Prepared by SHAIK MASOOD, Asst Prof in Finance, AIMS

Unit- I
FINANCIAL MANAGEMENT

Unit- I
FINANCIAL MANAGEMENT

“If I have no intention of becoming a financial manger, why do I need to

understand financial applications / Analyse of Financial decision/ corporate finance?”

1. Need of Knowing Finance – A Managerial Perspective

Finance is the life blood of business. Every decision made in a business has financial
implications, and any decision that involves the use of money is a corporate financial
decision, broadly every thing that a business does fits under the rubric of corporate
finance. In fact, the term, finance has to be understood clearly as it has different meaning
and interpretation in various contexts. The time and extent of the availability of finance in
any organization indicates the health of a concern. Every organization may it be a
company, firm, bank or university requires finance for running day to day affairs. As
every organization previews stiff competition, it requires finance not only for survival but
also for strengthening themselves. Finance is said to be the circulatory system of the
economy body, making possible the required cooperation between the innumerable units
of activity.
Before we are learning the financial management there is a need to understand
what is the firm or corporation
2. The Firm (or) Corporation: Structural Set up
We will use firm generically to refer to any business, large or small,
manufacturing or service, private or public. Thus, a corner grocery store and Microsoft
are both firms. The firm’s investments are generically termed assets. While assets are
often categorized by accountants into fixed assets, which are long-lived, and current
assets, which are short-term, we prefer a different categorization. The assets that the firm
has already invested in are called assets-in-place, whereas those assets that the firm is
expected to invest in the future are called growth assets. While it may seem strange that
a firm can get value from investments it has not made yet, high-growth firms get the bulk

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of their value from these yet-to-be-made investments. To finance these assets, the firm
can raise money from two sources. It can raise funds from investors or financial
institutions by promising investors a fixed claim (interest payments) on the cash flows
generated by the assets, with a limited or no role in the day-to-day running of the
business; we categorize this type of financing to be debt. Alternatively, it can offer a
residual claim on the cash flows (i.e., investors can get what is left over after the interest
payments have been made) and a much greater role in the operation of the business. We
term this equity. Note that these definitions are general enough to cover both private
firms, where debt may take the form of bank loans, and equity is the owner’s own money,
as well as publicly traded companies, where the firm may issue bonds (to raise debt) and
stock (to raise equity).
3. Some Fundamental Propositions about Corporate Finance (Financial
Management)
There are several fundamental arguments we will make repeatedly throughout
1. Corporate finance has an internal consistency that flows from its choice of maximizing
firm value as the only objective function and its dependence upon a few bedrock
principles: Risk has to be rewarded; cash flows matter more than accounting income;
markets are not easily fooled; every decision a firm makes has an effect on its value.
2. Corporate finance must be viewed as an integrated whole, rather than as a collection of
decisions. Investment decisions generally affect financing decisions, and vice versa;
financing decisions generally affect dividend decisions, and vice versa. While there are
circumstances under which these decisions may be independent of each other, this is
seldom the case in practice. Accordingly, it is unlikely that firms that deal with their
problems on a piecemeal basis will ever resolve these problems. For instance, a firm that
takes poor investments may soon find itself with a dividend problem (with insufficient
funds to pay dividends) and a financing problem (because the drop in earnings may make
it difficult for them to meet interest expenses).
3. Corporate finance matters to everybody. There is a corporate financial aspect to almost
every decision made by a business; while not everyone will find a use for all the
components of corporate finance, everyone will find a use for at least some part of it.
Marketing managers, corporate strategists, human resource managers and information

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technology managers all make corporate finance decisions every day and often don’t
realize it. An understanding of corporate finance may help them make better decisions.
4. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most
people associate corporate finance with numbers, accounting statements and hardheaded
analyses. While corporate finance is quantitative in its focus, there is a significant
component of creative thinking involved in coming up with solutions to the financial
problems businesses doing encounter. It is no coincidence that financial markets remain
the breeding grounds for innovation and change.
5. The best way to learn corporate finance is by applying its models and theories to real
world problems. While the theory that has been developed over the last few decades is
impressive, the ultimate test of any theory is in applications.
The successful manager will need to be much more of a team player that has the
knowledge and ability to move not just vertically within an organization but horizontally
as well developing cross-functional capabilities will be the rule, not the exception. The
mastery of basic financial management skills is key ingredient that will be required in the
work place of yours not in too distant future.
Important focal points in the study of finance:
• Accounting and Finance often focus on different things
• Finance is more focused on market values rather than book values.
• Finance is more focused on cash flows rather than accounting income.
Why is market value more important than book value?
• Book values are often based on dated values. They consist of the original cost of
the asset from some past time, minus accumulated depreciation (which may not
represent the actual decline in the assets’ value).
• Maximization of market value of the stockholders’ shares is the goal of the firm.
Why is cash flow more important than accounting income?
• Cash flow to stockholders (in the form of dividends) is the only basis for
valuation of the common stock shares. Since the goal is to maximize stock price,
cash flow is more directly related than accounting income.
• Accounting methods recognize income at times other than when cash is actually
received or spent.

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One more reason that cash flow is important:

When cash is actually received is important, because it determines when cash can
be invested to earn a return.

4. Fields of Finance
Business finance: The term business and business finance is a very broad term. It covers
all the activities carried out with the intention of earning profits.
Corporate finance: It is a part of business finance and deals with the financial practices,
policies and problems of corporate enterprises or companies.
International finance: It is the study of flow of funds between individuals and
organisations beyond national boundaries and developing methods to handle these funds
more effectively.
Public finance: It deals with the financial matters of the government. It becomes a
crucial as the government deals with huge sums of money which can be raised through
sources like taxes or other methods and are required to be utilised within the statutory and
other limitations.
Private finance: It deals with financial matters of non-government organizations.

5. Three Areas of Finance

Financial Markets: Securities Trading, Financial Intermediaries, Derivative Securities &

Risk Management

Investments: Financial Analysis, Portfolio Management, Real Estate

Corporate Finance: Financial Management, Investment Banking, Venture Capital

6. What Is Finance?
Finance can be defined as the art and science of managing money. Virtually all
individuals and organizations earn or raise money and spend or invest money. Finance is
concerned with the process, institutions, markets, and instruments involved in the transfer
of money among individuals, businesses, and governments. Most adults will benefit from
an understanding of finance, which will enable them to make better personal financial

