting regular flow of permanent income are not interested to invest equity shares.

Sweat Equity Shares:

Section 79 A of the Companies Act, 1956, has defined sweat equity shares as those shares which are issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value addition. Such shares are treated as the reward to the employees or directors.

The company may issue sweat equity shares if it has been authorised by a special resolution passed in the general meeting and not less than one year has elapsed since the date of commencement of business. The sweat equity shares of the company must be listed on a recognised stock exchange and all the restrictions and provisions relating to equity shares shall be applicable to sweat equity shares.

Right Shares:

If an existing company wants to make a further issue of equity shares, the issue must first be offered to the existing shareholders. The method of issuing shares is called right issue. The existing shareholders have right to entitlement of further shares in proportion to their existing shareholding.

For a shareholder who does not want to buy the right shares, his right of entitlement can be sold to someone else. The price of right shares will be generally fixed above the nominal value but below the market price of the shares.

Section 81 of the Companies Act, 1956, provides for the further issue of shares to be first offered to the existing members of the company, such shares are known as ‘right shares’ and the right of the members to be so offered is called the ‘right of pre-emption’.

Bonus Shares:

Sometimes a company may not be in a position to pay cash dividends in spite of adequate profits because of the adverse effect on the working capital of the company. However, to satisfy the equity shareholders, the company may issue shares—without payment being required to— its existing equity shareholders.

These shares are known as bonus shares or capitalisation of retained earnings. These shares are issued out of accumulated or undistributed profits to shareholders. Bonus shares may also be issued when a company wants to build up cash resources for expansion, or other purposes like repayment of liability.

Source of Fund # 2. Preference Shares:

These are shares which carry the following two rights:

(i) The right to receive dividend at a fixed rate before any dividend is paid on other shares.

(ii) The right to return of capital in the case of winding-up of company, before the capital of the equity shareholders is returned.

Long-term funds from preference shares are raised by a public issue of shares. It does not require any security nor ownership of a firm is affected. It has some characteristics of equity capital and some of debt capital. It resembles equity as preference dividend, like equity dividend is not tax deductible payment.

Again, it is similar to debt capital in the following ways:

(i) The rate of preference dividend is fixed,

(ii) Preference share capital is redeemable in nature, and

(iii) Preference shareholders do not enjoy the right to vote.

If preference dividend is not paid in a year of loss, it is carried over to the subsequent year till there is sufficient profits to pay the cumulative dividends. Cumulative convertible preference shares (CCPS) carry a cumulative dividend specified limit for a period, say 3 years on expiry of which these shares are compulsorily converted into equity shares.

These shares are generally issued to finance new projects, expansion programme, modernisation scheme etc. and also to provide further working capital.

Advantages and Disadvantages of Preference Shares:

The advantages of preference shares are:

1. The company can raise long-term funds by issuing preference shares.

2. Preference shareholders normally do not carry voting right. Hence, there is no dilution of control.

3. There is no legal binding to pay preference dividend. A company will not face any legal action if it fails to pay dividend.

4. There is no take-over risk. The shareholders become sure of their dividend from such investment.

5. There is a leveraging advantage since it has fixed charges.

6. Preference share capital is generally regarded as part of net worth. Hence it increases the creditworthiness of the firm.

7. Assets are not secured in favour of preference shareholders. The mortgageable assets of the company are freely available.

8. Preference shareholders enjoy the preferential right as to the payment of dividend and return of capital.

The disadvantages of preference shares are:

1. The dividend paid to preference shareholders is not a tax deductible expense. Hence it is a very expensive source of financing.

2. Preference shareholders get voting right if the company fails to pay preference dividends for a certain period.

3. Preference shareholders have preferential claim on the assets and earnings of the firm over equity shareholders.

Types of Preference Shares:

The various types of preference shares are:

(i) Cumulative Preference Shares:

The holders of these shares have the right to receive the arrears of dividend if for any year it has not been paid because of insufficient profit.

(ii) Non-cumulative Preference Shares:

The holders of these shares have the right to receive dividend out of the profits of any year. In case profits are not available in a year, the holders get nothing, nor can they claim unpaid dividends in subsequent years.

(iii) Participating Preference Shares:

The holders of these shares are entitled to a fixed preferential dividend and in addition, carry a right to participate in the surplus profits along with equity shareholders after dividend at a certain rate has been paid to equity shareholders.

Again, in the event of liquidation of the company, if after paying back both the preference and equity shareholders, there is still any surplus left, then the participating preference shareholders get additional shares in the surplus assets of the company.

(iv) Non-participating Preference Shares:

These preference shares have no right to participate in the surplus profits of the company on its liquidation. Such shareholders are entitled to a fixed rate of dividend only.

(v) Convertible Preference Shares:

These preference shares can be converted into equity shares after a specified period of time. The conversion of such shares can be made as per the provisions of the Articles of Association.

(vi) Non-convertible Preference Shares:

Non-convertible preference shares are those shares which cannot be converted into equity shares.

(vii) Redeemable Preference Shares:

These preference shares are redeemed before liquidation of the company as per terms of issue in accordance with the provisions of Articles of Association.

(viii) Irredeemable Preference Shares:

These preference shares are not redeemed before liquidation of the company. Such shares are not redeemed unless a company is liquidated. After the Commencement of Companies (Amendment) Act, 1988, no company can issue irredeemable preference shares or preference shares which are redeemable after the expiry of a period of ten years from the date of their issue.

Source of Fund # 3. Debentures:

A debenture is a document of acknowledgement of a debt with a common seal of the company. It contains the terms and conditions of loan, payment of interest, redemption of the loan and the security offered (if any) by the company.

According to Section 2(12) of the Companies Act, 1956, debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not.

Thus, a debenture has been defined as acknowledgement of debt, given under the common seal of the company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest at fixed rate/per cent until the principal sum is repaid and it may or may not give the charge on the assets to the company as security of loan. It is an instrument for raising long-term debt.

Debenture holders are the creditors of the company. They have no voting rights in the company. Debenture may be issued by mortgaging any asset or without mortgaging the asset, i.e., debentures may be secured or unsecured.

