MRCET MBA
Digital
Notes
Financial
Management
R20
MBA12
MBA
I
Year
II
Semester
AY
2020
-
22
MRCET MBA
Course Aim/s:
To give an overview of the problems facing a financial
manager in the commercial
world.
It will introduce the concepts and theories of corporate finance that underlie the
techniques that are offered as aids for the understanding, evaluation and resolution of
financial manager’s problems.
Learning Outcome/s:
Pr
ovides support for decision making.
It enables to monitor their decisions for any potential financial implications and for
Lessons to be learned from experience and to adapt or react as needed.
To ensure the availability of timely, relevant and reliable fi
nancial and nonfinancial
Information. FM helps in understanding the use of resources efficiently, effectively and
economically.
Unit
-
I: The Finance Function
Introduction to Finance: Nature and Scope
-
Finance Function
-
It’s Role in the Contemporary
Scena
rio
-
Goals of Finance Function
-
Maximizing vs. Satisfying
-
Profit vs. Wealth vs. Welfare
-
The Agency Relationship and Costs
-
Risk
-
Return Trade Off.
Time Value of Money: Concept
-
Future Value and Present Value and the Basic Valuation Model.
Unit
-
II:
The Investment Decision
Investment Decision Process: Project Generation
-
Project Evaluation
-
Project Selection and Project
Implementation
-
Developing Cash Flows
-
Data for New Projects.
Capital Budgeting Techniques: Traditional and DCF methods
-
The N
PV vs. IRR Debate. (Theory &
Problems)
Cost of Capital: Concept and Measurement of Cost of Capital
-
Debt vs. Equity
-
Cost of Equity
-
Preference Shares
-
Equity Capital and Retained Earnings
-
Weighted Average Cost of Capital and
Marginal Cost of
Capital (Theory & Problems)
-
Importance of Cost of Capital in Capital Budgeting
Decisions.
Unit
-
III: Capital Structure Decisions
Capital Structure vs. Financial Structure: Capitalization
-
Financial Leverage
-
Operating Leverage
and Composite Leverage. (
Theory & Problems)
EBIT
-
EPS Analysis: Indifference Point/Break
-
Even Analysis of Financial Leverage.
Capital Structure Theories: The Modigliani Miller Theory
-
Net Income
-
Net Operating Income
Theory and Traditional Theory (Theory & Problems)
-
A Critica
l Appraisal.
Unit
-
IV: Dividend Decisions
Major Forms of Dividends: Cash and Bonus Shares.
Dividends and Value of the Firm: Relevance of Dividends
-
The MM Hypothesis
-
Factors
Determining Dividend Policy
-
Dividends and Valuation of the Firm
-
The Basic
Models.
Dividend Theories: Major Theories centred on the works of GORDON, WALTER and LITNER.
(Theory & Problems)
Unit
-
V: Management of Current Assets
Working Capital Management: Components of Working Capital
-
Gross vs. Net Working Capital
-
Determinants of Working Capital Needs
-
The Operating Cycle Approach
-
Planning of Working
Capital
-
Financing of Working Capital through Bank Finance and Trade Cre
dit;
Management of Cash: Basic Strategies for Cash Management
-
Cash Budget (Problems)
-
Cash
Management Techniques/Processes;
Management of Receivables & Inventory.
MRCET MBA
REFERENCES:
IM Pandey, Financial Management, 10th Edition, Vikas.
M.Y Khan, P K Jain: “Financial Management
-
Text and Problems”, 6th Edition, TMH.
Prasanna Chandra, “Financial Management Theory and Practice”, 8th Edition, TMH.
Shashi K. Gupta, R. K. Sharma, “Financial Management” Kalyani Publishers.
Rajiv Srivastava, An
il Mishra, Financial Management” Oxford University Press, New Delhi.
James C Van Horne, Sanjay Dhamija, “Financial Management and Policy” Pearson
Education.
MRCET MBA
UNIT
1
MEANING
OF
FINANCE
Finance may be defined as the art and
science of managing money. It includes
financial service
and
financial
instruments.
Finance
also
is
referred
as
the
provision
of
money
at
the
time
when
it
is needed. Finance function is the
procurement of funds and their effective utilization in business
concerns
Definition:
According to GUTHMANN and DOUGALL, business finance may be broadly
defined as “the
activity concerned with the planning, raising, controlling and
administering the funds used in the
business.”
Financial decisions refer to decisions co
ncerning financial matters of a business
firm. There are
many kinds of financial management decisions that the firm
makers in pursuit of maximizing
shareholder‟s wealth, viz., kind of assets to be
acquired, pattern of capitalization, distribution of
firm‟s
income
etc.
We
can
classify
these
decisions
into
three
major groups:
Investment
decisions
Financing
decision.
Dividend
decisions.
Working
capital decisions.
NATURE
OF
FINANCE
FUNCTION:
I.
In
most of the organizations, financial operations are centralized.
This
results in
economies.
II.
Finance functions are performed in all business firms, irrespective of
their sizes /
legal
form of
organization.
III.
They
contribute
to
the
survival
and growth of
the firm.
IV.
Finance function is primarily involved with the data analysi
s for use in
decision
making.
V.
Finance
functions
are
concerned
with
the
basic
business
activities
of a
firm,
in
addition to external environmental factors which affect basic
business activities, namely,
production
and marketing.
VI.
Finance
functions
comprise
control
functions
also
VII.
The
central
focus
of finance
function
is
valuation
of
the
firm.
Finance
makes
use
of
economic
tools.
From
Micro
economics
it
uses
theories
and
assumptions.
From
Macro
economics
it
uses
forecasting
models.
Even
though
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finance
is
concerned
with
individual
firm
and
economics
is
concerned
with
forecasting
of an industry.
SCOPE
OF
FINANCIAL
MANAGEMENT:
The main objective of financial management is to arrange sufficient finance for meeting short
term and
long term needs. A financial manager will have to concentrate on the following areas of
finance function.
1.
Estimating
financial
requirements:
The
first
task
of
a
financial
manager
is
to
estimate
short
term
and
long
term
financial
requirements of his busines
s. The amount required for purchasing fixed assets as well as needs
for
working
capital will have
to be ascertained.
2.
Deciding
capital
structure:
Capital structure refers to kind and proportion of different securities for raising funds. After
deciding the q
uantum of funds required it should be decided which type of securities should be
raised.
A
decision about
various
sources
for
funds
should be
linked
to the
cost
of raising
funds.
3.
Selecting a source of finance:
An appropriate source of finance is selected
after preparing a
capital structure which includes share capital, debentures, financial institutions, public deposits
etc.
If
finance
is
needed
for
short
term
periods
then
banks,
public
deposits
and
financial
institutions may be the appropriate. On the oth
er hand, if long term finance is required then share
capital
and debentures may
be
the useful.
4.
Selecting a pattern of investment:
When funds have been procured then a decision about
investment pattern is to be taken. A decision will have to be taken as to
which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an appropriate portion
will
be
retained for working
capital and for
other requirements.
5.
Proper cash management:
Cash management is an important task of finance
manager. He
has to assess various cash needs at different times and then make arrangements for arranging
cash. Cash may be required to purchase of raw materials, make payments to creditors, meet wage
bills and meet day to day expenses. The idle cash with
the business will mean that it is not
properly
used.
6.
Implementing financial controls:
An efficient system of financial management necessitates
the
use
of
various
control
devices.
They
are
ROI,
break
even
analysis,
cost
control,
ratio
analysis,
cost
and
int
ernal
audit.
ROI
is
the
best
control
device
in
order
to
evaluate
the
performance
of various financial policies.
7.
Proper use of surpluses:
The utilization of profits or surpluses is also an important factor in
financial management. A judicious use of
surpluses is essential for expansion and diversification
plans and also in protecting the interests of share holders. A balance should be struck in using
funds
for
paying
dividend and retaining
earnings for
financing
expansion
plans.
MRCET MBA
EVOLUTION
OF
FINANCE
FUNCTION:
Financial management came into existence as a separate field of study from finance
function in
the early stages of 20
th
century. The evolution of financial management can be
separated
into
three
stages:
1.
Traditional
stage
(Finance
up
to
1940):
The
traditional
stage
of
financial
management
continued
till four decades.
Some of
the
important characteristics of
this stage
are:
i)
In
this
stage,
financial
management
mainly
focuses
on
specific
events
like
formation
expansion,
merger and liquidation of
the
firm.
ii)
The
techniques
and
methods
used
in
financial
management
are
mainly
illustrated
and
in
an organized manner.
iii)
The
essence
of
financial
management
was
based
on
principles
and
policies
used
in
capital
market,
equipments
of financing
and
lawful matters
of
financial events.
iv)
Financial
management
was
observed
mainly
from
the
prospective
of
investment
bankers,
lenders and others.
2.
Transactional stage (After 1940):
The transactional stage started in the beginning years of
1940‟s and continued till the
beginning of 1950‟s. The features of this stage were similar to the
traditional stage. But this stage mainly focused on the routine problems of financial managers in
the
field
of
funds
analysis,
planning
and
control.
In
this
stage,
the
essence
of
financial
management
was transferred
to working
capital management.
3.
Modern stage (After 1950):
The modern stage started in the middle of 1950‟s and observed
tremendous change in the development of financial management with the ideas from economic
theory and impleme
ntation of quantitative methods of analysis. Some unique characteristics of
modern
stage
are:
i)
The main focus of financial management was on proper utilization of funds so that
wealth
of current share
holders can be
maximized.
ii)
The techniques and methods
used in modern stage of financial management were
analytical
and quantitative.
Since
the
starting
of
modern
stage
of
financial
management
many
important
developments took place. Some of them are in the fields of capital budgeting, valuation models,
dividen
d
policy, option pricing
theory, behavioral
finance etc.
ROLE
OF
FINANCIAL
MANAGEMENT
IN
CONTEMPORARY
SCENARIO:
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GOALS
OF
FINANCE FUNCTION
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business
concern. It is the essential part of the financial manager. Hence, the financial manager
must
determine
the
basic
objectives
of
the
financial
management.
Objectives
of
Financial
Management may
be
broadly
divided into two parts such as:
1.
Profit
maximization
2.
Wealth
maximization.
1
.Profit
Maximization
Main aim of any kind of economic activity is earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow
approach, which aims at, maximizing the profit of the concern. Profit maximization
consists
of the
following
important features.
1.
Profit
maximization
is
also
called
as
cashing
per
share
maximization.
It
leads
to
maximize
the business operation for profit ma
ximization.
2.
Ultimate
aim
of
the
business
concern
is
earning
profit,
hence,
it
considers
all
the
possible
ways
to increase
the profitability
of the
concern.
3.
Profit
is
the
parameter
of
measuring
the
efficiency
of
the
business
concern.
So
it
shows
the
entire
position of
the
business concern.
4.
Profit
maximization
objectives
help
to
reduce
the risk
of
the
business.
Unfavorable
Arguments
and
Drawbacks
for
Profit
Maximization
The
following
important
points
are
against
the
objectives
of
profit
maximization:
(i)
Profit
maximization
leads
to
exploiting
workers and
consumers.
(ii)
Profit
maximization
creates
immoral
practices
such
as
corrupt
practice,
unfair
trade
practice,
etc.
(iii)
Profit
maximization
objectives
leads
to
inequalities
among the
stake
holders
such
as
customers,
suppliers, public
shareholders,
etc.
Profit
maximization
objective
consists
of
certain
drawback
also:
MRCET MBA
(i)
It is vague:
In this objective, profit is not defined precisely or correctly. It creates
some
unnecessary
opinion regarding
earning
habits o
f the
business concern.
(ii)
It ignores the time value of money:
Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It leads certain differences
between
the
actual
cash inflow
and net present
cash flow
during
a
particular
period.
(iii)
It ignores risk:
Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the business
concern.
Wealth
Maximization
Wealth maximization is
one of the modern approaches. The term wealth means shareholder
wealth or the wealth of the persons those who are involved in the business concern. Wealth
maximization is also known as value maximization or net present worth maximization. This
objective
is
an universally
accepted concept in the
field of
business .
Stockholder‟s
current
wealth
in
a
firm
=
(Number
of
shares
owned)
x(Current
Stock
Price
share)
Favorable
Arguments
for
Wealth
Maximization
(i)
Wealth
maximization
is
superior
to
the
profit
maximization
because
the
main
aim
of the business concern under this concept is to improve the value or wealth of the
shareholders.
(ii)
Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected
from the total cost incurred for the
business
operation.
It
provides extract value
of the business
concern.
(iii)
Wealth
maximization
considers
both
time
and
risk
of
the
business
concern.
(iv)Wealth
maximization provides efficient
allocation
of
resources.
(v)
It
ensures
the economic
interest
of
the
society.
Unfavorable
Arguments
for
Wealth
Maximization
(i)
Wealth
maximization
leads
to
prescriptive
idea
of
the
business
concern
but
it
may
not
be
suitable to present day
business activities.
(ii)
Wealth
maximization
creates
ownership
-
management
controversy.
(iii)
Management
alone
enjoy
certain benefits.
(iv)
The
ultimate
aim
of
the
wealth
maximization
objectives
is
to
maximize
the
profit.
(v)
Wealth
maximization
can
be
activated
only
with
the
help
of
the
profitable
position
of
the
business
concern.
MAXIMIZING
VS
SATISFYING
As share holders are the real owners of the organization, they appoint managers to take important
decisions with the objective of maximizing share holder‟s wealth. Though organizations have
many more objectives, but
maximizing stock price is considered to be an important objective of
all for
many
firms.
1)
Stock price maximization and social welfare
: It is advantageous for society, if
firm
maximize
its
stock
price.
But,
firm
must
not
have
any
intentions
of
forming
monopo
listic
market,
creating
pollution
and
avoiding
safety
measures.
When
stock
prices
are
maximized, it
benefits society
by:
MRCET MBA
i)
To greater extent the owners of stock are society
:
In past, ownership of stock was
with wealthy people in society. But
now, with the tremendous growth of pension funds,
life
insurance
companies
and
mutual
funds,
large
group
of
people
in
society
have
ownership of stock either directly or indirectly. Hence, when stock price is increased, it
ultimately
improves the
quality
of
life for
many
people in society.
ii)
Consumers benefit:
It is necessary to have effective low
-
cost businesses which
manufacture
good
quality
of
goods
and
services
at
the
cheapest
cost
possible
to
maximize stock price. Companies which are interested in
maximizing stock price must
satisfy all requirements of customers, provide good services and innovate new products
finally; it must increase its sales by creating value for customers. Some people believe
that
firms
increase
the
prices
of
goods
while
maximi
zing
stock
price.
But
it
is
not
true;
in order to survive in competitive market firms does not increase prices otherwise they
may
lose their market share.
iii)
Employees benefit:
In past years, it was an exception that decreases in level of
employees lead to
increase in stock price, but now a successful company which can
increase stock price can develop and recruit more employees which ultimately benefits
the society. Successful companies take advantage of skilled employees and motivated
employees
are
an
important source
of corporate success.
2)
Managerial Actions to Maximize Shareholder’s Wealth:
In order to identify the
steps
taken
by
managers
to
maximize
shareholder‟s
wealth,
the
ability
of
the
organization to generate cash must be known. Cash flows can b
e determined in three
ways, they
are:
i)
Unit Sales:
In first determinant, managers can increase the level of their sales either
by
satisfying
customers
or by
luck,
but which will not continue
in long
run.
ii)
After Tax Operating Margins:
In second determinant, m
anagers can generate cash
flows by increasing operating profit which is not possible in competitive environment or
by
decreasing
direct
expenses.
iii)
Capital Requirements:
In third determinant, managers can increase cash flows by
decreasing
assets requirements
which
ultimately
results in increase
of stock price.
Investment and financing decisions have an impact on level, timing and
risk of the cash flow of firm and finally on stock price. It is necessary for
manager
to make
decisions which
can maximize
the
stoc
k price
of the
firm.
3)
Maximizing
Earnings
Per
Share
is
Beneficent
or
Not:
In
order
to
maximize stock
price, many analyst
focus
on
cash
flows
by evaluating the
performance of the company and also focus of EPS as an accounting measure.
Along
with
cash
flow,
EPS
also
plays
an
important
role
in
identifying
stockholder‟s
value.
MRCET MBA
DIFFERENCE
BETWEEN
PROFIT AND
WEALTH
MAXIMIZATION
Goal
Objective
Advantages
Disadvantages
Profit
Large
amount
of
profits
-
Easy
to
calculate
profits.