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decisions. Those who work in financial jobs will benefit by being able to interface
effectively with the firm’s financial personnel, processes, and procedures.
Finance is the study of money (inflow and outflow) management, the acquiring of funds
(cash) and the directing of these funds to meet objective of financial management i.e.
wealth of the owner (share holders) this can be achieve by maximize returns and
minimizing risks.
Finance is
 Capital is wealth that is used to generate more wealth.
 Finance is the discipline concerned with or the study of how to acquire and utilize
capital to the greatest benefit.
 In other words, finance deals with how value is created.
The Value Creation Process
Capital$ Financial Management Shareholder Wealth
Decisions
Finance is
 The finance function is the process of acquiring and utilising funds of a business.
o R.C. Osborn
 Financing consists of the raising, providing, managing of all the money, and
capital of funds of any kind to be used in connection with business.
o Bonneville and Dewey
Financial Management- “It is Concerns the acquisition, financing, and management of
assets with some overall goal in mind to maximaise the value of the firm”.
Financial management “it is concerned with efficient use of an important economic
resources namely capital funds” By Ezra Solomon
Managerial finance is concerned with the duties of the financial manager in the business
firm.
Financial managers actively manage the financial affairs of any type of businesses—
financial and non financial, private and public, large and small, profit-seeking and not-
for-profit. They perform such varied financial tasks as planning, extending credit to
customers, evaluating proposed large expenditures, and raising money to fund the firm’s
operations. In recent years, the changing economic and regulatory environments have

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increased the importance and complexity of the financial manager’s duties. As a result,
many top executives have come from the finance area.
7. Approaches to the term Finance (Scope)
• Traditional approach
• Modern approach
According to the Traditional approach, the term finance was interpreted to mean the
procurement of funds by corporate enterprises to meet their financing needs. The term
‘procurement’ was used in a broad sense to include the whole gamut of raising the funds
externally.
This approach was criticized on various grounds such as:
 It is too narrow and restrictive in nature. Procurement of the funds is only one of the
functions of finance and other functions are ignored.
 It considers the financial problems only of corporate enterprises. In that sense, it
ignores the financial problems of non-corporate entities like proprietary concerns,
partnership firms etc.
 It considers only the basic and non-recurring problems relating to the business. Day-to-
day financial problems of a normal company do not receive any attention
 It concentrates only on long term financing. It means that the working capital
management is out of the purview of the finance function.
The Modern approach, which is a more, balanced one and hence the acceptable one to
the modern scholars, interprets the term finance as being concerned with procurement of
funds and wise application of funds.
8. Scope of Finance Function
According to the modern approach, the function of finance is concerned with the
following three types of decisions:
 Financing Decisions
 Investment Decisions
 Dividend Policy Decisions
 Liquidity Decision
The Financing Decisions (Capital Structure)

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Every business, no matter how large and complex it is, is ultimately funded with a
mix of borrowed money (debt) and owner’s funds (equity). With a publicly trade firm,
debt may take the form of bonds and equity is usually common stock. In a private
business, debt is more likely to be bank loans and an owner’s savings represent equity.
While we consider the existing mix of debt and equity and its implications for the
minimum acceptable hurdle rate as part of the investment principle, we throw open the
question of whether the existing mix is the right one in the financing principle section.
While there might be regulatory and other real world constraints on the financing mix
that a business can use, there is ample room for flexibility within these constraints.
Financing decisions are the decisions regarding the process of raising funds. This
function of finance is concerned with providing the answers to various questions.
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy?
How will the funds be physically acquired?
The Investment Decisions (Capital Budgeting)
Firms have scarce resources that must be allocated among competing needs. The first
and foremost function of corporate financial theory is to provide a framework for firms to
make this decision wisely. Accordingly, we define investment decisions to include not
only those that create revenues and profits (such as introducing a new product line or
expanding into a new market), but also those that save money (such as building a new
and more efficient distribution system). Further, we argue that decisions about how much
and what inventory to maintain and whether and how much credit to grant to customers
that are traditionally categorized as working capital decisions, are ultimately investment
decisions, as well. At the other end of the spectrum, broad strategic decisions regarding
which markets to enter and the acquisitions of other companies can also are considered
investment decisions. Corporate finance attempts to measure the return on a proposed
investment decision and compare it to a minimum acceptable hurdle rate (Hurdle Rate: A
hurdle rate is a minimum acceptable rate of return for investing resources in a project.) in
order to decide whether or not the project is acceptable or not. The hurdle rate has to be

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set higher for riskier projects and has to reflect the financing mix used, i.e., the owner’s
funds (equity) or borrowed money (debt).
Investment decisions are the decisions regarding the application of funds raised by the
organisation. The investment decisions relate to the selection of assets in which the funds
should be invested.
What is the optimal firm size?
What specific assets should be acquired?
What assets (if any) should be reduced or eliminated?
Liquidity decision (Working Capital Management)
How do we manage existing assets efficiently?
Financial Manager has varying degrees of operating responsibility over assets greater
emphasis on current asset management than fixed asset management.
The Dividend Policy Decisions (Profit Allocation decision)
Most businesses would undoubtedly like to have unlimited investment
opportunities that yield returns exceeding their hurdle rates, but all businesses grow and
mature. As a consequence, every business that thrives reaches a stage in its life when the
cash flows generated by existing investments is greater than the funds needed to take on
good investments. At that point, this business has to figure out ways to return the excess
cash to owners. In private businesses, this may just involve the owner withdrawing a
portion of his or her funds from the business. In a publicly traded corporation, this will
involve either dividends or the buying back of stock.
Dividend policy decisions are strategic financial decisions and are concerned with the
answers to the questions like:
1. What are the forms in which the dividends can be paid to the shareholders?
2. What are the legal and procedural formalities to be completed while paying the
dividend in different forms?

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9. Goals/Objectives of Finance Function tenor

Profit Maximization
According to this principle, all the functions of the business will have profit as
the main objective. Maximizing firms earnings after taxes.
Problems connected with this objective are:
1. The term profit is an ambiguous concept which isn't having precise connotation.
For example, profits can be long term or short term.
2. The profits always go hand in hand with risks.
3. Profit maximization as the goal of financial function ignores the time pattern of
returns.
4. Profit maximization as the objective doesn’t take into consideration the social
consideration as well as the obligations to various interests of workers,
consumers, society, etc…and ethical trade practices.
5. Could increase current profits while harming firm (e.g., defer maintenance, issue
common stock to buy T-bills, etc.).

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6. Ignores changes in the risk level of the firm.

Earnings per Share Maximization

Maximizing earnings after taxes divided by shares outstanding.
Problems connected with this objective are:
It does not specify timing and duration of expected returns.
It ignores changes in the risk level of the firm.
It calls for a zero payout dividend policy.
Shareholder Wealth Maximization
Value creation occurs when we maximize the share price for current shareholders.
Shortcomings of Alternative Perspectives
Wealth Maximization
• Due to limitations attached with profit maximization as an objective of the finance
function, it is no more accepted as the basic objective.
• The value of an asset is judged not in terms of its cost but in terms of the benefits
it produces.
• Thus, wealth maximization goal as a decision criteria suggests that , any financial
action which creates wealth or which has discounted stream of future benefits
exceeding its cost, is desirable and should be accepted and that which does not
satisfy this test should be rejected.
The goal of wealth maximization is supposed to be superior to the goal of profit
maximization due to the following reasons:
1. It uses the concept of future expected cash flows rather than the ambiguous
term of profits. As such, measurement of benefits in terms of cash flows
avoids ambiguity.
2. It considers time value of money. It recognises that the cash flows generated
earlier are more valuable than those generated later. That is why while
computing the value of total benefits, the cash flows are discounted at a
certain discounting rate.
3. Takes account of: current and future profits and EPS; the timing, duration,
and risk of profits and EPS; dividend policy; and all other relevant factors.

