Financial Management

Disha Institute of IT & Management
Financial Management
Unit I
Meaning of Financial Management:-
Financial Management is such a managerial process which is concerned with the

planning and control of Financial resources. It is being studied as a separate
subject in 20th century. Till now it was used as a part of economics. Now, its
scope has undergone some basic changes from time to time. In present time, it
analyses all financial problems of a business. Financial Manager estimates the
requirements of funds, plans the different sources of funds and perform functions
of collection of funds and its effective utilisation.
Finance is such a powerful source that it performs an important role to operate

and coordinate the various economic activities of business. Finance is of two
types:-
(1) Public finance.

(2) Private finance.
1. Public Finance:-
means government finance under which principles and practices relating to the
procurement and management of funds for central government, state
government and local bodies are covered.
2. Private Finance:-
means procurement and management of funds by individuals and private

institutions. Under it we observe as to how individuals and private institution
procure funds and utilise it.
Scope:-
What is finance? What are a firm’s financial activities? How are they related?
Firm create manufacturing capacities for production of goods, some provide
services to customers. They sell goods or services to earn profit and raise funds
to acquire manufacturing and other facilities. Thus, the 3 most important activities
of business firm are:-
(1) Production
(2) Marketing
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(3) Finance.
A firm secures whatever capital it needs and employs it (finance activity) in

activities which generate returns on invested capital (production and marketing
activities.)
Real and financial Assets:-
A firm acquire real assets to carry on its business. Real assets can be
tangible or intangible. Plant, machinery, factory, furniture etc. are examples of
tangible real assets, while technical know-how, patents, copy rights are examples
of intangible real assets.
The firm sells financial assets or securities such as shares and bonds or
debentures, to investors in capital market to raise necessary funds. Financial
assets also include borrowings from banks, finance institutions and other
sources.
Funds applied to assets by the firm are called capital expenditure or

investment. The firm expects to receive return on investment and distribute return
as dividends to investors.
EQUITY AND BORROWED FUNDS:-
There are two types of funds that a firm can raise:- Equity funds and
borrowed funds.
A firm sells shares to acquire equity funds. Shares represent ownership

rights of their holders. Buyers of shares are called share holders and they are
legal owners of the firm whose share they hold share holders invest their money
shares of a company in expectation of return on their invested capital. The return
on shares holder’s capital consists of dividend and capital gain by selling their
shares.
Another important source of securing capital is creditors or lenders.

Lenders are not the owners of the company. They make money available to firm
on a lending basis and retain title to the funds lent. The return on loans or
borrowed funds is called interest. Loans are furnished for a specified period at a
fixed rate of interest. Payment of interest is a legal obligation. The amount of
interest is allowed to be treated as expense for computing corporate income
taxes. Thus the payment of interest on borrowings provides tax shied to a firm.
The firm may borrow funds from a large number of sources, such as banks,
financial institutions, public or by issuing bonds or debentures. A bond or
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debenture is a certificate acknowledging the money lent by a bond holder to the

company. It states the amount, the rate interest and maturity of bonds or
dentures.
FINANCE AND OTHER MANAGEMENT FUNCTIONS:-
There exists an inseperable relationship between finance on the one hand

and production, marketing and other functions on the other. Almost, all kinds of
business activities, directly or indirectly, involve acquisition and use of funds. For
example, recruitment and promotion of employees in production is clearly a
responsibility of production department but it require payment of wages and
salaries and other benefits and thus involve finance. Similarly, buying a new
machine or replacing an old machine for the purpose of increasing productive
capacity affects flow of funds.
A company in tight financial position will of course, give more weight to

financial considerations and devise its marketing and production strategies in
light of financial constraint. On other hand, management of a company, which
has a regular supply of funds, will be more flexible in formulating its production
and marketing policies. In fact, financial policies will be devised to fit production &
marketing decision of firms in practice.
OBJECTIVES OF FINANCIAL MANAGEMENT:-
It is the duty of management to clarify the objectives of business so that

the departmental objectives could be determined accordingly. Financial
objectives of a firm provide a concrete framework within which optimum financial
decisions can be made. The main objective of any firm should be to maximise
the economic welfare of its shareholders. Accordingly, there are 2 approaches in
this regard.
(A) Profit maximisation Approach.

(B) Wealth maximisation Approach.
(A) PROFIT MAXIMISATION APPROACH:-
According to this approach, a firm should undertake all those activities

which add to its profits and eliminate all others which reduce its profits. This
objectives highlights the fact that all decisions:- financing, dividend and
investment, should result in profit maximisation. Following arguments are given in
favour of profit maximisation approach:-
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(i) Profit is a yardstick of efficiency on the basis of which economic

efficiency of a business can be evaluated.
(ii) It helps in efficient allocation and utilisation of scarce means because
only such resources are applied which maximise the profits.
(iii) The rate of return on capital employed is considered as the best
measurement of the profits.
(iv) Profit acts as motivator which helps the business organisation to be
more efficient through hard work.
(v) By maximising profits, social & economics welfare is also maximised.
However this approach has been criticised on various counts:-
(1) Ambiguity:-
Profit can be expressed in various forms i.e it can be short term or long
term or it can be profit before tax or after tax or it can be gross profit or net profit.
Now the question arises, which profits can be maximised under profit
maximisation approach.
(2) Time Value of Money
This approach is also criticised because it ignores time value of money i.e.
under this approach income of different years get equal weight. But, in fact, the
value of rupee today will be greater as compared to the value of rupee receivable
after one year. In the same manner, the value of income received in the first year
will be greater from that which will be received in later year e.g. the profits of 2
different projects are:-
Example:-
YEAR PROJECT1 PROJECT2

1 5,000 -
2 10,000 10,000
3 5,000 10,000
Both the projects have a total earnings of Rs 20,000 in 3 years and

according to this approach both will be considered equally profitable. But Project
1 has greater profits in the initial years of the project & therefore, is more
profitable in terms of value of income. The profits earned in initial years can be
reinvested and more profits can be earned.
(3) Risk Factor:-

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This approach ignores risk factor. The certainity or uncertainity of income

receivable in future can be high or less. High uncertainity increases risk and less
uncertainity reduces risk. Less income with more certainity is considered better
as compared to high income with greater uncertainity.
Thus, this approach was more significant for sole trader & partnership
firms because at that time when personal capital invested in business, they
wanted to increase their assets by maximising profits. Companies are now
managed by professional managers and capital is provided by shareholders,
debenture holders, financial institutions etc. one of the major responsibilities of
business management is to co-ordinate the conflicting interest of all these
parties. In such a situation profit maximisation approach does not appear proper
and practicable for financial decisions.
B Wealth Maximisation Approach
Value Maximisation Approach or Maximum net present worth.
According to this approach , financial management should take such

decision’s which increase net present value of the firm and should not undertake
any activity which decrease net present value. This approach eliminates all the 3
basic crificisms of the profit maximisation approach.
As the value of an asset is considered from view point of profit accruing

from it, in the same manner the evaluation of an activity depends on the profits
arising from it. Therefore, all 3 main decisions of financial manager-financing
decision, investment decision dividend decision affect net present value of the
firm. The greater the amount of net present value, the greater will be value of firm
and more it will be in the interest of share holders. When the value of firm
increases, the market price of equity shares also increase. Thus to maximise net
present worth means to maximise the market price of shares. Net present worth
can be calculated with the help of following equation.
A1 A2 An -c
W= + + --------------------- +
(1+k) (1+k)2 (1+k)n
n At
= ∑ -C
t
t=1 (1+k)
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Where W = Net present worth.
A, A2--- An= Stream of expected cash benefits from a course of action

over a period of time.
K = Discount rate to measure risk & timing.

C= Initial outlay to acquire that asset
If W is positive, the decision should be taken & vice versa.
If W is Zero, it would mean that it does not add or reduce the present value of the
asset.
This approach is considered good for the companies in present situation.

This approach gives due consideration to the time value of expected income
receivable over different period of time. Under this approach, risk and uncertainty
is analysed with the help of interest rate. If uncertainity & time period are greater,
higher rate of interest will be used to calculate present value of expected future
cash benefits where as the interest rate will be lower for the projects with low risk
& uncertainity. Besides, this approach uses cash flows instead of accounting
profits which removes ambiguity associated the term profit.
On the basis of above explanation, we can conclude that wealth

maximisation approach is better to profit maximisation approach to establish
mutual relation among the various data. It is possible only through statistics.
Cash and inventory management, forecast of financial needs, credit policy
decision all are based on the advanced techniques of statistics.
Finance is also related to law. Any decision regarding financial policy

should be in line with the laws of the country.
Organisation of Finance Function
The organisation of finance function implies the division and classification

of functions relating to finance because financial decisions are of utmost
significance to firms. Therefore, to perform the functions of finance, we need a
sound and efficient organisation.
Although in case of companies, the main responsibility to perform finance

function rests with the top management yet the top management (Board of
Directors) for convenience can delegate its powers to any subordinate executive
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which is known as Director Finance, Chief Financial Controller, Financial Manger

or Vice President of Finance. Besides it is finally the duty of Board of Directors to
perform the finance functions. There are various reasons to assign the
responsibility to the Board of Directors. Financing decisions are quite significant
for the survival of firm. The growth and expansion of business is affected by
financing policies. The loan paying capacity of the business depends upon the
financial operations.
The organisation of finance function is not similar in all businesses but it is

different from one business to another. The organisation of finance function for a
business depends on the nature, size financial system and other characteristics
of a firm. For a small business, no separate officer is appointed for the finance
function. Owner of the business himself looks after the functions of finance
including the estimation of requirements of funds, preparation of cash budget and
arrangement of the required funds, examination of all receipts and payments,
preparation of credit policy, collecting debtors etc. with the increase in the size of
business, specialists were appointed for the finance function and the
decentralisation of the finance function began. For a medium sized business, the
responsibility of the finance function is given to a separate officer who is known
as financial controller, finance manager, deputy chairman (finance), finance
executive or treasurer.
In a large sized company the finance function has become more difficult
and complex and the position of financial manager has become very important.
He is the member of top management of an organisation. For such large
organisations it is not possible for a finance manager to perform all the finance
functions or to co-ordinate with the various departments. Therefore, finance and
financial control are separated and allocated to two different sub-departments.
For the ‘finance’ sub-department treasurer is appointed and for the ‘financial
control’ sub department, financial controller is appointed. Each of them have
various sub-units under them.
Financial planning and financial control are quite significant for a large
sized organisation. Therefore, a finance committee is established between the
Board of Directors and Managing Director. It includes the financial Manger,
representatives of the directors and departmental heads of various departments.
Managing Director is the chairman of the committee. Its main function is to
advise the Board of Directors on financial planning and financial control and co-
ordinate the activities of various departments. The following chart 1.1. explains
the organisation of finance function.
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From the chart 1.1. it is clear that treasurer and financial control work
under finance Manager. Financial Manager is responsible to the Managing
Director for his actions.
Board of Directors
Managing Directing Finance Committee
Production Personnel Financial Marketing

Manager Manager Manager Manager
Treasurer Controller
Banking Cash Credit Assets Securities

Relations Magt. Analysis Protection Mgt.
Corporate Annual Internal Planning & Statistics

Accounting Reports Auding Budgeting
& Cost
Treasurer performs the functions of procurement of essential funds, their

utilisation, investment, banking, cash management credit management, dividend
distribution, pension, management etc. Financial, controller is responsible for
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general accounting, cost accounting, auditing, budget, reporting and preparing

financial statement etc. In India the function of financial manager is given to
secretary in most of the companies. He performs the functions of treasurer and
financial controller along with the routine functions of secretary. He collects
necessary data and information and sends them to the Managing Director.
Functions of the Chief Financial Manager.
Chief Financial manager is the top officer of finance department. In

America he is known as Vice-president finance and in India he is called Chief
Financial Controller. He performs following functions:
(1) Financial Planning :- He determines the capital structure and

prepares financial plan.
(2) Procurement of Funds:- Financial manager makes the necessary

funds available from different sources.
(3) Co-ordination:- Financial manager establishes co-ordination among

the financial needs of various departments. He is a member of finance
committee.
(4) Control:- Financial manager examines whether the work is being

performed as per pre-determined standards or not. He gets the reports prepared,
controls the cost and analyses profits.
(5) Business Forecasting:- Financial manager evaluates the effects of

all national, international, economic, social and political events on industry and
company.
(6) Miscellaneous Functions:- It includes the management of assets,

management of inventory, arrangement of data and management of bank
deposits etc.
Functions of Treasurer
The following are the functions of treasurer.
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(1) Provisions of finance:- It includes the estimation of funds necessary

for procurement preparing programmes and implementing them, establishing
relation among various sources of funds, issuing the securities and managing
debt etc.
(2) Banking Function:- It includes opening bank accounts, depositing

cash, payment of company liabilities, accounting cash receipts & payments,
responsibility for transacting actual assets etc.
(3) Custody:- The treasurer is the custodian of funds and securities.

(4) Management of credit and collection:- The treasurer determines
credit risk of customers and arranges for collection.
(5) Investments: It involves the investment of surplus funds.
(6) Insurance:- The treasurer signs the cheques, agreement and other
letters of company forecasts cash receipts and payments, pay property taxes and
follows government regulations.
Functions of controller
The controller performs the following functions:-

(1) Planning:- The controller prepares plan for controlling the business
activities which are the main constituents of management and in which proper
arrangement regarding profit planning, capital expenditure planning, sales
forecasting and expenditure budgeting is made.
(2) Accounting:- Controller determines the accounting system and

arrangements for costing and management accounting systems and prepares
financial statements.
(3) Auditing:- Controller Manages internal auditing.
(4) Reports :- Controller prepares financial reports according to various

needs and presents them to the managers. He advises the management to
correct the deviation between the standard performance and actual performance.
(5) Government Reporting :- Controller sends essential information’s to

the government by obeying the legal requirement.
(6) Tax Administration :- Controller prepares statement on tax liability.
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(7) Economic Appraisal :- He determines and analyses the effect of

economic and social factors on business.
Time Value of Money:-
The evaluation of capital expenditure proposals involves the comparison

between cash outflows & cash inflows. The pecularity of evaluation of capital
expenditure proposals is that it involves the decision to be taken today where as
the flow of funds, either outflow or inflow, may be spread over a number of years.
It goes without saying that for a meaningful comparison between cash outflows
and cash inflows, both the variables should be on comparable basis. As such,
the question which arises is “that is the value of flows arising in future the same
in terms of today.”
For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is
the value of this cash inflow really Rs 10,000 as on today when capital
expenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’.
The value of Rs 10000 received after one year is less than Rs 10,000 if received
today. The reasons for this can be stated as below:-
(i) There is always an element of uncertainety attached with the future cash
flows.
(ii) The purchasing power of cash inflows received after the year may be less
than that of equivalent sum if received today.
(iii) There may be investment opportunities available if the amount is received

today which cannot be exploited if equivalent sum is received after one year.
Time Value of money:
Example:- If Mr. X is given the option that he can receive an amount of Rs 10000
either on today or after one year, he will most obviously select the first option
why? Because, if he receives Rs 10000 today he can always invest the same say
in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice
is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000
plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs
10,000) only after one year, the real value of same in terms of today is not Rs
10000 but something less than that. This concept is called time value of money.
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Finance Functions:-
(a) Financing decisions

(b) Investment decisions
(C) Dividend policy decision
(d) Liquidity Decision
(a) Financing Decisions are decisions regarding process of raising the funds.
This function of finance is concerned with providing answers to various questions
like -
(a) What should be amount of funds to be raised.
(b) What are the various sources available to organisation for raisaing the
required amount of funds? For this purpose, the organisation can go for internal
& external sources.
(c) What should be proportion in which internal & external sources should be
used by organisation?
(d) If organisation, wants to raise funds from different sources, it is required to

comply with various legal & procedural formalities.
(e) What kinds of changes have taken place recently affecting capital market in
the country?
(b) Investment decisions:- are decisions regarding application of funds raised

by organisation. These relate to selection of the assets in which funds should be
invested.
The assets in which funds can be invested are of 2 types
(a) Fixed assets:- are the assets which bring returns to organisation over a
longer span of time. The investment decisions in these types of assets are
“capital budgeting decisions.” Such decisions include
1 How fixed assets should be selected to make investment ? What are various
methods available to evaluate investment proposals in fixed assets?
2 How decisions regarding investment in fixed assets should be made in situation

of risk & uncertainity?
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(b) Current assets:- are assets which get generated during course of operations
& are capable of getting converted in form of cash with in a short period of one
year. Such decisions include
(1) What is meaning of Working Capital management & its objectives?
(2) Why need for working capital orises?
(3) What are factors affecting requirements of working capital?
(4) How to quantity requirements of working capital?
(5) What are sources available for financing the requirement of working capital?
(c ) Dividend Policy Decisions:- Such decisions include
(1) What are forms in which dividend can be paid to share holders?
(2) What are legal & procedural formalities to be completed while paying dividend
different forms?
(d) Liquidity Decisions:- Current assets should be managed efficiently for safe
guarding firm against of liquidity & insolvency. In order to ensure that neither
insufficient nor unnecessary funds are invested in current assets, the financial
manager should develop sound technique of managing current assets.
DIVIDEND POLICY
Meaning:
Dividend is that part of business income which is distributed among share

holders. Dividend can be paid in the form of shares or securities or cash.
Dividend is given to share holders as a return on their investment in the
company. If a company does not pay regular dividend to its share holders, they
will not invest in it in future. Dividend is paid on equity as well as preference
shares. But it is paid at fixed rate on preference shares where as no rate is fixed
for equity shares. Business will either distribute its net profit among share holders
or retain it in business. The part of profit which is retained in business is called
retained earning & it is source of funds for business. Therefore, there is inverse
relationship between the amount to be distributed as dividend and amount of
profits to be retained in business.
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Business should, therefore, determine as proper dividend policy.
Definition
Dividend policy means that decision of the management through which it

is determined how much of net profits are to be distributed as dividend among
the share holders and how much are to be retained in the business.
Factors determining Dividend Policy
A External factors B Internal Factors.
1) Phase of Trade cycles 1) Attitude of Management

2) Legal Restrictions 2) Composition of share holding
3) Tax Policy 3) Age of Company.
4) Investment Opportunities. 4) Nature of Business
5) Restrictions Imposed by Lending 5) Growth Rate of Company
Institutions. 6) Liquidity Position
7) Customers & Traditions.
A External Factors:-
1) Phase of trade cycle:-
During the phase of boom, company may not like to distribute huge
amount of profit by way of dividend though earning capacity is more because
company will like to retain more profit which can be used during depression.
Similarly, during depression company will like to hold dividend payment in order
to preserve its liquidity position.
2) Legal Restrictions:-
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If a company wants to pay dividend in cash, provisions of companies act