Interest on debenture is payable to debenture holders even when the company does not make profit. The cost of debenture is very low as the interest payable on debentures is charged as an expense before tax.

Types of Debentures:

Debentures may be classified as:

1. Bearer Debentures:

These debentures are transferable like negotiable instruments, by mere delivery. The holder of such debenture receives the interest when it become due. The transfer of such debenture is recorded in the register of the company.

2. Secured or Mortgage Debenture:

These debentures are secured by creating a charge on the assets of the company. The charge may be fixed or floating. If a company fails to pay debentures interest in due time or repay the principal amount, the debenture holders can recover their dues by selling the mortgaged assets.

3. Simple or Naked Debentures:

When debentures are issued without any charge on the assets of the company, such debentures are called naked or unsecured debentures.

4. Redeemable Debentures:

These are debentures which are issued for a specified period of time. On the expiry of that specified time the company has the right to pay back the debenture holders. The redemption may be effected by direct payment or by purchase and cancellation of own debenture or by annual drawings or by periodical instalments etc.

5. Registered Debentures:

These are the debentures regarding which the names, addresses and other particulars of holdings of the debenture holders are recorded in a register maintained by the company. Transfer of these debentures will take place only on the execution of the transfer deed. Interest is payable to the person whose name is registered with a company.

6. Irredeemable Debentures:

These are the debentures which are not repayable during the lifetime of the company and will be repaid only when the company goes into liquidation.

7. Convertible Debentures:

A company may issue convertible debentures in which case an option is given to the debenture holders to convert them into equity or preference shares at stated rates of exchange, after a certain period. Such debentures—once converted into shares cannot be reconverted into debentures. Convertible debentures may be fully or partly convertible.

8. Non-Convertible Debentures:

These are the debentures which are not converted into shares and are redeemed at the expiry of specified period.

9. Right Debentures:

These debentures are issued to augment working capital finance in a long-term basis.

II. Advantages and Disadvantages of Debentures:

The advantages of debentures may be summarised:

(i) The cost of debenture is much lower than the cost of equity or preference share capital since interest on debenture is a tax-deductible expense.

(ii) There is a possibility of trading on equity (i.e., greater return on equity capital can be given, if the company is able to earn higher rate of return than the fixed rate of interest paid to the debenture holders.)

(iii) There is no dilution of control of the company by the issue of debentures. As the debenture holders have no voting rights, so the issue of debenture does not affect the management of the company.

(iv) Interest on debenture is a charge against profit. It is an admissible expense for the purpose of taxation. Hence; tax liability on the company’s profits is reduced which result in the debentures as a source of finance.

(v) Investors prefer debenture investment than equity or preference investment as the former provides a regular flow of permanent income.

(vi) During inflation, debenture issue is advantageous. The fixed monetary outgo diminishes in real terms as the price level rises.

(vii) Debentures are secured on the assets of the company and, therefore, carry lesser risk and assured return on investment.

(viii) At the time of winding-up, the debenture holders are placed before the equity or preference share capital providers.

(ix) Debentures can be redeemed when a company has surplus fund.

The disadvantages of debentures can be summarised:

(i) The cost of issuing debentures is very high because of higher rate of stamp duty.

(ii) Debenture financing involves fixed interest and principal repayment obligation. Any failure to meet these obligations may paralyze the company’s operations.

(iii) Debenture financing increases the financial risk of the company. This will, in turn increase the cost of capital.

(iv) Trading on equity is not always possible.

(v) There is a limit to the extent to which funds can be raised through long-term debt.

(vi) The debenture holders are treated as creditors of the company. They have no voting rights of the. company so the debenture holders become less interested in the affairs of the company.

Source of Fund # 4. Loans from Financial Institutions:

In India specialised financial institutions provide long-term financial assistance to private and public firms. Generally firms obtain long-term debt by raising term loans. Term loans, also referred to as term finance, represent a source of debt finance which is repayable in less than 10 years.

Before giving a term loan to a company the financial institutions must be satisfied regarding the technical, economical, commercial, financial and managerial viability of project for which the loan is needed. Term loans are secured borrowings and a significant source of finance for investment in the form of fixed assets and also in the form of working capital needed for new project.

The following financial institutions provide long-term capital in India:

(i) All Nationalized Commercial Banks.

(ii) Development Banks which include.

(a) Industrial Development Bank of India

(b) Small Industries Development Bank of India

(d) Industrial Credit and Investment Corporation of India

(e) Industrial Reconstruction Bank of India.

(iii) Government Financial Institutions which include.

(a) State Finance Corporation

(b) National Small Industries Corporation

(d) State Small Industries Development Corporation.

(iv) Other investment institutes which include.

(a) Life Insurance Corporation of India

(b) General Insurance Corporation of India

Source of Fund # 5. Retained Earnings:

When a company retains a part of undistributed profits in the form of free reserves and the same is utilised for further expansion and diversification programmes, is known as ploughing back of profit or retained earnings. These funds belong to the equity shareholders. It increases the net worth of the business.

Although it is essentially a means of long-term financing for expansion and development of a firm, and its availability depends upon a number of factors such as the rate of taxation, the dividend policy of the firm, Government policy on payment of dividends by the corporate sector, extent of profit earned and upon the firm’s appropriation policy etc.

Advantages and Disadvantages:

The advantages of ploughing back of profits are:

1. It is the cheapest method of raising capital

2. It has no specific cost of capital

3. It increases the net worth of business

4. There is no dilution of control of present owners

5. It does not require any pledge, mortgage etc. like other loans.

6. It provides required capital for expansion and development.

7. Firms do not need to depend on lenders or outsiders if retained earnings, are readily available.

8. It increases the reputation of the business.

It suffers from the following limitations:

1. It may lead to cause of dissatisfaction among the shareholders as they receive-a low rate of dividend.

2. Management may fail to properly use the profits retained.

3. Ploughing back or reinvestment of profit means depriving the shareholders a portion of the earning of the company. As a result, share price may come down in the market.

4. It may lead to over-capitalisation because of capitalisation of profits.

Unit III

MEANING OF CAPITAL BUDGETING

Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm. What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.

NATURE OF CAPITAL BUDGETING

Nature of capital budgeting can be explained in brief as under

Capital expenditure plans involve a huge investment in fixed assets.

Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.

Preparation of coital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.

It may be asserted here that decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely.

OBJECTIVES OF CAPITAL BUDGETING

The following are the objectives of capital budgeting.

1. To find out the profitable capital expenditure.

2. To know whether the replacement of any existing fixed assets gives more return than earlier.

3. To decide whether a specified project is to be selected or not.

4. To find out the quantum of finance required for the capital expenditure.

5. To assess the various sources of finance for capital expenditure.

6. To evaluate the merits of each proposal to decide which project is best.

PROCEDURE OF CAPITAL BUDGETING

Capital investment decision of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities so the careful consideration should be regarded to all aspects of financial management.

In capital budgeting process, main points to be borne in mind how much money will be needed of implementing immediate plans, how much money is available for its completion and how are the available funds going to be assigned tote various capital projects under consideration. The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process. The following procedure may be adopted in preparing capital budget :-

(1) Organisation of Investment Proposal. The first step in capital budgeting process is the conception of a profit making idea. The proposals may come from rank and file worker of any department or from any line officer. The department head collects all the investment proposals and reviews them in the light of financial and risk policies of the organisation in order to send them to the capital expenditure planning committee for consideration.

(2) Screening the Proposals. In large organisations, a capital expenditure planning committee is established for the screening of various proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-frame work of the organisation. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do no lead to department imbalances or they are profitable.

(3) Evaluation of Projects. The next step in capital budgeting process is to evaluate the different proposals in term of the cost of capital, the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques:-

§ Degree of Urgency Method (Accounting Rate of return Method)

§ Pay-back Method

§ Return on investment Method

§ Discounted Cash Flow Method.

(4) Establishing Priorities. After proper screening of the proposals, uneconomic or unprofitable proposals are dropped. The profitable projects or in other words accepted projects are then put in priority. It facilitates their acquisition or construction according to the sources available and avoids unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order.

§ Current and incomplete projects are given first priority.

§ Safety projects ad projects necessary to carry on the legislative requirements.

§ Projects of maintaining the present efficiency of the firm.

§ Projects for supplementing the income

§ Projects for the expansion of new product.

(5) Final Approval. Proposals finally recommended by the committee are sent to the top management along with the detailed report, both o the capital expenditure and of sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them in the capital budget.

(6) Evaluation. Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the net investment in the projects are compared periodically and on the basis of such evaluation, the budget figures may be reviewer and presented in a more realistic way.

SIGNIFICANCE OF CAPITAL BUDGETING

The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come.

The need of capital budgeting can be emphasized taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:-

(1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results.

(2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated.

(3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occur only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting.

(4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.

(5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders.

(6) Other Factors. The following other factors can also be considered for its significance:-

§ It assists in formulating a sound depreciation and assets replacement policy.

§ It may be useful n considering methods of coast reduction. A reduction campaign may necessitate the consideration of purchasing most up-to—date and modern equipment.

§ The feasibility of replacing manual work by machinery may be seen from the capital forecast be comparing the manual cost an the capital cost.

§ The capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting.

§ It facilitates the management in making of the long-term plans an assists in the formulation of general policy.

§ It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation, insure and there fixed assets.

Types of capital budgeting decisions

The objective of any firm is to increase its profitability, which has two major factors, the optimal, (minimum) costs and (maximum) revenue. While revenue generation is not under much control of the management, the cost structure can be so organized so as to increase the profitability of the firm. A key instrument of this task is to increase the efficiency of the operations of the firm. This includes adoption of latest technology, replacement of old and worn out machinery, targeting new products and making strategic investment decisions. Capital budgeting decisions help management in increasing efficiency of the firm's operations.

Depending upon the two factors of the profitability of the firm, capital budgeting decisions can be of two types.

(i) Revenue expanding investment decisions With an aim to increase the revenue of the firm, these decisions are regarding the expansion of the present operations of the firm or initiation and development of the new product lines.

(ii) Cost reducing investment decisions With an objective to reduce the costs of the firm, these decisions are regarding replacement of the old and worn out machinery and assets, acquisition of new technology and selection of the most suitable technology.

Cost reducing investment decisions are subject to less risk as compared to revenue expanding investment decisions due to the fact that the former have the lesser element of risk than the latter.

Depending upon the type of the decision to be taken, different decision criteria can be prescribed. (i) Acceptance-rejection criterion There can be several proposals before the management to decide upon. Out of these proposals the ones, which meet some specific criterion (e.g., rate of return exce4eding a specific limit or payback period less than a specific interval) are accepted. All these proposals are independent in the sense that acceptance of one does not affect the acceptance or rejection of the others.

(ii) One among several criterion All accepted decisions under acceptance-rejection criterion may not be implemented and at times, we may need to select one project out of several accepted projects. For example, if the decision is to buy a new machine, then several brands may fulfill the acceptance-rejection criterion. However, all the machines are not to be purchased and choice of one will eliminate the chances of the selection of the others. Such projects are mutually exclusive projects.

(iii) Capital rationing Under acceptance-rejection criterion, several projects may be selected and would be implemented if the firm had unlimited capital. But this is not the case and every firm has limited capital. In such situation, the selected projects are ranked according to some criterion (e.g., rate of return) and the projects on the top of ranking list are selected if they meet the limited capital criterion also. More than one projects may be undertaken if their joint capital requirement is meets the limited capital criterion.

LIMITATIONS OF CAPITAL BUDGETING

The following are the limitations of capital budgeting.

1. The economic life of the project and annual cash inflows are only an estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure cannot be exercised.

2. Capital budgeting process does not take into consideration of various non-financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.

3. It is also not correct to assume that mathematically exact techniques always produce highly accurate results.

4. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances.

CAPITAL BUDGETING TECHNIQUES

Capital Budgeting Techniques

Discounting techniques

Non-Discounting techniques

§ Discounted Pay back Period *Urgency Method

§ Net Present Value *Pay Back Period

§ Internal Rate of Return *Accounting OR Average rate of Return

§ Profitability Index

The basic difference between discounting and non discounting techniques is that time value of money has been considered in discounting techniques. But on the other hand there is no provision for time value of money in non discounting techniques.