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4. Thus, share price serves as a barometer for business performance.

The goal of the firm should be to maximize the stock price!
• This is equivalent to saying the goal is to maximize owners’ wealth.
• Note that the stock price is affected by management’s decisions affecting both
risk and profit.
• Stock price can be maintained or increased only when stockholders perceive that
they are receiving profits that fully compensate them for bearing the risk they
perceive.

FCF1 FCF2 FCF

Pr esentValue ( w)    .. .. 
(1  k ) 1
(1  k ) 2
(1  k ) 

Where:
W is present value or wealth of share holder
FCF is expected future Cash flows (income or earnings)
K is capitalization rate or cost of equity or WACC
The common stockholders are the owners of the corporation!
• Stockholders elect a board of directors who in turn hire managers to maximize the
stockholders’ well being.
• When stockholders perceive that management is not doing this, they might
attempt to remove and replace the management, but this can be very difficult in a
large corporation with many stockholders. More likely, when stockholders are
dissatisfied they will simply sell their stock shares.
• This action by stockholders will cause the market price of the company’s stock to
fall.
• When stock price falls relative to the rest of the market (or relative to the rest of
the industry)
• Management is failing in their job to increase the welfare (or wealth) of the
stockholders (the owners).
• Management is accomplishing their goal of increasing the welfare (or wealth) of
the stockholders (the owners).
10. The Role of the Financial Manager

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The financial manager stands between the firm’s operations and the financial (or
capital) markets, where investors hold the financial assets issued by the firm. The
financial manager’s role is illustrated in Figure 1.1, which traces the flow of cash from
investors to the firm and back to investors again. The flow starts when the firm sells
securities to raise cash (arrow 1 in the figure). The cash is used to purchase real assets
used in the firm’s operations (arrow 2). Later, if the firm does well, the real assets
generate cash inflows which more than repay the initial investment (arrow 3). Finally, the
cash is either reinvested (arrow 4a) or returned to the investors who purchased the
original security issue (arrow 4b). Of course, the choice between arrows 4a and 4b is not
completely free. For example, if a bank lends money at stage 1, the bank has to be repaid
the money plus interest at stage 4b. Our diagram takes us back to the financial manager’s
two basic questions. First, what real assets should the firm invest in? Second, how should
the cash for the investment be raised? The answer to the first question is the firm’s
investment, or capital budgeting, decision. The answer to the second is the firm’s
financing decision. Capital investment and financing decisions are typically separated,
that is, analyzed independently. When an investment opportunity or “project” is
identified, the financial manager first asks whether the project is worth more than the
capital required to undertake it. If the answer is yes, he or she then considers how the
project should be financed.
But the separation of investment and financing decisions does not mean that the financial
manager can forget about investors and financial markets when analyzing capital
investment projects. The dividend decision or returns distribution among the investors as
the basic financial objective of the firm is to maximize the value of the cash invested in
the firm by its stockholders. Look again at Figure 1.1. Stockholders are happy to
contribute cash at arrow 1 only if the decisions made at arrow 2 generate at least adequate
returns at arrow 3. “Adequate” means returns at least equal to the returns available to
investors outside the firm in financial markets. If your firm’s projects consistently
generate inadequate returns, your shareholders will want their money back.

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Flow of cash between financial markets and the firm’s operations.

Key: (1) Cash raised by selling financial assets to investors;
(2) cash invested in the firm’s operations and used to purchase real assets;
(3) cash generated by the firm’s operations;
(4a) cash reinvested; (4b) cash returned to investors.

Duties and Responsibilities of Finance manager

Classification of duties and responsibilities:
• Recurring Duties
• Non-recurring duties
Recurring duties
It comprises of Deciding financial needs, raising funds required, Allocation of funds
(Fixed asset management and Current assets management), Allocation of income, Control
of funds, and Evaluation of performance, corporate taxation and other duties
Non-recurring Duties: Involves preparation of financial plan at the time of company
promotion, financial readjustments in times liquidity crisis, valuation of the enterprise at
the time of acquisition and merger thereof etc.
11. Organization of the Financial Management Function
Their roles are summarized as the treasurer is responsible for looking after the
firm’s cash, raising new capital, and maintaining relationships with banks, stockholders,
and other investors who hold the firm’s securities.
For small firms, the treasurer is likely to be the only financial executive. Larger
corporations also have a controller, who prepares the financial statements, manages the
firm’s internal accounting, and looks after its tax obligations. You can see that the
treasurer and controller have different functions: The treasurer’s main responsibility is to

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obtain and manage the firm’s capital, whereas the controller ensures that the money is
used efficiently.
Still larger firms usually appoint a chief financial officer (CFO) to oversee both the
treasurer’s and the controller’s work. The CFO is deeply involved in financial policy and
corporate planning. Often he or she will have general managerial responsibilities beyond
strictly financial issues and may also be a member of the board of directors. The
controller or CFO is responsible for organizing and supervising the capital budgeting
process. However, major capital investment projects are so closely tied to plans for
product development, production, and marketing that managers from these areas are
inevitably drawn into planning and analyzing the projects. If the firm has staff members
specializing in corporate planning, they too are naturally involved in capital budgeting.

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mgt Preparing Fin Statements
Preparing Budgets
Tax Analysis/Planning

12. Financial planning

Financial planning indicates a firm’s growth, performance, investments and requirements

of funds during a given period of time, usually three to five years.
Financial planning help a firm’s financial manager to regulate flows of funds which is his
primary concern.

Examine interactions – help management see the interactions between decisions

Explore options – give management a systematic framework for exploring its
opportunities

Avoid surprises – help management identify possible outcomes and plan accordingly
Ensure feasibility and internal consistency – help management determine if goals can be
accomplished and if the various stated (and unstated) goals of the firm are consistent with
one another

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Steps in Financial Planning

Past performance
Operating characteristics
Corporate strategy and investment needs
Cash flow from operations
Financing alternatives
Consequences of financial plans
Consistency

Elements of Financial Planning

• Investment in new assets – determined by capital budgeting decisions

• Degree of financial leverage – determined by capital structure decisions
• Cash paid to shareholders – determined by dividend policy decisions
• Liquidity requirements – determined by net working capital decisions

Financial Planning Model Ingredients

• Sales Forecast – many cash flows depend directly on the level of sales (often
estimated sales growth rate)
• Pro Forma Statements – setting up the plan as projected financial statements
allows for consistency and ease of interpretation
• Asset Requirements – the additional assets that will be required to meet sales
projections
• Financial Requirements – the amount of financing needed to pay for the required
assets
• Plug Variable – determined by management decisions about what type of
financing will be used (makes the balance sheet balance)
• Economic Assumptions – explicit assumptions about the coming economic
environment

Financial Planning Process

Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and
long-run decisions (usually 2 – 5 years)
Aggregation - combine capital budgeting decisions into one big project
Evaluating the current financial condition of the firm.
Analysing the future growth prospects and options.
Appraising the investment options to achieve the stated growth objective.
Projecting the future growth and profitability.
Estimating funds requirement and considering alternative financing options.
Comparing and choosing from alternative growth plans and financing options.
Measuring actual performance with the planned performance.