1956, are required to be followed by company. If the company wants to issue
bonus shares, relevant SEBI guide lines are required to be followed by the
company.
Tax Policy:- From companies point of view dividend can be paid out of profit
after fax from share holders point of view, dividend received by them considered
to be a taxable income which increases their individual tax liability.
4) Investment Opportunities:- If investment opportunities involve higher rate of

return than cost of capital, the company will like to retain profits to be invested in
these projects.
5) Restrictions imposed by lending institutions:- Sometimes, lending banks

or financial institutions impose certain restrictions on the company preventing
payment of dividend if certain conditions are not fulfilled such as interest on loan
is not regularly paid by company.
Internal Factors:-
1) Attitude of Management:- If attitude of management is aggressive, it may

decide to pay more dividend as the management is interested in increasing
income of share holders. Where as if the attitude of management is conservative,
company will like to retain more profits to take care of contingencies.
2) Age of Company:- A growing concern will like to retain maximum profit in

business in order to raise the funds while old company may follow high dividend
policy.
3) Composition of Share Holders:- If a company is private ltd. Company having

less number of shareholders, the company having less number of shareholders,
the company will like to retain more profits and reduces dividend. If the company
is a public limited company, tax brackets of individual shareholders may not have
significant impact on dividend policy of company.
4) Nature of Business:- A stable company may follow long term dividend policy
where as an unstable company may like to retain its profits during boom to
ensure dividend policy is not affected by cyclical variations.
5) Growth rate of Company :- A rapidly growing company may like to retain

majority of its profits in order to take care of its expansion needs. However, care
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should be taken by management to invest only in those projects which yield more
returns than its cost of capital.
6) Liquidity Positions:- Before formulating dividend policy due considerations

should be given to liquidity position of company. Eg At present, company’s cash
position may be comfortable, but it may need cash within a short time to pay
installments of term loans or to pay creditors for materials. In such case, finance
manager may not like to impair its liquidity for making dividend payment.
7) Customs & Traditions:- also affect dividend policy.
For example:- if the company is following stable dividend policy for 20 years, it
may like to maintain trend in 21st year also, inspite of adverse profitability or
liquidity situations.
Unit III
Leverages:-
The term leverages measures relationships between 2 variables. In

financial analysis, the term leverage represents influence of one financial variable
over some other financial variable. In financial analysis generally 3 types of
leverages maybe computed:-
1) Operating leverage.
2) Financial leverage.
3) Combined leverage.
1) Operating Leverage:- It measures effect of change in sales quantity on

Earning Before Interest and Taxes (EBIT). It is Computed As:
Sales- Variable Cost (i.e Contribution)
Earnings before interest and tax.
Indications:-
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A high degree of operating leverage means that the component of fixed

cost is too high in the overall cost structure. A low degree of operating leverage
means that the component of fixed cost is less in over all cost structure. In other
words, it measures the impact of % increase or decrease in sales on earning
before interest and taxes.
For Example:-
Sales= Rs 20000 Contribution = Rs 10000

Earnings before interest and tax Rs 5000
As such operating leverage is –
Contribution = Rs 10000
____________________ = 2
EBIT Rs 5000
It means that every 1% increase in contribution will increase the EBIT by

2% and vice versa. As such, when contribution = Rs 9000 Instead of Rs 10000
I.e. the contribution is reduced by 10% the EBIT is reduced by 20% i.e. the EBIT
has became Rs 4000 instead of Rs 5000
Financial Leverage:-
It indicates firm’s ability to use fixed financial charges to magnify effects of

changes on EBIT on firm’s EPS. It indicates the extent to which Earnings per
Share (EPS) will be affected with change in Earnings Before Interest and Tax
(EBIT). It is computed as:-
EBIT
__________
EBIT- Interest
Indications:-
A high degree of financial leverage indicates high use of fixed income

bearings securities in capital structure of the company. A low degree of financial
leverage indicates less use of fixed income bearing securities is capital structure
of company.
For Example
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In case of A Ltd. EBIT is Rs 5000 and interest on debentures is Rs 900,

When sales are Rs 20000 where as in case of B. Ltd. The EBIT is Rs 5000 and
interest on debentures is Rs 100 when sales are Rs 20000. As such degree of
financial leverage can be computed as
EBIT
______________
EBIT-Interest
A. Ltd B. Ltd
Financial Leverage Rs 5000 Rs 5000
= =
Rs 5000- Rs 900 Rs 5000-Rs900
=1.22 = 1.02
High degree of financial leverage is supported by knowledge of fact that in

capital structure of A Ltd 90% is the debt capital component, where as in case of
B Ltd 10% is debt capital component.
It means that in case of A Ltd every 1% increase in EBIT will increase

EPS by 1.22% and vice versa.
As such, when EBIT is reduced from Rs 5000 to Rs 4000 (i.e. 20%

reduction), EPS of A Ltd, gets reduced from Rs 20.50 to Rs 15.50 (i.e.24.40 %
reduction) & EPS of B Ltd, gets reduced from Rs 2.72 to Rs 21.6 (i.e 20.40%
reduction)
Uses of Financial Leverage
The degree of financial leverage gives an indication regarding extent to

which EPS may be affected due to every change in EBIT. As the use of debt
capital in capital structure increase EPS, the company may like to use more &
more debt capital in its capital structure by using financial.
For Example:-
EPS in case of A Ltd, is Rs 20.50 when sales are Rs 20000 as 90% of its
capital is debt capital. But in case of B Ltd EPS is only Rs 2.72 when sales are
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Rs 20000 as only 10% of its total capital is debt capital. As such, the phase is
often used that financial leverage magnifies both profits and losses.
Financial leverage also acts as a guide line in setting maximum limit upto
which the company should use the debt capital.
Limitations:-
1) It ignores implicit cost of debt. It assumes that the use of debt capital may be
useful so long as company is able to earn more than cost of debt i.e. interest. But
it is not always connect. Increasing use of debt capital makes the investment in
the company a risky proposition, as such market price of shares may decline,
which may not be maximising share holder’s wealth. Before considering capital
structure, implicit cost of debt should be considered.
2) It assumes that cost of debt remain constant regardless of degree of leverage

which is not true. With every increase in debt capital, interest rate goes on
increasing due to increased risk involved with the same.
3) Combined Leverage:-
The combined effect of operating leverage & financial leverage measures the
impact of change in contribution on EPS.
It is computed as:-
Operating leverage X Financial leverage.
Sales-Variable Cost EBIT

= _______________ X___________
EBIT Ebit-Interest
Sales-Variable Cost
= __________________
EBIT- Interest
For Example:-
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In case of both A Ltd & B Ltd when sales are Rs 20000 contribution is Rs
10000 but earnings after interest and before tax are Rs 4100 and 4900. As such
combined leverage can be
Sales- Variable Cost (i.e. Contribution)

______________________________
EBIT-Interest
A Ltd. B Ltd.
_____ _____
10000 10000
= ______ = ______
4100 4900
= 2.44 = 2.04
It Means that in case of A Ltd every IX increase in contribution will increase EPS
by 2.44% & vice versa while in case of B Ltd. Every 1% increase in contribution,
will increase EPS by 2.04%. As such when contribution gets reduced from Rs
10000 to Rs 9000 i.e. 10% reduction, EPS of A Ltd gets reduced from Rs 20.50
to Rs 15.50 ( i.e. 24.4% reduction) & EPS of B Ltd gets reduced from Rs 2.72 to
Rs 2.16 (i.e. 20.4 reduction)
Indications:-
(1) High Operating Leverage, High Financial Leverage:-
It indicates very risky situation as a slight decrease in sales and contribution may
affect EPS to great extant. So, this situation is should be avoided.
(2) High Operating Leverage, Low Financial Leverage
it indicates that a slight decrease in sales and contribution may affect EBIT to
great extent due to existence of high fixed cost but this possibility is already
taken care by low proportion of debt capital in overall capital structure.
(3) Low Operating Leverage, High Financial Leverage
It indicates decrease in sales/contribution will not affect EBIT to great extent. This
situation may be considered an ideal situation.
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(4) Low Operating Leverage, Low Financial Leverage
It indicates decrease in sales/contribution will not affect EBIT to great extent as

the component of fixed cost is negligible in overall cost structure.
Unit II
Cost of Capital
The project’s cost of capital is minimum acceptable rate of return on funds

committed to the project. The minimum acceptable rate or required rate of return
is a compensation for time and risk in use of capital by project. Since investment
projects may differ in risk, each one of them will have its own unique cost of
capital. The firm represent aggregate of investment projects under taken by it.
Therefore, the firm’s cost of capital will be overall, or average, required rate of
return on aggregate of investment projects.
Determining Component Cost of Capital:-
1) Cost of Debt:-
A Company may raise debt in various ways. It may borrow funds from
financial institutions or public either in form of public deposits or debentures for a
specified period of time at certain rate of interest. A debenture or bond may be
issued at per or at discount or premium.
(a) Debt issued at Par:-
The before tax cost of debt is rate of return required by lenders. It is easy
to compute before tax cost of debt issued & to be redemed at par, it is simply
equal to contractual interest. For example, a company decides to sell a new
issue of 1 years 15% bond of Rs 100 Each at par. If company realises full face
value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, the
before tax cost of debt will simply be equal to rate of interest of 15%.
Thus:-
Kd= I= INT
___
Bo
Where,
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KD= before-tax cost of debt.

I = coupan rate of interest.
B = Issue price of debt.
INT = amt. of interest.
(B) Debt issued at Discount or Premium:-
n INTt Bn
Bo = ∑ _________ + _________
t=1 (1+kd)t (1+ kd)n
Where
Bn= repayment of debt on maturity and other variable as defined earlier. This
equation is used to find out whether cost of debt issued at par or discount or
premium.
i.e. Bo= f or Bo>f or Bo<F.
Tax adjustment:-
The interest paid on debt is tax deductible. The higher the interest
charges, the lower will be amount of tax payable by the firms. This implies that
the government indirectly pays a part of lender’s required rate of return. As a
result the interest tax shield, after tax cost of debt to the firm will be substantially
less than investor’s required rate of return. The before tax cost of debt, kd should
therefore, be adjusted for tax effect as follows.
After-tax cost of debt = kd (I-T)
Where T= Corporate tax rate.
2). Cost of Preference Capital:-
The measurement of cost of preference capital poses some conceptual difficulty.

In case of debt, there is binding legal obligation on the firm to pay interest &
interest constitutes basis to calculate cost of debt. However, in case of
preference capital, payment of dividends is not legally binding on the firm & even
if the dividends are paid, it is not a charge on earnings, rather it is a distribution
or appropriation of earnings to preference share holders.
Irre Deemable Preference share:-
The preference share may be treated as a perpetual security if it is

irredeemable Thus, its cost is given by following equation:-
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PDIV
KP= _______
PO
Where,
Kp= Cost of Preference share

PDIV= expected preference dividend
Po= Issue price of preference shares.
Redeemable Preference Share:-
n PDIVt PN
PO =∑ ____ + ________
T=1 (1+Kp)t (1+Kp)n
Cost of Preference share is not adjusted for taxes because preference dividend
is paid after corporate taxes have been paid. Preference dividends do not save
any taxes. Thus cost of Preference share is automatically computed on an after
tax basis. Since interest is tax deductible & preference dividend is not, the after
tax cost of preference is substantially higher than after tax cost of debt.
3) Cost of Equity Capital:-
Firms may raise equity capital internally by retained earnings. Alternatively, they
could distribute the entire earnings to equity share holders & raise equity capital
externally by issuing new shares. In both cases, shareholder are providing funds
to the firm to finance their capital expenditures. Therefore, equity shareholders
required rate of return will be same whether they supply funds by purchasing new
shares or by for going dividends which could have been distributed to them.
There is, however, a difference between retained earnings & issue of equity
shares from firms point of view.
Cost of Retained Earnings:-
The opportunity cost of retained earnings (internal earnings) is the rate of return
on dividends foregone by equity shareholders. The shareholders generally
expect dividend and capital gain from their investment. The required rate of
return of shareholder can be determined from dividend valuation model.
Normal Growth:- A firm whose dividend are expected to grow at a constant rate
of g is as follows
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Divl
Po =
Ke-g
Where
DWl= DIVo (1+g)
Super normal growth:-
Dividends may grow at different rates in future. The growth rate may be
very high for a few years & after wards, it may, it may become normal indefinitely
in future. The dividend valuation model can be used to calculate cost of equity
under different growth assumptions. For example, If the dividends are expected
to grow at a super normal growth rates g for n year & there after, at a normal
perpetual growth rate of In beginning in year n+1 then cost of equity can be
determined by following formula.
n DIV0 (1+gs)t Pn
Po= ∑ __________ + ________
t=1 (1+ke)t (1+ke)n
Pn= Discounted value of dividend stream, beginning in year n+1 & growing at a
constant, perpetual rate gn, at end of year n and therefore it is equal to :-
DIV n+1
Pn = ________
Ke-gn
Zero growth
DIVl
Ke =______
Po
The growth rate g will be zero if firm does not retain any of its earnings.
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Cost of External Equity
The minimum rate of return which equity share holders require on funds
supplied by them by purchasing new share to prevent a decline in existing
market price of equity share is the cost of external equity. The firm can induce
existing or potential share holders to purchase new shares when it promises to
earn a rate of return equal to:-
Divl
Ke= ______ + g
Po
Weighted Average (Cost of Capital)
After calculating costs, they are multiplied by weights of various sources of

capital to obtain a weighted cost of capital (WACC). The composite, cost of
capital is the weighted average of costs of various sources of funds. It is relevant
in calculating over all cost of capital.
The following steps are involved to calculate weighted average cost of capital:-
1) Calculate cost of specific sources of funds (i.e. cost of debt, cost of equity,
cost of preference capital etc).
2) Multiply cost of each sources by its proportion in capital structure.
3) Add weighed components costs to get firm’s weighted average cost of capital.
In order to calculate weighted cost of capital component cost should be

ofter tax costs. If we assume that a firm has only debt & equity in its capital
structure, then its weighted average cost of capital,
(Ro) Will be:-
Ko= kd (1-T) Wd+kewe

Ko= Kd (1-T) D+ + ke S
____ ___
D+S D+S
Where Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt
& equity D= amount of debt, S= amount of equity.
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Unit- III
Theories of Capital Structure
(1) Net Income Approach:-
The essence of net income approach is that the firm can increase its value or
lower the overall cost of capital by increasing proportion of debt in capital
structure.
The assumption of this approach are:-
1) The use of debt does not change the risk perception of investors, as a result
equity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant with
changes in leverage.
2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i.e. kd
< ke)
3) The corporate income taxes do not exist.
The first assumption implies that if ke & kd are constant, increased use of
debt by magnifying the shareholders earnings, will result in higher value of the
firm via higher value of equity. Consequently, overall or weighted average cost of
capital, ko will decrease. The overall cost of capital is measured by Eq-
X Noi
Ko= ___ =___
V V
Thus, with constant annual net operating income (NOI) overall cost of capital of
capital would decrease as the value of firm, V increases.
Ques6. Write notes on the following.
Ans. NET OPERATING INCOME APROACH
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According to the net operating income (NOI) approach the market value of
the firm is not affected by the capital structure changes. The market value of the
firm is found out by capitalizing the net operating income at the over all or the
weighted average cost of capital, which is constant.
The overall capitalisation rate depends on the business risk of the firm. It
is independent of financial mix. If NOI and average cost of capital are
independent of financial mix, market value of firm will be a constant are
independent of capital structure changes. The critical assumptions of the NOI
approach are:
a) The market capitalizes the value of the firm as a whole. Thus the
split between debt and equity is not important.
b) The market uses an overall capitalisation rate, to capitalize the net
operating income. Overall cost of capital depends on the business
risk. If the business risk is assumed to remain unchanged, overall
cost of capital is a constant.
c) The use of less costly debt funds increases the risk to shareholder.
This causes the equity capitalisation rate to increase. Thus, the
advantage of debt is offset exactly by the increase in the equity-
capitalisation rate.
d) The debt capitalisation rate is constant.
e) The corporate income taxes do not exist.
Thus, we find that the weighted cost of capital is constant and the cost equity
increase as debt is substituted for equity capital.
Ques7. Explain the concept of working capital. Discuss the working capital need
of a manufacturing firm.
Ans. Money required by the company to meet out day today expenses to finance
production and stocks to pay wages and other production etc is called the
working capital of the company. Working capital is used in operating the
business. It is mostly dept is circulation by releasing it back after selling the
products and reinvesting it in further production. It is because of this regular cycle
that the working capital requirements are usually for short periods. Though, both
fixed and working capitals shall be recovered from the business, the differences
lies in the rate of their recovery. Working capital shall be recovered much more
quickly as compared to fixed capitals which would last for several years. As the
process of production become more round about and complicated the production
to fixed working capital increase correspondingly.
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Therefore, working capital management refers to the management of current

assets and current liabilities. Working capital, however, represents investment in
current assets, such as cash, marketable securities, inventories and bills
receivables. Current liabilities mainly
Cost of Capital (Percent)

ke
ko
kd
Leverage
Figure 18.2 The effect of leverage on the cost of capital (NOI approach)
EXISTENCE OF OPTMUM CAPITAL STRUCTURE:

THE TRADITIONAL VIEW
The traditional view, which is also known as an intermediate approach, is a

compromise between the net income approach and the net operating approach.
According to this view, the value of the firm can be increased or the cost of
capital can be reduced by a judicious mix of debt and equity capital. This
approach very clearly implies that the cost of capital decreases within the
reasonable limit of debt and then increases with leverage. Thus, an optimum
capital structure exists, and it occurs when the cost of capital is minimum or the
value of the firm is maximum. The cost of capital declines with leverage because
debt capital is cheaper than equity capital within reasonable, or acceptable, limit
of debt. The statement that debt funds are cheaper than equity funds carries the
clear implication that the cost of debt, plus the increased cost of equity, together
on a weighted basis, will be less than the cost of equity which existed on equity
before debt financing.2 In other words, the weighted average cost of capital will
decrease with the use of debt.
According to the traditional position, the manner in which the overall cost
of capital reacts to changes in capital structure can be divided into three-stages.3
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First Stage: Increasing Value
In the first stage, the rate at which the shareholders capitalise their net income,
i.e., the cost of equity, ke, remains constant or rises slightly with debt. But when it
increases, it does not increase
1. The traditional capital structure theory has been popularised by

Ezra Solomon, op. cit.
2. Barges, Alexander, The Effect of Capital Structure on the Cost of
Capital, Prentice-Hall, Inc., 1963, p.11.
3. Solomon, op. cit., p. 94.
Fast enough to offset the advantage of low cost debt. During this stage, the cost
of debt, Kd, remains constant or rises negligibly since the market view the use of
debt as a reasonable policy. As a result, the value of the firm, V, increases or the
overall cost of capital, K0 = X/V= Ke (S/V) + kd (D/V), falls with increasing
leverage.
Under the assumption that Ke remains constant within the acceptable limit
of debt, the value of the firm will be:
X - KdD kdD X - kdD X (ke-kd)D