Factors to be considered while taking capital budgeting decisions:

§ Initial Investment

§ Operating Cash Flow

§ Economic life of an asset

Non-Discounting techniques

§ URGENCY METHOD

According to this criterion, projects, which are deemed to be most urgent, get priority over the projects that are regarded as less urgent.

However, it may be difficult to assign the degree of urgency in general. In certain situations, this may not be very difficult. For example, replacement of minor equipment may be immediate to ensure the continuity of production. In such situations, detailed analysis delay decisions.

Urgency is a relative concept. In general, the reliable relative degree of urgency may be difficult to determine. This is due to lack of an objective and quantifiable basis of assigning urgency levels to different alternatives. In such situations, persuasiveness and present ability of project proposers may be the determining criterion. But this is not a scientific basis of determining preferences and hence this is not a preferred criterion except for some emergency situations.

§ PAY BACK PERIOD

The payback period is the time required to recover the initial cost outlay of the project. A project with a short payback period is considered to be a desirable project. The firms using this criterion generally specify a maximum acceptable time period and the projects below this time period are considered to be worth accepting. This criterion is simple to use and useful particularly in those situations where the risk increases with time.

This method takes into account the face value of the cash flows without considering their time values, thus violating the fundamental principal of financial accounting to appropriately discount the money. Secondly, it ignores the cash flows beyond the payback period. For example, cash inflows of project D are attractive ninth year onwards but this method is rejecting this project because of a large payback period. Thus it is not measuring the project from profitability point of view.

If cash flows are even:

Payback period = Cash outlay (investment) / Annual cash inflow = C / A

If cash flows are uneven:

Payback period = Year before exact amount recovered + (Amount to be recovered/Cash flow in the corresponding year in which remaining amount will be recovered)

Advantages:

1. A company can have more favorable short-run effects on earnings per share by setting up a shorter payback period.

2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.

3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.

Limitations:

1. It fails to take account of the cash inflows earned after the payback period.

2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.

3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.

4. Administrative difficulties may be faced in determining the maximum acceptable payback period.

§ ACCOUNTING RATE OF RETURN

Also known as average rate of return, it is the ratio of income to the investment. Since, in accounting management, income and investments can be variously defined, so there are various measures of ARR. ARR reveals the annual return of a project as a % of the net investment in the project. Symbolically:

1) ARR= Annual Average Net Earnings/ Original Investment

Where,

Net earnings or Net cash flow= Net cash flow after interest, taxes and before depreciation

2) ARR= Annual Average Net earnings/Average investment

Where,

Average Investment= Original Investment /2

Methods to find out Average investments

1) Average investments= Original investment/2

2) Average investment= (Original Investment+ Scrap value of assets))/2

3) Average investment= (Original Investment- Scrap Value)/2

4) Average investment= ((Original Investment- Scrap Value)/2)+ Additional Net working capital + Scrap value.

Accept Reject Criteria:

If,

ARR>Target Rate (Accept the Project)

ARR< Target Rate (Reject the project)

ARR=Target rate (Indifferent situation, Personal judgement of finance manager)

Discounting techniques

· Discounted Payback period method

This is an improvement over the payback period method in the sense that it considers time value of money. Payback period is a quick and simple capital budgeting method that many financial managers and business owners use to determine how quickly their initial investment in a capital project will be recovered from the project's cash flows. Capital projects are those that last more than one year. The discounted payback period calculation differs only in that it uses discounted cash flows.

Example: An initial investment of Rs.50000 is expected to generate Rs.10000 per year for 8 years. Calculate the discounted payback period of the investment if the discount rate is 11%.

Given,

Initial investment = Rs. 50000 Years(n) = 8 Rate(i) = 11 % CF = 10000

To Find,

Discounted Payback Period (DPP)

Solution:

Year(n)	Cash Flow (CF)	Present Value FactorPV = 1/(1+i)ⁿ	Discounted Cash Flow (CF x PV)	Cumulative Discounted Cash Flow (CCF)
1	10000	0.9	9009.01	9009
2	10000	0.81	8116.22	17,125
3	10000	0.73	7311.91	24,436
4	10000	0.66	6587.31	31,023
5	10000	0.59	5934.51	36,957
6	10000	0.53	5346.41	42,303
7	10000	0.48	4816.58	47119
8	10000	0.43	4339.26	51,458

Discounted Payback Period = 7 + (2878.04 / 4339.26) = 7.66 years

· Net Present Value Method

Net present value is the difference between the present value of cash inflows and the present value of cash outflows that occur as a result of undertaking an investment project. It may be positive, zero or negative. These three possibilities of net present value are briefly explained below:

The summary of the concept explained so far is given below:

The following is the formula for calculating NPV:

where

C_t = net cash inflow during the period t

C_o= total initial investment costs

r = discount rate, and

t = number of time periods

· Profitability Index Method

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability index is a relative measure (i.e. it gives as the figure as a ratio).

Formula:

Profitability Index
=	Present Value of Future Cash Flows
	Initial Investment Required

Accept Reject Criteria

PI = 1 the projects benefits are expected to equal its costs.
PI < 1 the projects costs are expected to exceed its benefits; reject the project.
PI > 1 the projects benefits are expected to exceed its costs; accept the project.

· Internal Rate of Return Method

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

IRR Calculation

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus:

NPV = 0; or

PV of future cash flows − Initial Investment = 0; or

	CF₁	+	CF₂	+	CF₃	+ ...		− Initial Investment = 0
	( 1 + r )¹		( 1 + r )²		( 1 + r )³

Where,
   r is the internal rate of return;
   CF₁ is the period one net cash inflow;
   CF₂ is the period two net cash inflow,
   CF₃ is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However, there are alternative procedures which can be followed to find IRR. The simplest of them is described below:

Guess the value of r and calculate the NPV of the project at that value.
If NPV is close to zero then IRR is equal to r.
If NPV is greater than 0 then increase r and jump to step 5.
If NPV is smaller than 0 then decrease r and jump to step 5.
Recalculate NPV using the new value of r and go back to step 2.