-
Emphasizes
the
short
term.
maximization
-
Easy
to
determine
the
link
-
Ignores
risk
oruncertainty.
between
financial
decisions
-
Ignores
the
timing
of
and
profits.
Returns.
-
Requires
immediate
Resources.
Stockholder
Highest
market
value
of
-
Emphasizes
the
long
term.
-
Offers
no
clear
relationship
wealth
common
stock
-
Recognizes
risk
or
between
financial
decisions
maximization
Uncertainty.
and stock
price.
-
Consider
stockholders
-
Can
lead
to
management
return.
anxiety
and
frustration.
MRCET MBA
PROFIT
VS.
WEALTH
VS. WELFARE
S.NO.
PROFITMAXIMIZATION
WEALTH
MAXIMIZATION
WELFARE
MAXIMIZATION
1)
Profit
s
are
earned
Wealth
is
maximized,
so
that
Welfare
maximization is
maximized,
so
that
firm
wealth
of
share
-
holders
can
be
done
with the
help
of micro
can
over
-
come future
risks
maximized.
economic
techniques
to
which
are
uncertain.
examine
a
locative
distribution.
2)
Profit
maximization
is
a
In
wealth
maximization
In
welfare
maximization,
yards
stick
for
calculating
stockholders
current
wealth
is
social
welfare
is
evaluated
efficiency
and
economic
evaluated
in order to maximize
by
calculating
economic
prosperity
of the
concern.
the
value
of
shares
in
the
activities
of
individuals
in
market.
the
society.
3)
Profit
is
measured
in
terms
Wealth
is
measured
in
terms
of
Welfare
can
be
measured
in
of
efficiency
of the
firm.
market
price
of
shares.
two ways, either by
pare to
efficiency
or
in
units
or
dollars.
4)
Profit
maximization
Wealth
maximization
involves
Wealth
maximization
Involves
problem
of
problems
related
to
involves
problem
of
uncertainty
because profits
maximizing
shareholder‟s
combining
the
utilities
of
are
uncertain.
wealth
or
wealth
of the
firm
different
people.
MRCET MBA
AGENCY
RELATIONSHIP
AND
COST:
The relationship that exists in an organization between share holders and management
known as agency relationship. Agency relationship results when a principal
hires an agent
to
perform part of
his duties.
Agency Problem:
In this type of relationship there is a chance of conflicts to occur
between
the principal and
the agent. This
conflict
is termed
as agency
problem.
Agency
Costs:
The
costs
incurred
by
stockholders
in
order
to
minimize
agency
problem
and
maximize
the
owner‟s
wealth
are called
agency
costs.
The
two primary
agency
relationships exists
in a business
concern
are:
1)
Shareholders
Vs Bondholders
2)
Manager Vs
Share
holders
1)
Agency conflict
-
I (Shareholders Vs Bondholders):
Shareholders are the
real owners of the concern, they pay fixed and agreed amount of interest to
bondholders till the duration of bond is finished but bondholders have a
proceeding claim over the assets of t
he company. Since equity investors are
the owners of the company they possess a residual claim on the cash flows of
the company. Bondholders are the only sufferers if decisions of the company
are
not appropriate.
When a company invest in project by taking
amount from bondholders and if the
project is successful, fixed amount is paid to bondholders and rest of the profits are for
shareholders and suppose if project fails then sufferers will be the bondholders as their
money
have
been invested.
2)
Agency
conflict
-
II
(Managers
Vs
Shareholders):
Profits
generated
from
investments in projects can be utilized for reinvestment or provided back to shareholders
as dividends. If dividends are increased, it may leads to decrease in the resources which
are under the manager‟s control and also strict its growth. As managers are evaluated on
the basis of growth they might go for unproductive projects which cannot generate
appropriate
returns, which make the shareholders,
feel shocked. This is the main caus
e
of
conflicts between managers and shareholders.
RISK
RETURN TRADE
-
OFF
The Risk
-
Return Trade
-
Off is an essential concept in finance theory.
Risk implies the changes in expected return like sales, profits or cash flow and it
also
includes probability
that
problem.
Risk analysis is a procedure of calculating and examining the risk which
is
related
to
financial
and
investment
decision
of
the
company.
Finance
managers must focus on expected rate of return by comparing the level of risks
involved in investment
decision. When it is expected that rate of return will be
high
then it involves high
level of
risk and vice
versa.
MRCET MBA
TIME
VALUE
OF
MONEY
AND
MATHEMATICS OF
FINANCE
Concept
We
know that
100 in hand today
is more
valuable than
100
receivable
after
a
year.
We
will
not
part
with
100
now
if
the
same
sum
is
repaid
after
a
year.
But
we
might
part
with
100 now if
we
are
assured that
110
will
be
paid at
the
end
of
the first
year. This
“additional
Compensation”
required
for
parting
100 today, is
called “interest” or “the time value of
money”.
It is
expressed
in terms of percentage
per
annum.
Money
should have
time value
for the
following reasons:
□
Money
can
be employed
productively
to
generate real
returns;
□
In
an
inflationary
period,
a
rupee
today
has
higher
purchasing
power
than
a
rupee
in
the
future;
□
Due
to
uncertainties
in
the
future,
current
consumption
is
preferred
to
future
Consumption.
The
three
determinants
combined
together
can
be
expressed
to
determine
the
rate
of
interest
as follows :
Nominal
or
market
interest
rate
= Real
rate
of
interest
or
return
(+)
Expected
rate
of
inflation
(+)
Risk
premiums
to
compensate
for uncertainty.
Time
Value
of Money
and
mathematics
(1)
Compounding:
We
find
the
Future
Values
(FV)
of
all
the
cash
flows
at
the
end
of
the
time
period
at a
given
rate of
interest.
(2)
Discounting:
We
determine
the
Time
Value
of
Money
at
Time
“O”
by
comparing
the
initial
outflow
with the
sum of
the
Present Values
(PV)
of
the
future
inflows
at a given rate of
interest.
Time Value of
Money
Compounding
Discounting
(Future
Value)
(Present
Value)
(a)
Single
Flow
(a)
Single
Flow
(b)
Multiple
Flows
(b)
Uneven
Multiple Flows
(c)
Annuity
(c) Annuity
MRCET MBA
Future
Value
of a
Single
Flow
It
is
the process
to
determine
the future
value
of
a
lump
sum
amount
invested at
one
point
of
time.
FVn
=
PV
(1+i)
n
Where,FVn
=
Future
value
of
initial
cash
outflow after
n
years
PV
=
Initial
cash
outflow,i
=
Rate
of
Interest
p.a.,n
=
Life
of
the
Investment
and
(1+i)
n
=
Future
Value of
Interest
Factor
(FVIF)
Example
The
fixed
deposit
scheme
of
Punjab
National
Bank
offers the following
interest
rates
:
Period
of
Deposit Rate Per
Annum
46
days
to
179
days
5.0
180
days
<
1
year
5.5
1 year
and
above
6.0
An amount of Rs. 15,000 invested today for 3 years will be compounde
d too :
FVn
=
PV (1+i)
n
=
PV
×
FVIF
(6,
3)
=
PV ×
(1.06)3
=
15,000 (1.191)
=
17,865
Present
Value
of a
Single
Flow:
PV=
FVn
(1
i
)
n
Where, PV = Present Value, FVn = Future Value receivable after n years, i = rate of interest, n =
time
period
Example
Calculate
P.V. of
50,000
receivable
for
3
years
@
10%
P.V.
=
Cash
Flows
×
Annuity
@
10%
for
3
years.
=
50,000 ×
2.4868 =
1,24,340/
-
MRCET MBA
UNIT
2
Investment
Definition:
The term "investment" can be used to refer to any mechanism used for the purpo
se of generating
future income. In the financial sense, this includes the purchase of bonds, stocks or real estate
property. Additionally, the constructed building or other facility used to produce goods can be
seen
as an investment.
Capital
Definition:
The word
Capital
refers
to
be the total investment
of a company money in
,
tangible and
intangible
assets
Investment
decision
is
the
process
of
making
investment
decisions
in
capital
expenditure.
A
capital
expenditure
may be defined as
an expenditure the
benefits
of
which are expected to
be
received over period of time
exceeding
one
year.
The main characteristic of a capital expenditure is that the expenditure is incurred at one point of
time
whereas
benefits of the
expenditure
are
realized
at different
po
ints
of
time
in
future.
Capital
Budgeting
The
process
through
which
different
projects
are
evaluated
is
known
as
capital
budgeting.
Capital budgeting is defined “as the firm‟s formal process for the acquisition and investment of
capital.
It
involves
firm‟s
decisions
to
invest
its
current
funds
for
addition,
disposition,
modification
and replacement of
fixed assets”.
DEFINITION
Capital
budgeting
(investment decision)
as,
“Capital
budgeting
is long
term
Planning
for
making
and
financing
proposed capital
outlays.”
Charles
T.Horngreen
NEED
AND
IMPORTANCE
OF
CAPITAL
BUDGETING
1.
Huge investments:
Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control
its
capital expenditure.
2.
Long
-
term:
Capital
expenditure
is
long
-
term
in
nature
or
permanent
in
nature.
Therefore financial risks involved in
the investment
decision are more.
If
higher risks
are
involved, it needs
careful planning
of capital budgeting.
3.
Irreversible:
The capital investment decisions are irreversible, are not changed back.
Once
the
decision
is
taken
for
purchasing a
permanent
asset,
it
is
very difficult
to
dispose
of those
assets without involving
huge
losses.
MRCET MBA
Identification of
various
investments
Screening or
matching the
available
resources
Evaluation
of
proposals
Implementation
Final
Approval
Fixing
property
4.
Long
-
term effect:
Capital budgeting not only reduces the cost but also increases the
revenue in long
-
term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment. Over investments leads to be
unable to utilize assets or over utilization of fixed assets. Therefore before making the
investment,
it
is required
carefully
planning
and analysis
of the
project thoroughly.
CAPITAL
BUDGETING
PROCESS
Capital budgeting is a complex process as it
involves decisions relating to the investment of
current
funds
for
the
benefit
to
the
achieved
in
future
and
the
future
is
always
uncertain.
However
the
following
procedure
may
be
adopted
in
the
process of
capital
budgeting:
PROJECT
GENERATION
1.
Identification
of
Investment
Proposals:
The proposal
or the idea about potential investment opportunities may originate
from the top management or may come from the rank and file worker of any department
or
from any
officer of
the
organization.
2.
Screening
the
Proposals:
The expenditure planning committee
screens the various proposals received from
different
departments.
The
committee
views
these
proposals
from
various
angels
to
MRCET MBA
ensure that these are in accordance with the corporate strategies or a selection criterion‟s
of
the firm and also do
not lead
to departmental imbalances.
PROJECT
EVALUATION
3.
Evaluation
of
Various
Proposals:
The next step in the capital budgeting process is to evaluate the profitability of
various proposals. There are many
methods which may be used for this purpose such as
payback period method, rate of return method, net present value method, internal rate of
return
method etc.
PROJECT
SELECTION
4.
Fixing
Priorities:
After evaluating various proposals, the unprofitable or une
conomic proposals
may
be
rejected
straight
ways.
But
it
may
not
be
possible
for
the
firm
to
invest
immediately in all the acceptable proposals due to limitation of funds. Hence, it is very
essential
to
rank
the
various
proposals
and
to
establish
priorities
after
considering
urgency,
risk
and profitability
involved therein.
5.
Final
Approval
and
Preparation
of Capital
Expenditure
Budget:
Proposals meeting the evaluation and other criteria are finally approved to be
included
in the
Capital expenditure
budget.
PROJECT
EXECUTION
6.
Implementing
Proposal:
Preparation of a capital expenditure budgeting and incorporation of a particular
proposal in the budget does not itself authorize to go ahead with the implementation of
the project. A request for authority to spend
the amount should further be made to the
Capital
Expenditure
Committee.
Further, while implementing the project, it is better to assign responsibilities for
completing
the
project
within
the
given
time
frame
and
cost
limit
so
as
to
avoid
unnecessary
delays
and cost over runs by
applying
Network
techniques PERT and CPM.
7.
Performance
Review:
The last stage in the process of capital budgeting is the evaluation of the performance of
the project. The evaluation is made through post completion audit by way of co
mparison
of actual expenditure of the project with the budgeted one, and also by comparing the
actual return from the investment with the anticipated return. The unfavorable variances,
if any should be looked into and the causes of the same are identified
so that corrective
action may
be
taken in future.
MRCET MBA
DEVOLOPING
CAH
FLOW
DATA
(cash
inflow and
cash
outflow)
The process of cash flow estimation is problematic because it is difficult to
accurately forecast the costs and revenues associated with
large, complex projects that
are expected to affect operations for long periods of time. Forecasting project cash
inflows
involves numerous variables and many
participants in this exercise.
Capital
outlays
are
estimated
by
engineering
and
product
development
departments, revenue projections are provided by marketing group and operational cost
are
estimated
by
production
people,
cost
accountants,
purchase
managers,
personal
executives,
and
tax
experts and so on.
Calculation
of
cash
inflow
Sales
xxxx
Less:
Cash
expenses
xxxx
PBDT
xxxx
Less:
Depreciation
xxxx
PBT
xxxx
less:
Tax
xxxx
PAT
xxxx
Add:
Depreciation
xxxx
Cash
inflow
p.a
xxxx
Calculation
of
cash
outflow
Cost
of project/asset
xxxx
Transportation/installation
charges
xxxx
Working
capital
xxxx
Cash
outflow
xxxx
PROJECT
EVALUATION
TECHNIQUES
(OR)
CAPITAL
BUDGETING
TECHNIQUES
There
are
many
methods
of
evaluating
profitability
of
capital
investment
proposals.
The
various
commonly
used
methods
are
as
follows:
(A)
Traditional
methods:
(1)
Pay
-
back Period
Method or Pay
out
or Pay
off
Method.
MRCET MBA
Traditional
methods
Pay
-
back
Period
Method
post
payback
method
Accounting
or
Average
Rate
of
Return
Method
Discounted
methods
Net
Present
Value
Method
Internal
Rate
of
Return
Method
Profitability
Index
Method
(2)
Improvement
of
Traditional
Approach
to
pay
back
Period
Method.(post
payback
method)
(3)
Accounting
or
Average Rate of
Return
Method.
(B)
Time
-
adjusted
method
or
discounted
methods:
(4)
Net
Present Value
Method.
(5)
Internal
Rate
of
Return Method.
(6)
Profitability
Index Method.
(A)
TRADITIONAL
METHODS:
1.
PAY
-
BACK
PERIOD
ETHOD
The „pay back‟ sometimes called as pay out or pay off period method represents the period in
which the total investment in permanent assets pays back
itself. This method is based on the
principle
that
every capital
expenditure
pays
itself
back
within
a
certain
period
out
of
the
additional
earnings
generated from the
capital assets.
ACCEPT
/REJECT
CRITERIA
Under this method, various investments are
ranked according to the length of their payback
period in such a manner that the investment within a shorter payback period is preferred to the
one which has longer pay back period. (It is one of the non
-
discounted cash flow methods of
capital
budgeting).
MRCET MBA
MERITS
The
following
are
the
important merits
of
the pay
-
back
method:
1.
It
is
easy
to
calculate
and
simple
to
understand.
2.
Pay
-
back
method
provides
further
improvement
over
the
accounting
rate return.
3.
Pay
-
back
method
reduces the possibility
of
loss on account of
obsolescence.
DEMERITS
1.
It
ignores
the
time
value of
money.
2.
It
ignores
all
cash
inflows after
the
pay
-
back
period.
3.
It
is
one
of
the
misleading
evaluations
of
capital
budgeting.
AVERAGE
RATE
OF
RETURN:
This
method takes into account the earnings expected from the investment over their
whole life. It is known as accounting rate of return method for the reason that under this
method, the Accounting concept of profit (net profit after tax and depreciation) is us
ed
rather
than
cash inflows.
ACCEPT
/REJECT
CRITERIA
According to this method, various projects are ranked in order of the rate of earnings or
rate of return. The project with the higher rate of return is selected as compared to the
one with lower rate of
return. This method can also be used to make decision as to
accepting or rejecting a proposal. Average rate of return means the average rate of return
or
profit taken for considering.
2.
Average Rate
of Return
Method
(ARR):
Under this method average
profit after tax and depreciation is calculated and then it
is divided by the total capital outlay or total investment in the project. The project
evaluation.