V=S+D = + = +D= +
Ke kd ke ke ke
Thus, so long as Ke and Kd are constant, the value of the firm V increases at a
constant rate. (Ke-Kd)/Ke. as the amount of debt increases.
When equation(9) is solved for X/V, we get [See equation(6):
X D
= ko=ke-(ke-kd)
V V
This Implies that, with ke>Kd, the average cost of capital will decline with
leverage.
Second Stage: Optimum Value
Once the firm has reached a certain degree of leverage, increases in leverage
have a negligible effect on the value, or the cost of capital of the firm. This is so
because the increases in the cost of equity due to the added financial risk offsets
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the advantage of low cost debt. Within that range or at the specific point, the
value of the firm will be maximum or the cost of capital will be minimum.
Third stage: Declining value
Beyond the acceptable limit of leverage, the value of the firm decreases with
leverage or the cost of the capital increases with leverage. This happens
because investors perceive a high degree of financial risk and demand a higher
equity-capitalisation rate which offsets the advantage of low-cost debt.
Ke
Cost of capital ( per cent)
Ko
Kd
Leverage
0
L L
Figure 18.3 The costs of capital behaviour (traditional view)
The overall effect of these three stages is to suggest that the cost of capital is a
function of leverage. It declines with leverage and after reaching a minimum point
or range starts rising. The relation between costs of capital and leverage is
graphically shown in Figure 18.3 wherein the overall ITS costSTUDY CENTRE
of capital curve, ko is
saucer-shaped with a horizontal range. This implies that there SECTOR
SCF-54 (B’MNT) is a range15 of
capital structures in which the cost of capital is minimised. MARKET,
ke is assumed to
FARIDABAD PH 5002194-95
increase slightly in the beginning and then at a faster rate. In Figure 18.4 the cost
of capital curve is shown to be U-shaped. Under such a situation there is a
precise point at which the cost of capital would be minimum. This precise point
defines the optimum capital structure.
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Ke
Ko
Cost of Capital (Per cent)
-+
Figure 18.4 The costs of Capital behavior (traditional view-a variation)
Many variations of the traditional view exist. As indicated in Figures 18.3 and
18.4, some writers imply the cost of equity function to be horizontal over a certain
level and then rising, while others assume the cost of equity function rising
slightly in the beginning and then at a faster rate. Whether are cost of equity
function is horizontal or rising slightly is not very pertinent from the theoretical
point of view, as a number of different cost of equity curves can be consistent
with a declining average cost of capital curve. The relevant issue is whether or
not the average cost of capital curve declines at all as debt is used. 1 All the
supporters of the traditional view agree that the cost of capital declines with debt.
ILLUSTRATION 18.3 To illustrate the traditional approach, assume that a firm is

expecting a net operating income of Rs 1,50000 on a total investment of Rs
10,00,000 The equity capitalisation rate is 10 per cent, if the firm has no debt; but
it would increase to 10.56 per cent when the firm substitutes equity capital by
issuing debentures of Rs 3.00000 and, to 12.5 per cent when debentures of Rs
600000 are issued to substitute equity capital. Assume that Rs 300000
debentures can be raised at 6 per cent interest rate, whereas Rs 600000
debentures are raised at a rate of interest of 7 per cent.
The market value of the firm, value of shares and the average cost of
capital are shown in Table 18.6.
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1. Barges, op. cit., p.12.
Table 18.6 MARKET VALUE AND THE COST OF CAPITAL OF THE FIRM
(TRADIATIONAL APPROACH)
No Debt 6% Rs 7%Rs
3,00,000 6,00,000
Debt Debt
Net operating income, X 1,50,000 1,50,000 1,50,000
Total cost of debt, INT = KdD 0 18,000 42,000
Net income, X- INT 1,50,000 1,32,000 1,08,000
Cost of equity, Ke 0.10 0.1056 0.125
Market value of shares, S= (X- 15,00,000 12,50,000 8,64,000
INT)ke
Market value of debt, D 0 3,00,000 6,00,000
Total value of firm, V= S+D 15,00,000 15,50,000 14,64,000
Average cost of capital, Ko = X/V 0.10 0.097 0.103
Criticism of the Traditional View
The validity of the traditional position has been questioned on the ground that the
market value of the firm depends upon its net operating income and risk attached
to it. The form of financing can neither change the net operating income nor the
risk attached to it. It simply changes the way in which the income is distributed
between equity holder and debt-holders. Therefore, firms with identical net
operating income and risk, but differing in their modes of financing, should have
same total value. The traditional view it criticised because it implies that totality
of risk is distributed among the various classes of securities.1
Modigliani and Miller also do not agree with the traditional view. They
criticise the assumption that the cost of equity remains unaffected by leverage up
to some reasonable limit. They assert that sufficient justification does not exist for
such and assumption. They do not accept the contention that moderate amounts
of debt in ‘sound’ firms do not really add very much to ‘riskiness’ of the shares.
However, the argument of the traditional theorists that an optimum capital
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structure exists can be supported on two counts: the tax deductibility of interest
charges and market imperfections.
IRRELEVANCE OF CAPITAL STRUCTURE:

THE MODIGLIANI-MILLER HYPOTHESIS
WITHOUT TAXES
The Modigliani-Miller (M-M) hypothesis is identical with the net operating income
approach. (M-M) argue that, in the absence of taxes, a firm’s market value and
the cost of capital remain invariant to the capital structure changes. In their 1958
article,2 they provide analytically sound and logically consistent behavioural
justification in favour of their hypothesis, and reject any other capital structure
theory as incorrect.
1. Durand, op. cit., pp. 229-30.

2. Modigliani, and Miller op. cit., pp. 261-297.
Assumptions
The M-M hypotheses can be best explained in terms of their Propositions I and II.
It should, however, be noticed that their propositions are based on certain
assumptions. These assumptions, as described below, particularly relate to the
behaviour of investors and capital market, the actions of the firm and the tax
environment.
• Perfect capital markets Securities (share and debt instruments) are traded
in the Perfect capital market situation. This specifically means that (a)
investors are free to buy or sell securities; (b) they can borrow without
restriction at the same terms ad the firms do; and (c) they behave
rationally. It is also implied that the transaction cost, i.e., the cost buying d
selling securities, do not exist.
• Homogeneous risk classes Firms can be grouped into Homogenous risk
classes. Firms would be considered to belong to a homogenous risk class
if their expected earnings have identical risk characteristics. It is generally
implied under the M-M hypothesis that firms within same industry
constitute a homogenous class.
• Risk The risk of investors is defined in terms of the variability of the net
operating income (NOI). The risk of investors depends on both the random
fluctuations of the expected NOI and the possibility that the actual value of
the variable may turn out to be different than their best estimate.1
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• No taxes In the original formulation of their hypothesis, M-M assume that

no corporate income taxes exist.
• Full payout Firms distribute all net earnings to the shareholders, which
means a 100 per cent payout.
Proposition I
Given the above stated assumptions, M-M argue that, for firms in the same risk
class, the total market value is independent of the debt-equity mix and is given by
capitalizing the expected net operating income by the rate appropriate to that risk
class.2 This is their Proposition I and can be expressed as follows:
Value of the firm = Market value of equity + Market value of debt
Expected net operating income

=
Expected overall capitalization rate
X NOI
V=(S+D)= =
ko ko
Where
V= the market value of the firm

S= the market value of the firm’s ordinary equity
D= the market value of debt
X= the expected net operating income on the assets of the firm
K0 = the capitalisation rate appropriate to the risk class of the firm.
1. Robichek, A. and S. Myers, Optimal Financing Decisions, Prentice-Hall,

1965, PP. 31-34.
2. Modigliani and Miller op. cit., P. 266.
Proposition I can be stated in an equivalent way in terms of the firm’s average

cost of capital which is the ratio of the expected earning to the market value of all
its securities. That is:
X X
= = ko
(S+D) V
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If we define Kd as the expected return on the firm’s debt and Ke as the

expected return on the firm’s equity, then expected net operating income is given
as follows:
X=KoV=keS+kdD
As given in Equation (5), by definition
X
ko =
V
S D
Ko = ke + kd
S+D S+D
Cost of capital (per cent)
ko Ke
D/V
Leverage
Figure 18.5 The cost of capital under M-M proposition I
Equation (5) expresses Ko as the weighted average of the expected rate of

return of equity and debt capital of the firm. Since the cost of capital is defined as
the expected net operating income divided by the total market value of the firm,
and since M-M conclude that the total market value of the firm is unaffected by
the financing mix, it follows that the cost of capital is independent of the capital
structure and is equal to the capitalisation rate of a pure-equity stream of its
class. The cost of capital function, as hypothesized by M-M through Proposition I,
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is shown in Figure 18.5. It is evident from the figure that the average cost of
capital is a constant and is not affected by leverage.
Arbitrage Process
Why should proposition I hold good? The simple principle of proposition I is that
two firms identical in all respects except for their capital structures, cannot
command different market value or have different cost of capital. M-M do not
accept the NI approach as valid. Their opinion is that if two identical firms, except
for the degree of leverage, have different market values, arbitrage (or switching)
will take place to enable investors to engage in personal or home-made leverage
as against the corporate leverage to restore equilibrium in the market. Consider
an example.
ILLUSTRATION 18.4 Suppose two firms: unlevered firm U and levered firm L –
have identical expected net operating income (x) of Rs 10000. The value of the
levered firm (V) is Rs 11000 the value of equity shares (Su)=Vu) is Rs100000.
Firm L has borrowed at the expected rate of return (Kd) of 6 per cent. Assume
further that you hold 10 per cent shares of the levered firm L. What is your return
from your investment in the shares of firm L?
Since you own 10 per cent of the shares, you are entitled to 10 per cent of
the equity income:
Return = 0.10 (X-INT) (where INT= KdDt)

= 0.10 (10000-0.06X 50.000)
= 0.10 (10000- 3000= Rs 700
and the value of your investment is:

investment = 0.10 (1000-50000)= Rs 6000
You can earn same return at less investment through an alternate

investment strategy. This you can do by selling your investment in firm L’s Share
for Rs 6000, and by borrowing on your personal account an amount equal to your
share of firm L’s corporate borrowing at 6 percent rate of interest 010(50000) =
Rs5000. You have Rs 11000 with you. You can now buy 10 per cent of the
unlevered firm U’s shares. Your investment will be:
Investment = 0.10 (1,00,000) Rs= 10,000
And your return will be:
Return = 0.10 (10,000) Rs 1,000

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However, you have borrowed Rs 5,000 at 6 per cent. Therefore, you will have to
pay an interest of Rs 300:
Interest =0.06X5,000= Rs 300
Thus your net return is Rs 700 as shown below:
Rs
Equity return from U 1,000
Less: Interest on personal borrowing 300
Net Return 700
Note that you are also left with cash of Rs 1,000:
Rs
Sale of firm L’s shares, = 0.1 (60,000) 6,000
Add : Borrowing, 0.1 (50,000) 5,000
Less: Investment in firm U=0.1 (1,00,000) (10,000)
Remaining cash 1,000
Due to the advantage of the alternate investment strategy, a number of

investors will be induced towards it they will sell their shares in firm L and buy
shares and debentures of firm U. this arbitrage will tend to increases the price of
firm U’s shares and to decline that of firm L’s shares. It will continue until the
equilibrium price for firm U’s and firm L’s shares is reached.
The arbitrage would work in the opposite direction if we assume that the
value of the unlevered firm U (Vu) is greater than the value of the levered firm L
(Vl). Let us assume that Vu=Su= Rs 1,00,000 and Vl=Sl+Dt=Rs 40,000+ Rs
50,000 = Rs 90,000. Further, suppose that you own 10 per cent shares in the
unlevered firm U: Your return will be:
Return= 0.10 (10,000) = Rs 1,000
And your investment will be:
Investment = 0.10 (1,00,000) = Rs 10,000
You can design a better investment strategy. You sell your shares in firm
U for Rs 10,000. Now you buy 10 per cent of firm L’s share and debt. Your
investment in firm L is Rs 9,000.
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Investment= 0.10 (40,000+50,000) =4,000+5,000= Rs 9,000
Since you own 10 per cent of equity and debt of firm L, your return will include
both equity income and interest income. Thus your return is Rs 1,000:
Return = 0.10 (10,000) = Rs 1,000
You can also calculate your return as follows:
Rs
Equity income, 0.10 (10,000-3,000) 700
Interest income, 0.06 (5,000) 300
Return 1,000
Note that your alternative investment strategy pays you off the same return at a
lesser investment. You are left with Rs 1,000 cash.
Rs
Sale of firm U’s shares, 0.1(1,00,000) 10,000
Investment in firm L’s share, 0.1 (40,000) (4,000)
Investment in firm L’s debt, 0.1 (50,000) (5,000)
Remaining cash 1,000
Both strategies give the investor same return, but his alternative
investment strategy costs him less since Vt<Vu. In such a situation, marginal
investors will sell their shares in the unlevered firm and buy the shares and
debentures of the levered firm. As a result of this switching, the market value of
the levered firm’s shares will increases and that of the unlevered firm will decline.
In the equilibrium Vt=Vu.
We can generalize our discussion as follows. 1 In the first instance, let

Vt>Vu Both firms earn the same expected net operating income, X. The
borrowing and lending Rate is Kd.
1. Modigliani, F and Miller, M.H.,Reply to Heins and Sprenkle, American

Economic Review, 59 (Sept 1969), pp.592-95.
Assume that an investor hold  (alpha) fraction of firm L’s shares. His investment
and return will be as follows:
Investment Investment
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Investment in L’s share  )Vt-Dt) (X-kdDt)
The investor in our example can design the following alternative investment
strategy:
Investment Investment
Buy fraction of U’s share  Vu X
Borrow equal to fraction of L’s debt - Dt -kdDt
Total (Vu-Dt) (X-kdDt)
The investor obtains the same return,  (X-Kd D1), in both the cases, but his first
investment strategy costs more since V1> Vu. The rational investors at the margin
would prefer switching from levered to unlevered firm. The increasing demand for
the unlevered firm’s shares will decreases their market price. Ultimately,
ITS STUDY market
CENTRE
values of the two firms will reach equilibrium, and henceforth, arbitrage
SCF-54 (B’MNT) will not15
SECTOR be
beneficial. MARKET,
FARIDABAD PH 5002194-95
Let us take the opposite case where Vu>Vl. Suppose our investor holds 
fraction of firm U’s shares. His investment and return will be as follows:
Investment Return
Investment in U’s shares  Vu X
The investor can design an alternate investment strategy as follows:
Investment Return
Buy fraction of L’s shares  (Vl-Dt)  (X-kdDt)
Buy equal to fraction of L’s debt + Dt +  kdDt
Total  Vt X
If you can earn the same return with less investment, other can also
benefit similarly. Investors will therefore sell shares of firm U and buy shares of
firm L. This arbitrage will cause the price of firm U’s shares to decline and that of
firm L’s shares to increases. It will continue until the price of the levered firm’s
shares equals that of the unlevered firm. Thus, in equilibrium Vl=Vu.
On the basis of the arbitrage process, M-M conclude that the market value
of a firm (or its cost of capital) is not affected by leverage. Thus, the financing (or
capital structure) decision is irrelevant. It does not have any impact on the
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maximisation of market price per share. This implies that one capital structure is
as much desirable as the other.
Proposition II
M-M’s Proposition II, which defines the cost of equity, follows from their
Proposition I. The cost of equity Formula can be derived from M-M’s definition of
the average cost of capital. The expected yield on equity or the cost equity is
defined as follows:
X-kdD
Ke =
S
Since we know from Equation (4) that
X
ko =
V
And Ko and V are constant by definition, the following equation:
X=koV=ko(S+D)
Substituting Equation (10) into Equation (3), we have
Ko(S+D)-kdD KoS+koD-kdD D
Ke = = =Ko+(ko-kd)
S S S
Equation (7) states that, for any firm in a

given risk class, the cost of equity, Ke is
equal to the constant average cost of
capital, Ko, plus a premium for the
Cost of Capital
ke
financial risk, which is equal to debt-
Cost of capital
equity ration times the spread between ko

the constant average cost of capital and
the cost of debt, (Ko-Kd) D/S. the cost of kd
equity, Ke, is a linear function of
leverage, measured by the market value
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0 Leverage
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Figure 18.6 Cost of equity under the M-
M
of debt to equity, D/S. Thus, leverage

will result not only in more earnings per
share to shareholders but also
increased cost of equity. The benefit of
leverage is exactly taken off by the
increased cost of equity, and
consequently, the firm’s market value
will remain unaffected. It should,
however, be noticed that the functional
relationship, ke=ko+(ko-kd) D/S, is valid irrespective of any particular valuation

theory. For example, M-M assume Ko to be constant, while according to the more
popular traditional view Ko is a function of leverage.
The crucial part of the M-M thesis is that Ko will not rise even if very
excessive use of leverage is made. This conclusion could be valid if the cost of
borrowings, Kd. remains constant for any degree of leverage. But in practice Kd
increases with leverage beyond a certain acceptable, or reasonable level of debt.
However, M-M maintain that even if the cost of debt, Kd, increases Ke will
increases at a decreasing rate and may even turn down eventually.1 This is
illustrated in Figure 18.6. M-M insist that the arbitrage process will work and that
as Kd increases with debt, Ke will become less sensitive to further borrowing. The
reason for this is that debt-holders, in the extreme situations, own the firm’s
assets and bear some of the firm’s business risk. Since the risk of shareholders
is transferred to debt-holders, Ke declines.
1. Modigliani and Miller, “The Cost of Capital….’ Op. cit.
Criticism of the M-M Hypothesis
The arbitrage process is the behavioural foundation for the M-M thesis. The
shortcomings of this thesis lie in the assumption of perfect capital market in
which arbitrage is expected to work. Due to the existence of imperfections in the
capital market, arbitrage may fail to work and may give rise to discrepancy
between the market values of levered and unlevered firms. The arbitrage process
may fail to bring equilibrium in the capital market for the following reasons:1
Leading and borrowing rate discrepancy The assumption that firms and
individuals can borrow and lend at the same rate of interest does not hold good
in practice. Because of the substantial holding of fixed assets, firms have a
higher credit standing. As a result, they are able toITS borrow
STUDY at CENTRE
lower rates of
interest than individuals. If the cost of borrowings SCF-54
to an investor
(B’MNT) is SECTOR
more than15the
firm’s borrowing rate, then the equalization process will fall short of
MARKET, completion. In
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illustration 18.4, if the cost of debt paid by the firm is less than that paid by the
investor, then the value of the levered firm, Vl, must exceed the value of the
unlevered firm, VU, for total return to be equal. For example, if the investors can
borrow at 9 per cent, his returns after switching will be only Rs 550.
Consequently, it does not follow that market opportunities and forces will lead Vl
into equality with Vu.
Non-substitutability of personal and corporate leverages It is incorrect to

assume that “personal (home-made) leverage” is a perfect substitute for
“corporate leverage.” The existence of limited liability of firms in contrast with
unlimited liability of individuals clearly places individuals and firms on a different
footing in the capital markets. If a levered firm goes bankrupt, all investors stand
to lose to the extent of the amount of the purchase price of their shares. But, if an
investor creates personal leverage, then in the event of the firm’s insolvency, he
would lose not only his personal loan. Thus, in illustration 18.4 if the investor
keep his investment in the levered firm, his loss in the event of bankruptcy will be
Rs 6000. But if he engages in the arbitrage transactions and invests in the
unlevered firm, he can lose his principal investment of Rs 5000 and will also be
liable to return Rs 5000 borrowed by him on the personal account. Thus, it is
more risky to create personal leverage and invest in the unlevered firm than
investing directly in the levered firm.
Transaction costs The existence of transaction costs also interferes with the
working of arbitrage. Because of the costs involved in the buying and selling
securities, it would become necessary to invest a greater amount in order to earn
the same return. As a result, the levered firm will have a higher market value.
Institutional restrictions Institutional restrictions also impede the working of