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Financial forecasting is an integral part of financial planning. It uses past data to estimate
the future financial requirements.

A financial planning model establishes the relationship between financial variables and
targets, and facilitates the financial forecasting and planning process.

A financial planning model has the following three components:

1. Inputs
2. Model
3. Output
Prepare pro forma financial statements
Based on the model inputs and assumptions, the planning team developed the
model equations for pro forma profit and loss statement, funds flow statement and
balance sheet.

To prepare the next year’s pro forma profit and loss statement, balance sheet and
funds flow statement, the planning team through a consultative process in the
company, made several assumptions and models about the relationships between
financial variables.

In practice, long-term financial forecasts are prepared by relating the items of profit
and loss account and balance sheet to sales. This is called the percentage to sales
method.

Sustainable Growth Model

Sustainable growth may be defined as the annual percentage growth in sales that is
consistent with the firm’s financial policies (assuming no issue of fresh equity). The
following model can be used to determine the sustainable growth (gs) in sales:

Sustainable Growth Model and Financial Policy Trade-off

A simple way of ascertaining the growth potential of a company, given its current
financial conditions, is to examine the interaction between four financial policy goals
expressed as ratios:

 Target sales growth

 Target return on investment (net assets)
 Target dividend payout and
 Target debt-equity (capital structure)

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 Growth Potential of a Single-product Company.

 Sustainable Growth Model for a Multi-product Company.
 Growth Potential of a Single-product Company
 Sustainable growth may be defined as the annual percentage growth in sales that
is consistent with the firm’s financial policies (assuming no issue of fresh equity):

Net margin × Retention × Leverage

Sustainable Growth 
Assets Turnover – (Net Margin × Retention X Leverage)

Growth Potential of a Multi-product Company

Sustainable growth rate in the case of multi-product or multi-division company is to
calculate the sustainable growth rate at the corporate level in terms of growth in
assets.

Growth = Retained earnings

(1+Debt/equity ratio)
Net assets

Sg Asset turnover × Profit margin × Lever age factor × Retention ratio × (1+D/E)

Assumptions and Scenarios

 Make realistic assumptions about important variables

 Run several scenarios where you vary the assumptions by reasonable amounts
 Determine at least a worst case, normal case and best case scenario

13. Time Value of Money

Time Preference for Money

Time preference for money is an individual’s preference for possession of a given

amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for money:

1. Risk
2. Preference for consumption
3. Investment opportunities

Required Rate of Return

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The time preference for money is generally expressed by an interest rate. This rate
will be positive even in the absence of any risk. It may be therefore called the risk-free
rate.

An investor requires compensation for assuming risk, which is called risk premium.
The investor’s required rate of return is:

Risk-free rate + Risk premium.

Time Value Adjustment

Two most common methods of adjusting cash flows for time value of money:

Compounding—the process of calculating future values of cash flows and

Discounting—the process of calculating present values of cash flows.

Future Value

Amount to which an investment will grow after earning interest

Future Value

Compounding is the process of finding the future values of cash flows by applying the
concept of compound interest.

Compound interest is the interest that is received on the original amount (principal) as
well as on any interest earned but not withdrawn during earlier periods.

Simple interest is the interest that is calculated only on the original amount (principal),
and thus, no compounding of interest takes place.

The general form of equation for calculating the future value of a lump sum after n
periods may, therefore, be written as follows:

Fn  P(1  i ) n

The term (1 + i) is the compound value factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for positive i, indicating that CVF increases as i and n
increase.

Future Value of an Annuity

Annuity is a fixed payment (or receipt) each year for a specified number of years. If you
rent a flat and promise to make a series of payments over an agreed period, you have
created an annuity.

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The term within brackets is the compound value factor for an annuity of Re 1, which we
shall refer as CVFA.

Future Values

Future Value of $100 = FV

FV  $100  (1  r ) t

Example - FV

What is the future value of $5400,000 if interest is compounded annually at a rate of 5%

for one year?

FV  $400,000  (1  .05)1  $420,000

Present Value

Value today of a future cash flow.

Discount Factors and Rates
Discount Rate
Interest rate used to compute present values of future cash flows.
Discount Factor

 Present value of a $1 future payment.

 Present value of a future cash flow (inflow or outflow) is the amount of current
cash that is of equivalent value to the decision-maker.
 Discounting is the process of determining present value of a series of future cash
flows.
 The interest rate used for discounting cash flows is also called the discount rate.
 The computation of the present value of an annuity can be written in the following
general form:

Present Value Present Value = PV

PV = discount factor  C1

PV = A (1/1+r)

Discount Factors can be used to compute the present value of any cash flow.

Discount Factor = DF = PV of $1
DF  1
(1 r ) t

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The term within parentheses is the present value factor of an annuity of Re 1, which we
would call PVFA, and it is a sum of single-payment present value factors.

Present Value of Perpetuity

Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in
financial decision-making:

Risk-return Trade-off

o Risk and expected return move in tandem; the greater the risk, the greater the
expected return.
o Financial decisions of the firm are guided by the risk-return trade-off.
o The return and risk relationship:

Return = Risk-free rate + Risk premium

o Risk-free rate is a compensation for time and risk premium for risk.

14. Role of Management

Management acts as an agent for the owners (shareholders) of the firm.

An agent is an individual authorized by another person, called the principal, to act in the
latter’s behalf.

Agency Theory
Jensen and Meckling developed a theory of the firm based on agency theory.
Agency Theory is a branch of economics relating to the behavior of principals and their
agents.

Principals must provide incentives so that management acts in the principals’ best
interests and then monitor results.
Incentives include stock options, perquisites, and bonuses.

UNIT 2
1. INTRODUCTION

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Capital structure is one of the most complex areas of financial decision making
because of its interrelationship with other financial decision variables. Any business or a
company or firm requires capital to acquire assets. The capital structure of a company
will be planned and implemented when the company is formed and incorporated. The
initial capital structure would therefore be designed very carefully. The management of a
company would set a target capital structure and the subsequent financing decisions
would be made with a view to achieve the target capital structure. The management has
also to deal with an existing capital structure. The company will need to fund or finance
its activities continuously. Every time a need arises for funds, the management will have
to weigh the pros and cons of the various sources of finance and then select the
advantageous source keeping in view the target capital structure. Thus capital structure
decisions are a continuous one and they have to be made whenever the company needs
additional finance.
The capital structure decision centers on the allocation between debt and equity in
financing the business needs. An efficient mixture of capital employed reduces the price
of capital. “Lowering the over all cost of capital increases net economic returns which
ultimately increase business value”.
An unleveled business uses only equity capital. A levered business uses a mix of equity
and various forms of other liabilities. Understanding why the current proportion of debt
in the capital structure lowers the cost of capital and increases stock price holds attention.
Basic characteristics of an un-levered company (total equity and no debt financing). In
such a company there are no external creditors. Only the shareholders as a group have a
claim on the expected net income and they bear the risk associated with the expected net
income. Therefore the total risk faced by such a company is business risk and the risk
associated with the tax environment.
In a levered company, shareholders use the debt (fixed cost return) cheapest source of
fund by using the debt they can make money from it, i.e. known as financial leverage or
trading on equity. In fact, the focal point of capital structure theory hinges on
shareholders recognizing that debt use can add to their returns. The equity holders
demand higher returns to compensate themselves for the additional risk they bear. Thus,
shareholders require higher returns for the added financial risk of creditors.