This method is one
of the
traditional
methods for
evaluating
The
project
proposals
PAY
BACK
PERIOD
=
INITIAL
INVESTMENT
/
ANNUAL
CASH
INFLOWS
ARR
=
(Total
profits
(after
dep
&
taxes))/
(Net
Investment
in
the
project
X
No.
of
years of
profits) x
100
OR
ARR
=
(Average
Annual
profits)/
(Net
investment
in
the
project)
x
100
MRCET MBA
Average
Return
on
Average
Investment
=
(Average
Annual
Profit
after
depreciation
and
taxes)/ (Average
Investment)
x
100
NPV
=
Total
Present
value
of cash
inflows
–
Net
Investment
(
b)
Average
Return
on
Average
Investment Method:
This is the most
appropriate method of rate of return on investment Under this
method, average profit after depreciation and taxes is divided by the average amount of
investment; thus:
Merits
1.
It
is
easy
to
calculate
and
simple
to
understand.
2.
It
is
based on
the
accounting
information
rather
than
cash
inflow.
3.
It
is not
based on
the time
value of
money.
4.
It
considers
the
total
benefits
associated
with
the
project.
Demerits
1.
It
ignores
the
time
value of
money.
2.
It
ignores
the
reinvestment
potential
of
a
project.
3.
Different
methods
are
used
for
accounting
profit.
So,
it
leads
to
some
difficulties
in
the
calculation of
the project.
(B)
TIME
–
ADJUSTED
OR
DISCOUNTED
CASH
FLOW
METHODS:
or
MODERN
METHOD
The
traditional
methods
of
capital
budgeting
i.e.
pay
-
back
method
as
well
as
accounting rate of return method, suffer from the serious limitations that give equal
weight
to
present
and
future
flow
of
incomes.
These
methods
do
not
take
into
consideration the time value of money, the fact that a rupee earned today has more value
than
a
rupee
earned
after
five years.
1.
NET
PRESENT
VALUE
Net present value method is one of the modern methods for
evaluating the project
proposals. In this method cash inflows are considered with the time value of the money.
Net present value describes as the summation of the present value of cash inflow and
present value of cash outflow. Net present value is the difference between the tot
al
present
values
of future
cash
inflows and
the
total
present
value
of future
cash
outflows.
MRCET MBA
Present
value
of
$7000to
be
received
in
two
years
=
$ 7000/(1+0.10)
2
=
$5785.12
If offered an investment that costs $5,000 today and promises to pay you $7,000
two
years from today and if your opportunity cost for projects of similar risk is 10%, would
you
make
this investment?
You
Need to compare your $5,000 investment with the $7,000 cash flow you expect in two
years. Because you feel that a discount rate of 10
% reflects the degree of uncertainty
associated
with the $7,000 expected in two
years, today
it is worth:
By investing $5,000 today, you are getting in return a promise of
a cash flow in the
future that is worth $5,785.12 today. You increase your wealth by $785.12 when you
make
this
investment.
Accept/Reject
criteria
If the present value of cash inflows is more than the present value of cash outflows, it
would
be
accepted.
If
not, it would be
rejected.
Merits
1.
It
recognizes
the
time
value
of
money.
2.
It
considers the
total benefits arising
out of
the
proposal.
3.
It
is
the
best method
for
the
selection
of
mutually
exclusive
projects.
4.
It
helps
to
achieve
the
maximization
of
shareholders‟
wealth.
Demerits
1.
It
is
difficult
to
understand
and calculate.
2.
It
needs the
discount factors
for
calculation
of
present
values.
3.
It
is
not
suitable
for
the
projects
having
different
effective
lives.
2.
INTERNAL
RATE
OF RETURN
METHOD
This method
is popularly known as time adjusted rate of return method/discounted rate
of return method also. The internal rate of return is defined as the interest rate that
equates the present value of expected future receipts to the cost of the investment outlay.
Th
is
internal rate of return is found by
trial
and
error.
First we compute the present value of the cash
-
flows from an investment, using an
arbitrarily elected interest rate. Then we compare the present value so obtained with the
investment cost. If the pres
ent value is higher than the cost figure, we try a higher rate of
interest and go through the procedure again. Conversely, if the present value is lower
than
the
cost, lower the
interest rate and repeat the
process.
MRCET MBA
Cash
inflow /
Initial
Investment
F
=
Cash
outlay
or
Initial
Investment
/
Cash
Inflow
IRR=
Base
Factor
+
(
Positive
NPV/
Difference
in
Positive
and
Negative
NPV
)
x
DP
The
interest
rate that bri
ngs
about
this equality
is
defined
as the internal
rate
of return.
In
other
words it is a rate
at
which
discount cash flows to zero.
This rate of return is compared to the cost of capital and the project having higher
difference, if they are mutually
exclusive, is adopted and other one is rejected. As the
determination
of internal
rate
of return
involves
a number
of
attempts
to
make the
present value of earnings equal to the investment, this approach is also called the Trial
and Error Method. Internal
rate of return is time adjusted technique and covers the
disadvantages
of the
Traditional techniques.
Accept/Reject
criteria
If the present value of the sum total of the compounded reinvested cash flows is greater
than
the
present
value
of
the
outflows,
the
proposed
project
is
accepted.
If
not
it
would
be
rejected.
It
is expected by
the
following
ratio
S
teps
to
be
followed:
Step1.
Find
out
factor.
Factor
is
calculated
as
follows:
Step 2.
Find out positive net present value
Step
3.
Find
out
negative
net
present
value
Step
4.
Find out
IRR
Base factor = Positive Discount
Rate
DP=
Difference
in Percentage
Merits
1.
It
considers
the
time value
of
money.
2.
It
takes
into
account the
total
cash inflow
and
outflow.
3.
It
does
not
use
the
concept of
the
required
rate
of
return.
4.
It gives
the
approximate/nearest
rate
of
return.
MRCET MBA
Demerits
1.
It
involves
complicated
computational
method.
2.
It
produces multiple
rates
which
may
be
confusing for
taking
decisions.
3.
It
is
assume
that
all
intermediate
cash
flows
are
reinvested
at
the
internal
rate
of
return.
NPV
vs. IRR Methods
¶
Key differences
between the most popular methods, the NPV (
Net Present Value
)
Met
hod
and
IRR (
Internal Rate
of
Return
) Method, include:
•
NPV
is
calculated
in
terms
of
currency
while
IRR
is
expressed
in
terms
of
the
percentage
return
a
firm
expects
the
capital
project to return;
•
Academic
evidence
suggests
that
the
NPV
Method
is
preferred
over
other
methods
since
it
calculates additional
wealth and
the
IRR Method
does not;
•
The IRR Method cannot be used to evaluate projects where there are
changing
cash
flows
(e.g.,
an
initial
outflow
followed
by
in
-
flows
and
a
later
out
-
flow,
such
as
may
be
required in the
case
of
land reclamation by
a
mining
firm);
•
However, the
IRR Method does have one significant advantage
--
managers tend to
better
understand
the
concept
of
returns
stated
in
percentages
and
find
it
easy
to
compare
to the
required
cost
of capital; and, finally,
•
While both the NPV Method and the IRR Method are both DCF models and can even
reach similar conclusions about a single project, the use
of the IRR Method can lead to
the
belief
that
a
smaller
project
with
a
shorter
life
and
earlier
cash
inflows,
is
preferable
to a
larger project that
will generate more
cash.
•
Applying
NPV
using
different
discount
rates
will
result
in
different
recommendations.
The
IRR
method
always
gives
the
same
recommendation.
COST
OF
CAPITAL
The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of various sources of finance used by a firm.
The
capital used by a firm may be in the form of debt, preference capital, retained
earnings and equity shares. The concept of cost of capital is very important in the
financial management. A decision to invest in a particular project depends upon the cost
of
capital of the firm or the cut off rate which is the minimum rate of return expected by
the investors.
DEFINITIONS
MRCET MBA
Kdb=
I/P
Where
Kdb =
before tax
cost
of debt, I
=
Interest, P
=
Principal
According
to
Solomon
Ezra,
“Cost
of
capital
is
the
minimum
required
rate
of
earning
or
the
cut
-
off
rate of capital
expenditures”.
MEASUREMENT
OF
COST
OF
CAPITAL
The term cost of capital is an overall cost. This is the combination cost of the
specific cost
associated
with
specific source of financing.
The computation
of cost
capital therefore, involves two steps: The co
mputation of the different elements of the
cost
in term of the cost
of
the different source
of finance.
The
calculation
of
the
overall
cost
by
combining
the
specific
cost
into
a
composite
cost.
From
the
view
point
of
capital
budgeting
decisions
the
long
-
term
sources of fund are relevant as the constitute the major source of financing of fixed cost.
In
calculating
the cost of
capital,
therefore, the
focus
is to
be
on the
long
-
term funds.
In other words the specific cost has to be calculated for: 1) Lo
ng term debt 2)
Preference
Shares 3) Equity
Shares 4) Retained earnings
COST
OF
DEBT
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Dividend
Price
Approach:
This
is
also
known
as
dividend
valuation
model.
This
model
makes
an
assumption
that
the
market price
of share
is the
present value
of
its future
dividends stream.
As
per
this
approach
the
cost
of
equity
is
the
rate
which
equates
the
future
dividends
to
the
current market price.
The
cost
of
equity
capital
is
calculated
by
dividing
the
expected
dividend
by
market
price
per share.
In
this
approach
dividend
is
constant,
which
means
there is
no
-
growth
or zero
growth
in
dividend.
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The WACC represents the minimum rate of return at
which a company produces value for
its
investors.
Let’s say company produces a return of 20% and has WACC of 11%. By contrast, if the
company return is less than WACC, the company is shedding value, which indicates that
investors
should
put their money
elsewhere.
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UNIT
-
III
Funds are the basic need of every firm to fulfill long term and working capital requirement.
Enterprise
raises these funds from long term and short term sources. In this context, capital
structure and financial structure are often used.
Capital Structure
covers only the long term
sources
of
funds,
whereas
financial
structure
implies
the
way
assets
of
the
com
pany
are
financed, i.e. it represents the whole liabilities side of the Position statement, i.e. Balance Sheet,
which
includes both long term and
long
term debt
and current liabilities.
Definition
of Capital
Structure
The combination of long
-
term sources
of funds, i.e. equity capital, preference capital, retained
earnings
and
debentures
in
the
firm‟s
capital
is
known
as Capital
Structure.
It
focuses
on
choosing such a proposal which will minimize the cost of capital and maximize the earnings per
share.
Fo
r
this purpose
a
company
can opt for the
following
capital structure
mix:
Equity
capital
only
Preference capital
only
Debt only
A
mix
of equity
and debt
capital.
A
mix of
debt
and
preference
capital.
A
mix
of equity
and preference
capital.
A
mix
of
equity,
preference
and
debt
capital
in
different
proportions.
There are certain factors which are referred while choosing the capital structure like, the pattern
opted for capital structure should reduce the cost of capital and increase the returns, the c
apital
structure mix should contain more of equity capital and less of debt to avoid the financial risk, it
should provide liberty to the business and management to adapt itself according to the changes
and so
on.
Definition
of
Financial
Structure
The
mix of long term and short term funds employed by the company to procure the assets which
are required for day to day business activities is known as Financial Structure. Trend Analysis
and
Ratio Analysis
are
the
two tools used
to analyze
the financial str
ucture of
the
company.
The composition of the financial structure represents the whole equity and liabilities side of the
Balance Sheet, i.e. it includes equity capital, preference capital, retained earnings, debentures,
short
-
term
borrowings,
account
pay
able,
deposits
provisions,
etc.
The
following
factors
are
considered
at the
time of designing
the financial
structure:
Leverage
:
Leverage
can
be
both
positive
or
negative,
i.e.
a
modest
rise
in
the
EBIT
will
give a
high
rise
to the
EPS but simultaneously
it
increases the
financial
risk.
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Cost of Capital
: The financial structure should focus on decreasing the cost of capital.
Debt and preference share capital are cheaper sources of finance as compared to equity
share
capital.
Control
:
The
risk
of loss
and dilution
of
control of the
company
should be
low.
Flexibility
:
Any firm
cannot
survive
if
it
has
a
rigid
financial
composition.
So
the
financial structure should be such that when the business environment changes structure
should
also be adjust
ed to cope
up
with the
expected or
unexpected changes.
Solvency
: The financial structure should be such that there should be no risk of getting
insolvent.
ort
term
cture
of
retained
rowings,
gs
etc.
cture.
Capitalization
Capitalization is an important constituent of financial plan. ln common parlance, the
phrase „Capitalization‟ refers to total amount of capital employed in a
business. However,
scholars are not unanimous in so far as capitalization
is concerned. The term c
apitalization
connotes the process of determining the quantum of funds that a firm would require to run its
business. Capitalization is distinct from share capital which refer only to the paid
-
up value of
shares
issued
and
definitely
excludes
bonds
and
other
forms
of
borrowings.
Similarly,
it
should
be distinguished form „capital‟. The term capital refers to the total investment of a company in
money, tangible assets like goodwill. It is in a way the total wealth of a company. When used in
the sense of n
et capital, it indicates the excess of total assets over liabilities. Here, then, it
includes “the gains or profits from the use and investment of the capital that has not been
distributed to the stockholders” and excludes losses that have resulted from th
e use of capital.
Capitalization, on the other hand, refers only to the par value (i.e., face value indicated on the
security itself) of the long
-
term securities (shares and debentures) plus by any reserves which are
meant
to
be
used
for
meting
long
-
term
a
nd
permanent
needs
of
a
company.
Thus
capital
includes
Basisfor
Comparison
Capital
Structure
Financial
Structure
Meaning
The combination of long term sources of
funds, which are raised by the business is
known
as Capital Structure.
The combination of long term and sh
financing represents the financial stru
the
company..
Appearson
Balance
Sheet
Under
the
head
Shareholders
fund
and
Non
-
current
liabilities.
The
whole
equities
and
liabilities
side.
Includes
Equity
capital,
preference
capital,
retained earnings, debentures, long term
borrowings
etc.
Equity
capital,
preference
capital,
earnings,
debentures,
long
term
bor
account
payable,
short
term
borrowin
One
in
another
The
capital
structure
is
a
section
of
financial
structure.
Financial
structure
includes
capital
stru
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all the loans and reserves of the concern but Capitalization includes only long
-
term loans and
retained
profits besides the capital.
Capitalization comprises of share capital, debentures,
loans, free reserves,etc. Capitalization
represents permanent investment in companies excluding long
-
term loans. Capitalization can be
distinguished from capital structure. Capital structure is a broad term and it deals with qualitative
aspect
of
finance.
While capitalization
is
a
narrow term
and
it
deals
with
the
quantitative
aspect.
Capitalization
is generally
found
to be
of following
types
-
Normal
Over
Under
Overcapitalization
Overcapitalization is a situation in which actual profits of a company are
not sufficient enough to
pay interest on debentures, on loans and pay dividends on shares over a period of time. This
situation arises when the company raises more capital than required. A part of capital always
remains
idle. With a
result, the
rate of
re
turn shows
a declining
trend. The causes can be
-
1.
High promotion cost
-
When a company goes for high promotional expenditure, i.e.,
making contracts, canvassing, underwriting commission, drafting of documents, etc. and
the actual returns are not adequate in
proportion to high expenses, the company is over
-
capitalized
in such cases.
2.
Purchase of assets at higher prices
-
When a company purchases assets at an inflated
rate, the result is that the book value of assets is more than the actual returns. This
situat
ion
gives rise to over
-
capitalization of
company.
3.
A company’s floatation n boom period
-
At times company has to secure it‟s solvency
and thereby float in boom periods. That is the time when rate of returns are less as
compared
to
capital
employed.
This
results
in
actual
earnings
lowering
down
and
earnings
per
share declining.
4.
Inadequate provision for depreciation
-
If the finance manager is unable to provide an
adequate rate of depreciation, the result is that inadequate funds are available when the
asset
s
have
to
be
replaced
or
when
they
become
obsolete.
New
assets
have
to
be
purchased
at high prices
which prove
to be
expensive.
5.
Liberal dividend policy
-
When the directors of a company liberally divide the dividends
into the shareholders, the result is
inadequate retained profits which are very essential for
high
earnings
of
the
company.
The
result
is
deficiency
in
company.