arbitrage. Durand point out that “home-made” leverage is not practically feasible
as a number of institutional investors would not be able to substitute personal
leverage for corporate leverage, simply because they are not allowed to engage
in the “home-made” leverage.
1. The M-M hypotheses have been widely debated and criticised. The basic
criticisms of the M-M hypotheses are contained in Durand, op. cit. and Ezra
Solomon, Leverage and the Cost of Capital, Journal of Finance, XVIII, (May
1963). Also see Pandey, I.M., Capital Structure and the Cost of Capital, Vikas,
reprint 1996.
Unit IV
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INVENTORY MANAGEMENT
Inventories constitutes the most significant part of current assets of large

majority of companies in India. On an average, inventories are approximately
60% of current assets in public limited companies in India. Because of the large
size of inventories maintained by firms, a considerable amount of funds is
required to be committed to them. It is, therefore absolutely imperative to
manage inventories efficiently in order to avoid unnecessary investment. A firm
nelegecting the management of inventories may fail ultimately. It is possible for a
company to reduce its level of inventories to a considerable degree e.g. 10 to
20% without any adverse effect on production and sales, by using simple
inventory planning and control techniques. The reduction in ‘Excessive’
inventories carries a favourable impact on a company’s profitability.
Nature of Inventories:- Management of inventory constitutes one of the major

investments in current assets. The various forms in which a manufacturing
concern may carry inventory are:
1) Raw Material: These represents inputs purchased and stored to be converted

into finished products in future by making certain manufacturing process of the
same.
2) Work in Process: These represent semi-manufactured products which need

further processing before they can be treated as finished products.
3) Finished Goods: These represents the finished products ready for sale in
market.
4) Stores and Supplies: These represents that part of inventory which does not
become a part of final product but are required for production process. They may
be in form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc.
Normally they form a very major part of total inventory and do not involve
significant investment.
MOTIVE/NEEDS OF HOLDING INVENTORY
A Company may hold the inventory with the various motives as stated below:
1) Transaction Motive: The company may be required to hold the inventory in

order to facilitate the smooth and unintrupped production and sale operations. It
may not be possible for the company to procure the raw material whenever
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necessary. There may be a time lag between the demand for the material and its
supply. Hence it is needed to hold the raw material inventory. Similarly it may not
be possible to produce the goods immediately after they are demanded by the
customers. Hence it is needed to hold the finished goods inventory. They need to
hold work in progress may arise due to production cycle.
2) Precaution Motive: In addition to the requirement to hold the inventory for

routine transactions, the company may like hold them to guard against risk of
unpredictable changes in demand and supply forces. Eg. The supply of raw
material may get delayed due to factors like strike, transport, disruption, short
supply, lengthy processes involved in import of raw material etc. hence the
company should maintain sufficient level of inventory to take care of such
situations. Similarly, the demand for finished goods may suddenly increases
(especially in case of seasonal type of products) and if the company is unable to
supply them, it may mean gain of competition. Hence, company will like to
maintain sufficient supply of finished goods.
3) Speculative Motive: The Company may like to purchase and stock the
inventory in the quantity which is more than needed for production and sales
purpose. This may be with the intention to get advantage in term of quantity
discounts connected with bulk purchasing or anticipating price rise.
Objectives of Inventory Management
Through the efficient Management of Inventory of the wealth of owners will

be maximised. To reduce the requirement of cash in business, inventory turnover
should be maximised and management should save itself from loss of production
and sales, arising from its being out of stock. On the other hand, management
should maximise stock turnover so that investment in inventory could be
minimised and on the other hand, it should keep adequate inventory to operate
the production & sales activities efficiently. The main objective of inventory
management is to maintain inventory at appropriate level so that it is neither
excessive nor short of requirement Thus, management is faced with 2 conflicting
objectives.
(1) To keep inventory at sufficiently high level to perform production and sales
activities smoothly.
(2) To minimise investment in inventory at minimum level to maximise

profitability.
Both in adequate & excessive quantities of inventory are undesirable for

business. These mutually conflicting objectives of inventory management can be
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explained is from of costs associated with inventory and profits accruing from it
low quantum of inventory reduces costs and high level of inventory saves
business from being out of stock & helps in running production & sales activities
smoothly.
The objectives of inventory management can be explained in detail as under:-
(i) To ensure that the supply of raw material & finished goods will remain
continuous so that production process is not halted and demands of customers
are duly met.
(ii) To minimise carrying cost of inventory.
(iii) To keep investment in inventory at optimem level.
(iv) To reduce the losses of theft, obsolescence & wastage etc.
(v) To make arrangement for sale of slow moving items.
(vi) To minimise inventory ordering costs.
Techniques of Inventory Management
(i) A.B.C. Analysis
A.B.C. analysis is a selective technique of controlling different items of

inventory. In actual practice, thousands of items are included in business as
inventories. But all these items are not equally important. According to this
technique, only those items of inventory are paid more attention which are
significant for business. According to this technique, all items are classified into 3
categories A.B. and C. In ‘A’ category those items are taken which are very
precious and their quantity or number is small.
(ii) In ‘B’ category those items are reserved which are less costly than the items
of category ‘A’ but their number is greater.
(iii) In category ‘C’ all those items are included which are low priced but their
number is highest.
The rate of use of items of category ‘A’ is the highest and that of category ‘C’ is
the lowest. In a manufacturing organisation, the items of inventory can be
classified as under:-
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Example:-
Class Number of items in terms % as per their value

of their %
A 15 70
B 30 20
C 55 10
100 100
Thus, the number of items of category ‘A’ are 15% but their value is 70%
of total inventory. Therefore, inventory management can be made more effective
by concentrating control on this category. Effort are made to minimise investment
items of this category. The % of number of items in category ‘B’ is 30 but their
value is 20%. Therefore this category will be paid less attention. The items in
category ‘C’ is 55% but their value is just 10% of total. Therefore, management
need not spend much time for control of this class of inventory because very little
investment is made in them. These items are purchased in bulk quantity once in
2-3 years. The management must be aware that theses items may be less
important in terms of value but their non-availabetety can break down the
production process. Therefore, these item should available in time A.B.C.
analysis can be presented by following diagram also.
Y
0 10 20 30 40 50 60 70 80 90 100
% of Costs
10 20 30 40 50 60 70 80 90 100 X
% of Units
Advantages of ABC Analysis
(1) A Close and strict control is facilitated on the most important items which
constitute a major portion of overall inventory valuation or overall material
consumption & due to this, costs associated with inventories maybe reduced.
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(2) The investment in inventory can be regulated in proper manner & optimum
utilisation of available funds can be assured.
(3) A strict control on inventory items in this manner help in maintaining a high
inventory turnover rates.
2) FIXATION OF INVENTORY LEVELS:
Fixation of various inventory levels facilitates initiating of proper action in respect

of the movement of various materials in time so that the various materials may be
controlled in a proper way. However, the following propositions should be
remembered.
(i) Only the fixation of inventory levels does not facilitates the inventory control.
These has to be a constant watch on the actual stock level of various kinds of
materials so that proper action can be taken in time.
(ii) The various levels fixed are not fixed on a permanent basis and are subject to
revision regularly.
The various levels which can be fixed are as below.
1) Maximum level:
It indicates the level above which the actual stock should not exceed. If it
exceeds, it may involved unnecessary blocking of funds in inventory while fixing
this level, following factors are considered.
i) Maximum usage.
ii) Lead time.
iii) Storage facilities available, cost of storage and insurance etc.
iv) Prices for material
v) Availability of funds.
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vi) Nature of material eg If a certain type of material is subject to government

regulation in respect of import of goods etc maximum level may be fixed at a
higher level.
vii) Economic order Quantity.
2) Minimum Level: It indicates the level below which the actual stock not
reduce, If it reduces, it may involve the risk of non-availability of material
whenever it is required. While fixing this level, following factors are considered.
i) Lead time.
ii) Rate of consemption
3). Re-order level
It indicates that level of material stock at which it is necessary to take the

steps for the procurement of further lots of material. This is the level falling in
between the two existences of maximum level and minimum level and is fixed in
such a way that the requirements of production are met properly till the new lot of
material is received.
4). DANGER LEVEL:
This is the level fixed below minimum level. If the stock reaches this level,
it indicates the need to take urgent action in respect of getting the supply. At this
stage, the company may not be able to make the purchases in the systematic
manner but may have to make rush purchases which may involve higher
purchase cost.
CALCULATION OF VARIOUS LEVELS:
The various levels can be decided by using the following mathematical

expressions.
1). Re-Order level:-

Maximum lead time X Maximum usage.
2). Maximum level:-

Re-order level + Re order Quantity- (Minimum Usage X Maximum lead
time)
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3). Minimum level:-

Re-order level- (Normal usage + Normal lead time)
4). Average level:-

Minimum level + Maximum level
2
5). Danger level:-
Normal Usage X Lead time for emergency Purchases.
3). INVENTORY TURNOVER:
Inventory turnover indicates the ratio of materials consumed to the

average inventory held. It is calculated as below:
Value of Material Consumed

_______________________
Average inventory held
Where value of material consumed can be calculated as:
Opening stock + purchases- closing stock. Average inventory held can be

calculated as:
Opening stock + closing stock

__________________________
2
Inventory turnover can be indicated in terms of number of days in which average

inventory is consumed. It can be done by dividing 365 days (a year) by inventory
turnover ratio.
4. EOQ:- Economic order Quantity as per notes
include bills payable, notes payable and miscellaneous accruals. Net working
capital is the excess of current assets over current liabilities here. Current assets
are those assets which are normally converted into cash within an accounting
year; and current liabilities are usually paid within an accounting year.
What for is working capital required by firm very much depends on the nature of
the business which the firm is conducting. If the firm has business which deals
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with public utility services, obviously the requirement will be low. It is primarily
because the amount becomes available as soon as services are sold and also
the services arranged by the firm and immediately sold, without much difficulty
and complication. On the other hand trading concerns need heavy amounts
because these require funds for carrying goods traded. Similarly many industrial
units will also need heavy amounts for carrying on their business. Many
manufacturing concerns will also need sufficiently heavy amounts, the of course
depends on the nature of commodities which are being manufactured.
MANUFACTURING FIRM
We now come to manufacturing firm. If it is complex and complicate, it will be

another determinant. In this complex process obviously more capital will be
needed and goods will be produced after considerable delays. Longer it take to
produce a good, more will be its cost and more working capital will become
unavoidable. When the companies are engaged in the production of heavy
machinery and equipment, a way out is found out by demanding some advance
money from the party or parties which plea orders or which usually take away the
goods.
Ques. 8 Define EOQ. How is it computed ? Give an example.
Ans. Economic order quantity refers to the size of the order which gives
maximum economy is purchasing any item of raw materials or finished product. It
is fixed mainly after talking into account the following costs:
I. INVENTORY CARRYING COST
It is the cost of keeping items in stock. It includes interest on investment.

Obsolescence losses, store- keeping cost, insurance premium, etc. the larger the
volume of inventory, the higher will be the inventory carrying cost and vice versa.
II ORDERING COST
It is the cost of placing an order and securing the supplies. It various from time to
time depending upon the number or orders placed and the number of times
ordered. The more frequently the order are placed and fewer the quantities
purchased an each order, the greater will be the ordering cost and vice versa.
The economic ordering quantity can be determined by any of the following

two methods.
1) FORMULA METHOD
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In this case the EOQ can be determined as per the following for formula:
E= Economic ordering quantity.

U= Quantity purchase in a year.
P= Cost of placing an order.
S= Annual cost of storage of one unit.
For Example:-
A refrigeration manufacture, purchase 1600 units of a certain component

from 13. His annual usage is 1600 units. The order placing cost is Rs 100 and
the cost of carrying one unit for a year is Rs 8.
Calculate the economic ordering qty by formula method:
E = Sqrt. (2u*p)/s
= Sqrt. (2*1.600*100)/8
= Sqrt. (40,000)=200 units
EOQ model is based on the following assumptions:
I. The firm knows with certainly the annual usage or demand of the
particular item of inventories.
II. The rate at which the firm uses the inventories or makes sales is
constant through out a year.
III. The order the replenishment of inventory are placed exactly when
inventories reach the zero level.
The above assumption may also be called as limitation of EOQ modes. There is
every likelihood of a discrepancy between actual and estimated demand for a
particular items of inventory. Similarly, the assumptions as to constant usage or
sale of inventories and instantaneous replenishment of inventories are also of
doubtful validity. On account of these reasons, EOQ model may sometimes give
wrong estimate about economic order quantity.
2. TABULAR METHOD
This method is to be used in those circumstances where the inventory

carrying cost per units is not constant. This will be clear with the following.:
Calculating the Economic Ordering Quantity using Tabular Method on the basis
of data given.
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Annual Orders Units Order Avg. Carrying Total

Requirement per year per placing stock in costs amount
order costs units cost
(50% of
order
placed)
1600 1 1600 100 800 6400 6500
2 800 200 400 3200 3400
3 533 300 267 2136 2436
4 400 400 200 1600 2000
5 320 500 160 1280 1780
6 267 600 134 1072 1672
7 229 700 115 920 1620
8 200 800 100 800 1600
9 178 900 89 712 1612
10 160 1000 80 640 1640
The above table shows that total cost in the minimum when each is of 200 units.
Therefore, economics ordering quantity is 200 units only.
As graphic presentation of the economic ordering quantity on the basis of figures

given in the above table will be as follows:
_____________ Total cost on inventory management
_____________ Inventory carrying costs.
_________ Ordering cost [ EOQ =2000 units]
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Cost in thousand (Rs)
0 1 2 3 4 5 6 7 8 9 10
(5) Bill of Materials:
In order to ensure proper inventory control, the basic principle to be kept in mind
is that proper material is available for production purpose whenever it is required.
This aim can be achieved by preparing what is normally called as “Bill of
Materials”.
A bill of material is the list of all the materials required for a job, process or
production order. It gives the details of the necessary materials as well as the
quantity of each item. As soon as the order for the job is received, bill of
materials is prepared by Production Department or Production Planning
Department.
The form in which the bill of material is usually prepared is as below:
BILL OF MATERIALS
No. Date of Issue Production/Job Order No
Department authorized
S. No Description Code Qty. For Department Use Only Remarks

of Material No
Material Date Quantity
Requisition Demanded
No
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The function of bill of materials are as below:
(1) Bill of materials gives an indication about the orders to be executed to all
the persons concerned.
(2) Bill of materials gives an indication about the materials to be purchased by
the Purchase Department if the same is not available with the stores.
(3) Bill of material may serve as a base for the Production Department for
placing the material requisition slips.
(4) Costing/Accounts Department may be able to compute the material cost in
respect of a job or a production order. A bill of material prepared and
valued in advance may serve as base for quoting the price for the job or
production order.
(6) Perpetual Inventory System:
As discussed earlier, in order to exercise proper inventory control, perpetual

inventory system may be implemented. It aims basically at two facts.
(1) Maintenance of Bin Cards and Stores Ledger in order to know about eh
stock in quantity and value at any point of time.
(2) Continuous verification of physical stock to ensure that the physical
balance and the book balance tallies.
The continuous stock taking may be advantageous from the following angles:
(1) Physical balances and book balance can be compared and adjusted
without waiting for the entire stock taking to be done at the year end.
Further, it is not necessary to close down the factory for Annual stock
taking.
(2) The figures of stock can be readily available for the purpose of periodic
Profit and Loss Account.
(3) Discrepancies can be located and adjusted in time.
(4) Fixation of various levels and bin cards enables the action to be taken for
the placing the order for acquisition of material.
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(5) A systematic maintenance of perpetual inventory system enables to locate

slow and non-moving items and to take remedial action for the same.
(6) Stock details are available correctly for getting the insurance of stock.
ILLUSTRATIVE PROBLEMS
(1) A company uses annually 50,000 units of an item each costing Rs. 1.20
Each order costs Rs. 45 and inventory carrying cost 15% of the annual
average inventory value.
(a) Find EOQ

(b) If the company operates 250 days a year, the procurement time is 10
days, and safety stock is 500 units. Find reorder level, maximum,
minimum and average inventory.
Unit II
Investment decisions
The investment decisions of a firm generally known as capital budgeting or

capital expenditure decisions. A capital budgeting decision may be defined as the
firm’s decision to invest its current funds most efficiently in the long term assets
in anticipation of an expected flow of benefits over a series of year. The long term
assets are those which affect the firm’s operations beyond the one year period.
The firm’s investment decision would generally include expansion, acquisition,
modernisation and replacement of long term assets. Sale of a division or
business (Investment) is also analysed as an investment decision. Activities such
as changes in the methods of sales distribution or undertaking an advertisement
compaign or a research and development programme have long-term
implication’s for the firm’s expenditure and benefits and therefore, they may also
be evaluated as investment decisions.
Features:-
1) The exchange of current funds for future lengths.
2) The funds are invested in long term assets.
3) The future benefits will occur to the firm over a series of year.
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Importance of Investment Decisions
Investment decision require special attention because of the following reasons:
1) They influence the firm’s growth in the long turn.
2) They affect the risk of the firm.
3) They involve commitment of large amount of funds.
4) They are irreversible or reversible at substantial loss.
5) They are among the most difficult decisions to make.
1) GROWTH:
A firm’s decision to invest in long term assets has a decisive influence on

rate and direction of its growth. A wrong decision can prove disastrous for
continued survival of firm, unwanted or unprofitable expansion of assets will
result in heavy operating costs to the firm. On other hand, inadequate investment
in assets would make it difficult for the firm to complete successfully and maintain
its market share.
2) Risk:
A long-term commitment of funds may also change risk complexity of the

firm. If the adoption of an investment increases overage gain but causes frequent
fluctuations in its earnings the firm will become more risky.
3) Funding:
Investment decisions generally involve large amount of funds which make

it imperative for firm to plan its investment programmes very carefully and make
an advance arrangement for procuring finance internally or externally.
4) Irreversibility:
It is difficult to find a market for such capital items once they have been
acquired. The firm will incur heavy losses if such assets are scrapped.
5) Complexity:
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Investment decisions are an assessment of future events which are

difficult to predict. It is really a complex problem to correctly estimate future cash
flow of an investment. The uncertainty in cash flow is caused by economic,
political, social and technological forces.
Techniques of Capital Budgeting:
it may be grouped in the following two categories:-
(A) Discounted cash flow (DCF) Criteria.
(1) Net present value (NPV)

(2) Internal Rate of Return (IRR)
(3) Profitability Index (PI)
(4) Discounted Payback Period.
(B) Non-discounted Cash flow Criteria:
(1) Pay back period (PB)

(2) Accounting rate of return (ARR)
(A) Discounted Cash Flow (DCP) Criteria – These techniques are considered
good because they take into account time value of money.
(1) Net Present Value (NPV)
This method take into account time value of money. In this method
present value of cash flows is calculated for which cash flows are discounted.
The rate of interest is called cost of capital and is equal to minimum rate of return
which must accrue from the project. Later, present value of cash out flows is
calculated in same manner and subtracted from present value of cash inflows.
This difference is called Net Present value or NPV. In case investment is made
only in beginning of the project, it present value is equal to the amount invested
in the project. Taking this assumption, NPV can be calculated as under:
NPV = CF1 CF2 Cfn

+ +-- -C
(1+k)1 (1+k)2 (1+k)n
n Cft
= ∑ -C
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t=1 (1+k)t
Where Cf1, Cf2 represent cash inflows
K = Cost of Capital
C = Cost of investment proposal
n = Expected life of Proposal
If the project has a salvage value also, it should be added in cash inflows of last
year. Similarly, if some working capital is also needed, it will be added to initial
cost of project and to cash flows of last year.
Acceptance Rule:-
1) Accept if NPV >O (i.e. NPV is Positive)

2) Reject if NPV <O (i.e. NPV is Negative)
3) May accept if NPV= O
Advantage:
1) It takes into account time value of money.