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The use of appropriate amount of debt adds value if the company enjoys a tax deduction
for interest payments. Thus moving away from entire equity (Un-levered) to part equity
and part debt (levered) financing will result in the following fruitful journey for the
shareholders.
- Corporate debt increases – financial risk increase
- Total risk increase since financial risk is increasing
- Equity decreases – the number of shares of stock decreases – the company does not
need as much equity financing because debt is replacing equity in the capital structure
- Expected earnings per share increase since fewer shares exist and the expected tax
benefits of using debt contribute to the EPS
Hence making crucial decision on the capital structure – either entire equity or part equity
and part debt financing – is very vital for the development and growth of any business
organisation.
Therefore before get into the in depth analysis first we focus on some fundamentals are:

2. CAPITAL STRUCTURE

Capital means “funds” employed in business. Capital structure gives us the various
components of capital – both debt capital and share capital. In short, capital structure tells
us about how much funds have been brought into business. It gives us the relationship
between debt and equity, known as “debt to equity” relationship or capital structure or
financing. Working capital is employed for a short time and hence ignored.
4. FINANCIAL STRUCTURE

The term financial structure, on the other hand, is used in a broader sense, and it includes
equity and all liabilities of the firm.

4. NEED FOR A CAPITAL STRUCTURE

Why do we need a capital structure? Can’t we do without it? In other words, can’t
we only have equity or debt instead of both the components? One can have a business
enterprise only with equity funds without taking any loans. However, the financial risk
that he will be taking would be tremendous, without anybody to share it with. Referring
to debt we cannot have a business enterprise only with debt. It is impossible as no lender

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would be willing to give entire amount by way of loan. Any lender wants the owner to
put in some money by way of equity share capital so that the balance funds can be given
in the form of loans. The market norm for lending is debt to equity not to exceed or idle
to be considering as 2:1. To sum up, any business enterprise would have what is known
as “capital structure”. It is advisable for a business enterprise to have both debt and equity
components in its capital structure although it is possible to run the business entirely on
equity. It is beneficial to have a mix of debt and equity as it increases the “Earnings Per
Share” (EPS) to the shareholders. At the same time, having regard to increasing risk due
to increasing debt, it is better to be within the lending norms of 2:1.

5. COMPONENTS OF A CAPITAL STRUCTURE (SOURCES OF LONG TERM

FINANCE)

Share capital:Equity share capital (external equity)

Retained earnings (internal equity)
Preference share capital
Debt capital: Debentures, Loans, Fixed deposits from the public, Bonds, Unsecured
loans from promoters, friends and relatives etc,

6. OPTIMAL MIX OF DEBT AND EQUITY – A DISCUSSION

Is there an optimal mix of debt and equity for a business enterprise? The answer to this
question has been daunting Financial Analysts and Academicians and Theoreticians for a
long time now. The perfect answer has so far been elusive. This indicates that the best
capital structure or the most suitable capital structure for a business enterprise is still a
“dream”. In the meanwhile, the business enterprise and “Finance experts” keep trying to
evolve a perfect capital structure model. In this discussion it is better to remember that
while “equity” is cushion available to a business enterprise, debt is a “sword”. Debt has
to be paid back and hence risk increases. The “process of maintaining proper balance
between debt and equity there by increase market value of the firm and minimaise the
overall cost of capital”. The objective of optimal debt to equity mix should be to
“maximise the firm value”. This involves the following steps:

 Identify the economic and financial market conditions facing the firm and analyze the
competitive features of the business

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 Invest in projects that yield a return greater than the minimum acceptable hurdle rate
(cost of capital)

 Manage financial risks that investors cannot easily manage, to maximise the firm’s
debt and investment capacity

7. FACTORS INFLUENCING CAPITAL STRUCTURE OR “DETERMINANTS”

OF CAPITAL STRUCTURE

1. Profitability: It should be profitable from the equity shareholders and the

organisation, the higher the profits more the chances for debt capital because of
ability to service higher debt – both by way of interest and repayment of principal
amount. This is reflected in a very critical ratio called “Interest coverage ratio”.
EBIT/I. The higher the ratio, the more the chances of debt in the capital structure.

2. Reliable cash flows: the more they are reliable the more the lenders are willing to
give debt capital to the enterprise. Once debt is taken cash outflows get fixed for the
future. Accordingly the reliability of firm’s cash flows assumes great significance
here.

3. Flexibility: It refers to the ability of the firm to meet the requirements of the
changing situations.

4. Solvency: The use of excessive debt may threaten the solvency of the company.

5. Minimization of Risk: Capital structure must be consistent with business risk and it
should result in a certain level of financial risk. Degree of risk associated with the
enterprise – the higher the risk less the chances of debt capital and more the chances
of equity. Example – IT industry (at least in the late 90’s in India) run predominantly
on equity

6. Management’s risk aversion attitude: conservative managements take less of

external debt and try to utilise internal accruals to maximum extent and equity to the
extent necessary; on the contrary aggressive managements go in for debt to a larger
extent. Examples – Sundaram group of companies in Chennai in general and
Sundaram Claytons in particular – conservative attitude towards debt and debt to

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equity ratio being less than 1:1. On the contrary, Essar oils have very high debt to
equity ratio – close to 3:1.

7. Tax: Whether the business enterprise enjoys tax concessions in a big way like till
recently the IT industry? Owing to high level of exports till recently the IT sector was
enjoying 100% tax concession on the exports profits. There was no difference in cost
of debt (interest) and cost of equity (primarily dividend) in the absence of taxes.
Please refer to the Chapter on “Leverages”. Such enterprises are indifferent to debt
and have more of equity only.

8. Debt Source: Availability of different kinds of debt instruments like “deep

discounted” bonds, floating rate notes (where the rate of interest is adjusted to the
market rates) etc. that are attractive to the enterprises to go in for maximum debt
within the debt to equity ratio norms specified by the lenders or the market. These
instruments have entered the market only in the 90s and hence the debt market is
getting more and more attractive and limited companies have started using them
instead of only depending upon institutional finance.

9. Control: It should reflect the management’s philosophy of control over the firm.
Attitude of the promoters towards financial and management control - if this is high,
first preference would be given for debt and then preference shares. Last preference
would be given for public equity where financial control gets diluted because of
larger number of shareholders and managerial control is likely to be affected.