Risk Analysis in Capital Budgeting

Capital budgeting is used to ascertain the requirements of the long-term investments of a company.Examples of long-term investments are those required for replacement of equipments and machinery, purchase of new equipments and machinery, new products, and new business premises or factory buildings, as well as those required for R&D plans.The different techniques used for capital budgeting include:

Besides these methods, other methods that are used include Return on Investment (ROI), Accounting Rate of Return (ARR), Discounted Payback Period and Payback Period.

The different types of risks that are faced by entrepreneurs regarding capital budgeting are the following:

Corporate risk
International risk
Stand-alone risk
Competitive risk
Market risk
Project specific risk
Industry specific risk

The following methods are used for
Risk Analysis in Capital Budgeting:

Sensitivity Analysis:
This is also known as a “what if analysis”. Because of the uncertainty of the future, if an entrepreneur wants to know about the feasibility of a project in variable quantities, for example investments or sales change from the anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV, or net present value.

Scenario Analysis:
In the case of scenario analysis, the focus is on the deviation of a number of interconnected variables. It is different from sensitivity analysis, which usually concentrates on the change in one particular variable at a specific point of time.

Break Even Analysis:
The Break Even Analysis allows a company to determine the minimum production and sales amounts for a project to avoid losing money. The lowest possible quantity at which no loss occurs is called the break-even point. The break-even point can be delineated both in financial or accounting terms.

Hillier Model:
In particular situations, the anticipated NPV and the standard deviation of NPV can be incurred with the help of analytical derivation. This was first realized by F.S. Hillier. There are situations where correlation between cash flows is either complete or nonexistent.

Simulation Analysis: Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of random blending of variable values that carry a relationship with the selected criterion.

Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the alternatives.

Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash flow of the firm. The corporate risk of a project refers to its share of the total risk of a company.

Risk Management: Risk management focuses on factors such as pricing strategy, fixed and variable costs, sequential investment, insurance, financial leverage, long term arrangements, derivatives, strategic alliance and improvement of information.

Selection of project under risk: This involves procedures such as payback period requirement, risk adjusted discount rate, judgmental evaluation and certainty equivalent method.

Practical Risk Analysis: The techniques involved include the Acceptable Overall Certainty Index, Margin of Safety in Cost Figures, Conservative Revenue Estimation, Flexible Investment Yardsticks and Judgment on Three Point Estimates.

Cost of Capital

The cost of capital is the minimum rate of return required on the investment projects to keep the market value per share unchanged.

In other words, the cost of capital is simply the rate of return the funds used should produce to justify their use within the firm in the light of the wealth maximisation objective.

Concept of Cost of Capital

There is bulk of finance literature to describe this concept. Numerous studies have shown that Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. It is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the decrease of overall prosperity of the shareholders. Famous theorist, John J. Hampton described cost of capital as "the rate of return the firm required from investment in order to increase the value of the firm in the market place". Solomon Ezra stated that "Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure" According to James C. Van Horne, Cost of capital is "A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock". Another theorist, William and Donaldson explained that "Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due".

Future cost and Historical cost:

It is commonly known that, in decision-making, the relevant costs are future costs are not the historical costs. The financial decision-making is no exception. It is future cost of capital which is significant in making financial decisions.

Specific cost and combined cost:

The cost of each component of capital (ex-common shares, debt etc.,) is known as specific cost of capital. The combined or composite cost of capital is an inclusive: cost of capital from all sources. It is, thus, the weighted average cost of capital.

Explicit cost and implicit cost:

The explicit cost of capital is the internal rate of return of the financial opportunity and arises when the capital is raised. The implicit of capital arises when the firm considers alternative uses of the funds rained. The methods of calculating the specific costs of different sources of funds are discussed.

Computation of cost of capital:

1. Cost of debt:

It is relatively easy to calculate cost of debt, it is rate of return or the rate of interest specified at the time of debt issue. When a bond or debenture is issued at full face value and to be redeemed after some period, then the before tax cost of debt is simply the normal rate of interest.

Cost of debt

Redeemable Debts

Irredeemable Debts

Cost of Debt before tax (KdBT)= I/NP

Where,

I= Interest

NP= Net Proceeds= Par value-Discount or(+Premium)- Flotation cost

Cost of Debt after tax (KdAT)= (1-T) KdBT

Where,

T= Tax Rate

KdBT= (I+P-NP/N)/(P+NP/2)

Where,

I= Interest, P=Principal value or par value, NP= Net Proceeds, N= Number of years.

KdAT= KdBT(1-T)

Where,

T=Tax Rate

Cost of Preference Shares (Kp)

Preference shares represent a special type of ownership interest in the firm. They are entitled to a fixed dividend, but subject to availability of profit for distribution. The preference share holders have to be paid their fixed dividends before any distribution of dividends to the equity shareholders. Their dividends are not allowed as an expense for the purpose of taxation. In fact, the preference dividend is a distribution of profits of the business. Because dividends are paid out of profits after taxes, the question of after tax or before tax cost of preference shares does not arise as in case of cost of debentures.

Preference shares can be divided into:

Irredeemable preference shares
Redeemable preference shares

· Cost of Redeemable preference shares

Kp=( P.D.+P-NP/N)/(P+NP/2)

Where,

P.D.=Preferential dividend

P=Principal Value

NP= Net Proceeds

N= Number of years till maturity

Cost of Irredeemable preference shares

Kp=P.D./NP

Cost of Equity Shares

· Dividend Approach

Ke= D/NP(fresh issue of shares) or D/MP (Existing Shares)

Where,

NP=Net Proceeds

D=Dividend

MP= Market price

· Earnings Approach

Ke=E/NP or E/MP

Where,

E= Earnings

Cost of Retained Earnings

Re= Ke(1-T)(1-B)

Where,

T=Tax rate

B= Brokerage cost

Unit IV

Dividend Decision

DEFINITION: DIVIDEND

According to the Institute of Chartered Accountants of India, dividend is "a distribution to shareholders out of profits or reserves available for this purpose."

"The term dividend refers to that portion of profit (after tax) which is distributed among the owners / shareholders of the firm.

"Dividend may be defined as the return that a shareholder gets from the company, out of its profits, on his shareholdings."