2) It considers cash inflows form project throughout its life.
3) In this method variable discount rates can be used for the projects with longer
life period.
4) This method is more closely related to firm’s objective of maximising wealth of
shareholders.
5) True measure of profitability.
Disadvantages:
(1) Difficult to use, calculate & understand.
(2) In calculating NPV, discount rate is most significant because with different
discount rates NPV will be different. Thus comparable profitability of projects will
change with the change in discount rate. To determine required rate of return
which is called cost of capital, is a difficult task. Different authors have their
different opinions regarding its calculation.
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(3) When the initial cost of 2 projects is different, this method is not very useful
because we will accept or project whose NPV is higher and such a project may
have more initial cost as compared to other. This method evaluates absolute
profitability rather than relative profitability.
(4) When life of 2 projects is dissimilar, this method does not give satisfactory
results. Normally, project with less life time is preferred. But as per this method,
NPV of the project with longer life may be more, and thus finds will be blocked for
a longer period, in this project. In such cases, NPV method may not present
actual worth of alternate projects.
3) PROFITABILITY INDEX
It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1).
It is the ratio of value of future cash benefits at required rate or return to

the initial cash outflow of the investment. PI method should be adopted when the
initial costs of projects are different. NPV method is considered good when the
initial cost of different projects is the same. Thus NPV is an absolute measure of
evaluating projects and PI is an absolute measures. Pl can be calculated as
under:-
Present Value of Cash Inflows

PI _________________________
Present Value of Cash outflows

Acceptance rule
• Accept if Pl>1.0
• Reject if Pl<1.0
• Project may be accepted if Pl= 1.0
MERITS
• Considers all cash flows.

• This method considers all benefits during the life time of the project.
• This method takes into account the time value of money.
• Pl method is considered better to NPV in case when the initial costs of
projects are different for eg. The NPV of two project is equal ie, Rs 5000.
The initial cost of project is Rs 40,000 and that of project B Rs 20,000.
Project should be selected on the basis of profitability index, whereas
under NPV method both the projects will be considered equally profitable.
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• Generally consistent with the wealth maximisation principle.
Disadvantages/ Demerits
1). It is difficult to understand and implement this method.

2). The calculations in this method are complex as compared to traditional
methods.
3). Requires estimates of the cash flows which is a tedious task.
4). At times fails to indicate correct choice between mutually exclusive projects.
4). Discounted Pay Back Period:
This is an improvement over the pay back period method in the sense that it
considers time value of money. Thus discounted pay book period indicates that
period with which the discounted cash inflows equal to the discounted cash
outflows involved in a project.
Pay Back Method:
Under this method the pay back period of each project/ investment proposal is
calculated. The investment proposal, which has the least pay back period is
considered profitable. Actual pay back period is compared with the standard one.
If actual pay back period is less than the standard, the project will be accepted
and in case, actual payback period is more than the standard pay back period,
the project will be rejected. Thus, the project with the least payback period is
considered profitable.
“Pay Back Period is the number of year required for the original investment to be
recouped.
For eg, if the investment required for a project is Rs 20,000 and it is likely to
generate cash flow of Rs 10,000 for 5 years, its payback period will be 2 years. It
means that investment will be recovered in first 2 year of the project.
There are two methods of calculating payback period. First method is

used when cash flows remains the same during the life time of the project. In
such a case payback (PB) is calculated as under:-
INVESTMENT CO
PB = _______________________ =___
CONSTANT ANNUAL CASH FLOW C

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For eg, if the investment for a machinery is Rs 50,000 and it will generate Rs
10,000 such year for 10 years, then its Pay Back period will be:-
Rs 50000
PB = _________ = 5 Years
Rs 10000
For the pay back period of 5 years, it can be observed that the investment of Rs
50,000 will be recovered by the business in 5 years.
ACCEPTANCE RULE
• Accept if PB < standard pay back.

• Accept if PB > standard pay back.
MERITS
1. Easy to understand and compute.

2. This method follows short terms view point, as a result, the obsolescence
are minimum.
3. Emphasis liquidility, therefore useful for the companies which faces the
problem of liquidity. Such companies will invest their funds in such
projects in which investment can be recovered in minimum time.
4. Used to find out internal Rate of Return.
5. Suitable for those organisations which emphasise on short-term
investments rather than long terms development.
6. Uses cash flow information.
7. Easy and crude way to cope with risk.
Demerits
1. Ignores the value of money.

2. Ignores the cash flows occurring after the pay back period. Thus does not
take into account the whole profitability of the project. For eg: investment
in a project is Rs 50,000. Its life 10 years and cash flows every year are
Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows
of Rs 50,000 during the last 5 years have been taken into account.
3. No objective way to determine the standard payback.
4. This method also does not take into account the time value of money. The
time value of money is the interest on investment. The payback period of
two projects may be the same but a project may get more CFAT in the
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initial years and less in the later years. In such a case the cash flows in
the initial years can fetch additional income of interest. Such a project may
become more profitable than the others. But this method ignores this fact.
5. This method does not take into account the total life time of the project.
6. No relation with the wealth maximisation principle.
7. not a measure of profitability.
II. Average Rate of Return Method: This method is also called Accounting Rate
of Return Method. This method is based on accounting information rather than
cash flows. There are various ways of calculating Average Rate of Return. It can
be calculated as:-
Average annual Profit after Tax

ARR = ___________________________X100
Average Investment
Average Annual Profit = Total of after tax profit of all the year
___________________________
No. Of years
Average Investment = Original Investment + Salvage Value

________________________________
or Original Investment – Salvage Value

________________________________ + Salvage Value
If working Capital is also required in the initial year of the project, the average
investment will be= Net working Capital + Salvage value + ½ (initial cost of
Machine- Salvage Value).
In another method instead of average investment original cost is used.
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In this method, to evaluate the project all those projects are accepted on which
average rate of return is more than the predetermined rate. Thus, the project is
given more significant on which the average rate of return is the highest.
Acceptance Rule
• Accept if ARR > minimum rate.

• Accept if ARR < minimum rate.
Merits
1). Easy to understand. Necessary informations to calculate average rate of

return are available easy.
2). This method takes into account all the profits during the life time of the
project, whereas pay back period ignores the profits accruing after the pay back
period
3). Give more weightage to future receipts.

4). Easy to understand and calculate.
5). Uses accounting data with which executives are familiar.
Demerits
1). Ignore the time value of money.

2). Does not use cash flow.
3). No objective way to determine the minimum acceptable rate of return.
4). This method does not account for the profits arising on sale of profit on old
machinery on replacement.
5). ARR method does not consider the size of investment for each project. It may
be time that the competing ARR of two projects may be the same but they may
require different average investments. It becomes difficult for the management to
decide which project should be implemented.
Unit IV
MANAGEMENT OF RECEIVABLE
“Receivables are asset accounts representing amounts owned to a firm as

a result of sale of goods or services in ordinary course of business.”
Receivables are also turned as trade receivables, accounts receivables,
customer receivables, sundry debtors, bills receivable etc. Management of
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receivable is also called management of trade credit. The receivable arising from
credit sales contain risk element.
Purpose of Receivables
There a 3 purposes of investing or maintaining Receivables.
(1) Growth in Sales:-
In comparison to cash sales, firm can make high sales by selling on credit,
because many customers do not want to pay cash. Some of the customers may
have deficit of cash. Therefore, if any firm does not sell on credit, it sales may go
down.
(2) Increased Profits:-
Due to credit sale of goods and services, the total sales of business can
increases. As a result of it, it profits also start increasing.
(3) Meeting Competition:-
Various firm sell goods on credit to their customer only because their
competitors are doing so. If a firm does not follow credit policy of it competitors,
its total sales will decrease because its customers will be attracted towards other
firms.
Objectives of Receivable Management
From creation of receivables the firm gets a few advantages & it has to
bear bad debts, administrative expenses, financing costs etc. In the management
of receivables financial manager should follow such policy through which cash
resources of the firm can be fully utilised. Management of receivables is a
process under which decisions to maximise returns on the investment blocked in
them are taken. Thus, the main objectives of management receivable is to
maximise the returns on investment in receivables & to minimise risk of bad
debts etc. Because investment in receivables affects liquidity and profitability, it
is, therefore, significant to maintain proper level of receivables. In other words,
the basic objectives of receivables management is to maximise the profits.
Efficient credit management helps to increase the sales of the firm. Thus,
following are the main objectives of receivables management:-
(1) To optimise the amount of sales.

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(2) To minimise cost of credit.

(3) To optimise investment in receivables.
Therefore, the main objective of receivable management is to establish a

balance between profitability and risk (cost). A business can afford to invest in its
receivables unless the marginal costs and marginal profits are the same.
Although the level of receivables is affected by various external factors like
standards of industry, economic conditions, seasonal factors, rate of competition
etc, management can control its receivables. Though credit policies, credit terms,
credit standards and collection procedures.
Aspects/Areas/Variables of RM
Formulation of Credit Analysis Collection Polices Evaluation of

Credit Policies Credit Policies
- Trade References
- Bank References Turnover of Aging
- Financials statement Accounts schedule
Credit Credit Standards- Credit Bureau Report Receivable of
Terms - Past Experience Receivable
a) Credit period
b) Cash Discount
c) Cash Discount
Period
(A) Formulation of Credit Policies:-

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Credit Policy means such factors which affect the amount of investment in
receivable and about which management has to take decisions for example
credit period, cash discount period etc.
Following are the main constituents of credit policy-
(1) Credit Terms:- are these terms on the basis of which credit sales are made
to customers. These are also called terms of repayment of receivable. These are
3 main constituents of credit terms. They are:
(a) Credit Period:-
It is the period for which goods are sold on credit to customers i.e. the
period after which payment is to be made by customers. For example, if
customers are required to pay before the end of 30 ITS daysSTUDY CENTRE
from date of sale, it will
SCF-54 (B’MNT)
be written as ‘Net 30’. Credit period normally depends on the SECTOR
standard 15 of the
MARKET,
industry. By raising credit period, not only the sales and profits of firm rise but its
costs also rise. Similarly, by reducing the credit FARIDABAD
period sales &PH 5002194-95
profits decline on
one hand & cost of fund & bad debt go down on the other. Therefore, on
optimum credit policy should be determined by establishing balance in costs and
profits of different credit periods.
(b) Cash Discount:-
A Firm gives cash discount to encourage its customers to pay

quickly. In terms of cash discount, we include rate of cash discount and period for
cash discount. The customers who do not to avail of cash discount, they have to
make payment before expiry of general credit period. Due to availability of cash
discount average collection period is reduced. As a result, the amount locked up
in receivables declines. Cash discount is a loss to the firm. Therefore, decision to
allow cash discount or to change its rate should be undertaken on the basis
analysis of its costs and benefits.
(c ) Cash Discount Period:-
is the period during which cash discount is available. The period of cash
discount affects average collection period.
Thus, the terms of credit collectively include credit period, cash discount
and period of cash discount. For example, if terms of credit are expressed as
‘2/10, Net 30’ , it means that if the payment is made with in 10 days, 2% cash
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discount will be paid. If this cash discount is not avaited of, the payment has to
be made with in 30 days of date of sale.
(2) Credit Standards:-
The term ‘Credit standard’s is basic yardstick of making credit sales

to the customers. On the basis of credit standard it is determined to whom goods
are to be sold or not to be sold. The credit standards followed by a firm affect
sales, profits, investment in receivable & costs. If a firm follow loose credit
standards, its sales and receivables will be more as standards, its sales and
receivables will be more as compared, to firm which uses tight credit standards.
(B) Credit Analysis:-
is made to evaluate ability of the customers before making credit sales. A

firm should determine procedure to evaluate applications for credit. On the basis
of credit analysis only, a firm should decide to whom it will sell on credit & for how
much amount. To sell on credit, all customers should not be treated a like. Each
customer should be examined properly before selling goods on credit to him.
1) Trade Refrences:-
Firm can ask its customers to mention such names/firms with which they
are dealing at present. This is an important source of credit information after
receiving trade references, firm should get desired informations from them.
Sometimes, customer provides names of wrong persons, therefore, before
believing the informations received, the honesty and sincerity of traders should
be examined.
2) Bank References:-
The bank of the customers can also provide important credit information’s
about the customer. Such information’s are obtained by the firm with the help of
its bank. Sometimes, firm ask customers to direct his bank to provide necessary
information’s to it. The information’s like average bank balance of customer, loan
given to customer, experience with customer etc can be obtained from bank of
customer. Normally, bank does not give clear answer to firm’s question Therefore
the firms should collect information’s from other sources.
3) Financial Statements:-
This is one of easiest way to obtain information’s about credit worthiness

of prospective customers. If prospective customer is a public limited company,
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there may not be any difficulty in getting financial statements, in form of profit &
loss Account & balance sheet. However, getting financial statements may be
difficult in case of Private Limited companies of partnership firms.
Past Experience:-
This can be considered to be most reliable source of getting information

about credit-worthiness of customer who is dealing with company presently. If
there is the question of extending further credit to existing customer, the
company should inevitable consider pas experience while dealing with that
customer.
(c ) Collection Policies:-
are needed because all customers do not pay in time. Some customers
pay at slow rate and some do not make payment at all. The objective of
collection policy is to fasten the collection of debt. If the collection from debtors is
delayed, additional funds have to be procured for smooth operation of selling and
production activities. Delay in realisation from debtors also increases possibility
of bad debts. Thus, the main objectives of realisation policy is to reduce the ratio
of bad debt & reduce average collection period.
The collection policy means the steps which are taken to realise the debts
from debtors for their default in non payment with in the stipulated time.
Proper coordination in sales and accounting department should be

established to determine clear collection policy.
Another aspect of collection policy is the methods employed to realise the

over dues. After the end of credit period, firm should undertake necessary steps
to make collection from debtors. Initially the efforts should be polite but with the
passage of time they can be made stringent. Among these methods following are
included:-
(1) Reminder letters

(2) Telephone
(3) Telegram
(4) Extension of Payment Period
(5) Legal Action
Before taking any action, difficulties of customers should be examined.

Therefore, following points must be considered for determining collection
procedures:-
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(1) Collection procedure must be clear.

(2) Before Starting action for collection, the nature of the customers and their
business connections should be considered.
(3) The time gap between due date and action for realisation of debts should
be determined separately for different classes of customers like regular
customers, seasonal customers etc.
(4) So far as possible, legal action should be avoided.
(5) The expenses incurred on collection should not exceed the amount of
collection of debt.
(6) While estimating collection cost, past experience should be considered.
(D) Evaluation of Credit Policies/ Monitering Receivable:-
The collection policy followed by firm should be optimum. It should neither

be too liberal nor too strict. Proper adjustment in credit policies should be made
according to changing ciramstances. To observe whether credit policy followed
by firm is suitable or not, following methods can be used.
(1) Turnover of Accounts Receivable:-
This ratio is calculated by dividing annual credit sales by average

accounts of receivables. The objective of this ratio is to measure liquidity.
Credit Sales during the Year

Turnover of Accounts Receivable =________________________
Average Accounts Receivable.
Months or Days in a year

Average collection Period = _____________________
Turnover of Accounts Receivable
2) Aging Schedule of Receivable:-

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In this schedule, receivables are classified on basis of their age. The main
objective of preparing this schedule is to find out how much old are the
receivable. It is prepared in form of a statement. With the help of this schedule
management can find out such debtors & can adopt appropriate collection
method for them whose average credit period is higher and which are older. Thus
management can reduce possibility of bad debts. A specimen of this schedule is
given as under:-
Aging schedule of Accounts Receivables

Period (No of No of Amt (Rs) No as % Total Amt as % of
Days) Accounts no. total
0-20 100 30000 23.8 16.2
21-40 200 80000 41.6 43.2
41-60 40 20000 9.5 10.8
61-80 50 40000 11.9 21.6
81-100 20 10000 4.7 5.4
Over 100 10 5000 2.5 2.8
420 185000 100.00 100.00
Management Of Cash
Management of cash is one of most important ITS STUDY

areas ofCENTRE
overall working
SCF-54 (B’MNT)
capital management. This is due to the fact that cash is the most SECTOR 15 of
liquid type
MARKET,
current assets. As such, it is the responsibility of finance function to see that
FARIDABAD
various functional areas of business have sufficient PH 5002194-95
cash whenever they require
the same. At the same time, it has also to be ensured that funds are not blocked
in form of idle cash, because it will effect interest cost & opportunity cost. As
such, management of cash has to find a mean between these 2 extremes of
shortage of cash as well as idle cash.
Motives of holding Cash/ Need:-
1) Transactive Motive:- Business needs cash for various payments in ordinary

course of its operation which includes payment for purchase of material, wages,
dividend, taxes etc. Similary business gets cash from its selling activities & other
investment. But there is no coordination between inflow and outflow of cash.
When expected cash receipt is short of required payment, cash is needed by firm
so that liabilities could be paid, if cash receipts match with cash payments
business does not need cash for transactional purpose.
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2) Precautionary Motive:- Firms need cash to meet some contingencies. For

example.
(1) Strikes, floods, failure of important customers.

(2) Slow rate of cash collection from debtors.
(3) Rejection of orders by customers due to their dissatisfaction.
(4) Rise in cost of raw material etc.
3) Speculative Motive:- It means to make use of profitable opportunities by firm.

Sometimes, firm wants to make use of such profitable opportunities which are
outside operation of business. For this purpose, firm retains some cash. Some of
these opportunities are:-
(1) Opportunity to purchase raw material at low price by payment of cash

immediately.
(2) Opportunity to purchase securities at falling prices.
(3) Purchasing raw material at a time when its prices are lowest.
(4) Compensation Motive:- Bank provide number of services to its customers

like clearance by cheque, credit information about other customers, transfer of
funds etc. for certain services banks charge commission but same of services
are provided by them free of cost for which they require indirect compensation.
For this purpose they wish their customer to maintain minimum cash balance.
Objective of Cash Management:-
1) To make Payment According to Payment Schedule:-
Firm needs cash to meet its routine expenses including wages, salary,
taxes etc.
Following are main advantages of adequate cash-
(1) To prevent firm from being insolvent.

(2) The relation of firm with bank does not deteriorate.
(3) Contingencies can be met easily.
(4) It helps firm to maintain good relation’s with suppliers.
(2) To minimise Cash Balance:-
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The second objective of cash management is to minimise cash balance.