To
fill
up
the
deficiency, fresh capital is raised which proves to be a costlier affair and leaves the
company
to be over
-
capitaliz
ed.
6.
Over
-
estimation of earnings
-
When the promoters of the company overestimate the
earnings
due
to
inadequate
financial
planning,
the
result
is
that
company
goes
for
borrowings which cannot be easily met and capital is not profitably invested. This
results
in
consequent decrease
in earnings per share.
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Effects
of
Overcapitalization
1.
On
Shareholders
-
The
over
capitalized
companies
have
following
disadvantages
to
shareholders:
a.
Since
the
profitability
decreases,
the
rate
of
earning
of
share
holders
also
decreases.
b.
The
market
price
of
shares
goes
down
because
of low profitability.
c.
The profitability going down has an effect on the shareholders. Their earnings
become
uncertain.
d.
With the decline in goodwill of the company, share prices decline.
As a result
shares
cannot be marketed in capital market.
2.
On
Company
-
a.
Because
of
low
profitability,
reputation
of company
is
lowered.
b.
The
company‟s
shares
cannot
be
easily
marketed.
c.
With the decline of earnings of company, goodwill of the company declines
and
the
result
is
fresh
borrowings
are
difficult
to
be
made
because
of
loss
of
credibility.
d.
In
order
to
retain
the
company‟s
image,
the
company
indulges
in
malpractices
like
manipulation
of
accounts
to show high earnings.
e.
The company cuts down it‟s
expenditure on maintainance, replacement of assets,
adequate
depreciation, etc.
3.
On Public
-
An
overcapitalized
company
has
got many
adverse
effects
on
the
public:
a.
In
order
to
cover
up
their
earning
capacity,
the
management
indulges
in
tactics
like
increase
in prices or
decrease
in quality.
b.
Return
on
capital
employed
is
low.
This
gives
an
impression
to
the
public
that
their
financial resources
are
not utilized properly.
c.
Low
earnings
of
the
company
affects
the
credibility
of
the
company
as
the
company
is not
able
to
pay
it‟s
creditors
on time.
d.
It
also
has
an
effect
on
working
conditions
and
payment
of
wages
and
salaries
also
lessen.
Undercapitalization
An undercapitalized company is one which incurs exceptionally high profits as compared to
industry. An
undercapitalized company situation arises when the estimated earnings are very low
as
compared
to
actual
profits.
This
gives
rise
to
additional
funds,
additional
profits,
high
goodwill, high earnings and thus the return on capital shows an increasing trend
. The causes can
be
-
1.
Low
promotion
costs
2.
Purchase
of
assets
at
deflated
rates
3.
Conservative
dividend
policy
4.
Floatation
of
company
in
depression
stage
5.
High
efficiency
of
directors
6.
Adequate
provision
of
depreciation
7.
Large
secret
reserves
are
maintained.
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Effects
of Under
Capitalization
1.
On
Shareholders
a.
Company‟s
profitability
increases.
As
a
result,
rate
of
earnings
go
up.
b.
Market
value
of
share
rises.
c.
Financial
reputation
also increases.
d.
Shareholders can
expect a
high
dividend.
2.
On
company
a.
With
greater
earnings, reputation
becomes
strong.
b.
Higher
rate
of
earnings
attract
competition
in
market.
c.
Demand
of
workers
may
rise
because of high
profits.
d.
The
high
profitability
situation
affects
consumer
interest
as
they
think
that
the
company
is
overcharging on products.
3.
On
Society
a.
With high earnings, high profitability, high market price of shares, there can be
unhealthy
speculation in
stock market.
b.
„Restlessness in general public is developed as they link high profits with high
prices
of
product.
c.
Secret reserves are maintained by the company which can result in paying lower
taxes
to government.
d.
The
general
public
inculcates
high
expectations
of
these
companies
as
these
companies can import innovations, high technology and thereby best qual
ity of
product.
Bases
of Capitalization:
The major problem faced by the
financial manager
is determination of value at which a firm
should
be
capitalized
because
it
have
to
raise
funds
accordingly
there
are
two
theories
that
contain
guidelines with which
the amount of capitalization
can be
summarized;
1.
Cost Theory
of Capitalization
According to this
theory capitalization
of a firm is regarded as the sun of cost actually incurred in
setting of the business. A film needs funds to acquire fixed assets, to defray promotional and
organizational expenses and to meet current asset requirements
of the enterprise sum of the costs
of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to
provide with
necessary worki
ng capital
and to cover possible initial losses, it will capitalized
under this method more emphasis is laid on current investments. They are static in nature and do
not have any direct relationship with the future earning capacity. This approach is given
as the
value
of
capital
only
at a particular point of
time
which
would not reflect
the
future changes.
2.
Earning
Theory
of
Capitalization
According to this theory, firm should be capitalized on the basis of its expected earning A firm is
profit is seeking
entity and hence its value is determiner according to What it earns. The probable
earning
are
forecast
and
them
they
are
capitalized
at
a
normal
representative
rate
of
return.
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Capitalization
of
a
company
as
per
the
earning
theory
can
thus
be
determined
with
help
following
formula.
Capitalization
=
Annual
Net
Earnings
X
Capitalization
Rate
Thus for the purpose of determining amount of Capitalization in an enterprise the financial
manager has to fist estimate of annual net earnings of the
enterprise where after he will have to
determine the capitalization rate. The future earning cannot be forecast exactly and depend to a
large
extent on such
external factors which
are
beyond the control of management.
LEVERAGES
Financial
and
Operating
Leverage
Leverage is common term in financial management which entails the ability to amplify results at
a comparatively low cost. In business, company's managers make decisions about leverage that
affect profitability. According to James Horne, leverage
is, "the employment of an asset or fund
for which the firm pays a fixed cost or fixed return". When they evaluate whether they can
increase production profitably, they address operating leverage. If they are expecting taking on
additional
debt,
they
have
e
ntered
the
field
of
financial
leverage.
Operating
leverage
and
financial leverage both heighten the changes that occur to earnings due to fixed costs in a
company's capital structures. Fundamentally, leverage refers to debt or to the borrowing of funds
to
finance the purchase of a company's assets. Business proprietors can use either debt or equity
to finance or buy the company's assets. Use of debt, or leverage, increases the company's risk of
bankruptcy. It also upsurges the company's returns, specificall
y its return on equity. It is a fact
because, if debt financing is used rather than equity financing, then the owner's equity is not
diluted by issuing more shares of stock. Investors in a business like for the business to use debt
financing but only up to
a point. Investors get nervous about too much debt financing as it drives
up
the company's default risk.
Types
of leverage
There are many types of leverage. The company may use finance leverage or operating leverage,
to
increase
the
EBIT and
EPS.
Financial
Leverage
The
ability
of
a
firm
to
use
fixed
financial
charges
to
magnify
the
effect
of
changes
in
EBIT/Operating
profits,
on
the levels
of EPS is
knows as
Financial
Leverage.
Financial leverage measures the extent to which the fixed financing
costs arise out of the use of
debt
capital
A
firm
with
high
financial
leverage will
have
relatively
high
fixed
financing costs.
Formula
for
Degree
of
Financial
Leverage
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Financial Leverage
Formula
example
is
given
below:
Degree
of
financial
leverage=
%
Change
in
EPS/
% Change
in EBIT
(OR)
EBIT/
EBT
Why
financial
leverage
important?
It
provides
a
framework
for
financial
decisions.
It helps in choosing the best mixture of source of funds and helps to maintain a desirable
capital structure
for the firm. The structure of the funds influences the shareholder‟s in
terms
of return
and risk.
In order to quantify the risk
-
return relationship of various alternative capital structures,
firms
use
financial leverages.
Financial Leverages help in makin
g prudent investment decisions by providing an upper
limit
of risk and by
balancing
the return on investment against charges of
debt.
Limitations
of
Financial
Leverages
In
view
of
the
limitations
given
below,
financial
decisions
should
not
be
solely
base
d
on
financial leverages. It should rather be used to support or supplement those decisions. Given
below
are financial leverage
limitations examples:
Financial leverages do not take into account implicit costs of debt.
It implies that as
long as the
future earnings of the firm are greater than the interest payable on debt i.e.
explicit
cost,
the
firm
should
rely
on
debt
to
raise
additional
funds.
However,
that
may
not always help maximize the wealth of shareholders because it results in a decline in t
he
market
price
of the
common
stock as a result of
increased financial risk.
Financial Leverages are based on certain unrealistic assumptions
. Financial leverages
assume that costs of debt remain constant irrespective of the degree of leverage of the
firm.
That
is
an
unrealistic
assumption
because
as
the
amount
of
debt
increases,
the
firm
is exposed to greater risk and therefore, the interest rate charged to the firm also increases
simultaneously.
Operating
Leverage
Definition
of
Operating
Leverage
It
measures the extent of the fixed operating costs of a firm. If the operating leverage of a
firm is high, it implies that it has high fixed costs in comparison to a firm with a low
operating
leverage.
It measures
the effect
of change
in sales
on the
level o
f EBIT.
Degree of operating leverage refers to a firm‟s ability to use fixed operating costs to
magnify
effects of changes in
sales on its earnings
before
interest and taxes.
Formula
for
Degree
of Operating
Leverage
Sales
-
variable Cost/EBIT
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An operating Leverage of 1.5 means that an increase in sales by 1% would cause the operating
profit to increase
by
1.5%
Combined
Leverage
The Combined Leverage measures the effect of percentage change in sales on the percentage
change in EPS. It
indicates the effect that change in sales has on EPS. It helps to maintain a
proper
balance
between
operating
profit and
sales
without
exposing
the
firm to too
much risk.
Formula
for
Combined
Leverage
Combined
Leverage=
Operating
Leverage
X
Financial
Leverage
Illustration
1:
Calculate the Degree of Operating Leverage (DOL), Degree of Financial
leverage (DFL) and
the Degree of Combined
Leverage (DCL) for the following firms
and
interpret
the
results.
Firm
A
Firm
B
Firm
C
Output
(units)
60,000
15,000
1,00,000
Fixed
Costs (Rs)
7,000
14,000
1,500
Variable cost
per
unit
(Rs.)
0.20
1.50
0.02
Interest
on
borrowed
funds
4,000
8,000
-----
Selling
price
per unit
(Rs)
0.60
5.00
0.10
Solution:
Firm
A
Firm
B
Firm
C
Output
(units)
60,000
15,000
1,00,000
Selling
price
per
unit (Rs)
0.60
5.00
0.10
Variable cost
per
unit
(Rs.)
0.20
1.50
0.02
Contribution
per
unit
0.40
3.50
0.08
Total
Contribution
Rs.24,000
Rs.52,500
RS.8,000
Less fixed
costs
7,000
14,000
1,500
EBIT
17,000
38,500
6,500
Less
Interest
4,000
8,000
---
Profit
before
Tax
13,000
30,500
6,500
MRCET MBA
Degree
of
Operating
Leverage
Contribution/EBIT
24,000/17,000
=
1.41
52,500/38,000
=1.36
8,000/6,500
=
1.23
Degree
of
Financial
Leverage
EBIT/PBT
17,000/13,000
38,500/30,500
6,500/6,500
=
1.31
=
1.26
=
1.00
Degree
of
Combined
Leverage
Contribution/
EBIT
24,000/13,000
52,500/30,500
8,000/6,500
=
1.85
=
1.72
=
1.23
Illustration 2:
A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of
Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating, financial
and combined leverages. If the firm wants to double its earnings before interest and tax (EBIT),
how
much of a
rise
in sales would be
needed on a
percentage
basis?
Solution:
Statement
of
Existing
Profit
Sales
Rs.10,00,000
Less
Variable
cost
7,00,000
Contribution
3,00,000
Less fixed
cost
2,00,000
EBIT
1,00,000
Less
Interest
@
10%
on 5,00,000
50,000
Profit
after
Tax
50,000
Operating
leverage
Contribution/
EBIT =
3,00,000/1,00,000
= 3
Financial
Leverage
EBIT/PBT
=
1,00,000/50,000
=
2
Combined
Leverage
=
3x
2=
6
Statement
of
sales
needed
to
double
EBIT
Operating Leverage is 3 times i.e. 33
–
1/3% increase in sales volume causes a 100%
increase in
operating profit or EBIT. Thus, at the sales of Rs. 13,33,333, operating profit or EBIT
will
become Rs. 2,00,000 i.e. double existing
one.
MRCET MBA
Sales
Variable
Operating
Cost
(40%)
Contribution
Less Fixed Operating Cost
EBIT
Less interest (10% of 80,000)
PBT
Tax
at 50%
PAT
Number
of
shares
EPS
6,00,000
2,40,000
3,60,000
1,00,000
2,60,000
8,000
2,52,000
1,26,000
1,26,000
6,000
Rs.21
Verification:
Sales
Rs.13,33,333
Variable
cost
(70%)
9,33,333
Contribution
4,00,000
Fixed
Costs
2,00,000
EBIT
2,00,000
Illustration 3:
The
balance
sheet
of
Well Established
Company
is
as
follows:
Liabilities
Amount
Assets
Amount
Equity
share
capital
60,000
Fixed
Assets
1,50,000
Retained
Earnings
20,000
Current
Assets
50,000
10%
long
term debt
80,000
Current
Liabilities
40,000
------------
2,00,000
2,00,000
The company‟s total assets turnover ratio is 3, its fixed operating costs are Rs.1,00,000
and its variable operating cost ratio is 40%. The income tax rate is 50%. Calculate the
different
types
of leverages
given that the
face
value of
share
is Rs.10.
Solution:
Total
Assets
Turnover Ratio
=
Sales /
Total
Assets
3
=
Sales/2,00,000
MRCET MBA
Illustration
4:
The
following
information
is
available for
ABC
&
Co.
EBIT
Rs.
11,20,000
Profit
before
Tax
3,20,000
Fixed
Costs
7,00,000
Calculate
%
change
in EPS
if
the sales are
expected to increase
by
5%.
Solution:
In
order
to
find
out
the
%
change
in
EPS
as
a
result
of
%
change
in
sales,
the
combined
leverage
should be
calculated as follows:
Operating
Leverage
=
Contribution/
EBIT
=
Rs.11,20,000
+
Rs. 7,00,000/11,20,000
=
1.625
Financial Leverage
=
EBIT
/
Profit
before
Tax
=
Rs. 11,20,000/3,20,000
=
3.5
Combined Leverage
=
Contribution/
Profit
before
Tax
=
OL
x
FL
=
1.625 x
3.5 =
5.69
The combined leverage of 5.69 implies that for 1% change in sales level, the % change in
EPS would be 5.69% So, if the sales are expected to increase by 5%, then the % increase in EPS
would
be
5 x
5.69 =
28.45%.
Illustration 5:
The
data
relating
to two companies
are
as
given below
:
Company
A
Company
B
Capital
Rs.6,00,000
Rs.3,50,000
Debentures
Rs.
4,00,000
6,50,000
Output
(units)
per
annum
60,000
15,000
Selling
price/unit
Rs.30
250
Fixed
costs
per
annum
7,00,000
14,00,000
Variable
cost
per
unit
10
75
Degree
of
Operating
Leverage
=
Contribution/EBIT
=
3,60,000/2,60,000 = 1.38
Degree
of
Financial
leverage
=
EBIT
/
PBT
=
2,60,000/2,52,000 = 1.03
Degree
of
Combined
Leverage =1.38
x 1.03
=
1.42
MRCET MBA
You are required to calculate the Operating leverage, Financial leverage and Combined Leverage
of
two companies.
Solution
:
Computation
of
Operating
leverage, Financial
Leverage
and
Combined
leverage
Company
A
Company
B
Output
(units)
per
annum
60,000
15,000
Selling
price/unit
Rs.30
250
Sales
Revenue
Less
variable
costs
18,00,000
37,50,000
@
Rs.10 and Rs.75
6,00,000
11,25,000
Contribution
12,00,000
26,25,000
Less fixed
costs
7,00,000
14,00,000
EBIT
5,00,000
12,25,000
Less
Interest
@
12%
on
debentures
48,000
78,000
PBT
4,52,000
11,47,000
DOL
=
Contribution/EBIT
12,00,000/5,00,000
=
2.4
26,25,000/12,25,000
=
2.14
DFL
=
EBIT/
PBT
5,00,000/4,52,000
12,25,000/11,47,000
DCL
=
DOL
x
DFL
1.11
2.14 x
1.11 =
2.66
=1.07
2.14 x
1.07 =
2.2
Illustration 6:
X Corporation has estimated that for a new product its break
-
even point is 2,000
units
if
the
item
is
sold
for Rs.