10. Nature of the industry: more competitive = higher equity and less debt; more
monopolistic = less equity and more debt. Further depending upon the nature of
industry the lenders do have different lending norms. This means that the leverage
ratios in a particular industry are more or less uniform. These serve as the benchmark
for determining the capital structure for any unit in the industry

The cost of capital is the rate of return that a firm must earn on the projects in which it
invests to maintain the market value of its stock. It can also be thought of as the rate of
return required by the market suppliers of capital to attract their funds to the firm. If risk
is held constant, projects with a rate of return above the cost of capital will increase the
value of the firm, and projects with a rate of return below the cost of capital will decrease

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the value of the firm. The cost of capital is an extremely important financial concept. It
acts as a major link between the firm’s long-term investment decisions and the wealth of
the owners as determined by investors in the marketplace. It is in effect the “magic
number” that is used to decide whether a proposed corporate investment will increase or
decrease the firm’s stock price. Clearly, only those investments that are expected to
increase stock price would be recommended. Because of its key role in financial decision
making, the importance of the cost of capital cannot be overemphasized.
Some Key Assumptions
The cost of capital is a dynamic concept affected by a variety of economic and
firm-specific factors. To isolate the basic structure of the cost of capital, we make some
key assumptions relative to risk and taxes:
1. Business risk—the risk to the firm of being unable to cover operating costs— is
assumed to be unchanged. This assumption means that the firm’s acceptance of a given
project does not affect its ability to meet operating costs.
2. Financial risk—the risk to the firm of being unable to cover required financial
obligations (interest, lease payments, preferred stock dividends)—is assumed to be
unchanged. This assumption means that projects are financed in such a way that the
firm’s ability to meet required financing costs is unchanged.
3. After-tax costs are considered relevant. In other words, the cost of capital is measured
on an after-tax basis. This assumption is consistent with the framework used to make
capital budgeting decisions.

8. COST OF CAPITAL-KEY CONCEPTS:

The term cost of capital refers to the minimum rate of return a firm must earn on its
investments.
This is in consonance with the firm’s overall object of wealth maximization. Cost of
capital is a complex, controversial but significant concept in financial management. The
following definitions give clarity management.
Hamption J.: The cost of capital may be defined as “the rate of return the firm requires
from investment in order to increase the value of the firm in the market place”.

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James C. Van Horne: The cost of capital is “a cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the
market price of the stock”.
Soloman Ezra:”Cost of Capital is the minimum required rate of earinings or the cut-off
rate of capital expenditure”.
It is clear from the above difinitions that the cast of capital is that minimum rate of return
which a firm is expected to earn on its investments so that the market value of its share is
maintained.
9. IMPORTANCE OF COST OF CAPITAL:
The cost of capital is very important in financial management and plays a crucial role in
the following areas:
i) Capital budgeting decisions: The cost of capital is used for discounting cash flows
under Net Present Value method for investment proposals. So, it is very useful in capital
budgeting decisions.
ii) Capital structure decisions: An optimal capital is that structure at which the value of
the firm is Value of the firm is maximaise and cost of capital is the lowest. So, cost of
capital is crucial in designing optimal capital structure.
iii) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitabily is compared to the expected and
actual cost of capital of funds and if profit is greater than the cast of capital the
performance nay be said to be satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other
financial decisions as dividend policy, capitalization of profits, making the rights issue,
etc.
10. DETERMINATION OF CAST OF CAPITAL:
As stated already, cost of capital plays a very important role in making decisions relating
to financial management. It involves the following problems.
Problems in determination of cost of capital:
i) Conceptual controversy regarding the relationship between cost of capital and capital
structure is a big problem.

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ii) Controversy regarding the relevance or otherwise of historic costs pr future costs in
decision making process.
iii) Re Computation of cost of equity capital depends upon the excepted rate of return by
its investors. But the quantification of expectations of equity shareholders is a very
difficult task.
iv) Retained earnings has the opportunity cost of dividends forgone by the shareholders.
Since different shareholders may have different opportunities for reinvesting dividends, it
is very difficult to compute cost of retained earnings.
v) Whether to use book value or market value weights in determining weighted average
cost of capital poses another problem.
11. THE COST OF SPECIFIC SOURCES OF CAPITAL
This chapter focuses on finding the costs of specific sources of capital and
combining them to determine the weighted average cost of capital. Our concern is only
with the long-term sources of funds available to a business firm, because these sources
supply the permanent financing. Long-term financing supports the firm’s fixed-asset
investments.
The specific cost of each source of financing is the after-tax cost of obtaining the
financing today, not the historically based cost reflected by the existing financing on the
firm’s books. Techniques for determining the specific cost of each source of long-term
funds are presented
12. COMPUTATION OF COST OF CAPITAL:
Computation of cost capital of a firm involves the following steps:
i) Computation of cost of specific sources of a capital, viz., debt, preference capital,
equity and retained earnings, and
ii) Computation of weighted average cost of capital.
1) COST OF DEBT (Kd)
Debt may be perpetual or redeemable debt. Moreover, it may be issued at par, at premium
or discount. The computation of cost debt in each is explained below.
i) Perpetual / irredeemable debt:
i) At par:
Kd = Cost of debt before tax =I/Po

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Kd = Cost of debt; I= interest; Po = net proceeds

Kd (after-tax) = I/P(I-t)
Where T = tax rate
Illustration1.
Y Ltd issued Rs. 2, 00,000, 9% debentures at a premium of 10%. The costs of floatation
are 2% . The tax rate is 50%. Compute the after tax cost of debt. I Rs. 18,000
Answer: kd (after-tax)= 18000/ 215600 (1- .50) =4.17%
NP Rs. 2,15,600 [net proceeds = Rs. 2,00,000 + 20,000 – (2/100x2,20,000)]
ii) Redeemable debt
The debt repayable after a certain period is known ad redeemable debt. Its cost computed
by using the following formula:

i) Before – tax cost of debt = ½ (P+NP)

I = interest: P= proceeds at par;
NP = net proceeds; n = No. of years in which debt is to be redeemed

ii)
Illustration2.
A company issued Rs. 1, 00,000 10% redeemable debentures at a discount of 50%. The
cost of floatation to Rs. 3,000. The debentures are redeemable after 5 years. Compute
before – tax and after – tax Cost of debt. The rate is 50%.