Excessive amount of cash balance helps in quicker payments, but excessive
cash may remain unused & reduces profitability of business. Contrarily, when
cash available with firm is less, firm is unable to pay its liabilities in time.
Therefore optimum level of cash should be maintain.
Managing Cash Flows:-
The main objective of managing cash flows is to accelerate collection of

cash and delay disbursement of cash without damaging credit worthiness. After
preparing cash budget, management should try that there should not be any
significant difference in actual & budgeted cash flows.
Accelerating Cash Collections:-
The customers should be encouraged to make early payment by giving

cash discount to fill time gap between sale of goods and its payment by cheque.
There are 2 methods of reducing these time gaps:-
(1) Concentration Banking:-
It is a system of collecting cash from customers of large sized firms which

have large number of branches. Some of these branches are selected for
collection of cash from debtors which are called collection centres. Firm opens its
account in local banks of these collection centre. On receiving cheque, centre
sends them to local branch of bank and then they are transferred to Head office
daily for disbursements.
Thus, this method is profitable technique of realising debts at the earliest

because it reduces time gap between sending of cheque by customer and their
receipts by firm.
(2) Lock box System:-
Under concentration banking, cheques or drafts received by collection

centres are deposited in local banks & therefore, sometime is wasted before
cheques or drafts are sent for collection. Under the lock box system, this time
gap can be reduced.
Under this system, firm takes on rent a lock box from post office at
important collection centres.
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Customers are instructed to send their cheques/drafts in lock-box. Firm

authorises local banks to withdraw these cheques/drafts from lock box and credit
the same to firm’s account. Bank operates this lock-box several times a day.
Local banks are also instructed to transfer funds exceeding a particular level to
Head office. This system is considered better to concentration banking because
in this system, time involving in receiving cheque, their accounting & deposit of
these cheque in banks is saved.
But under this system, firm has to bear additional expenses of post office
& bank.
Slowing Disbursements:-
The main objective of disbursement management is to slow down the

payments without farming goodwill & credit worthiness of firm. Following methods
can be used for slowing disbursements.:-
1) Avoidance of Early Payments:-
Under this management, firm should make payment on due date only,
neither early nor afterwards. Firm is allowed some time to make payment. But
firm should not bear loss of cash discount.
2) Centralised Disbursements:-
Under this system, all payments should be made from the central account
by Head Office. This system will help in delaying payments and it will increase
time gap in payment before they reach creditors. If payment is made by local
branch, it will not take much time to reach to creditors by post.
In this system, firm will have to maintain lesser total cash as against
deentralised disbursement.
Where each branch will have to maintain some cash. In this method, greater time
will be involved in the presentation & collection of cheques. Control over
payments will also become easier.
3). Float-
Float is the amount which is trapped in cheques but which are yet to be
collected. It means that although cheque has been issued but actual cash will be
required later when it will be actually presented for payment.
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For Example:- if the payment of wages and salaries is made by cheque on Ist of
every month. It is not necessary that all cheques would be presented on Ist day.
In actual practice, some cheques will be presented on Ist day, some on 2nd &
some on 3rd. Thus firm need not deposit extra amount in bank on very Ist day.
4) Accruals:-
Wages & other expenses can be paid after the date of actual services
rendered to them.
Determining Optimum cash Balance:-
If available cash is more than operating requirements of firm, additional

cash should be invested in short-terms securities. Optimum cash balance is that
level of cash at which transaction cost & opportunity cost are minimum. If firm
maintains more cash than optimum level, opportunity cost increases and
transaction decreases and vice versa.
Investing Surplus Cash:-
If nature of surplus cash is permanent, it can be invested in long term

assets. While investing cash in securities, their safety, maturity and marketability
should be considered.
a) Safety:- Cash should be invested in those securities, the prices of which do

not change substantially and there is no risk in repayment of its principal &
interest.
b) Maturity:- more changes take place in long term securities.
c) Marketability:- of securities means easiness in converting them into cash.

Therefore, the surplus cash should be invested in such securities which can be
converted into cash with out much loss.
Unit-II
Risk analysis
Risk exists because of inability of decision maker to make perfect

forecasts. Forecasts cannot be made with perfection or certainity since the future
events on which they depend are uncertain. An investment is not risky if, we can
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specify a unique sequence of cash flows for it. But the whole trouble is that cash
flows cannot be forecast accurately, & alternative sequence of cash flows can
occur depending on future events. Thus, risk arises in investment evaluation
because we cannot anticipate occurrence of possible future events with certainity
& consequently, cannot make any connect prediction about cash flow sequence.
Techniques to handle Risk
1) Pay back
2) Risk-adjusted discount rate.
3) Certainty equivalent.
2) Risk-adjusted Discount Rate:-
To allow a risk, businessman required a premium over and above an

alternative which was risk free. Accordingly, more uncertain the returns in future,
the greater the risk & greater premium required. Based on this reasoning, it is
proposed that risk premium be incorporated into capital budgeting analysis
through discount rate. That is, if time preference for money is to be recognised by
discounting estimated future cash flows, at same risk-free rate, to their present
value, than, to allow for riskiness of those future cash flows a risk premium rate
may be added to risk free discount rate. Such a composite discount rate, called
risk-adjusted discount rate, will allow for both time preference & risk preference &
will be a sum of risk-free rate & risk-premium rate reflecting the investors attitude
towards risk. The risk adjusted discount rate method can be expressed as
follows:
n
NPV = ∑ NCFt
t=0 (1+k)t
Where
K= Risk-adjusted rate.
That is,
Risk-adjusted discount rate= Risk free Rate+ Risk Premium
K= kf+kr
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Under CAPM risk- premium is difference between market rate of return & risk
free rate multiplied by beta of the project.
The risk adjusted discount rate accounts for risk by varying discount rate
depending on degree of risk of investment projects. A higher rate will be used for
riskier projects & a lower rate for less risky projects. The net present value will
decrease with increasing k, indicating that riskier a project is perceived, the less
likely it will be accepted.
In contrast to net present value method, if firm uses IRR method, then to
allow for risk of an investment project, the IRR for project should be compared
with risk-adjusted minimum required rate of return. If IRR is higher than this
adjusted rate, the project would be accepted, otherwise it should be rejected.
Evaluation:-
Advantages:-
1) Simple to understood.
2) Has a great deal of intuitive appeal for risk averse businessman.
3) It incorporates an attitude towards uncertainity.
Disadvantages:-
1) There is no easy way of deriving a risk-adjusted discount rate.

2) It does not make any risk adjustment is numerator for cash flows that are for
cast over future years.
3) It is based on assumption that investors are risk-averse. Though it is generally
true, there exists a category of risk seekers who do not demand premium for
assuming risks, they are willing to pay a premium to take risks. Accordingly,
composite discount rate would be reduced, not increased, as the level of risk
increases.
• It is based on the assumption that investors are risk averse. Though it is

generally true, there exists a category or risk seekers who do not demand
premium for assuming risks; they are willing to pay a premium to take risk.
Accordingly, the composite discount rate would be reduced, not increased,
as the level of risk increases.1
Certainty Equivalent
Yet another common procedure for dealing with risk in capital budgeting is to
reduce the forecasts of cash flows to some conservative levels. For example, if
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an investor, according to his ‘best estimate,’ expects a cash flow of Rs 60,000

next year, he will apply an intuitive correction factor and may work with Rs
40,000 to be on safe side. There is a certainty-equivalent cash flow. In formal
way, the certainty equivalent approach may be expressed as:
n tNCFt
NPV = ∑
t=0 (1+kf)t
Where, NCFt= the forecasts of net cash flow without risk-adjustment

t = the risk-adjustment factor or the certainty equivalent coefficient
kf = risk-free rate assumed to be constant for all periods.
The certainty- equivalent coefficient, t assumes a value between 0 and 1,

and varies inversely with risk. A lower t will be used if greater risk is perceived
and a higher t will be used if lower risk is anticipated. The coefficients are
subjectively or objectively established by the decision maker. These coefficients
reflect the decision-maker’s confidence in obtaining a particular cash flow in
period t. For example, a cash flow of Rs 20,000 may be estimated in the next
year, but if the investor feels that only 80 per cent of it is a certain amount, then
the certainty-equivalent coefficient will be 0.80. That is, he considers only Rs
16000 as the certain cash flow. Thus, to obtain certain cash flows, we will
multiply estimated cash flows by the certainty-equivalent coefficients.
The certainty-equivalent coefficient can be determined as a relationship

between the certain cash flows and the risky cash flows. That is:
NCFt* Certain net cash flow

t = =
NCFt Risky net cash flow
For example, if one expected a risky cash flow of Rs 80,000 in period t and
considers a certain cash flow of Rs 60,000 equally desirable, then t will be
0.75=60,000/80,000.
ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000,
Rs 3,000, Rs 2,000 and Rs 1,000 in year 1 through 4. Assume that the
associated t factors are estimated to be: o = 1.00, 1=0.90, 2=0.70, 3=0.50
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and 4=0.30, and the risk free discount rate is 10 per cent. The net present value
will be:
0.90(4,000) 0.70(3,000) 0.50(2,000) 0.30(1,000)

NPV = 1.0(-6,000) + + + + = Rs 37
(1+0.10) (1+0.10)2 (1+0.10)3 (1+010)4
The project would be rejected as it has a negative net present value.
If the internal rate of return method is used, we will calculate that rate of
discount which equates the present value of certainty-equivalent cash inflows
with the present value of certainty-equivalent cash outflows. The ratio so found
will be compared with the minimum required risk-free rate. Project will be
accepted if the internal rate is higher than, the minimum rate; otherwise it will be
unacceptable.
Evaluation of Certainty Equivalent
The certainty-equivalent approach explicitly recognizes risk, but the procedure for
reducing the forecasts of cash flows is implicit and is likely to be inconsistent
from one investment to another. Further, this method suffers from many dangers
in a large enterprise. First, the forecaster, expecting the reduction that will be
made in his forecasts, may inflate them in anticipation. This will no longer give
forecasts according to ‘best estimate.’ Second, if forecasts have to pass through
several layers of management, the effect may be to greatly exaggerate the
original forecasts or to make it ultra conservative. Third, by focusing explicit
attention only on the gloomy outcomes, chances are increased for passing by
some good investments.
Risk-adjusted Discount Rate VS. Certainty-Equivalent
The certainty-equivalent approach recognizes risk in capital budgeting analysis

by adjusting estimated cash flows and employs risk-free rate to discount the
adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts
for risk by adjusting the discount rate. It has been suggested that the certainty
equivalent approach is theoretically a superior technique over the risk-adjusted
discount approach because it can measure risk more accurately.1
The risk-adjusted discount rate approach will yield the same result as the
certainty-equivalent approach if the risk-free rate is constant and the risk-
adjusted discount rate is the same for all future periods. Thus,
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t NCFt NCFt
=
(1+kf)t (1+k)t
To solve for l
t NCF(1+k)t = NCFt (1+kf)t
NCFt(1+kf)t (1+kf)t
t = =
NCFt(1+k)t (1+k)t
For period t+1, Equation (6) will becomes
(1+kf)t+1
t+1 =
(1+k)t+1
Earlier, we have stated that the values of 1 will vary between 0 and 1.
Thus, if Kf and k are constant for all future periods, then K must be larger than Kf
to satisfy the condition that t varies.
1. Robichek and Myers, op. cit., pp. 82-86.
Unit IV
16
Management Of Working Capital
Working capital management is an important component of overall

financial management. Management of working capital like long-term financial
decisions affects the risk and profitability of business. In business two types of
assets are used.
(1) Fixed Assets

(2) Current Assets
Fixed Assets include land, building, plant and machinery, furniture and
fittings etc. fixed assets are used in the business for a long period and they are
not purchased for the purpose of selling them to earn profit.
Current Assets, on the other hand, are used for day to day operation of
business. For the efficient and effective use of fixed assets, there should be
adequate working capital in the business. Current assets include cash, bank
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stock debtors, bills receivable, marketable securities etc. the capital employed in
these assets is called working capital. In any business, there should be proper
balance between fixed capital and working capital.
The problem relating to management of working capital is different from that

of management of fixed assets. Fixed assets are purchased for long term use in
business and the return on them is received during their lifetime. On the other
hand, current assets get converted into cash in short term. One more significant
characteristic of the current assets is that, if the amount of current assets is more
in a business, it will increases the liquidity but profitability will reduce. On the
other hand, if current assets are relatively lesser, profitability will improve but
liquidity will be adversely affected. Therefore, the main objective of working
capital management is to determine optimum amount of investment in current
assets so that balance in profitability and liquidity of the business could be
ascertained.
Definition of Working Capital
There is difference of opinion among different authors about the definition

of working capital. Considering the objectives and scope of working capital, it can
be defined in two ways:
(i) Gross Concept

(ii) Net Concept
(i) Gross Concept:- According to the gross concept, working capital

means total of all the current assets of a business. It is also called gross working
capital.
Gross Working Capital= Total Current Assets
(ii) Net Concept:- According to the net concept of working capital, net
working capital means the excess of current assets over current liabilities. If
current assets are equal to current liabilities then according to this concept
working capital will be zero and in case current liabilities are more than current
assets, the working capital will be called negative working capital.
Net Working Capital= Current Assets-Current Liabilities
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Current assets are those assets which are converted into cash within one
accounting period, for example, stock, debtors, bills receivables, prepaid
expenses, cash and bank balance. Similarly, current liabilities are those liabilities
which have to be paid within an accounting year, for example, creditors bills
payables, short term loans etc.
Net working capital can also be defined in another manner. Net working
capital is the part of current assets which has been financed from long term
funds. It is, therefore also called circulating capital.
Gross concept and net concept of working capital have their own
significance. When individual current assets are to be managed, gross concept of
working capital is used. Net concept of working capital emphasizes on how much
current assets have been financed out of long term funds. Under this concept the
relationship between current assets and current liabilities is established or their
liquidity is determined. The difference between gross working capital and net
working capital can be understood with the help of following illustration.
ILLUSTRATION I.
From the following balance sheet, you are required to calculate the
amount of Gross Working Capital and Net Working Capital:-
Balance Sheet
Rs Rs
Share Capital 10,00,000 Land and Building 10,00,000
Reserves 1,00,000 Plant and Machinery 2,90,000
Debentures 4,00,000 Cash and Bank Balance 10,000
Short-term Loan 50,000 Marketable Securities 90,000
Trade Creditors 40,000 Trade Debtors 1,00,000
Bills Payable 10,000 Bills Receivable 40,000
Inventory 70,000
16,00,000 16,00,000
Solution :
Gross Working capital= Cash and Bank Balance+ Marketable Securities+

Trade Debtors+ Bills Receivable+ Inventory
= Rs. 10,000+Rs90,000+Rs1,00,000+Rs40,000+Rs70,000
= Rs. 3,10,000
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Net Working Capital= Current Assets- Current Liabilities
= Rs10,000 + Rs 90,000 + 1,00,000 + Rs 40,000 + Rs70,000- Rs50,000 – Rs

40,000 – Rs 10,000
= Rs 3,10,000- rs 1,00,000 = Rs 2,10,000
Need For Working Capital
For the efficient operation of the business, working capital is required

along with the fixed capital. Working capital is needed for the purchase of raw
material and for the payment of various day to day expenses. There will be
hardly any business which does not require working capital. The need for
working capital is different businesses. Financial management aims at
maximising the wealth of shareholders. To achieve this objective, it is necessary
to earn adequate profits. The profit depends largely on sales but sales do not
result in cash immediately. To increase sales goods are to be sold on credit, the
collection of which takes place after time terms. Thus,
ITS there
STUDYexists a gap between
CENTRE
the sale of goods and realisation of cash. During this (B’MNT)
SCF-54 period expenses
SECTORare 15 to be
incurred to continue business operations. For this purpose, working
MARKET, capital is
required. The need for working capital canFARIDABAD
be explained PH with the help of
5002194-95
operating cycle or cash cycle. Operating cycle means that time period which is
required to convert raw material into cash. In a manufacturing enterprise raw
material is purchased with cash, then raw material is converted into work-in
progress, which in turn gets converted into finished goods; both receivable
through sales and lastly cash is received from debtors and bills receivable.
In the operating cycle, following events are included:
(1) Conversation of cash into raw material.

(2) Conversation of raw material into work-in-progress.
(3) Conversation of work in progress into finished goods.
(4) Conversation of finished goods into Debtors and Bills Receivable.
(5) Conversation of Debtors and Bills receivable through sales into cash.
Debtors and Bills Receivable
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Raw Materials Work-in-
Operating Cycle
The greater the period of operating cycle, more will be the requirement of
working capital. Business enterprises engaged in manufacturing work have larger
duration of operating cycle as compared to those engaged in trading business
because in such enterprises cash is directly converted into finished goods.
Because no business is able to match its cash inflows and cash outflows,
therefore, the business needs to maintain some cash to pay its current liabilities
in time. Similarly, to maintain supply of goods to meet the demand in the market,
the stock of finished goods has to be kept. For the smooth running of
manufacturing work stock of raw material has to be maintained. Firm has to sell
on credit due to competition. Thus, business needs adequate working capital.
Permanent And Variable Working Capital

In business current assets are required because of the operating cycle.
But the need for working capital does not end with the completion of operating
cycle. Operating cycle goes on continuously and therefore, in order to
understand the need for working capital, it becomes essential to distinguish
between permanent or regular and variable or seasonal or temporary working
capital.
(a) Permanent Working Capital:- The requirements for current assets do

not remain stable throughout the year and it fluctuates from time to time. A
certain minimum amount of raw material, work in progress and finished goods
and cash must be maintained regularly in the business so that day to day
operation of the business could continue without any obstacles. This minimum
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requirement of current assets is called permanent or regular working capital. The

arrangement of permanent working capital should be made from long term
sources only, for example share capital, debentures, long term loans etc.
(b) Variable Working Capital:- In certain months of the year the level of
business activities is higher than normal and therefore, additional working capital
may be required along with the permanent working capital. It is known as
variable or temporary working capital. This part of the working capital is required
due to changes in demand and supply of goods on account of change in seasons
etc. for example, in boom period, stock is to be kept to fulfill demand and the
amount of debtors increases due to more sales. Similarly, in depression, the
amount of stock and debtors declines. Thus, extra working capital required due
to changes in demand and production is called variable working capital.
In order to run the business smoothly both types of working capital is

required. Variable working capital is required for a short time. Therefore, it should
be financed from the short term sources only so that later on it can be refunded
when it is not required.
Y
Amount of working capital (RS.)
TEMPARARY WORKING CAPITAL
PERMANENT WORKING CAPITAL
X
TIME
Fig. 1. Permanent and Temporary Working Capital
From Fig.1 it is clear that the need for regular working capital remains the same
for whole the year, whereas variable working capital needs are sometimes high
and sometimes low. In a growing concern the need for working capital goes on
rising because in the level of business activities. It is presented in Fig. 2)
Y
UNT OF WORKING CAPITAL (RS.)
TEMPARARY WORKING CAPITAL
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PERMANENT TEMPARARY CAPITAL
X
Fig. 2. Permanent and Temporary Working Capital
Factors Affecting Working Capital
Business should prepare its financial plan in such a way that it has neither
surplus nor inadequate working capital. The needs for every business are
different but generally the following factors must be considered while determining
the requirement of working capital.
(1) Nature of Business:- Nature of business affects the working capital

requirements of the business. Railways, transport, electricity, water and other
public utilities require relatively lower working capital because the demand for
their services is regular and fixed. They also get immediate payment. They need
not keep much stock. On the other hand, the trading institutions require more
working capital because they have to keep adequate stock, cash and debtors. In
financial institutions and banks, the need for working capital is more than
permanent capital.
(2) Growth and Expansion:- the large sized businesses require more
permanent and variable working capital in comparison to small business. If a
company is growing, its working capital requirements will also go on increasing.
Thus, the growing concerns require more working capital as compared to the
stable industries.
(3) Production Cycle:- Production cycle means the time period between
the purchase of raw material and converting it into finished product. The
requirements of working capital in a business depends upon the production
cycle. It the period of production cycle is longer, more working capital will be
required. If the production cycle is small, the requirements of working capital will
also be small. Therefore, business should choose such an alternate method of
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production which takes lowest time. Before selecting specific production process,
it should be seen that it is completed in pre-determined time.
(4) Business Fluctuations:- Business has to pass through the stages of

boom and depression. These fluctuations affect the requirement of working
capital. During the boom period the business grows rapidly. Management has to
invest more in stock and debtors. This requires additional working capital. on the
other hand, during depression, sale of business decreases. As a result the
quantum of stock and debtors also reduces. It decreases the need for working
capital.
(5) Production Policy:- The determination of working capital needs
depends upon the production policy of the business. The demand for certain
products is seasonal i.e, such product are purchased in certain months of a year.
For such industries two type of production policy can be followed.
Firstly they can produce the goods in the months of demand or secondly, they
produce for the whole year. If the second alternative is followed, it would mean
that till the time of demand finishes, product will have to be kept in stock. It would
require additional working capital.
(6) Credit Policy:- Credit policy affects the working capital requirements
in two ways:-
(i) Terms of credit allowed by customers to the firm.