In other words, dividend is that part of the net earnings of a corporation that is distributed to its stockholders. It is a payment made to the equity shareholders for their investment in the company.

DEFINITION: DIVIDEND POLICY

"Dividend policy determines the ultimate distribution of the firm's earnings between retention (that is reinvestment) and cash dividend payments of shareholders."

"Dividend policy means the practice that management follows in making dividend payout decisions, or in other words, the size and pattern of cash distributions over the time to shareholders."

In other words, dividend policy is the firm's plan of action to be followed when dividend decisions are made. It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm.

Dividend policy means policy or guideline followed by the management in declaring of dividend. A dividend policy decides proportion of dividend and retains earnings. Retained earnings are an important source of internal finance for long term growth of the company while dividend reduces the available cash funds of company.

TYPES OF DIVIDENDS:

Classifications of dividends are based on the form in which they are paid. Following given below are the different types of dividends:

· Cash dividend:

Companies mostly pay dividends in cash. A Company should have enough cash in its bank account when cash dividends are declared. If it does not have enough bank balance, arrangement should be made to borrow funds. When the Company follows a stable dividend policy, it should prepare a cash budget for the coming period to indicate the necessary funds, which would be needed to meet the regular dividend payments of the company. It is relatively difficult to make cash planning in anticipation of dividend needs when an unstable policy is followed.

The cash account and the reserve account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and net worth of the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of the cash dividend distributed.

· Bonus Shares : (OR Stock -dividend in USA)

An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend. Hence, Companies in India may supplement cash dividend by bonus issues. Issuing bonus shares increases the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership.

The declaration of the bonus shares will increase the paid-up Share Capital and reduce the reserves and surplus retained earnings) of the company. The total net-worth (paid up capital plus reserves and surplus) is not affected by the bonus issue. Infect, a bonus issue represents a recapitalization of reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid up capital.

· Special dividend :

In special circumstances Company declares Special dividends. Generally company declares special dividend in case of abnormal profits.

· Extra- dividend:

An extra dividend is an additional non-recurring dividend paid over and above the regular dividends by the company. Companies with fluctuating earnings payout additional dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular dividends.

· Annual dividend:

When annually company declares and pay dividend is defined as annual dividend.

· Interim dividend

During the year any time company declares a dividend, it is defined as Interim dividend.

· Regular cash dividends:

Regular cash dividends are those the company exacts to maintain every year. They may be paid quarterly, monthly, semiannually or annually.

· Scrip dividends:

These are promises to make the payment of dividend at a future date: Instead of paying the dividend now, the firm elects to pay it at some later date. The ‘scrip’ issued to stockholders is merely a special form of promissory note or notes payable.

· Liquidating dividends:

These dividends are those which reduce paid-in capital: It is a pro-rata distribution of cash or property to stockholders as part of the dissolution of a business.

· Property dividends:

These dividends are payable in assets of the corporation other than cash. For example, a firm may distribute samples of its own product or shares in another company it owns to its stockholders.

Factors affecting Dividend Decisions of Firms:

There are many factors affecting the decisions relating to dividends to be declared to shareholders.

These are discussed below:

i. Expectation of Investors:

People who invest in the firms have basically done so, with the view of long-term investment in a particular firm to avoid the necessity of shifting from one firm to another. The expectation of the investor has been two fold. They expect to receive income annually and have a stable investment.

Capital Gains:

All investors who are less interested in speculation and more interested in long-term investment do so with a view to making some capital appreciation on their investment. Capital gain is the profit, which results from the sale of any capital investment. If the investor invests in equity stock, the capital gain would be out of the sale of equity stock after holding it for a reasonable period of time.

Current Income:

The investor would like to have some current earnings which are also continuous in nature and it is the price of abstinence from current consumption to more profitable avenues.

The expectation of the shareholder should be considered before taking any appropriate decision regarding dividends. In this sense, the company has to think of both maximization of wealth of the investor as well as its own internal requirements for long-term financing.

ii. Reducing of Uncertainty:

Dividends should be declared in a manner that the investor is confident about the future of his earnings. If he receives dividends annually and the amount is such that it satisfies him then the company is able to gain his confidence because it reduces his uncertainty about future capital gains or appreciation of the company’s equity stock.

A current dividend is the present value cash in-flow to the investors. This also helps him to assess the kind of future that his investments will carry for him. The decisions for paying dividend should also considered this point.

iii. Financial Strength:

The payment of dividend which is regular, stable and continuous with a promise of capital appreciation, helps the company in judging its own financial strength and also it receives financial commitments from creditors and financial institutions because they are in a position to gauge the kind of working of the firm through the information they receive regarding the amount of dividend and the market value of their shares.

While all investors would like to maximize their wealth, the company must also see its requirement for expansion programs. The company also has certain limitations or environmental constraints which enable it to pay dividend in a limited form.

Limitation on Dividend Payments:

The firm has the following limitations in paying dividends.

The management of the firm while making decision in paying out dividends to its shareholders should also analyse these problems:

i. Cash Requirements:

Many firms are unable to pay dividends regularly. A company which is going through its gestation period or is small in nature and is trying to expand its business has the problem of paying high dividends.

If it does, it will be surrounded by inefficiency because of the insufficiency of cash. Sometimes, a firm has the problem of tying up all resources in inventories or in the commitment of purchasing long-term investments. This acts as a restraint of the firm to pay out dividends.

ii. Limitations Placed by Creditors:

Sometimes, a firm requires funds for long-term purpose and to fulfil this obligation it makes, the use of funds on long-term loans. While taking these loans the firm makes an arrangement with the creditors that it will not pay dividends to its shareholders till its debt equity ratio depicts 2:1.

Sometimes, the firm also makes contractual obligations with its creditors to maintain a certain pay-out ratio till the time that it is using the loan facilities. Under these contractual obligations, the firm cannot pay more than the dividends it can, or is allowed to pay, under the agreement.

iii. Legal Constraints:

In India, there are many legal constraints in payment of dividends. The payment of dividends is subject to government policy and tax laws. This restraint also covers bonds, debentures and equity shares.