2) Cost of preference Capital (Kp)

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In case of preference share dividend are payable at a fixed rate. However, the dividends
are not allowed to be deducted for computation of tax. So no adjustment for tax is
required just like debentures, preference share may be perpetual or redeemable. Future,
they may be issued at par, premium or discount.
i) Perpetual preference Capital
i) If issued at par; Kp = D/P
Kp = Cost of preference capital
D = Annual preference dividend
P = Proceeds at par value
ii) If issued at premium or discount
Kp = D/NP Where NP = net proceeds.
Illustration3.
A company issued 10,000, 10% preference share of Rs. 10 each, Cost of issue is Rs. 2 per
share. Calculate cost of capital, of these shares are issued (a) at par , (b) at 10%
premium, and (c) at 5% discount.

ii) Redeemable preference shares - It is calculated with the following formula:

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Where, Kp = Cost of preference capital

D = Annual preference dividend
MV = Maturity value of preference shares
NP = Net proceeds of preference shares
Illustration 4.
A company issues 1, 00,000 10% preference share of Es. 10 each. Calculate the cost of
preference capital if it is redeemable after 10 years. a) At par b) at 5% premium

3) Cost of Equity capital

Cost of Equity is the expected rate of return by the equity shareholders. Some
argue that, as there is no legal for payment, equity capital does not involve any cost. But
it is not correct. Equity shareholders normally expect some dividend from the company
while making investment in shares. Thus, the rate of return expected by them becomes
the cost of equity. Conceptually, cost of equity share capital may be defined as the
minimum rate of return that a firm must earn on the equity part of total investment in a

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project in order to leave unchanged the market price of such shares. For the determination
of cost equity capital it may be divided into two categories:
i) External equity or new issue of equity shares.
ii) Retained earnings.
The cost of external equity can be computed as per the following approaches:
i) Dividend Yield / Dividend Price Approach-According to this approach, the cost of
equity will be that rate of expected dividends which will maintain the present market
price of equity shares. It is calculated with the following formula:
Ke = D/NP (for new equity shares)
Or
Ke = D/MP (for existing shares)
Where,
Ke = Cost of equity
D = Expected dividend per share
NP = Net proceeds per share
Mp = Market price per share
This approach rightly recognizes the importance of dividends. However, it ignores the
importance of retained earnings on the market price of equity shares. This method is
suitable only when the company has stable earnings and stable dividend policy over a
period of time.
Illustration5.
A company issues, 10,000 equity shares of Rs. 100 each at a premium of 10%. The
company has been paying 20% dividend to equity shareholders for the past five years and
expected to maintain the same in the future also. Compute cost of equity capital. Will it
make any difference if the market price of equity share is Rs. 150 ?

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ii) Dividend yield plus Growth in dividend methods

According to this method, the cost of equity is determined on the basis if the expected
dividend rate plus the rate of growth in dividend. This method is used when dividends are
expected to grow at a constant rate.
Cost of equity is calculated as:
Ke = D1 /NP +g (for new equity issue)
Where,
D1 = expected dividend per share at the end of the year. [D1 = Do(1+g)]
Np = net proceeds per share
g = growth in dividend for existing share is calculated as:
D1 / MP + g
Where,
MP = market price per share.
Illustration6.
MM Ltd plans to issued 1,00,000 new equity share of Rs. 10 each at par. The floatation
costs are expected to be 5% of the share price. The company pays a dividend of Rs. 1 per
share and the growth rate in dividend is expected to be 5%. Compute the cost of new
issue share. If the current the cost of new issue of shares.

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iii) Earnings Yield Method - According to this approach, the cost of equity is the
discount rate that capitalizes a stream of future earnings to evaluate the shareholdings. It
is called by taking earnings per share (EPS) into consideration. It is calculated as:
i) Ke = Earnings per share / Net proceeds = EPS / NP [For new share]
ii) Ke = EPS / MP [ For existing equity]
Illustration7.
XYZ Ltd is planning for an expenditure of Rs. 120 lakhs for its expansion programme.
Number of existing equity shares are 20 lakhs and the market value of equity shares is
Rs. 60. It has net earnings of Rs. 180 lakhs.
Compute the cost of existing equity share and the cost of equity capital assuming that
new share will be issued at a price of Rs. 52 per share and the costs of new issue will be
Rs. 2 per share.

iv) Cost of Retained Earnings (Kr)

Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms
generally distribute only past of them in the form of dividends and the rest will be
retained within the firms. Since no dividend is required to paid on retained earnings, it is

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stated that ‘retained earnings carry no cost’. But this approach is not appropriate.
Retained earnings has the opportunity cost of dividends in alternative investment
becomes cost if retained earnings. Hence, shareholders expect a return on retained
earnings at least equity.
Kr = Ke = D/NP+g
However, while calculating cost of retained earnings, two adjustments should be made:
a) Income-tax adjustment as the shareholders are to pay some income tax out of
dividends, and b) adjustment for brokerage cost as the shareholders should incur some
brokerage cost while investment dividend income. Therefore, after these adjustments,
cost of retained earnings is calculated as:
Kr = Ke (1-t)(1-b)
Where, Kr = cost of retained earnings
Ke = Cost of equity
t = rate of tax
b = cost of purchasing new securities or brokerage cost.
Illustration8.
A firm‘s cost of equity (Ke) is 18%, the average income tax rate of shareholders is 30%
and brokerage cost of 2% is excepted to be incurred while investing their dividends in
alternative securities. Compute the cost of retained earnings.
Solution : Cost of retained earnings = (Kr) = Ke (1-t)(1-b)=18(1-.30)(1-.02)
=18x.7x.98=12.35%
13. WEIGHTED AVERAGE COST OF CAPITAL:
It is the average of the costs of various sources of financing. It is also known as
composite or overall or average cost of capital.
After computing the cost of individual sources of finance, the weighted average cost of
capital is calculated by putting weights in the proportion of the various sources of funds
to the total funds.
Weighted average cost of capital is computed by using either of the following two types
of weights: 1) Market value 2) Book Value

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Market value weights are sometimes preferred to the book value weights as the market
value represents the true value of the investors. However, market value weights suffer
from the following limitations:
i) Market value are subject to frequent fluctuations.
ii) Equity capital gets more importance, with the use of market value weights.
Moreover, book values are readily available. Average cost of capital is computed as
following
Illustration9 WACC - Book Value & Market Value Proportions - with / without
tax-RTP.
The following information has been extracted from the Balance Sheet of ABC Ltd.as on
31st March -

1. Determine the WACC of the Company. It had been paying dividends at a consistent
rate of 20% per annum.
2. What difference will it make if the current price of the Rs.100 share is Rs.160?
3. Determine the effect of Income Tax on WACC under both the above situations. (Tax
Rate = 40%).

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3. Effect of Tax Rate of 35% on WACC

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14. THEORIES OF CAPITAL STRUCTURE :

Equity and debt capital are the two major sources of long-term funds for a firm. The
theories on capital structure suggests the proportion of equity nad debt in the capital
structure.
Assumptions
There are only two sources of funds, i.e., the equity and the debt, having a fixed interest.
The total assets of the firm are given and there would be no change in the investment
decisions of the firm.
EBIT (Earnings Before Interest & Tax)/NOP (Net Operating Profits) of the firm are given
and is expected to remain constant.