14
per
unit,
the
cost
accounting department
has
currently
identified variable cost of
Rs. 9 per unit. Calculate the degree of operating leverage for sales
volume of 2,500 units and 3,000 units. What do you infer from the degree of operating leverage
at
the
sales volume of
2,500 units and
3,000
units
and their
difference
if any?
Solution:
Particulars
2500
units
3000
units
Sales
@ Rs.14 per
unit
35,000
42,000
Variable
cost
22,500
27,000
Contribution
12,500
15,000
Fixed
Cost
(2,000
x (Rs.14
–
9)
10,000
10,000
EBIT
2,500
5,000
Operating
Leverage
=
Contribution/
EBIT
12,500/2,500
15,000/5,000
MRCET MBA
Illustration 7:
The
following
data
is
available for
XYZ
Ltd.
Sales
Rs.
2,00,000
Less:
Variable
cost
60,000
Contribution
1,40,000
Fixed
Cost
1,00,000
EBIT
40,000
Less Interest
5,000
Profit
before
tax
35,000
Find
out:
(a)
Using
concept
of
financial
leverage,
by
what
percentage
will
the
taxable
income
increase,
if
EBIT increases by
6 %.
(b)
Using
the
concept
of
operating
leverage,
by
what
percentage
will
EBIT
increase
if
there
is
10%
increase
in sales and,
(c)
Using
the
concept
of
leverage,
by
what
percentage
will
the
taxable
income
increase
if
the
sales
increase
by
6%.
Also verify
the results in view
of the
above
figures.
Solution:
(i)
Degree
of
Financial
Leverage:
FL
=
EBIT/Profit
before Tax
=
40,000/35,000
= 1.15
If
EBIT
increases
by
6%,
the
taxable
income
will
increase
by
1.15
x
6
=
6.9%
and
it
may
be
verified
as
follows:
EBIT
(after
6%
increase)
Rs. 42,400
Less
Interest
5,000
Profit
before
Tax
37,400
Increase
in taxable income
is Rs. 2,400 i.e
6.9%
of Rs. 35,000
(ii)
Degree
of
Operating
Leverage:
OL
=
Contribution /
EBIT =
1,40,000/40,000
=
3.50
If sale
increases
by
10%,
the
EBIT
will increase
by
3.50 x
10 =
35%
and it
may
be
verified
as
follows:
Sales
(after
10%
increase)
Rs. 2,20,000
Less
variable expenses
@
30%
66,000
=
5
=
3
MRCET MBA
Contribution
1,54,000
Less Fixed
cost
1,00,000
EBIT
54,000
Increase
in
EBIT
is
Rs.
14,000 i.e
35%
of Rs. 40,000
(iii)
Degree
of Combined leverage
CL
=
Contribution/ Profit before
tax
=
1,40,000/35,000 =
4
If sales increases by 6%, the profit
before tax will increase by 4x6= 24% and it maybe verified as
follows:
Sales
(after
6%
increase)
Rs.
2,12,000
Less Variable
expenses@
30%
63,600
Contribution
1,48,400
Less Fixed
cost
1,00,000
EBIT
48,400
Less Interest
5,000
Profit
before
tax
43,400
Increase
in Profit
before
tax
is Rs.
8,400 i.e
24%
of
Rs. 35,000
EBIT
and
EPS
Analysis
One of the primary
valuation
metrics used by investors to assess a business' worth and financial
stability is
earnings per share (EPS)
. EPS reflects a company's net income divided by the number
of common shares outstanding. EPS, of course, largely depends on a company's earnings. For the
pu
rposes of EPS calculation,
earnings before interest and taxes (EBIT)
is used because it reflects
the amount of profit that remains after
accounting those expenses necessary to keep the business
going.
EBIT is also often
referred
to
as
operating
income.
The
relationship
between
EBIT and
EPS
is
as
follows:
EPS = (EBIT
-
Debt Interest) * (1
-
Tax Rate)
-
Preferred Share Dividends
/ Number of Common
Shares
Outstanding
When assessing the relative effectiveness
leverage
versus
equity financing
, companies look for
the level of EBIT where EPS remains unaffected, called the EBIT
-
EPS break
-
even point. This
calculation determines how much additional revenue would need to be generated in order to
maintain
a
constant EPS under different financing plans.
To
calculate
the
EBIT
-
EPS
break
-
even
point,
rearrange
the
EPS
formula:
MRCET MBA
EBIT = (EPS * Number of Common Shares Outstanding) + Preferred Share Dividends / (1
-
Tax
Rate)
+
Debt
Interest
For example, assume a company generates $150,000 in earnings and is financed entirely by
equity
capital
in
the
form
of
10,000
common
shares.
The
corporate
tax
rate
is
30%.
The
company's EPS is ($150,
0000
-
0) * (1
-
0.3) + 0 / 10,000, or $10.50. Now assume the company
takes out a loan of $10,000 with a 5% interest rate and sells an additional 10,000 shares. To
calculate the level of
EBIT
where EPS remains stable, simply input the debt interest, current EPS
and
updated
shares
outstanding
values
and
solve
for
EBIT:
($10.50
*
20,000
)
+
0
/
(1
-
0.3)
+
$500 = $300,500. Under this financing plan, the company must more than double its earnings to
maintain a
stable EPS.
Effective business management requires careful planning and decision
-
making about the
balance of debt and equity used
in financing the business. The
EBIT
-
EPS approach is one
method available to managers to guide them in making decisions about capital structure. It refers
to the relationship between two numbers:
earnings before interest
and taxes, or EBIT,
and
earnings per
share, or EPS. To benefit from the EBIT
-
EPS approach, it helps to understand the
basics
of
how it works, as
well as its advantages
and drawbacks.
Business
Capital
Structure
Capital structure refers to a business's balance of debt and equity financing.
Businesses have two
options for financing the purchases of equipment, expenses and materials necessary for their
operations. They can raise money from investors, which is equity financing, or they can borrow
from banks and creditors
–
leverage or debt fina
ncing. Most businesses engage in a degree of
both, paying careful attention to the costs associated with either source. Relying too heavily on
equity increases the cost to investors and cuts into return. But relying too much on debt puts the
business
in a
more
precarious
position and comes with
the substantial costs of
interest.
Understanding
the
EBIT
-
EPS
Approach
The EBIT
-
EPS approach is one tool managers use to decide on the right mix of debt and equity
financing in a business's capital structure.
In th
e EBIT
-
EPS approach, the business plots graphs
of
its
performance
at
different
possible
debt
-
to
-
equity
ratios,
such
as
40
percent
debt
to
60
percent equity. In a basic graph, the earnings per share as a data point is plotted for each level of
earnings
before interest and taxes at different debt
-
to
-
equity ratios. The graph is then analyzed to
determine
the ideal level
of
debt
-
to
-
equity
for
the
business.
Analysis
for
Risk
and
Return
Once the relationship between EBIT and EPS is plotted for different
cap
ital structures, the
investor can analyze the graph, focusing on two key challenges. The level of EBIT where EPS is
zero, called the break
-
even point, and the graph's slope, which visually represents the company's
risk. A steeper slope conveys a higher ris
k
–
greater loss per share at at lower EBIT level. A
steeper
slope
also
means
a
higher
return,
and
that
the
company
needs
to
earn
less
EBIT
to
MRCET MBA
produce greater EPS. The breakeven point is also important because it tells the business how
much
EBIT there
must be
to avoid losses,
and
varies
at different
proportions of debt
to equity.
Drawbacks
to
the
Approach
The
EBIT
-
EPS
approach
is
not
always
the
best
tool
for
making
decisions
about
capital
structuring. The EBIT
-
EPS approach places heavy
emphasis on maximizing earnings per share
rather
than
controlling
costs
and
limiting
risk.
It's
important
to
keep
in
mind
that
as
debt
financing increases, investors should expect a higher return to account for the greater risk; this is
known as a risk pre
mium. The EBIT
-
EPS approach does not factor this
risk premium
into the
cost
of
financing,
which
can
have
the
effect
of
making a
higher
level
of
debt
seem
more
advantageous
for
investors than it actually
is.
ABC Ltd. which is expecting the EBIT of
Rs.1,50,000 per annum on an investment
Rs.5,00,000, is considering the finalization of the capital structure or the financial plan.
The
company has access to raise funds of varying amounts by issuing equity share capital, 12%
preference
share
and
10%
debenture
or
any combination
thereof.
Suppose,
it
analyzes
the
following
four options to raise the
required funds
of
Rs.5,00,000.
1.
By
issuing equity
share
capital
at
par.
2.
50%
funds by
equity
share capital and
50% funds
by
preference shares.
3.
5%
funds
by
equity
share
capital,
25%
by
preference
shares
and
25%
by
issue
of
10%
debentures.
4.
25%
funds
by
equity
share
capital,
25%
as
preference
share
and
50%
by
the
issue
of
10%
debentures.
Assuming
that
ABC
Ltd.
belongs
to
50%
tax
bracket,
the
EPS
under
the
above
four
options
can
be
calculated as follows:
Option 1
Option 2
Option 3
Option 4
Equity
share
capital
Rs.5,00,000
Rs.2,50,000
Rs.2,50,000
Rs.1,25,000
Preference
share
capital
---
2,50,000
1,25,00
1,25,000
10%
Debentures
---
---
1,25,000
2,50,000
Total
Funds
5,00,000
5,00,000
5,00,000
5,00,000
EBIT
1,50,000
1,50,000
1,50,000
1,50,000
-
Interest
---
---
12,500
25,000
Profit
before
Tax
1,50,000
1,50,000
1,37,500
1,25,000
-
Tax
@
50%
75,000
75,000
68,750
62,500
MRCET MBA
Profit
after
Tax
75,000
75,000
68,750
62,500
-
Preference
Dividend
---
30,000
15,000
15,000
Profit
for
Equity
shares
75,000
45,000
53,750
47,500
No.
of
Equity
shares
(of
Rs.100
each)
5000
2500
2500
1250
EPS (Rs.)
15
18
21.5
38
In this case, the financial plan under option 4
seems to be the best as it is giving the
highest EPS of Rs.38.
In this plan, the firm has applied maximum financial leverage. The firm
is expecting to earn an EBIT of Rs.1,50,000 on the total investment of Rs.5,00,000 resulting in
30% return.
On an afte
r
-
tax basis, this return comes to 15%
i.e.
, 30% x (1
-
.5).
However, the
after tax cost of 10% debentures is 5% i.e., 10% (1
-
.5) and the after tax cost of preference shares
is 12% only.
In the option 4, the firm has employed 50% debt, 25% preference shares
and 25%
equity share capital, and the benefits of employing 50% debt (which has after tax cost of 5%
only)
and
25%
preference
shares
(having
cost
of
12%
only)
are
extended
to
the
equity
shareholders.
Therefore the firm is expecting
an
EPS
of Rs.38.
In case
, the company opts for all
-
equity financing only, the EPS is Rs.15 which is just
equal to the after tax return on investment.
However, in option 2, where 5% funds are obtained
by the issue of 12% preference shares, the 3% extra is available to the equity s
hareholders
resulting
in
increase
in
of
EPS
from
Rs.15
to
Rs.18.
In
plan
3,
where
10%
debt
is
also
introduced,
the
extra
benefit
accruing
to
the
equity
shareholders
increases
further
(from
preference
shares
as
well
a
from
debt)
and
the
EPS
further
increases
to
Rs.21.50.
The
company
is expecting this increase in EPS when more and more preference share and debt financing is
availed because the after tax cost of preference shares and debentures are less than the after tax
return
on total investment.
Hence, the financial leverage has a favourable impact on the EPS
-
only if the ROI is more
than the cost of debt.
It will rather have an unfavourable effect if the ROI is less than the cost of
debt.
That is why
financial
leverage
is also called
the twin
-
edge
d
sword.
Break
Even
Analysis
of
Financial
Leverage
Financial
BEP
is
the
amount
EBIT
at
which
net
profit
becomes
zero
and
is
calculated
by
the
following
formula.
Financial BEP
=
EBIT=
I+ PD/1
-
t
Capital
Structure
Theories
A
corporate
can
finance
its
business
mainly
by
2
means
i.e.
debts
and
equity.
However,
the
proportion
of
each
of
these
could
vary
from
business
to
business.
A
company
can
choose
to
have
MRCET MBA
a structure which has 50% each of debt and equity or more of one and less of
another. Capital
structure is also referred to as
financial leverage
, which strictly means the proportion of debt or
borrowed
funds in the financing
mix
of a
company.
Debt structuring can
be a handy option because the interest payable on debts is tax deductible
(deductible from
net profit
before tax). Hence, debt is a cheaper source of finance. But increasing
debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest
obligations
etc.
For finding the optimum capital structure in order to maximize shareholder‟s wealth or value of
the
firm,
different theories
(approaches) have
evolved.
Let
us now
look at
the
first
approach
Modigliani
and
Miller
(MM) Approach
Modigliani and Miller approach to capital theory, revised in the 1950s advocates
capital structure
irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure
of a company. Whether a firm is highly leveraged or has lower debt component, it has no bearing
on
its
market
value.
Rather
,
the
market
value
of
a
firm
is
dependent
on
the
operating
profits
of
the
company.
The
capital structure
of a company is the way a company finances its assets. A company can
finance its operations by either debt or equity or different combinations of these two sources. The
capital structure of a company can have a majority of debt component or a majority of
equity,
only one of the 2 components or an equal mix of both
debt and equity.
Each approach has its
own set of advantages and disadvantages. There are various capital structure theories, trying to
establish
a
relationship
between
the
financial
leverage
of
a
company
(the
proportion
of
debt
in
the company‟s capital structure) with its market value. One such approach is the Modigliani and
Miller
Approach.
Modigliani
and
Miller
Approach
This
approach
was
devised
by
Modigliani
and
Miller
during
1950s.
The
fundamentals
of
Modigliani and Miller Approach resemble that of
Net Operating Income
Approach. Modigli
ani
and Miller advocate capital
structure irrelevancy theory. This
suggests
that the valuation
of a
firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has
lower
debt component in
the financing
mix,
it has
no
bearing
on the value
of a
firm.
Modigliani and Miller Approach further states that the market value of a firm is affected by its
future growth prospect apart from the risk involved in the investment. The theory stated that
value of the firm is not depende
nt on the choice of capital structure or financing decision of the
firm. If a company has high growth prospect, its market value is higher and hence its stock prices
would be high. If investors do not see attractive growth prospects in a firm, the market v
alue of
that
firm would not be
that great.
MRCET MBA
Assumptions
of
Modigliani
and
Miller
Approach
There
are
no
taxes.
Transaction
cost for buying
and
selling
securities
as well
as bankruptcy
cost is
nil.
There
is
a symmetry
of information.
This
means
that
an
investor
will
have
access
to
same
information
that a corporation
would and investors
would behave
rationally.
The
cost
of borrowing
is the
same
for
investors
as
well as
companies.
Debt
financing
does
not
affect
companies
EBIT.
Modigliani and Miller Approach indicates that value of a leveraged firm ( a firm which has a mix
of debt and equity) is the same
as the value of an unleveraged firm ( a firm which is wholly
financed by equity) if the operating profits and future prospects are same. That is, if an investor
purchases shares of a leveraged firm, it would cost him the same as buying the shares of an
un
leveraged
firm.
Modigliani
and
Miller
Approach:
Two Propositions
without
Taxes
Proposition
1
With the above assumptions of “no taxes”, the capital structure does not influence the valuation
of a firm. In other words, leveraging the company does not incr
ease the market value of the
company.
It
also
suggests
that debt
holders
in
the company and equity
shareholders
have the
same priority
i.e. earnings are
split
equally
amongst them.
Proposition
2
It says that financial leverage is in direct proportion to the
cost of equity.
With an increase in
debt compone
nt, the equity shareholders perceive a higher risk to for the company. Hence, in
return, the shareholders expect a higher return, thereby increasing the cost of equity. A key
distinction here is that proposition 2 assumes that debt
-
shareholders have upper
-
hand
as far as
the
claim on earnings is
concerned.
Thus, the
cost
of
debt
reduces.
Modigliani
and
Miller
Approach:
Propositions
with
Taxes
(The
Trade
-
Off
Theory
of
Leverage)
The
Modigliani
and
Miller
Approach
assumes
that
there
are
no
taxes.