There are regulatory authorities such as Reserve Bank of India, Securities Exchange Board of India, Insurance Regulatory Authority of India. Income Tax Act of India and Companies Act followed in India. These legal constraints should be carefully analysed before paying dividends to the shareholders.

Dividend Decision and Valuation of Firms

The value of the firm can be maximized if the shareholders wealth is maximized. There are conflicting views regarding the impact of dividend decision on valuation of the firm. According to one school of thought, dividend decision does not affect shareholders wealth and hence the valuation of firm. On other hand, according to other school of thought dividend decision materially affects the shareholders wealth and also valuation of the firm. We have discussed below the views of two schools of thought under two groups:

1. The Relevance Concept of Dividend a Theory of Relevance.

2. The Irrelevance Concept of Dividend or Theory of Irrelevance.

The Relevance Concept of Dividend

The advocates of this school of thought include Myron Gordon, James Walter and Richardson. According to them dividends communicate information to the investors about the firm’s profitability and hence dividend decision becomes relevant. Those firms which pay higher dividends will have greater value as compared to those which do not pay dividends or have a lower dividend pay out ratio. It holds that dividend decisions affect value of the firm.

We have examined below two theories representing this notion: (i) Walter’s Approach and (ii) Gordon’s Approach.

(i) Walter’s Approach: According to Prof. James E. Walter, in the long run, share prices reflect the present value of future+ dividends. According to him investment policy and dividend policy are inter related and the choice of a appropriate dividend policy affects the value of an enterprise. His formula for determination of expected market price of a share is as follows:

P = D + r/k(E-D) K

Where, P = Market price of equity share

D = Dividend per share

E = Earnings per share

(E-D) = Retained earnings per share

r = Internal rate of return on investment

k = cost of capital

Assumptions of Walter’s model

(i) The firm has a very long life.

(ii) Earnings and dividends do not change while determining the value.

(iii) The Internal rate of return ( r ) and the cost of capital (k) of the firm are constant.

(iv) The investments of the firm are financed through retained earnings only and the firm does not use external sources of funds.

(ii) Gordon’s Approach : The value of a share, like any other financial asset, is the present value of the future cash flows associated with ownership. On this view, the value of the share is calculated as the present value of an infinite stream of dividends. Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of establishing share value. Gordon's model uses the dividend capitalization approach for stock valuation. The formula used is as follows:

Po = E1 (1-b) K-br

Where,

Po = price per share at the end of year 0

E1 = earnings per share at the end of year 1

(1-b) = fraction of earnings the firm distributes by way of dividends

b = fraction of earnings the firm ploughs back

k = rate of return required by shareholders

r = rate of return earned on investments made by the firm

br = growth rate of dividend and earnings

The models, provided by Walter and Gordon lead to the following implications:

If r > k Price per share increases as dividend payout ratio decreases

If r = k Price per share remains unchanged with changes in dividend payout ratio

If r < k Price per share increases as dividend payout ratio increases.

The Irrelevance Concept of Dividend

The other school of thought on dividend policy and valuation of the firm argues that what a firm pays as dividends to share holders is irrelevant and the shareholders are indifferent about receiving current dividend in future. The advocates of this school of thought argue that dividend policy has no effect on market price of share. Two theories have been discussed here to focus on irrelevance of dividend policy for valuation of the firm which are as follows:

1. Modigliani and Miller Approach (MM Model)

Modigliani Miller approach According to them the price of a share of a firm is determined by its earning potentiality and investment policy and not by the pattern of income distribution. The model given by them is as follows:

Po = D1 + P1/ (1/Ke)

Where,

Po = Prevailing market price of a share

Ke = Cost of equity capital

D1 = Dividend to be received at the end of period one

P1 = Market price of a share at the end of period one

Assumptions of MM Hypothesis

(1) There are perfect capital markets.

(2) Investors behave rationally.

(3) Information about company is available to all without any cost.

(4) There are no floatation and transaction costs.

(5) The firm has a rigid investment policy.

(6) No investor is large enough to effect the market price of shares.

(7) There are either no taxes or there are no differences in tax rates applicable to dividends and capital gains.

Working capital Managment

Meaning of Working Capital

Capital required for a business can be classified under two main categories viz.

(i) Fixed capital

(ii) Working capital.

Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long-term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, Building etc. Investments in these assets represent that part of firm’s capital which is blocked on permanent basis and is called fixed capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of wages and other day-to-day expenses etc. These funds are known as working capital which is also known as Revolving or circulating capital or short term capital. According to Shubin, “Working capital is amount of funds necessary to cover the cost of operating the enterprise”.

Concept of Working Capital

There are two concepts of working capital:

(i) Gross working capital

(ii) Net working capital.

Gross working capital is the capital invested in total current assets of the enterprise. Examples of current assets are : cash in hand and bank balances, Bills Receivable, Short term loans and advances, prepaid expenses, Accrued Incomes etc. The gross working capital is financial or going concern concept. Net working capital is excess of Current Assets over Current liabilities.

Net Working Capital = Current Assets – Current Liabilities

When current assets exceed the current liabilities the working capital is positive and negative working capital results when current liabilities are more than current assets. Examples of current liabilities are Bills Payable, Sunday debtors, accrued expenses, Bank Overdraft, Provision for taxation etc. Net working capital is an accounting concept of working capital.

Classification or Kinds of Working Capital

Working capital may be classified in two ways:

(a) On the basis of concept

(b) On the basis of time

On the basis of concept working capital is classified as gross working capital and net working capital. On the basis of time working capital may be classifies as Permanent or fixed working capital and Temporary or variable working capital.

Permanent or Fixed working capital

It is the minimum amount which is required to ensure effective utilisation of fixed facilities and for maintaining the circulation of current assets. There is always a minimum level of current assets which its continuously required by enterprise to carry out its normal business operations. As the business grows, the requirements of permanent working capital also increase due to increase in current assets. The permanent working capital can further be classified as regular working capital and reserve working capital required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on. Reserve working capital is the excess mount over the requirement for regular working capital which may be provided for contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.

Temporary or Variable working capital

It is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital is further classified as seasonal working capital and special working capital. The capital required to meet seasonal needs of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research etc.