(ii) Terms of credit available to the firm.
If the firm sells goods on credit to its customers, it would require more
working capital. If the firm follows tight credit policy, the requirement for working
capital will decrease. Similarly, if the firm purchases raw material on credit, lesser
working capital would be required. Thus, a liberal credit policy towards purchase
will reduce the amount of working capital requirement against a tight credit policy.
(7) Availability of Raw Material:- Availability of raw material on the

continuous basis affects the requirement of working capital. There are certain
types of raw materials which are not available regularly. In such a situation firm
requires greater working capital to meet the requirements of production. Some
raw materials are available in particular season only for example wool, cotton oil
seeds, etc. They have to be kept in stock for the whole year for which additional
working capital is needed.
(8) Availability of Bank Credit:- If the firm is in a position to get financial

help easily from the bank at the time of its need, it keep a low level of working
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capital but if such facility is not available, firm will have to keep greater working
capital.
(9) Turnover of Inventories:- The greater the turnover of inventories i.e.,

finished product. Work-in-progress, raw material, lesser will be the requirement of
working capital. If turnover is lower, more working capital is needed.
(10) Magnitude of Profit:- Magnitude of profit is different for different

businesses. Nature of product, control on the market and ability of managers etc.
determine the quantum of profit. If the profit margin is high, it will help to arrange
funds internally which will also increases the working capital.
(11) Level of Taxes:- Whole of the cash profit is not available for working
capital. Taxes and dividends are to be paid out of profits. Taxes are a statutory
liability but it can be planned. Taxes are to be paid within a reasonable time. If
tax liability is high, more working capital will be needed.
(12) Dividend Policy:- Dividend policy also affects working capital needs.
When dividend is paid in cash it has unfavourable effect on working capital. If the
management does not pay dividend and the profits are retained, it increases
working capital. Dividend as bonus shares does not affect the working capital.
How much dividend is to be paid in cash and how much profits to be retained in
business, it all depends upon number of factors including liquidity position of
business, past dividend policy, need of capital for business.
(13) Depreciation Policy:- It also affects the working capital. Depreciation

does not result in outflow of cash. Therefore , it affects working capital directly. It
affects tax liability and dividend. High depreciation means lesser profit and
accordingly lesser taxes. Amount of dividend will also be lower. In all, there will
be lesser outflow of cash.
(14) Price Level Changes:- Price level changes also affect working
capital needs. If the prices of different goods increase, to maintain same level of
production, more working capital is needed.
Debtors may be due to tight credit

Minimum Cost Total Cost
policy, which would impair sales further.
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Cost
Cost of Liquidity
Cost of Illiquidity
Thus, the low level of current assets

involves costs which increases as this
level falls. In determining the optimum
level of current assets, the firm should
balance the profitability solvency tangle
by minimizing total cost-cost of liquidity
and cost of illiquidity. This is illustrated
in Figure 22.5. It is indicated in the
figure that with the level of current
assets the cost of liquidity increases
while the cost of illiquidity decreases
and vice versa. The firm should maintain
its current assets at that level where the
sum of these two costs is minimized.
The minimum cost point indicates the
optimum level of current assets in
Figure 22.5
Figure 22.5 Cost trade-off
ESTIMATING WORKING CAPITAL NEEDS
The most appropriate method of calculating the working capital needs of a firm is
the concept of operating cycle. However, a number of other methods may be
used to determine working capital needs in practice. We shall illustrate here three
approaches which have been successfully applied in practice:
Current assets holding period To estimate working capital requirements

on the basis of average holding period of current assets and relating them to
costs based on the company’s experience in the previous year. This method is
essentially based on the operating cycle concept.
Ratio of sales To estimate working capital requirements as a ratio of

sales on the assumption that current assets change with sales.
Ratio of fixed investment To estimate working capital requirements as a

percentage of fixed investment.
To illustrate the above methods of estimating working capital requirement

and their impact on of return we shall take two hypothetical firms (as given in
Table 22.6).
The calculations are based on the following assumptions regarding each

of the three methods:
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Method 1. Inventory: one Month’s supply of each of raw material, semi finished
goods and finished material. Debtors: one month’s sales. Operating cash: one
month’s total cost.
Method 2: 25-35% of annual sales.
Method 3: 10-20% of fixed capital investment.
The following calculations based on data of firm A are made to show how three
methods work:
Method 1: Let us first compute inventory requirements.

Raw material: one month’s supply:
Rs 2,48,000+12= Rs 20,667
Semi-finished material: one month’s supply (based on raw material plus one half
of normal conversion cost):
Rs 20,667+ (Rs 1,71,200 + Rs 1,60,000+ Rs 57,600) ½ ÷12

= Rs 20,667+16,200= Rs 36,867
Table 22.6 DATA FOR TWO FIRMS
Firm A (Rs) Firm B (Rs)

Material Cost,
Raw Material consumed 2,48,000 2,48,000
Less: By product 68,800 68,800
Net material cost 1,79,200 1,79,200
Manufacturing cost,
Labour 1,71,200 1,71,200
Maintenance 1,60,000 1,60,000
Power and fuel 57,600 57,600
Factory overheads 2,40,000 2,40,000
Depreciation (DEP) 1,60,000 3,20,000
Total product cost 7,88,800 9,48,800
Total product cost 9,68,000 11,28,000
Annual sales 14,48,000 14,48,000
PBIT 4,80,000 3,20,000
Investment (INVST) 16,00,000 32,00,000
Period 1 year 1 year
Plant life 10 year 10 year
PBDIT 6,40,000 6,40,000
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ROI [{PBIT/INVST-DEP)] 33.3% 11.1%
Finished material: one month’s supply:

Rs 9,68,000 ÷ 12= Rs 80,666
The total inventory needs are:
Rs 20,667+ Rs 36,867 + Rs 80,666= Rs 138,200
After determining the inventory requirements, projection for debtors and

operating cash should be made.
Debtors: one month’s sales:

Rs14,48,000÷12= Rs 1,20,667
Operating Cash: one month’s total Cost:
Rs 9,68,000÷ 12= Rs 80,667
Thus the total working capital required is:

Rs 1,38,200+ Rs 1,20,667+ Td 80,666= Rs 3,39,533
Method 2: The average ratio is 30 per cent. Therefore, 30% of annual sales (Rs
14,48,000 is 4,34,400.
Method 3. 15% (the average rate) of fixed investment (Rs 16,00,000) is Rs

2,40,000.
The first method gives details of the working capital items. This approach
is subject to markets are seasonal.
As per the first method the working capital requirement is Rs 3,39,533. if

this figure is in calculating the rate of return, it is lowered from 33.3% to 27%. On
the other hand, the return of firm B drops from 11.1% to 9.9%. the estimated
working capital for firm B as per the method is Rs 3,66,200. Rates of return are
calculated as follows:
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Unit –III
Dividend Models
A WALTER’S MODEL
This model was propounded by Prof. James E. Walter who argues that the
choice of dividend policies almost always affect the value of the firm. He shows
the importance of relationship between the firm’s rate of return ® and its cost of
capital (K) in determining the dividend policy that will maximise the wealth of
shareholders.
Assumptions:-
1) Internal financing:-
The firm finances all investment through retained earnings, that is debt or
new equity is not issued.
2) Constant return and cost of capital:-

The firm’s rate of return (r ) and its cost of capital (k) are constant.
3) 100% payout or retention:-

All earning are either distributed as dividends or reinvested internally
immediately.
4) Constant EPS and DIV:-

Beginning earnings and dividends never change. The value of the
earnings per share, (EPS) and dividend per share (DIV) may be changed in the
model to determine results, but any given values of EPS or DIV are assumed to
remain constant forever in determining a given value.
5) Infinite time:-
The firm has a very long or infinite life.
Walter’s formula to determine the market price per share is as follows:-
DIV r (EPS-DIV)/k
P = +
K K
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Where P= market price per share.

DIV = Dividend price per share.
EPS = Earning price per share.
R= firm’s rate of return (average).
K= firm’s cost of capital or capitalisation rate.
Equation (1) reveals that the market price per share is the sum of present value
of 2 sources of income
(i) Present value of infinite stream of constant dividends, (DIV/k) and

(ii) Present value of infinite stream of capital gain
r (EPS-DIV)/k
When the firm retains a perpetual sum of (EPS-DIV) at rate of return ®,its
present value will be:
R (EPS-DIV)/R This quantity can be known as a capital gain which occurs
when earnings are retained within the firm. If this retained earnings occur every
year, the present value of an infinite number of capital gains, r (EPS-DIV)/k will
be equal to : [r(EPS-DIV)] /k. Thus, the value of a share is the present value of all
dividends plus the present value of all capital gain as show in eg (1) which can
be rewritten as follows:
P= DIV+(r/K) (EPS-DIV)
____________________
K
To show the effect of dividend or retention policy on the market value of share,
we shall use Eq (2)
E.g The effect of different dividend policies on the value of shares respectively for
the growth firm, normal firm and declining firm is constructed through given table.
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Dividend Policy and the value of share (Walter’s Model)
Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k)

Basic Data
r= 0.15 T= 0.10 r= 0.08
k=0.10 K= 0.10 k = 0.10
EPS = Rs 10 EPS = Rs 10 EPS = Rs 10
Payout Ratio 10%
DIV R 50
P= [0+(0.15/0.10)(10-0)] DIV = Rs 0 DIV =Rs 50
0.10 P = 100 P= 80
= Rs = 150
Payout Ratio 40% DIV=Rs54
DIV = Rs 4 DIV=Rs 4 P= Rs 88
P=[4+0.15/0.10)(10-4) P= Rs= 100
0.10
=Rs 130
Payout Ratio 80% DIV = Rs 8 DIV = Rs 8
DIV = Rs 8 P = 100 P = 96
P = 110
Payout Ratio 100% DIV= Rs 10 DIV = Rs 10
DIV = Rs 10 P = Rs 100 P = Rs 100
P = Rs 100
The above table shows that dividend policy depends on the relationship
between the firm’s rate of return ® and its cost of capital (k). Walter’s view on the
optimum dividend pay out ratio can be summarised as follows.
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Growth firm: Internal Rate More than Opportunity Cost of Capital (r>k)
Growth firms are those firms which expand rapidly because of ample
investment opportunities yielding returns higher than the opportunity cost of
capital. These firms are able to reinvest earning at a rate ® which is higher than
the rate expected by shareholders (k). They will maximise value per share if they
follow a policy of retaining all earnings for internal investment. It can be seen
from table above that the market value per share for growth firm is maximum (i.e.
Rs150) when it retain 100% earnings & minimum (Rs100) if distributes all
earnings. Thus, the optimum payout ratio for a growth firm is zero. The market
value per share P, increases as payout ratio decline when r>k.
Normal firms: Internal Rate equal opportunity cost of Capital (r=k)
Most of the firms do not have unlimited surplus-generating investment

opportunities, yielding returns higher than opportunity cost of capital. After
exhausting super profitable opportunities, these firms earns on their investments
rate of return equal to cost of capital (r=K). for normal firms with r=K, the dividend
policy has not effect on market value per share in Walter’s Model. From above
table it is shown that market value per share for normal firm is same (i.e. Rs 100)
for different dividend-payout ratio. Thus, there is no unique optimum pay out ratio
for normal firm. One dividend policy is as good as the other. The market value
per share as not affected by payout ratio when r=k.
Declining firms: Internal Rate less than Opportunity Cost of Capital (r<k).
Some firms do not have any profitable investment opportunities to invest

earnings. The market value per share of declining firm with R<k will be maximum
when it does not retain earnings at all from above table it is observed that
declinings firm’s payout ratio is 100% (i.e. o retained earnings) the market value
per share is Rs 100 & it is Rs 80 when payout ratio is zero. Thus, optimum
payout ratio for declining firm is 100%. The market value per share, P, increases
as payout ratio increases when r<k.
Thus,
• Retain all earnings when r>k.

• Distribute all earnings when r<k.
• Dividend (or retention) policy has no effect when r=k.
Criticism:-
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(1) No External Financing:-
Walter’s model of share valuation mixes dividend policy with investment

policy of firm. The model assumes that the investment opportunities of the firm
are financed by retained earnings only & no external financing debt or equity is
used for the purpose. When such a situation exists, either the firm’s investment
or its dividend policy or both will be sub-optimum.
(2) Constant rate of Return,
This model is based on the assumption that r is constant. In fact, r

decreases as more and more investment is made. This reflects the assumption
that the most profitable investment are made first & then poorer investment is
made. The firm should stop at a point where r=k.
(3) Constant opportunity Cost of Capital, k
A firm’s cost of capital or discount rate, k, does not remain constant, it

changes directly with the firm’s risk. Thus the present value of firm’s income
moves inversely with cost of capital. By assuming that the discount rate, k, is
constant, Walter’s model abstracts from the effect of risk on the value of firm.
Constant Opportunity Cost of Capital, k
A firm’s cost of capital or discount rate, k, does not remain constant; it changes
directly with the firm’s risk. Thus the present value of the firm’s income moves
inversely with the cost of capital. By assuming that the discount rate, k, is
constant, Walter’s model abstracts from the effect of risk on the value of the firm.
• DIVIDEND RELEVANCE: GORDON’S MODEL
One very popular model explicitly relating the market value of the firm to dividend
policy is developed by Myron Gordon.1 Gordon’s model is based on the following
assumptions:2
o All-equity firm The firm is an all-equity firm, and it has no debt.

o No external financing No external financing is available. Consequently
retained earnings would be used to finance any expansion. Thus, just as
Walter’s model Gordon’s model too confounds dividend and investment
policies.
o Constant return The internal rate to return, r, of the firm is constant. This
ignores the diminishing marginal efficiency of investment as represented
in Figure 20.1
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o Constant cost of capital The appropriate discount rate K for the firm
remains constant. Thus, Gordon’s model also ignores the effect of a
change in the firm’s risk-class and its effect on K.
o Perpetual earnings The firm and its stream of earnings are perpetual.
o No taxes Corporate taxes do not exist.
o Constant retention The retention ratio, b, once decided upon, is
constant. Thud, the growth rate, g=br, is constant forever.
o Cost of capital greater than growth rate The discount rate is greater
than growth rate, K>br=g. If this condition is not fulfilled, we cannot get a
meaningful value for the share.
According to Gordon’s dividend-capitalisation model, the market value of a share

is equal to the present value of an infinite stream of dividends to be received by
the shareholders as explained earlier in Chapter 8. Thus:
DIV1 DIV2 DIV DIVt

Po = + +… =∑
(1+k) (1+k)2 (1+k) t=1 (1+k)t
However, the dividend per share is expected to grow when earnings are retained.
The dividend per share is equal to the payout ratio, (1-b), times earnings, i.e.,
DIVt = (1-b) EPS, where b is the fraction of retained earnings. The retained
earnings are assumed to be reinvested within the all-equity firm at a rate of return
of r. This allows earnings to grow at the rate of g= br per period. When we
incorporate growth in earnings and dividend, resulting from the retained earnings,
in the dividend-capitalisation model, the present value of a share is determined
by the following formula:
DIV(1+g) DIV(1+g)2 DIV(1+g)3 DIV(1+g)

Po = + + +….+
(1+k) (1+k)2 (1+k)3 (1+k)t
1. Gordon, Myron J., The Investment, Financing and Valuation of Corporation.