But
in
the
real
world,
this
is far from the truth. Most countries, if not all, tax a company. This theory recognizes the tax
benefits accrued by interest
payments. The interest paid on borrowed funds is tax deductible.
However, the same is not the case with dividends paid on equity. To put it in other words, the
actual cost of debt is less than the nominal cost of debt because of tax benefits. The trade
-
off
theory advocates that a company can capitalize its requirements with debts as long as the cost of
distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts,
until
a given threshold value will add value to a
company.
This
approach
with
corporate
taxes
does
acknowledge
tax
savings
and
thus
infers
that
a
change
in
debt
-
equity
ratio
has
an
effect
on
WACC
(
Weighted
Average
Cost
of
Capital
).
This
means
MRCET MBA
higher the debt, lower is the WACC. This Modigliani and Miller approa
ch is one of the modern
approaches
of Capital Structure
Theory.
Net
Income
Approach
Net Income Approach suggests that value of the firm can be increased by decreasing the overall
cost
of
capital
(WACC)
through
higher
debt
proportion.
There
are
various
theories
which
propagate the „ideal‟ capital mix /
capital structure
for a firm.
Capital structure
is the proportion
of
debt
and
equity
in
which
a
corpo
rate
finances
its
business.
The
capital
structure
of
a
company/firm
plays a very
important role
in
determining
the value of a
firm.
Net
Income Approach was
presented by Durand. The theory suggests
increasing value of the
firm by decreasing the overall cost of capital which is measured in terms of
Weighted Average
Cost of Capital
. This can be done by having a higher proportion of debt, which is a cheaper
source
of
finance
compared to
equity
finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where
the
weights are
the amount of capital raised from each source.
WACC
=
Required
Rate
of
Return
x
Amount
of
Equity
+
Rate
of Interest
x
Amount
of Debt
Total
Amount
of
Capital
(Debt
+ Equity)
According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of
Capital (WACC) and also the value of
the company. The Net Income Approach suggests that with the increase in leverage (proportion
of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a
decrease
in
the
leverage,
the W
ACC
increases and thereby
the
value
of
the firm
decreases.
For example, vis
-
à
-
vis equity
-
debt mix of 50:50, if the equity
-
debt mix changes to 20: 80, it
would have a positive impact on the value of the business and thereby increase the value per
share.
Assumptions
of
Net
Income
Approach
Net Income
Approach
makes
certain
assumptions
which
are
as
follows.
The
increase
in
debt
will
not
affect
the
confidence
levels
of
the
investors.
The
cost of debt
is less than the
cost of equit
y
.
There
are
no
taxes levied.
Net
Operating
Income
Approach
Net Operating Income Approach was also suggested by Durand. This approach is of the opposite
view of Net Income approach. This approach suggests that the capital structure decision of a firm
is
irrelevant
and
that
any
change
in
the
leverage
or
debt
will
not
result
in
a
change
in
the
total
MRCET MBA
value
of the firm
as well
as
the market
price
of its
shares.
This
approach also
says
that
the overall
cost
of capital is independent of the
degree
of leverage.
Features
of NOI
approach:
1.
At all degrees of leverage (debt), the overall capitalization rate would remain constant.
For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would
be
equal to EBIT/overall
capitalization rate.
2.
The value of equity of a firm can be determined by subtracting the value of debt from the
total
value
of
the firm. This can be denoted as follows:
Value
of
Equity
=
Total
value of
the firm
-
Value
of
debt
3.
Cost of equity increases with every increase in debt and the weighted average cost of
capital
(WACC)
remains
constant.
When
the
debt
content
in
the
capital
structure
increases, it increases the risk of the firm as well as its shareholders.
To compensate for
the higher risk involved in investing in highly levered company, equity holders naturally
expect
higher
returns which in
turn increases the cost of
equity
capital.
MRCET MBA
UNIT
IV
INTRODUCTION
Once a company makes a profit, it
must decide on what to do with those profits. They could
continue to retain the profits within the company, or they could pay out the profits to the owners
of the firm in the form of dividends. The dividend policy decision involves two questions: 1)
What f
raction of earnings should be paid out, on average, over time? And, 2) What type of
dividend policy should the firm follow? I.e. issues such as whether it should maintain steady
dividend policy or a policy increasing dividend growth rate etc. On the other
hand Management
has to satisfy various stakeholders from the profit. Out of the Stakeholders priority is to be given
to equity
share
-
holders as they
are
being
the highest risk.
DIVIDEND
-
DEFINED DEFINITION:
DIVIDEND
According to the Institute of Charte
red Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose."7 "The term dividend refers to
that portion of profit
(after tax) which is distributed among the owners
/
shareholders of the
firm.
"
"Dividend may be defined as the return that a shareholder gets from the company, out of its
profits,
on his shareholdings."
In other words, dividend is that part of the net earnings of a corporation that is distributed to its
stockholders.
It
is
a
payment
made
to
the
equity
shareholders
for
their
investment
in
the
company.
As
per
the
section
2(22)
of
the Income
Tax
Act,
1961,
dividend defined
as:
-
"Any distribution of accumulated profits whether capitalized or not, if such distribution entails a
release
of assets or part thereof".
Dividend is a reward to equity shareholders for their investment in the company.
It is a basic
right of equity shareholders to get dividend from the earnings of a company. Their share should
be distributed among the memb
ers within the limit of an act and with rational behavior of
directors.
The
word
dividend
has
not
been
defined
in
The
Indian
Companies
Act,
1956.
It
may
be
described as a periodical cannot be declared from capital gains under following conditions: i)
Provision in Articles of Association. ii) Capital
gain
must be realized. All assets
& liabilities
must be
revalued before
distributing
this capital gain.
DEFINITION:
DIVIDEND
POLICY
MRCET MBA
"Dividend policy determines the ultimate distribution of the
firm's earnings between retention
(that
is reinvestment) and
cash
dividend payments
of
shareholders."
"Dividend
policy
means
the
practice
that
management
follows
in
making
dividend
payout
decisions,
or
in
other
words,
the
size
and
pattern
of
cash
distributions
over
the
time
to
shareholders."
In
other words, dividend
policy is
the firm's
plan of action
to
be followed
when
dividend
decisions are made. It is the decision about how much of earnings to pay out as dividends versus
retaining
and reinvesti
ng
earnings in the
firm.
Dividend
policy
means
policy
or
guideline
followed
by
the
management
in
declaring
of
dividend.
A
dividend
policy
decides
proportion
of
dividend
and
retains
earnings.
Retained
earnings are an important source of internal finance for
long term growth of the company while
dividend
reduces the
available
cash funds of company.
"As long as the firm has investment project whose returns exceed its cost of capital, it will use
retained
earnings to finance
these
projects".
There is a
reciprocal relationship between retained earnings and dividend i.e. larger the retained
earnings, lesser the dividend and smaller the retained earnings, larger the dividend. James E.
Walter
(1963)
says
"Choice
of
dividend policy
almost effects the
value of
the
enterprise”
The dividend policy of a company reflects how prudent its financial management is. The future
prospects, expansion, diversification mergers are effected by dividing policies and for a healthy
and buoyant capital market, both dividends and
retained earnings are important factors. Most of
the company follows some kind of dividend policy. The usual policy of a company is to retain a
position of net earnings and distribute the remaining amount to the shareholders. Many factors
have
to be
evaluated before
forming
a
long
term dividend policy.
TYPES
OF
DIVIDENDS:
Classifications of dividends are based on the form in which they are paid. Following given below
are
the different types of
dividends:
1.
Cash
dividend
2.
Bonus
Shares
3.
Property
dividend
i
nterim dividend,
annual
dividend
4.
Special
-
dividend,
extra
dividend
etc.
5.
Regular
Cash
dividend
6.
Scrip
dividend
7.
Liquidating
dividend
8.
Property
dividend
MRCET MBA
Cash
dividend:
Companies mostly pay dividends in cash. A Company should have enough cash in
its bank
account when cash dividends are declared. If it does not have enough bank balance, arrangement
should be made to borrow funds. When the Company follows a stable dividend policy, it should
prepare a cash budget for the coming period to indicate the
necessary funds, which would be
needed to meet the regular dividend payments of the company. It is relatively difficult to make
cash
planning
in
anticipation of
dividend needs
when an unstable policy
is
followed.
The cash account and the reserve account o
f a company will be reduced when the cash dividend
is paid. Thus, both the total assets and net worth of the company are reduced when the cash
dividend is distributed. The market price of the share drops in most cases by the amount of the
cash
dividend dis
tributed.
Bonus
Shares:
An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In
India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend.
Hence, Companies in India may sup
plement cash dividend by bonus issues. Issuing bonus shares
increases the number of outstanding shares of the company. The bonus shares are distributed
proportionately
to the
existing
shareholder. Hence
there
is no dilution of
ownership.
The declaration of
the bonus shares will increase the paid
-
up Share Capital and reduce the
reserves and surplus retained earnings) of the company. The total net
-
worth (paid up capital plus
reserves and surplus) is not affected by the bonus issue. Infect, a bonus issue repre
sents a
recapitalization of reserves and surplus. It is merely an accounting transfer from reserves and
surplus
to paid up capital.
The
following
are
advantages
of
the
bonus
shares
to
shareholders:
1)
Tax benefit: One of the advantages to shareholders in the
receipt of bonus shares is the
beneficial
treatment of such dividends with
regard
to income taxes.
2)
Indication of higher future profits: The issue of bonus shares is normally interpreted by
shareholders
as an indication of
higher profitability.
3)
Future divi
dends may increase: if a Company has been following a policy of paying a fixed
amount of dividend per share and continues it after the declaration of the bonus issue, the total
cash
dividend of
the shareholders will increase
in
the future.
4)
Psychological
Value: The declaration of the bonus issue may have a favorable psychological
effect on shareholders. The receipt of bonus shares gives them a chance sell the shares to make
capital
gains
without
impairing
their
principal
investment.
They
also
associate
it
with
the
prosperity
of
the
company.
MRCET MBA
Special dividend :
In special circumstances
Company declares Special dividends. Generally
company
declares special
dividend in case
of
abnormal profits.
Extra
-
dividend: An extra dividend is an additional n
on
-
recurring dividend paid over and above
the regular dividends by the company. Companies with fluctuating earnings payout additional
dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular
dividends.
Annual
dividend:
When
annually company declares
and
pay dividend
is
defined
as
annual
dividend.
Interim dividend: During the year any time company declares a dividend, it is defined as Interim
dividend.
Regular cash dividends: Regular cash dividends are those the
company exacts to maintain every
year. They
may
be
paid quarterly, monthly, semiannually
or
annually.
Scrip dividends: These are promises to make the payment of dividend at a future date: Instead of
paying the dividend now, the firm elects to pay it at so
me later date. The „scrip‟ issued to
stockholders
is merely
a
special form of
promissory
note or notes payable
Liquidating dividends: These dividends are those which reduce paid
-
in capital: It is a pro
-
rata
distribution
of
cash or property
to
stockholders
as
part of
the
dissolution of
a
business
Property dividends: These dividends are payable in assets of the corporation other than cash. For
example, a firm may distribute samples of its own product or shares in another company it owns
to its
stockholders.
DIVIDENDS
AND
VALUE
OF
THE FIRM
The company's Board of Directors makes dividend decisions. They are faced with the decision to
pay
out dividends or to reinvest the
cash into new
projects.
The tradeoff between paying dividends and retaining profits within
the company The dividend
policy
decision is a
trade
-
off between
retaining
earnings v/s paying
out cash
dividends.
Dividend
policies
must
always
consider
two
basic objectives:
Maximizing
owners'
wealth
Providing
sufficient financing
FACTORS
DETERMINING
DIVIDEND
POLICY
While determining a firm's dividend policy, management must find a balance between current
income
for
stockholders (dividends)
and future
growth of
the company
(retained
earnings).
MRCET MBA
In
applying
a
rational
framework
for
dividend
policy,
a
firm
must
consider
the
following
two
issues:
How much cash is available for paying dividends to equity investors, after meeting all
needs
-
debt payments, capital expenditures and working capital (i.e. Free Cash Flow to
Equity
-
FCFE)
To what extent are good projects available to the firm (i.e. Return on equity
-
ROE >
Required
Return)
The
potential
combinations
of
FCFE
and
Project
Quality
and
the
generalizations
of
the
dividend
policy to
be
adapted
in
each
situation
are
presented
below
:
Dividend
Decision
Matrix
Factors
FCFE>
Dividends
FCFE<Dividends
ROE>
Cost of
Equity
Good Projects
Cash
flow
surplus
No
Change
Good Projects
Decrease
Dividends
Invest
in
Projects
ROE<
Cost of
Equity
Poor Projects
Cash
flow
surplus
Increase
Dividends
Reduce
Investment
Poor Projects
Cash
flow
Deficit
Decrease Dividends
Reduce
Investment
DIVIDEND
POLICY
THEORIES
1.
The
Residual
Theory
of
Dividend
Policy
The residual theory of dividend policy holds that the firm will only pay dividend from
residual
earnings, that is dividends should be paid only if funds remain after the optimum
level of capital expenditures is incurred i.e. all suitable investment opportunities have been
financed.
With a residual dividend policy, the primary focus of the firm is on
investments and hence
dividend policy is a passive decision variable. The value of a firm is a direct function of its
investment
decisions thus making
dividend policy
irrelevant.
2.
Dividend
Irrelevancy
Theory,
(Miller
&
Modigliani,
1961)
The dividend
irrelevancy theory asserts that dividend policy has no effect on either the price
of
the firm or its cost of capital.
This theory argues that dividend policy does not affect share price because the value of the
firm
is
a
function
of
its
earning
power
and
the
risk
of
its
assets.
If
dividends
do
affect
value,
it is only
due
to:
MRCET MBA
Information
effect
:
The
informational
content
of
dividends
relative
to
management's
earnings expectations
Clientele effect:
A clientele effect exists which allows firms
to attract shareholders
whose
dividend preferences
match
the firm's
historical dividend
payout patterns.
Signaling effect:
Rise in dividend payment is viewed as a positive signal whereas a
reduction
in
dividend
payment
is
viewed
as
a
negative
signal
about
the
future
earnings prospects of the company, thus leading to an increase or decreases in share
prices of the firm. Managers use dividends as signals to transmit information to the
capital
market.
Theoretical
models
by
Bhattacharya
(1979)19,
Miller
and
Ro
ck
(1985)20
and
John
and
Williams
(1985)21
and
Williams
(1988)22
tell
us
that
dividend
increases convey
good news
and dividend decreases convey
bad
news.
However, this theory
is based on the following
assumptions:
There
is
an
existence
of
perfect
capital
markets
i.e.
No
personal
or
corporate
taxes
and
no transaction costs.
The
firm's
investment
policy
is
independent
of its
dividend
policy.
Investors
behave
rationally
and information
is freely
available to them
Risk or uncertainty
does
not exist.
The
above
-
mentioned
assumptions
exclude
personal
and
corporate
taxes
as
well
as
any
linkage to capital investment policy as well as other factors that limit its application to real
world
situations.
3.
The
Bird
in
the
Hand
Theory,
(John
Lintner
1962
and
Myron
Gordon,
1963)
The
essence
of
this
theory
is
not
stockholders
are
risk
averse
and
prefer
current
dividends
due to their lower level of risk as compared to future dividends. Dividend payments reduce
investor uncertainty and thereby increase stock value. Thi
s theory is based on the logic that '
what is available at present is preferable to what may be available in the future'. Investors
would prefer to have a sure dividend now rather than a promised dividend in the future (even
if the promised dividend is lar
ger). Hence dividend policy is relevant
and does affect the
share
price
of
a
firm.
A
Summary View
of
Dividend
Policy
Theories
The
dividend
policy
theories
focus
on
the
issue
of
the
relevancy
of
dividend
policy
to
the
value
of
a
firm.
Dividend
Irrelevance
Dividends do
not make
any
difference
(M
&
M theory)
If
there are
no
taxes
disadvantages
associated
with
dividends.
MRCET MBA
Dividend
Relevance
Dividends
are
relevant
and
have
positive
impact
on
firm
value
If stockholders like dividends, or
dividends operate as a signal of
future prospects. (Lintner &
Gordon)
Dividends help to resolve agency problem and thus enhancing
shareholder value.
(Jenson)
Dividends are not good (Graham and Dodd)
If dividends have a tax disadvantage and
increasing di
vidends
reduce value. There are therefore, conflicting viewpoints regarding the
impact
of dividend decision on value of
a
firm.