Importance or Advantages of Adequate Working Capital : Working capital is the life blood and nerve centre of a business. Hence, it is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows:

1. Solvency of the Business: Adequate working capital helps in maintaining solvency of business by providing uninterrupted flow of production.

2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill.

3. Easy Loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms.

4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on purchases and hence it reduces cost.

5. Regular Supply of Raw Material: Sufficient working capital ensure regular supply of raw materials and continuous production.

6. Regular payment of salaries, wages and other day to day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day to day commitments which raises morale of its employees, increases their efficiency, reduces costs and wastages.

7. Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression.

8. Quick and regular return on investments: Every investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to is investor as there may not be much pressure to plough back profits which gains the confidence of investors and creates a favourable market to raise additional funds in future.

9. Exploitation of Favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices.

10. High Morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business.

Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business operations. It should have neither excess working capital nor inadequate working capital. Both excess as well as short working capital positions are bad for any business.

Disadvantages of Excessive Working Capital

Excessive working capital means idle funds which earn no profits for business and hence business cannot earn a proper rate of return.
When there is a redundant working capital it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses.
It may result into overall inefficiency in organization.
Due to low rate of return on investments, the value of shares may also fall.
The redundant working capital gives rise to speculative transaction.
When there is excessive working capital, relations with banks and other financial institutions may not be maintained.

Disadvantages of Inadequate working capital

A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
It cannot buy its requirements in bulk and cannot avail of discounts.
It becomes difficult for firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital.
The rate of return on investments also falls with shortage of working capital.
The firm cannot pay day-to-day expenses of its operations and it created inefficiencies, increases costs and reduces the profits of business.

The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and realisation of cash from sales. There is an operating cycle involved in sales and realisation of cash. There are time gaps in purchase of raw materials and production, production and sales, and sales and realisation of cash. Thus, working capital is needed for following purposes.

For purchase of raw materials, components and spares.
To pay wages and salaries.
To incur day-to-day expenses and overhead costs such as fuel, power etc.
To meet selling costs as packing, advertisement
To provide credit facilities to customers.
To maintain inventories of raw materials, work in progress, stores and spares and finished stock.

Greater size of business unit large will be requirements of working capital. The amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity. At maturity the amount of working capital needed is called normal working capital.

Factors Determing the Working Capital Requirements

The following are important factors which influence working capital requirements:

1. Nature or Character of Business: The working capital requirements of firm depend upon nature of its business. Public utility undertakings like electricity, water supply need very limited working capital because they offer cash sales only and supply services, not products, and such no funds are tied up in inventories and receivables whereas trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets and as such they need large amount of working capital. Manufacturing undertaking require sizeable working capital between these two.

2. Size of Business/Scale of Operations: Greater the size of a business unit, larger will be requirement of working capital and vice-versa.

3. Production Policy: The requirements of working capital depend upon production policy. If the policy is to keep production steady by accumulating inventories it will require higher working capital. The production could be kept either steady by accumulating inventories during slack periods with view to meet high demand during peak season or production could be curtailed during slack season and increased during peak season.

4. Manufacturing process / Length of Production cycle: Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for longer period in the process with progressive increment of labour and service costs before finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen.

5. Credit Policy: A concern that purchases its requirements on credit and sell its products/services on cash requires lesser amount of working capital. On other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

6. Business Cycles: In period of boom i.e. when business is prosperous, there is need for larger amount of working capital due to increase in sales, rise in prices etc. On contrary in times of depression the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have large amount of working capital lying idle.

7. Rate of Growth of Business: The working capital requirements of a concern increase with growth and expansion of its business activities. In fast growing concerns large amount of working capital is required whereas in normal rate of expansion in the volume of business the firm may have retained profits to provide for more working capital.

8. Earning Capacity and Dividend Policy. The firms with high earning capacity generate cash profits from operations and contribute to working capital. The dividend policy of concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits need more working capital than firm that retains larger part of its profits and does not pay so high rate of cash dividend.

9. Price Level Changes: Changes in price level affect the working capital requirements. Generally, the rising prices will require the firm to maintain large amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms.

10. Working Capital Cycle: In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with realisation of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work in progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle again from cash to purchase of raw material and so on. The speed with which the working capital completes one cycle determines the requirements of working capital longer the period of cycle larger is requirement of working capital.

Management of Working Capital

Working capital refers to excess of current assets over current liabilities. Management of working capital therefore is concerned with the problems that arise in attempting to manage current assets, current liabilities and inter relationship that exists between them. The basic goal of working capital management is to manage the current assets and current of a firm in such a way that satisfactory level of working capital is maintained i.e. it is neither inadequate nor excessive. This is so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earns no profits for the business. Working capital Management policies of a firm have a great effect on its profitability, liquidity and structural health of organization. In this context, evolving capital management is three dimensional in nature.

Dimension I is concerned with formulation of policies with regard to profitability, risk and liquidity.
Dimension II is concerned with decisions about composition and level of current assets.
Dimension III is concerned with decisions about composition and level of current liabilities.

Principles of Working Capital Management

1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases opportunity for gain or loss. On other hand less investment in current assets with greater dependence on short-term borrowings increases risk, reduces liquidity and increases profitability.

There is definite direct relationship between degree of risk and profitability. A conservative management prefers to minimize risk by maintaining higher level of current assets while liberal management assumes greater risk by reducing working capital. However, the goal of management should be to establish suitable tradeoff between profitability and risk. The various working capital policies indicating relationship between current assets and sales are depicted below:-

2. Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and degree of risk involved. Generally, higher the risk lower is cost and lower the risk higher is the cost. A sound working capital management should always try to achieve proper balance between these two.

3. Principle of Equity Position: This principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by firm’s equity position. Every rupee invested in current assets should contribute to the net worth of firm. The level of current assets may be measured with help of two ratios.

(i) Current assets as a percentage of total assets and

(ii) Current assets as a percentage of total sales.

4. Principle of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital. According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater inability to meet its obligations in time.

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School of Business Management

Financial Management BBA 205 Notes

LIMITATIONS OF CAPITAL BUDGETING

Risk Analysis in Capital Budgeting

Principles of Working Capital Management

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