Richard D. Irwin, 1962.
2. Francis, op. cit., p. 352.
DIV (1+g)t
= ∑
t=1 (1+k)t
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When Equation (4) is solved it becomes:
DIV1
Po =
K-g
Substituting EPS1 (1-b) for DIV, and br for g. Equation (5) can be rewritten as
EPS1 (1-b)
Po =
k-br
Equation(6) explicitly shows the relationship of expected earnings, EPS1,

dividend policy, b, internal profitability, r, and the all-equity firm’s cost of capital,
k, in the determination of the value of the share. Equation (6) is particularly useful
for studying the effects of dividend policy (as represented by b) on the value of
the share.
Let us consider the case of a normal firm where the internal rate of return
of the firm equals its cost of capital, i.,e., r=k. Under such a situation, Equation (6)
maybe expressed as follows:
EPSl (1-b) rA(1-B)

Po = = (since EPS =rA,A total assets per share)
K-br k-br
If r=k, then
EPSl(1-b) rA(1-b) EPS1 rA

Po = = = = =A
K(1-b) k(1-b) k r
Equation (8) shows that regardless of the firm’s earnings, EPS1, or riskiness
(which determines K), the firm’s value is not affected by dividend policy and is
equal to the book value of assets per share. That is, when r=k, dividend policy is
irrelevant since b, which represents the firm’s dividend policy, completely cancels
out of equation (8). Interpreted in economic sense, this finding implies that, under
competitive conditions, the opportunity cost of capital, k, must be equal to the
rate of return generally available to investors in comparable shares. This means
that any funds distributed as dividends may be invested in the market at the rate
equal to the firm’s internal rate of return. Consequently, shareholders can neither
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lose nor gain by any change in the company’s dividend policy, and the market
value of their shares must remain unchanged.1
Considering the case of the declining firm where r<k, Equation (8) indicates that,
if the retention ratio, b, is zero or payout ratio, (1-b), is 100 per cent the value of
the share is equal to:
rA
Po = (if b=0)
k
If r<k then r/k<1 and from Equation (9) it follows that Po is smaller than the
firm’s investment per share in assets. A. It can be shown that if the value of b
increases, the value of the share continuously falls. 2 These result may be
interpreted as follows:
1. Dobrovolsky, Sergie P., The Economics of Corporation Finance,

McGraw Hill, 1971, p.55.
2. ibid., p. 56.
It the internal rate of return is smaller than k, which is equal to the rate available
in the market, profit retention clearly becomes undersirable from the
shareholders’ standpoint. Each additional rupee (sic) retained reduces the
amount of funds that shareholders could invest at a higher rate elsewhere and
thus further depress the value of the company’s share. Under such conditions,
the company should adopt a policy of contraction and disinvestment, which
would allow the owner to transfer not only the net profit but also paid in capital (or
a part of it) to some other, more remunerative enterprise.1
Finally, let us consider the case of a growth firm where r>k. The value of a
share will increase as the retention ratio, b increases under the condition of r>k.
however, it is not clear as to what the value of b should be to maximise the value
of the share, P0. For example, if b=k/r, Equation (6) reveals that denominator, k-
br=0, thus making P0 infinitely large, and if b=1,k- br becomes negative, thus
making P0 negative. These absurd result are obtained because of the
assumption that r and k are constant, which underlie the model. Thus, to get the
meaningful value of the share, according to Equation (6), the value of b should
be less than k/r. Gordon’s model is illustrated in Illustration 20.2.
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ILLUSTRATION 20.2 Let us consider the data in Table 20.2. The implications of
dividend policy, according to Gordon’s model, are shown respectively for the
growth, the normal and the declining firms.
Table 20.3 DIVIDEND POLICY AND THE VALUE OF THE FIRM (GORDON’S
MODEL)
Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k)
Basic Data
r= 0.15 T= 0.10 r= 0.08
k=0.10 K= 0.10 k = 0.10
EPS1 = Rs 10 EPS1 = Rs 10 EPS1 = Rs 10
Payout Ratio, (1-b) =, Retention g=br=0.6X0.10=0.06 g=br=0.6X0.08=0.048
Ratio, B = 60%
g=br=0.6X0.15=0.09 10(1-0.6) 10(1-0.6)
P= P=
10(1-0.6) 0.10-0.06 0.010-0.048
P= 4 4
0.10-0.09 = Rs 100 = Rs 77
4 0.04 0.052
= Rs 400
0.01
Payout Ratio = (1-b) = 60% Retention g=br=0.4X0.10=0.04 g=br=0.4X0.08=0.032
Ratio, b = 40%
g=br=0.4X0.15=0.06 10(1-0.4) 10(1-0.4)
10(1-0.4) P= P=
p= 0.10-0.04 0.10-0.032
0.10-0.06
6 6 6
= Rs 150 = Rs 100 = Rs 88
0.04 0.06 0.068
Payout Ratio = (1=b) = 90% , g=br= 0.10X0.10= 0.01 g=br=0.10X0.08=0.008
Retention Ratio, b =10%
g=br=0.10X0.15= 0.015 10(1-0.1) 10(1-0.1)
P = P =
10(1-0.1) 0.10-0.01 0.10-0.008
P=
0.10-0.015 9 9
= Rs 100 = Rs 98
9 0.09 0.092
= Rs 106
0.085
It is revealed that under Gordon’s model:
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• The market value of the share, P0, increases with the retention ratio, b, for
firms with growth opportunities, i.e. when r>k.
• The market value of the share, P0, increases with the payout ratio, (1-b),
for declining firms with r<k.
• The market value of the share is not affected by dividend policy when r=k.
Gordon’s model’s conclusions about dividend policy are similar to that of

Walter’s model. This similarity is due to the similarities of assumptions which
underlie both the models. Thus the Gordon model suffers from the same
limitations as the Walter model.
• DIVIDENDS AND UNCERTAINTY: THE BIRD-IN-THE HAND ARGUMENT
According to Gordon’s model, dividend policy is irrelevant where r=k, when all
other assumptions are held valid. But when the simplifying assumptions are
modified to conform more closely with reality, Gordon concludes that dividend
policy does affect the value of a share even when r=k. This view is based on the
assumption that under conditions of uncertainty, investors tend to discount
distant dividends (capital gains) at a higher rate than they discount near
dividends. Investors, behaving rationally, are risk-averse and, therefore, have a
preference for near dividends to future dividends. The logic underlying the
dividend effect on the share value can be described as the bird-in-the-hand
argument. The bird-in-the hand argument was put forward, first of all by
Kirshman in the following words:
Of two stocks with identical earnings record, and prospects but the one paying a
larger dividend that the other, the former will undoubtedly command a higher
price merely because stockholders prefer present to future values. Myopic vision
plays a part in the price-making process. Stockholders often act upon the
principle that a bird in the hand is worth two in the bush and for this reason are
willing to pay a premium for the stock with the higher dividend rate, just as they
discount the one with the lower rate.1
1. Krishman, Johan, E., Principles of Investment. McGraw Hill, 1933, p. 737; cf.
in Mao J.C.T., Quantitative Analysis of Financial Decision, Macmillan, 1969.
Where Pb is the price of the share when the retention rate b is positive i.e., b>0.
The value of Pb calculated in this way can be determined by discounting this
dividend stream at the uniform rate, k.
Iz the weighted average of Kt:1
DIV0(1+g) DIV0(1+g)2 DIV0((1+g)t

Po = + +……..+
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(1+kt) (1+kl)2 (1+kl)t
DIVl (1-b) EPSl

= =
kl – g kl - br
Assuming that the firm’s rate of return equals the discount rate, will Pb be
higher or lower than P0? Gordon’s View, as explained above, it that the increase
in earnings retention will result in a lower value of share. To emphasise, he
reached this conclusion through two assumptions regarding investor’s behaviour:
(i) investors are risk averters and (ii) they consider distant dividends as less
certain than near dividends. On the basis of these assumptions, Gordon
concludes that the rate at which an investor discounts his dividend stream from a
given firm increases with the futurity of this dividend stream. If investors discount
distant dividend at a higher rate than near dividends, increasing the retention
ratio has the effect of raising the average discount rate, K, or equivalently
lowering share prices.
Thus, incorporating uncertainty into his model, Gordon concludes that

dividend policy affects the value of the share. His reformulation of the model
justifies the behaviour of investors who value a rupee of dividend income more
than a rupee of capital gains income. These investors prefer dividend above
capital gains because dividends are easier to predict, are less uncertain and less
risky, and are therefore, discounted with a lower discount rate.2 However all do
not agree with this view.
• DIVIDEND IRRELEVANCE: MODIGLIANI AND MILLER’S HYPOTHESIS
According to Modigliani and Miller (M-M) under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect the value of the firm. 3
They argue that the value of the firm depends on the firm’s earnings which result
from its investment policy. Thus, when investment decision of the firm is given,
dividend decision the split of earnings between dividends and retained earnings
is of no significance in determining the value of the firm.
A firm, operating in perfect capital market conditions, may face one of the
following three situations regarding the payment of dividends:
• The firm has sufficient cash to pay dividends.

• The firm does not have sufficient cash to pay dividends, and therefore, it
issues new shares to finance the payment of dividends.
• The firm does not pay dividends, but a shareholder needs cash.
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1. Mao, James C.T., Quantitative Analysis of Financial Decision, Macmillan.

1969, p. 482.
2. Francis, op. cit., p.354.
3. Merton H. Miller and France Modigliani, Dividend Policy, Growth and
Valuation of the Shares, Journal of business XXIV (October 1961), pp.
411-433.
In the first situation, when the firm pays dividends, shareholders get cash in
their hand, but the firm’s assets reduce (its cash balance declines). What
shareholders gain in the form of cash dividends, they lose in the form of their
claims on the (reduced) assets. Thus, there is a transfer of wealth from
shareholder’s one pocket to their another pocket. There is no net gain or loss.
Since it is a fair transaction under perfect capital market conditions, the value of
the firm will remain unaffected.
In the second situation, when the firm issues new shares to finance the
payment of dividends, two transactions take place. First, the existing
shareholders get cash in the form of dividends, but they suffer an equal amount
of capital loss since the value of their claim on assets reduces. Thus, the wealth
of shareholders does not change. second, the new shareholders part with their
cash to the company in exchange for new shares at a fair price per share. The
fair price per share is share price before the payment of dividends less dividend
per share to the existing shareholders. The existing shareholders transfer a part
of their claim(in the form of new shares) to the new shareholders in exchange for
cash. There is no net gain or loss. Both transactions are fair, and thus, the value
of the firm will remain unaltered after these transactions.
In the third situation, if the firm does not pay any dividend a shareholder
can create a “home-made dividend” by selling a part of his/her shares at the
market (fair) price in the capital market for obtaining cash. The shareholder will
have less number of shares. He or she has exchanged a part of his claim on the
firm to a new shareholder for cash. The net effect is the same as in the case of
the second situation. The transaction is a fair transaction is a fair transaction, and
no one loses or gains. the value of the firm remains the same, before or after
these transactions. consider the example in illustration 20.3.
ILLUSTRATION 20.3 The Himgir Manufacturing Company Limited currently has

2 crore outstanding shares selling at a market price of Rs 100 per share. The firm
has no borrowing. It has internal funds available to make a capital expenditure
(capex) of Rs 30 crores. The capex is expected to yield a positive net present
value of Rs 20 crore. The firm also wants to pay a dividend per share of Rs 15.
Given the firm’s capex plan and its policy of zero borrowing, the firm will have to
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issue new shares to finance payment of dividends to its shareholders. How will
the firm’s value be affected (i) if it does not pay any dividend; (ii) if it pays
dividend per share Rs 15?
The firm’s current value is: 2X100= Rs200 crore. After the capex, the
value will increases to:200+20= Rs220 crore. If the firm does not pay dividends,
the value per share will be: 220/2 = Rs 110.
If the firm pays a dividend of Rs 15 per share, it will entirely utilize its
internal funds (15X2=Rs 30 crores), and it will have to raise Rs 30 crore by
issuing new shares to undertake capex. The value of a share after paying
dividend will be: 110-15= Rs 95. Thus, the existing shareholders get cash of Rs
15 per share in the form of dividends, but incur a capital loss of Rs 15 in the form
of reduce share value. They neither gain nor lose. The firm will have to issue: 30
crores/95= 31,57,895 (about 31.6 lakh) share to raise Rs 30 crore. The firm now
has 2.316 crore shares at Rs 95 each share. Thus, the value of the firm remains
as: 2.316X95 = Rs 220 Crore.
The crux of the M-M dividend hypothesis, as explained above, is that

shareholders do not necessarily depend on dividends for obtaining cash. In the
absence of taxes, flotation costs and difficulties in selling shares, they can bet
cash by devising “home-made dividend” without any dilution in their wealth.
Therefore, firms paying high dividends (i.e. high-payout firms) need not
command higher prices for their shares. A formal explanation of the M-M
hypothesis is given in the following pages.
M-M’s hypothesis of irrelevance is based on the following assumptions:1
• Perfect capital markets The firm operates in perfect capital markets

where investors behave rationally, information is freely available to all and
transactions and flotation costs do not exist. Perfect capital markets also
imply that no investor is large enough to affect the market price of a share.
• No taxes Taxes do not exist,: or there are no differences in the tax rates
applicable to capital gains and dividends. This means that investors value
a rupee of dividend as much as a rupee of capital gains.
• Investment policy given The firm has a fixed investment policy.
• No risk Risk of uncertainty foes not exist. That is, investors are able to
forecast future prices and dividends with certainty, and one discount rate
is appropriate for all securities and all time periods. Thus, r=k=kt for all t.
Under the M-M assumptions, r will be equal to the discount rate, k and
identical for all shares. As a result, the price of each share must adjust so that
the rate of return, which is composed of the rate of dividends and capital gains,
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on every share will be equal to the discount rate and be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated as
follows:
Dividends + Capital gains (or loss)
r=
Share price
(13)
DIV1 + (P1 –Po)
r=
Po
Where P0 is the market or purchase price per share at time 0, P1 is the market
price per share at time 1 and DIV1 is dividend per share at time 1. As
hypothesized by M-M, r should be equal for all shares. If it is not so, the low-
return yielding shares will be sold by investors who will purchase the high return
yielding share. This process will tend to reduce the price of the low-return shares
and increase the prices of the high-return shares. This switching or arbitrage will
continue until the differentials in rates of return are eliminated. The discount rate
will also be equal for all firms under the M-M assumptions since there are no risk
differences.
From M-M’s fundamental principle of valuation described by Equation

(13), we can derive their valuation model model as follows:
DIV1 + (P1 –Po)

r=
Po
DIV1+P1 DIV1+P1
Po = =
(1+r) (1+k)
(14)
Since r=K in the assumed world of certainty and perfect markets. Multiplying both
sides of equation (14) by the number of shares outstanding. n, we obtain the total
value of the firm if no new financing exists:
nDIV1+P1)
V = nPo =
(1+k) (15)
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If the firm sells m number of new share at time 1 at a price of P1, the value
of the firm at time 0 will be:
n(DIV1+ P1) + mPl - mPl
nPo =
(1+k)
(16)
M-M’ s valuation Equation (16) allows for the issue of new shares, unlike
Walter’s and Gordon’s models. Consequently, a firm can pay dividends and raise
funds to undertake the optimum investment policy (as explained in figure 20.1).
Thus, dividend and investment policies are not confounded in the M-M model,
like Walter’s and Gordon’s models. As such, M-M’s model yields more general
conclusions.
The investment programmes of a firm, in a given period of time, can be

financed either by retained earnings or the issue of new shares or both thus, the
amount of new shares issued will be:
mP1=I1-(X1-nDIV1)=I1-X1+nDIV1
(17)
where I1 represents the total amount of investment during first period and
X1 is the total net profit of the firm during first period.
By substituting Equation (17) into Equation (16), M-M showed that the
value of the firm is unaffected by its dividend policy, thus,
nDIV1 + Pl) + mPl - mPl

nPo =
(1+k)
nDIVl + (n+m) Pl – (Il – Xl + nDIVl)

=
(1+k)
(n+m) Pl – Il + Xl
=
(1+k) (18)
A firm which pays dividends will have to raise funds externally to finance it
investment plans. M-M’s argument, that dividend policy does not affect the
wealth of the shareholders, implies that when the firm pays dividends, its
advantage is offset by external financing. This means that the terminal value of
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the share (say, price of the share at first period if the holding period is one year)
declines when dividends are paid. Thus, the wealth of the shareholders dividends
plus terminal price-remains unchanged. As a result, the present value per share
after dividends and external financing is equal to the present value per share
before the payment of dividends. Thus, the shareholders are indifferent between
payment of dividends and retention of earnings.
ILLUSTRATION 20.4 The Vikas Engineering Ltd. Co., currently has 1,00,000
outstanding shares selling at Rs 100 each. The firm has net profits of Rs
10,00,000 and wants to make new investments of Rs 20,00,000 during the period
the firm is also thinking of declaring a dividend of Rs 5 per share at the end of the
current fiscal year. The firm’s opportunity cost of capital is 10 per cent. What will
be the price of the share at the end of the year if (i) a dividend is not declared, (ii)
a dividend is declared, (iii) How many new shares must be issued?
The price of the share at the end of the current fiscal year is determined as
follows:
DIVl + Pl
Po =
(1+k)
The value of P when dividend is not paid is:

Pl = Rs100(1.10)-0=Rs110
When dividend is paid it is:
Pl = Rs 100(1.10)-Rs 5 = Rs 105
In can be observed that whether dividend is paid or not the wealth of
shareholders remains the same. When the dividend is not paid the shareholder
will get Rs 110 by way of the price per share at the end of the current fiscal year.
On the other hand, when dividend is paid, the shareholder will realise Rs 105 by
way of the price per share at the end of the current fiscal year plus Rs as
dividend.
The number of new shares to be issued by the company to finance its

investments is determined as follows:
mPl = I – (X-nDIVl)
105m = 20,00,000 – (10,00,000-5,00,000)
105m = 15,00,000
m = 15,00,000/ 105= 14,285 shares
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RELEVANCE, OF DIVIDEND POLICY:MARKET IMPERFECTIONS
M-M hypothesis of dividend irrelevance is based on simplifying assumptions as

discussed in the preceding section. Under these assumptions, the conclusion
derived by them is logically consistent and intuitively appealing. But the
assumptions underlying M-M’s hypothesis may not always be found valid in
practice. For example. We may not find capital markets to be perfect in reality;
there may exist issue costs; dividends may be taxed differently than capital
gains; investors may encounter difficulties in selling their shares. Because of the
unrealistic nature of the assumptions, M-M’s hypothesis is alleged to lack
practical relevance. This suggests that internal financing and external financing
are not equivalent. Dividend policy of the firm may affect the perception of
shareholders and, therefore, they may not remain indifferent between dividends
and capital gains. The following are the situations where the M-M hypothesis
may go wrong.
Tax Differential: Low Payout Clientele
M-M’s assumption that taxes do not exist is far from reality. Investors have to pay
taxes on dividends and capital gains. But different tax rates are applicable to
dividends and capital gains. Dividends are generally treated as the ordinary
income, while capital gains are specially treated for tax
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Financial Management

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Disha Institute of IT & Management

Meaning of Financial Management:-

Financial Management is such a managerial process which is concerned with the

Finance is such a powerful source that it performs an important role to operate

(1) Public finance.

means procurement and management of funds by individuals and private

A firm secures whatever capital it needs and employs it (finance activity) in

Real and financial Assets:-

Funds applied to assets by the firm are called capital expenditure or

EQUITY AND BORROWED FUNDS:-

A firm sells shares to acquire equity funds. Shares represent ownership

Another important source of securing capital is creditors or lenders.

debenture is a certificate acknowledging the money lent by a bond holder to the

FINANCE AND OTHER MANAGEMENT FUNCTIONS:-

There exists an inseperable relationship between finance on the one hand

A company in tight financial position will of course, give more weight to

OBJECTIVES OF FINANCIAL MANAGEMENT:-

It is the duty of management to clarify the objectives of business so that

(A) Profit maximisation Approach.

(A) PROFIT MAXIMISATION APPROACH:-

According to this approach, a firm should undertake all those activities

(i) Profit is a yardstick of efficiency on the basis of which economic

However this approach has been criticised on various counts:-

(2) Time Value of Money

YEAR PROJECT1 PROJECT2

Both the projects have a total earnings of Rs 20,000 in 3 years and

(3) Risk Factor:-

This approach ignores risk factor. The certainity or uncertainity of income

B Wealth Maximisation Approach

Value Maximisation Approach or Maximum net present worth.

According to this approach , financial management should take such

As the value of an asset is considered from view point of profit accruing

Where W = Net present worth.

A, A2--- An= Stream of expected cash benefits from a course of action

K = Discount rate to measure risk & timing.

If W is positive, the decision should be taken & vice versa.

This approach is considered good for the companies in present situation.

On the basis of above explanation, we can conclude that wealth

Finance is also related to law. Any decision regarding financial policy

Organisation of Finance Function

The organisation of finance function implies the division and classification

Although in case of companies, the main responsibility to perform finance

which is known as Director Finance, Chief Financial Controller, Financial Manger

The organisation of finance function is not similar in all businesses but it is

Managing Directing Finance Committee

Production Personnel Financial Marketing

Banking Cash Credit Assets Securities

Corporate Annual Internal Planning & Statistics

Treasurer performs the functions of procurement of essential funds, their

general accounting, cost accounting, auditing, budget, reporting and preparing

Functions of the Chief Financial Manager.

Chief Financial manager is the top officer of finance department. In

(1) Financial Planning :- He determines the capital structure and

(2) Procurement of Funds:- Financial manager makes the necessary

(3) Co-ordination:- Financial manager establishes co-ordination among

(4) Control:- Financial manager examines whether the work is being

(5) Business Forecasting:- Financial manager evaluates the effects of

(6) Miscellaneous Functions:- It includes the management of assets,

The following are the functions of treasurer.

(1) Provisions of finance:- It includes the estimation of funds necessary

(2) Banking Function:- It includes opening bank accounts, depositing

(3) Custody:- The treasurer is the custodian of funds and securities.

(5) Investments: It involves the investment of surplus funds.