DIVIDEND
MODELS
The
various
models
that
support
the
above
-
mentioned
theories
of
dividend
relevance
and
irrelevance are as
follows:
Modigliani
Miller
approach
(MM
Hypothesis)
According to them the price of a share of a firm is determined by its earning potentiality and
investment policy and not by the pattern of income distribution. The model given by them is as
follows:
Po
=
D1
+ P1/ (1/Ke)
Where,
Po
=
Prevailing
market
price
of
a
share
Ke
=
Cost of equity
capital
D1
=
Dividend
to
be
received
at
the
end
of
period one
P1
=
Market price
of a
share
at the
end of
period one
According to the MM hypothesis, market value of a share
before dividend is declared is equal to
the
present
value
of dividends
paid
plus
the
market
value
of
the share
after
dividend
is declared.
Walter's
approach
According to Prof. James E. Walter, in the long run, share prices reflect the present value of
fut
ure+ dividends. According to him investment policy and dividend policy are inter related and
the choice of a appropriate dividend policy affects the value of an enterprise. His formula for
determination
of
expected market price
of a
share is as follows:
P
= D + r/k(E
-
D)
K
Where,
P
=
Market
price
of
equity
share
D
=
Dividend per share
E
=
Earnings
per
share
(E
-
D)
=
Retained
earnings
per
share
r
=
Internal
rate
of
return on investment
MRCET MBA
k
=
cost
of capital
Gordon's
approach:
Dividend
Yield
Basis
The value of a share, like any other financial asset, is the present value of the future cash flows
associated with ownership. On this view, the value of the share is calculated as the present value
of
an infinite stream of dividends.
Myron Gordon's
Dividend Growth Model explains how dividend policy of a firm is a basis of
establishing share value. Gordon's model uses the dividend capitalization approach for stock
valuation.
The
formula
used is as
follows:
Po =
E1 (1
-
b)
K
-
br
Where,
Po = price per sha
re at the end of year 0
E1
=
earnings
per
share
at
the
end
of
year
1
(1
-
b)
=
fraction of
earnings the firm
distributes by
way
of
dividends
b
=
fraction of
earnings the
firm ploughs back
k
=
rate of return required by
shareholders
r
=
rate
of
return earned
on investments
made
by
the
firm
br
=
growth rate of
dividend and earnings
The
models, provided
by
Walter
and Gordon lead
to the
following
implications:
If
r
>
k
Price
per
share
increases
as
dividend
payout
ratio
decreases
If r
=
k
Price
per
share
remains
unchanged
with
changes
in
dividend payout
ratio
If r
<
k
Price
per
share
increases
as
dividend
payout
ratio
increases.
WORKING
CAPITAL MANAGEMENT
Working
Capital
The capital of a business which is used in its day
-
by
-
day trading operations, calculated as
the
current assets minus the current liabilities. Working capital is also called operating assets or net
current
assets.
WC=
CA
-
CL
Working
Capital
Management
Working capital management refers to a company‟s managerial accounting strategy designed to
monit
or and utilize the two components of working capital, current assets and current liabilities,
to
ensure
the most financially
efficient operation of the
company.
Need
of
Working
Capital Management
1.
Inventory
management
2.
Receivable
management
3.
Cash
management
Factors affecting
working
capital
management
Nature
of
business
MRCET MBA
Production
policy
Credit
policy
Inventory
policy
Abnormal
factor
Market
conditions
Conditions of
supply
Business
cycle
Taxation policy
Dividend policy
Operating
efficiency
Price
level
changes
Depreciation
policy
Availability
of raw material
Determining
the
Working
Capital
Needs
It
depends on the
following
factors
-
Size
of
the
firm
Activities
of
the
firm
Availability
of
credits
Attitudes
towards
profit
Attitude
toward
risks
Others
Importance
of
Adequate Working
Capital
1.
Smooth
running
of business
2.
Profitability
with
manage
risk
3.
Growth
and
development possibility
4.
Smooth
payment
5.
Increase
in
goodwill
6.
Trade
relationship
better
7.
Others
In
managing
WC two
processes are
there
-
Forecasting
requirement
of
fund
Arrangement
of
fund
The
Operating
Cycle
Approach
The
determination
of
WC
helps
in
forecast,
control&
management
of
WC.
The
duration
of
WC
may
vary
depending
upon
the
nature
of
business.
The
duration
of
operating
cycle
(WC
cycle)
MRCET MBA
Operating
Cycle =
R+W+F+D
-
C
for the purpose of estimating WC is equal to the sum of duration of each of above events less the
credit
period
allowed by
the supplier
For ex.
-
A co. holds raw material on an average for 60 days, it gets credit firm supplier for 15
d
ays, production process needs15 days, finished products are held 30 days & 30 days is the total
WC
cycle. So, 60+15+30+30
-
15=120 days.
Various
Components
of Operating
Cycle
A)
Raw
material shortage
period =
Average
stock
of
raw
material
Average
cost of
raw
material consumed
per day
B)
WIP
holding
period =
Average WIP inventory
Average
cost
of
production
per
day
C)
Finished
goods
storage
period
=
Estimated
production (in
units)
*
direct lab
permit
12
months
/
360
days
OR
Average stock of finished goods
Average
cost
of
goods
sold
per
day
D)
Debtors
collection
period
=
Average goods debtors
Average
credit
sale
per
day
E)
Credit
period
available
to
suppliers
=
Average
rate
credit
Average
credit
purchase
per
day
Financing
of Working
Capital
Financing
of working
capital can
be
done
in
two ways:
A.
Long
term
sources
B.
Short
term
sources
A.
Long
term
sources
1.
Share
capital
a.
Equity
share
capital
b.
Preference
share
capital
2.
Debentures
a.
Convertible
debentures
b.
Non
-
convertible
debentures
c.
Redeemable
debentures
MRCET MBA
d.
Non
-
Redeemable
debentures
3.
Bonds
4.
Loans from
banks &
financial
institutions
5.
Retained
earnings
6.
Venture
capital
fund
for
innovative
projects
B.
Short
term
sources
1.
Bank
credit
2.
Transaction
credit
3.
Advances from
customers
4.
Bank
advances
5.
Loans
6.
Overdraft
7.
Bills
purchase and
discounted
8.
Advance
against
documents
of
title
of
goods
9.
Term loans
by
bank
10.
Commercial
paper
11.
Bank
deposits
Financing
of Working
Capital
through
Bank
Finance
and
Trade
Credit
Traditionally
bank credit:
Source
of meeting
of
working
capital needs
of
business firms.
In
other words,
they
have
been extending
credit to
industry
&
trade
on
the
basis
of security.
RBI has appointed various committees to ensure equitable distribution of bank resources to
various sectors of economy.
The committees suggest ways & means to make the bank credit
&
effective instrument of
industrialization.
Recommendation
of
Daheja
and
Tondon
Committee
on
Working
Capital
1.
DAHEJA
COMMITTEE:
In
September
1969,
Daheja
committee
of
RBI
pointed
out
in
his
report
that
in
the
financing
practice of the banks. There was no relationship between the optimum requirement & bank loan.
The
committee
also
pointed
out
that
banks
do
not
give
proper
attention
to
financing
patterns.
So
clients
move
towards double &
multiple financing.
The
Daheja
committee
suggested:
The heart
hole which
represents
the minimum
level
of raw material,
finished
goods
&
stores
which
any
industrial concerned
is required to
hold
for
maintaining certain
level of production.
The
strictl
y
short
term
components
which
should
be
the
fluctuating
path
of
the
accounting,
the
path
should
represents
the
short
term
inventory,
taxes,
dividend,
bonus
payments.
Conclusion
of
Daheja
committee:
Orientation
towards
project &
need based
lending.
2.
TONDON
COMMITTEE
MRCET MBA
In
July
1974,
RBI
constituted
a
study
group
under
the
chairpersonship
of
Mr.
P.L
Tondon.
The
study
group
was asked to
give
its recommendations on the
following
matter:
What
contsitutes
the
working
capital
requirement
of
industry
and
what
is
end
use
of
credit?
How
is
the
quantum
of
bank
advanced
to
be
decided?
Can
norms
be
involved
of
current
assets
&
for
debt
equity
ratio
to
ensure
minimum
dependents
on
bank
finance?
Canthe
current
manner
&
stage
of
lending
be
imposed?
Can
an
adequate
planning
assessment
&
implementation
system
be
involved
to
ensure
a
discipline
flow
of
credit to meet genuine
production needs
&
its proper supervision?
The
study
group
reviewed
the
system
of
working
capital
financing
and
identified
its
major
shortcoming
as
follows:
The
cash
credit
system
of
lending
wherein
the
borrower
can
draw
freely
within
limits
sanctioned by
the banker hinders
sound
credit
planning
on the
part
of
the
banker
and
induces
financial
indiscipline
in
the
borrower.
The
sec
u
r
i
t
y
-
o
r
i
e
nted
a
pproa
c
h
to
lendi
n
g
f
a
v
o
re
d
bor
r
o
w
e
rs
with
strong
fi
n
a
n
c
ial
r
e
sourc
e
s
and also led to diversion of funds, borrowed against the security of current assets, for financing
fixed assets.
Relatively
easy
access
to
working
capital
finance
led
to
large
inventory
levels
with
industry.
Working
capital
finance
provided
by
banks,
theoretically
supposed
to
be
short
term
in
nature,
tended
to
be,
in
practice,
a
long
-
term
source
of
finance.
For
the
regulating
bank
credit,
the
study
group
made
comprehensive recommendations
which have
been made by and large
accepted by
the
Reserve Bank of
India.
The
final
recommendations
for
committee
were:
A.
Banks
finance
essentially
for
meeting
working
capital
needs.
B.
To
fill
up
the
working
capital
gap.
C.
Norms: The borrowing requirement of industrial unit depends on the length of working capital
cycle.
D.
Three
different
methods
for
calculating
the
borrowing
limit
to
finance
working
capital
requirements
are:
First
step
is
to
use required
fund deposit
your
money
in
term
deposit,
never
purchase
excessive
inventory.
The
borrower
will
have
to
provide
a
minimum
25%
of
total
current
assets
from
the
term
fund.
To
decide
the
limit
as
per
current
assets
&
current
liabilities.
E.
Style
of
credit
`
F.
Information
system
for
banks
MRCET MBA
UNIT
5
Introduction
Cash is one of the current assets of a business. It is needed at all times to keep
the
business
going.
A
business
concern
should
always
keep
sufficient
cash
for
meeting its obligations. Any shortage of
cash will hamper the operations of a concern
and any excess of it will be unproductive. Cash is the most unproductive of all the
assets.
While
fixed
assets
like
machinery,
plant,
etc.
and
current
assets
such
as
inventory will help the business in increasin
g its earning capacity, cash in hand will
not add
anything
to the concern. It is in
this context that cash
management has
assumed much importance.
Nature
of
Cash
For some persons, cash means only money in the form of currency (cash in
hand). For other pers
ons, cash means both cash in hand and cash at bank. Some even
include near cash assets in it. They take marketable securities too as part of cash.
These
are
the
securities
which
can
easily
be
converted into cash.
Cash itself does not produce good or servic
es. It is used as a medium to acquire
other assets. It is the other assets which are used in manufacturing goods or providing
services.
The
idle
cash
can
be
deposited
in
bank
to earn
interest.
A business has to keep required cash for meeting various needs.
The assets
acquired by cash again help the business in producing cash. The goods manufactured
of services produced are sold to acquire cash. A firm will have to maintain a critical
level of cash. If at a time it does not have sufficient cash with it, it w
ill have to borrow
from
the
market
for reaching the
required
level.
There remains a gap between cash inflows and cash outflows. Sometimes cash
receipts
are
more
than
the payments
or
it may
be
vice
-
versa at another
time. A
financial
manager
tries
to synchro
nize
the
cash
inflow and cash outflows.
Motives
for
Holding
Cash
The
firm‟s
needs
for
cash
may
be
attributed
to
the
following
needs:
Transactions motive, Precautionary motive and Speculative motive. These motives
are
discussed as follows:
1.
Transaction Motive:
A firm needs cash for making transacions in the day
-
to
-
day operations. The cash is needed to make purchases, pay expenses, taxes, dividend,
etc. The cash needs arise due to the fact that there is no complete synchronization
between cas
h receipts and payments. Sometimes cash receipts exceed cash payments
or
vice
-
versa.
The
transaction
needs
of
cash
can
be
anticipated
because
the
expected
MRCET MBA
payments
in
near
future
can
be
estimated.
The
receipts
in
future
may
also
be
anticipated
but
the
things
do
not
happen
as
desired.
If
more
cash
is
needed
for
payments than receipts, it may be raised through bank overdraft. On the other hand if
there
are
more
cash
receipts
than
payments,
it
may
be
spent
on
marketable
securities.
2.
Precautionary Motive:
A firm is required to keep cash for meeting various
contingencies. Though
cash
inflows and
cash outflows are anticipated but there may
be variations
in
these estimates.
For
example
a debtor who was to pay after 7 days
may
inform
of
hi
s
inability
to
pay;
on
the
other
hand
a
supplier
who
used
to
give
credit for 15 days may not have the stock to supply or he may not be in a position to
give credit at present. In these situations cash receipts will be less then expected and
cash payments
will be more as purchases may have to be made for cash instead of
credit. Such contingencies often arise in a business. A firm should keep some cash for
such contingencies
or
it
should
be
in
a
position to raise
finances
at
a
short
period.
3.
Speculative Motive:
The speculative motive relates to holding of cash for
investing in profitable opportunities as and when they arise. Such opportunities do not
come in a regular manner. These opportunities cannot be scientifically predicted but
only
conj
ectures
can
be
made
about
their
occurrence.
The
price
of
shares
and
securities may be low at a time with an expectation that these will go up shortly. Such
opportunities
can
be
availed
of
if
a
firm
has cash
balance
with
it.
Cash
Management
Cash management
has assumed importance because it is the most significant of
all the current assets. It is required to meet business obligations and it is unproductive
when
not
used.
Cash
management
deals
with
the
following:
(i)
Cash
inflows
and
outflows
(ii)
Cash
flows
within the
firm
(iii)
Cash
balances
held
by
the
firm
at
a
point
of
time.
Cash
Management
needs
strategies
to
deal
with
various
facets
of
cash.
Following
are
some
of
its facets.
(a)
Cash Planning:
Cash planning is a technique to plan and control the use of
cash. A projected
cash flow statement may be prepared, based on the present business
operations and
anticipated
future activities. The cash
inflows from various sources
may
be
anticipated
and cash outflows
will
determine
the
possible
uses
of
cash.
(b)
Cash Forecasts and Budgeti
ng:
A cash budget is the most important device
for
the
control
of
receipts
and
payments
of
cash.
A
cash
budget
is
an
estimate
of
cash
MRCET MBA
receipts and disbursements during a future period of time. It is an analysis of flow of
cash in a business
over a future, short or long period of time. It is a forecast of
expected
cash
intake and
outlay.
The short
-
term forecasts can be made with the help of cash flow projections.
The finance manager will make estimates of likely receipts in the near future and
the
expected
disbursements
in
that
period.
Though
it
is
not
possible
to
make
exact
forecasts
even
then
estimates
of
cash
flow
will
enable
the
planners
to
make
arrangement
for
cash
needs.
A
financial
manager
should
keep
in
mind
the
sources
from where he
will meet short
-
term needs. He should also plan for productive use of
surplus
cash
for short
periods.
The long
-
term cash forecasts are also essential for proper cash planning. These
estimates may be for three, four, five or more years. Long
-
term forecasts
indicate
company‟s
future
financial
needs
for
working
capital,
capital
projects,
etc.
Both
short
term
and
long
term
cash
forecasts
may
be
made
with
help
of
following methods.
(a)
Receipts
and
Disbursements
method
(b)
Adjusted
net
income
method
Receipts
and
Disbursements
method
In this method the receipt and payment of cash are estimated. The cash receipts
may be from cash sales, collections from debtors, sale of fixed assets, receipts of
dividend or other income of all the items; it is difficult to forecast
the sales. The sales
may be on cash as well as credit basis. Cash sales will bring receipts at the time of
sales while credit sale will bring cash later on. The collections from debtors will
depend upon the credit policy of the firm. Any fluctuation in sal
es will disturb the
receipts of cash. Payments may be made for cash purchases, to creditors for goods,
purchase
of
fixed assets etc.
The receipts and disbursements are to be equalled over a short as well as long
periods. Any shortfall in receipts will have
to be met from banks or other sources.
Similarly, surplus cash may be invested in risk free marketable securities. It may be
easy to make
estimates
for
payments
but
cash
receipts
may
not
be
accurately made.
Adjusted
Net Income
Method
This method may also
be known as sources and uses approach. It generally has
three sections: sources of cash, uses of cash and adjusted cash balance. The adjusted
net income method helps in projecting the company‟s need for cash at some future
date and to see whether the compa
ny will be able to generate sufficient cash. If not,
then it will have to decide about borrowing or issuing shares etc. in preparing its
statement
the
items
like
net
income,
depreciation,
dividends,
taxes
etc.
can
easily
be
MRCET MBA
determined
from
company‟s annual operating budget. The estimation
of working
capital movement becomes difficult because items like receivables and inventories are
influenced by factors such as fluctuations in raw material costs, changing demand for
company‟s products. Thi
s method helps in keeping control on working capital and
anticipating financial
requirements.
Managing
Cash
Flows
After
estimating
the
cash
flows,
efforts
should
be
made
to
adhere
to
the
estimates or receipts and payments of cash. Cash management will be
successful only
if cash collections are accelerated and cash disbursements, as far as possible, are
delayed.
The
following methods
of
cash management
will
help:
Methods
of
Accelerating
Cash
Inflows
1.
Prompt
Payment
by
Customers
:
In
order
to
accelerate
cash
inflows,
the
collections from customers should be prompt. This will be possible by prompt
billing. The customers
should be promptly
informed
about
the amount payable
and the time by which it should be paid. Another method for prompting customers
to pay
earlier is
to
allow
them
cash discount.
2.
Quick Conversion of Payment into Cash:
Cash inflows can be accelerated by
improving the cash collecting process. Once the customer writes a cheque in
favour of the
concern
the
collection
can be quickened by
its early
collection.
There is a time gap between the cheque sent by the customer and the amount
collected against it. This is due to many factors, (i) mailing time, i.e. time taken by
post office for transferring cheque from customer to the firm, referred to as
po
stal
float
; (ii) time taken in processing the cheque within the organization and sending
it to bank for collection, it is called
lethargy
and (iii) collection time within the
bank, i.e. time taken by the bank in collecting the payment from the customer‟s
b
ank, called
bank float
. The postal float, lethargy and bank float are collectively
referred to as
deposit float
.
The term deposit float refers to cheques written buy
customers
but
the
amount
not
yet
usable
by
the
firm.
3.
Decentralised Collections
:
A big firm
operating over wide geographical area can
accelerate collections by using the system of decentralized collections. A number
of collecting centres are opened in different areas instead of collecting receipts at
one place. The idea of opening different coll
ecting centres is to reduce the mailing
time
for
customer‟s
dispatch
of
cheque
and
its
receipt
in
the
firm
and
then
reducing the
time
in
collecting
these
cheques.
4.
Lock Box System
:
Lock box system is another technique of reducing mailing,
processing
and
collecting
time.
Under
this
system the
firm
selects
some
collecting
MRCET MBA
centres at different places. The places are selected on the basis of number of
consumers
and
the
remittances to be received
from
a
particular
place.
Methods
of
Slowing
Cash
O
utflows
A
company
can
keep
cash
by
effectively
controlling
disbursements.
The
objective of controlling cash outflows is slow down the payments as far as possible.
Following methods
can be
used
to
delay
disbursements:
1.
Paying
on
Last
Date:
The
disbursements
can
be
delayed
on
making
payments on the last due date only. It is credit is for 10 days then payment should be
m
ade
o
n
1
0
t
h
d
a
y
on
l
y
.
It
c
a
n
he
l
p
i
n
us
i
n
g
t
he
m
on
e
y
fo
r
s
ho
rt
p
e
r
io
ds
a
nd
t
he
fi
rm
can make
use
of
cash
discount
also.
2.
Payments through Drafts:
A company can delay payments by issuing drafts
to the suppliers instead of giving cheques. When a cheque is issued then the company
will have to keep
a balance in
its account so
that the cheque is paid whenever it
comes. On the
other hand a draft is payable only on presentation to the issuer. The
receiver will give the draft to its bank for presenting it to the buyer‟s bank. It takes a
number of days before it is actually paid. The company can economies large resources
by
using
t
his method.
3.
Adjusting Payroll Funds:
Some economy can be exercised on payroll funds
also. It can be done by reducing the frequency of payments. If the payments are made
weekly then this period can be extended to a month. Secondly, finance manager can
plan
the
issuing
of
salary
cheques
and
their
disbursements.
If
the
cheques
are
issued
on Saturday then only a few cheque may be presented for payment, even on Monday
all
cheques
may
not
be
presented.
4.
Centralisation
of
Payments
: The
payments
should
be
centralized
and
payments should be made through drafts or cheques. When cheques are issued from
the main office then it will take time for the cheques to be cleared through post. The
benefit
of
cheque
collecting
time
is
availed.
5.
Inter
-
bank Transfer:
An eff
icient use of cash is also possible by inter
-
bank
transfers. If the company has accounts with more than one bank then amounts can be
transferred to the bank where disbursements are to be made. It will help in avoiding
excess
amount
in
one
bank.
6.
Making use
of Float:
Float is a difference between the balance shown in
company‟s cash book (Bank column) and balance in passbook of the bank. Whenever
a cheque is issued, the balance at bank in cashbook is reduced. The party to whom the
cheque is issued may not pres
ent it for payment immediately. If the party is at some
other
station
then
cheque
will
come
through
post
and
it
may
take
a
number
of
days
MRCET MBA
before it is presented. Until the time; the cheques are not presented
to bank
for
payment
there
will
be
a
balance
in
the
bank.
The
company
can
make
use
of
this
float
if
it is able
to
estimate it
correctly.
Determining
Optimum
Cash
Balance
A firm has to maintain a minimum amount of cash for settling the dues in time.
The cash is needed to purchase raw
materials, pay creditors, day
-
to
-
day expenses,
dividend etc.
An appropriate amount of cash balance to be maintained should be determined
on the basis of past experience and future expectations. If a firm maintains less cash
balance then its liquidity posit
ion will be weak. If higher cash balance is maintained
then an opportunity to earn is lost. Thus, a firm should maintain an optimum cash
balance,
neither a
small
nor a
large
cash
balance.
There
are
basically
two
approaches
to
determine
an
optimal
cash
bala
nce,
namely, (i) Minimizing Cost Models and (ii) Preparing Cash Budget. Cash budget is
the
most
important tool
in
cash management.
Cash
Budget
A
cash
budget
is
an
estimate
of
cash
receipts
and
disbursements
of
cash
during
a future period of time. In the
words of soloman Ezra, a cash budget is “an analysis of
flow of cash in a business over a future, short or long period of time. It is a forecast of
expected cash intake and outlay.” It is a device to plan and control the use of cash.
Thus a firm by prepari
ng a cash budget can plan the use of excess cash and make
arrangements
for the
necessary cash
as and when
required.
The cash receipts from various sources are anticipated. The estimated cash
collections for sales, debts, bills receivable, interests,
dividends and other incomes and
sale of investments and other assets will be taken into account. The amounts to be
spent
on
purchase
of
materials,
payment
to
creditors
and
meeting
various
other
revenue
and
capital
expenditure
needs
should
be
considered.
Ca
sh
forecasts
will
include all possible sources from which cash will be received and the channels in
which
payments
are
to
be
made
so that
a
consolidated cash
position is
determined.
Baumol’s
Model
William J. Baumol has suggested a model for determining the
optimum balance
of cash based upon carrying and transaction costs of cash. The carrying cost refers to
the
cost
of
the
holding
cash
i.e.
interest;
and
transaction
cost
refers
to
the
cost
involved
in
getting
the
marketable
securities
converted
into
cash,
t
he
algebraic
representation of
the
model
is:
MRCET MBA
where,
C = Optimum
cash
balance
A = Annual (or monthly) cash disbursements)
F
= Fixed
cost
per transaction
O
=
Opportunity
cost
of
cash
Limitations
of
Model:
1.
The
model
assumes
a
constant
rate
of
use
of
cash.
This
is
hypothetical
assumption. Generally the cash outflows in any firm are not regular and hence this
model
may
not
give
correct
results.
2.
The transaction cost will also be difficult to be measured since these depend upon
the
type
of
investment
as well
as
the
maturity
period.
Miller
-
Orr
Model
The Miller
–
Orr model argues that changes in cash balance over a given period are
random in size as well as in direction. The cash balance of a firm may fluctuate
irregularly over a period of time.
The model assumes (i) out of the two assets i.e. cash
and marketable securities, the latter has a marginal yield, and (ii) transfer of cash to
marketable securities and vice versa is possible without any delay but of course of at
some
cost.
The model has
specified two control limits for cash balance. An upper limit, H,
beyond which cash balance need not be allowed to go and a lower limit, L, below
which the cash level is not allowed to reduce. The cash balance should be allowed to
move within these limits.
If the cash level reaches the upper control limit, H, then at
this point, apart of the cash should be invested in marketable securities in such a way
that
the
cash
balance
comes
down
to
a
predetermined
level
called
return
level,
R,
If
the
cash
balance
reaches
the
lower
level,
L
then
sufficient
marketable
securities
should be sold to realize cash so that cash balance is restored to the return level, R. No
transaction between cash and marketable securities is undertaken so long as the cash
balance
is
betw
een
the
two
limits
of
H
and
L.
The
Miller
–
Orr
model
has
superiority
over
the
Baumol‟s
model.
The
latter
assumes constant need and constant rate of use of funds, the Miller
-
Orr model, on the
other hand is more realistic and maintains that the actual cash
balance may fluctuate
between
higher
and
the
lower limits.
The
model
may be
defined
as:
Z
=
(
3
T
V
/
4
i
)
1/3
MRCET MBA
Where, T = Transaction cost of conversion
V =
Variance
of
daily cash flows
i
=
Daily
%
interest
rate
on investments.
Investment
of
Surplus
Funds
There
are,
sometimes
surplus
funds
with
the
companies
which
are
required
after sometime. These funds can be employed in liquid and risk free securities to earn
some income. There are number of avenues where these funds can be invested. The
selection of securities or method of investment is very important. Some of these
methods
are
discussed
herewith:
Treasury Bills :
The treasury bills or T
-
Bills are the bills issued by the Reserve
Bank of India for different maturity periods. These bills ar
e highly safe investment an
are easily marketable. These treasury bills usually have a vary low level of yield and
that
too
in
the form of
difference purchase
price
and
selling
price
as
there
is
no
interest
payable
on
these
bills.
Bank Deposits:
All the co
mmercial banks are offerings short term deposits
schemes at varying rate of interest depending upon the deposit period. A firm having
excess cash can make deposit for even short period of few days only. These deposits
provide
full
safety,
facility of
pre
-
mature
retirement
and a
comfortable
return.
Inter
-
Corporate Deposits:
A firm having excess cash can make deposit with
other
firms
also.
When
company
makes
a
deposits
with
another
company,
such
deposit is known as inter corporate deposits. These deposit
s are usually for a period of
three months to one year. Higher rate of interest is an important characteristic of these
deposits.
Bill Discounting:
A firm having excess cash can also discount the bills of other
firms in the same way as the commercial banks
do. On the bill maturity date, the firm
will get the money. However, the bill discounting as a marketable securities is subject
to 2 constraints (i) the safety of this investment depends upon the credit rating of the
acceptor
of
the
bill,
and (ii)
usually
the
pre
mature
retirement
of
bills
is
not
available.
MRCET MBA
Illustration
1:
From
the
following
forecast
of
income
and
expenditure,
prepare
cash
budget
for
the
months January to
April,
1995.
Months
1994
Nov
Dec
1995
Jan
Feb
March
April
Sales
30,000
35,000
25,000
30,000
35,000
40,000
Purchases
15,000
20,000
15,000
20,000
22,500
25,000
Wages
3,000
3,200
2,500
3,000
2,400
2,600
Manufac
-
ring
expenses
1,150
1,225
990
1,050
1,100
1,200
Adminis
trative
expenses
1,060
1,040
1,100
1,150
1,220
1,180
Selling
Expenses
500
550
600
620
570
710
Additional
information
is
as
follows:
-
1.
The
customers
are
allowed
a
credit
period
of
2
months.
2.
A
dividend
of
Rs.
10,000 is
payable
in
April.
3.
C
api
t
al
e
x
pe
n
d
itu
re
t
o
be
i
n
c
u
r
r
e
d:
Pl
a
nt
pu
rch
a
sed
o
n
1
5
t
h
J
a
n
ua
r
y
f
or
R
s.
5
,
0
00
;
a
B
u
il
d
i
ng
h
a
s
b
e
e
n
p
u
r
c
has
e
d
o
n
1
s
t
M
a
r
c
h
a
nd
t
he
p
a
y
m
ents
a
r
e
t
o
be
ma
de
i
n
monthly installments of
Rs.
2,000 each.
4.
The
creditors
are
allowing
a
credit
of
2
months.
5.
W
a
ges
are
pa
i
d
o
n
t
he
1
s
t
of
t
he
next
m
o
n
t
h.
MRCET MBA
6.
Lag
in
payment
of
other
expenses is
one
month.
7.
Balance
of
cash in
hand on
Ist
January,
1995
is
Rs.
15,000.
Solution:
Details
Receipts
Opening
Balance
of
cash
Cash
realized
from
debtors
Payments
Payments
to
customers
Wages
Manufacturing
expenses
Administrative
expenses
Selling expenses
Payment of dividend
Purchase
of
plant
Instalment
of
building
plant
Total Payments
Closing
Balance
January
15,000
30,000
15,000
3200
1225
1040
560
------
5000
-----
26,015
18,985
February
18,985
35,000
20,000
2500
990
1100
600
------
-----
----
25,190
28,795
March
28,795
25,000
15,000
3000
1050
1150
620
------
------
2,000
22,820
30,975
April
30,975
30,000
20,000
2400
1100
1220
570
10,000
------
2,000
37,290
23,685
Illustration 2:
ABC Co. wishes to arrange overdraft facilities with its bankers during
the period April to June, 1995 when it will be manufacturing mostly for stock. Prepare
a
cash
budget
for
the
above
period
from
the
following
data,
indicating
the
extent
of
the
bank facilities
the
company will
require
at
the
end of
each
month:
MRCET MBA
1995
Sales
Rs.
Purchases
Rs.
Wages
Rs.
February
1,80,000
1,24,800
12,000
March
1,92,00
1,44,000
14,000
April
1,08,000
2,43,000
11,000
May
1,74,000
2,46,000
10,000
June
1,26,000
2,68,000
15,000
(c)
50 per cent of credit sales are realised in the month following the sales and
remaining 50 per cent in the second month following. Creditors are paid in the
month following
the
month
of
purchase.
(d)
Cash
at
bank
on
1.4.1995
(estimated)
Rs.25000
Solution:
Receipts
Opening Balance
Sales
Amount
received
from
sales
Total
Receipts
Payments
Purchase
Wages
Total
Payments
Closing
Balance
(a
-
b)
April
25,000
90,000
96,000
2,11,000
1,44,000
14,000
1,58,000
53,000
May
53000
96,000
54,000
2,03,000
2,43,000
11,000
2,54,000
(
-
)51,000
June
(
-
)
51000
54000
87000
90000
246000
10000
256000
(
-
)1,66,000
Lets Sum
Up
Cash Management refers to management of ash and bank balance or in a broader
sense
it
is
the
management of
cash inflows and
outflows.
Every firm must have minimum cash. There may be different motives for holding
cash. These may be Transactionary motive, Precautionary motive or Speculative
motive
for
holding
cash.
MRCET MBA
The objectives of cash management
may be defined as meeting the cash outflows
and minimizing
the
cost
of
cash
balance.
Cash budget is the most important technique for planning the cash movement. It is
a summary of cash inflows and outflows during particular period. In cash budget
all expec
ted receipts and payments are noted to find out the cash shortage or
surplus
during
that
period.
Optimum level of cash balance is the balance which firm should have in order to
minimize the cost of maintaining cash. Baumol‟s model gives optimum cash
balanc
e which aims at minimizing the total cost of maintaining cash. The Miller
–
Orr
model says that a firm should
maintain
its cash
balance within
a range of
lower
and
higher limit.