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Retention Ratio is NIL, i.e., total profits are distributed as dividends. [100% dividend
pay-out ratio]
The firm has a given business risk which is not affected by the financing wise.
(vi) There is no corporate or personal taxes.
(vii) The investors have th same subjective probability distribtuion of expected operating
profits of the firm.
(viii) The capital structure can be altered without incurring transaction costs.
In discussing the theories of capital structure, we will consider the following notations:
E = Market value of the Equity
D = Maket valu of the Debt
V = Market value of the Firm = E +D
I = Total Interest Payments
T = Tax Rate
EBIT/NOP = Earnings Before Interest and Tax or Net Operating Profit
PAT = Profit After Tax
D0 = Dividend at time 0 (i.e. now)
D1 = Expected dividend at the end of Year 1.
Po = Current Market Price per share
P1 = Expected Market Price per share at the end of Year 1.

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15. Net Income Approach

As suggested by David Durand, this theory states that there is a relationship between the
Capital Structure and the value of the firm.
Assumptions
(1) Toal Capital requirement of the firm are given and remain constant
(2) Kd < Ke
(3) Kd and Ke are constant
(4) Ko decreases with the increase in leverage

Illustration10.
Net Income Approach – Valuation of Firm
The following data arelates to four Firms—

Assuming that there are no taxes and rate of debt is 10%, determine the value of each
firm using the Net Income approach. Also determine the Overall Cost of Capital of each
firm.

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Solution :

Under NI Approach, increase in Debt content implies leads to increase in value of Firm &
decrease in WACC.
16. Net Operating Income (NOI) Approach
According to David Durand, under NOI approach, the total value of the firm will not be
affected by the composition of capital structure.
Assumptions
(1) K0 and Kd is constant.
(2) Ke will change with the degree of leverge.
(3) There is no tax.

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Illustration11.
A firm has an EBIT of Rs. 5,00,000 and belongs to a risk class of 10%. What is the cost
of Equity if it employs 8% debt to the extent of 30%, 40% or 50% of the total capital
fund of Rs. 20,00,000?

17. Modigliani – Miller (MM) Hypothesis

The Modigliani – Miller hypothesis is identical with the net operating Income approach.
Modigliani and Miller argued that, in the absence of taxes the cost of capital and the
value of the firm are not affected by the changes in capital structure. In other words,
capital structure decisions are irrelevant and value of the firm is independent of debt –
equity mix.
Basic Propositions
M - M Hypothesis can be explained in terms of two propositions of Modigliani and
Miller. They are :
i. The overall cost of capital (KO) and the value of the firm are independent of the capital
structure. The total market value of the firm is given by capitalising the expected net
operating income by the rate appropriate for that risk class.
ii. The financial risk increases with more debt content in the capital structure. As a result
cost of equity (Ke) increases in a manner to offset exactly the low – cost advantage of
debt. Hence, overall cost of capital remains the same.

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Assumptions of the MM Approach

1. There is a perfect capital market. Capital markets are perfect when
i) Investors are free to buy and sell securities,
ii) They can borrow funds without restriction at the same terms as the firms do,
iii) They behave rationally,
iv) They are well informed, and
v) There are no transaction costs.
2. Firms can be classified into homogeneous risk classes. All the firms in the same risk
class will have the same degree of financial risk.
3. All investors have the same expectation of a firm’s net operating income (EBIT).
4. The dividend payout ratio is 100%, which means there are no retained earnings.
5. There are no corporate taxes. This assumption has been removed later.
Arbitrage Process
According to M –M, two firms identical in all respects except their capital
structure cannot have different market values or different cost of capital. In case, these
firms have different market values, the arbitrage will take place and equilibrium in
market values is restored in no time. Arbitrage process refers to switching of investment
from one firm to another. When market values are different, the investors will try to take
advantage of it by selling their securities with high market price and buying the securities
with low market price. The use of debt by the investors is known as personal leverage or
home made leverage. Because of this arbitrage process, the market price of securities in
higher valued market will come down and the market price of securities in the lower
valued market will go up, and this switching process is continued until the equilibrium is
established in the market values. So, M –M, argue that there is no possibility of different
market values for identical firms.
Reverse Working of Arbitrage Process
Arbitrage process also works in the reverse direction. Leverage has neither
advantage nor disadvantage. If an un levered firm (with no debt capital) has higher
market value than a levered firm (with debt capital) arbitrage process works in reverse

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direction. Investors will try to switch their investments from unlevered firm to levered
firm so that equilibrium is established in no time.
Thus, M – M proved in terms of their proposition I that the value of the firm is not
affected by debt-equity mix.
Criticism of M-M Hypothesis
The arbitrage process is the behavioral and operational foundation for M M
Hypothesis. But this process fails the desired equilibrium because of the following
limitations.
1. Rates of interest are not the same for the individuals and firms. The firms generally
have a higher credit standing because of which they can borrow funds at a lower rate of
interest as compared to individuals.
2. Home – Made leverage is not a perfect substitute for corporate leverage. If the firm
borrows, the risk to the shareholder is limited to his shareholding in that company. But if
he borrows personally, the liability will be extended to his personal property also.
Hence, the assumption that personal or home – made leverage is a perfect substitute for
corporate leverage is not valid.
3. The assumption that transaction costs do not exist is not valid because these costs are
necessarily involved in buying and selling securities.
4. The working of arbitrage is affected by institutional restrictions, because the
institutional investors are not allowed to practice home – made leverage.
5. The major limitation of M – M hypothesis is the existence of corporate taxes. Since the
interest charges are tax deductible, a levered firm will have a lower cost of debt due to tax
advantage when taxes exist.
M – M Hypothesis Corporate Taxes
Modigliani and Miller later recognised the importance of the existence of
corporate taxes. Accordingly, they agreed that the value of the firm will increase or the
cost of capital will decrease with the use of debt due to tax deductibility of interest
charges. Thus, the optimum capital structure can be achieved by maximising debt
component in the capital structure. According to this approach, value of a firm can be
calculated as follows:
Value of Un levered firm (Vu) =

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Where,
EBIT = Earnings before interest and taxes
Ko = Overall cost of capital
t = Tax rate.
I = Interest on debt capital
Illustration:
Two companies X and Y belong to the equivalent risk group. The two companies are
identical in every respect except that Y is a levered while company X is unlevered. The
outstanding amount of debt of the levered company is Rs 6,00,000 in 10 per cent
debentures. The other information for the two companies is as follows:
Particulars X Y
Net operating income (EBIT) Rs 1, 50,000 Rs 1,50,000
Interest on debt (I) — 60,000
Earnings to equity holders (NI) 1, 50,000 90,000
Equity-capitalisation rate (ke) 0.15 0.20
Market value of equity (S) 10, 00,000 4,50,000
Market value of debt (B) — 6, 00,000
Total value of firm (V) 10, 00,000 10,50,000
Over all capitalisation rate (k0) 0.15 0.143
Debt/equity ratio 0 1.33

An investor owns 5 per cent equity shares of company Y. Show the arbitrage process and
the amount by which he could reduce his outlay through the use of leverage. Are there
any limits to the ‘process’?
Abritrage process
(a) Investor’s current position (in firm Y)
Dividend income (0.05 ´ Rs 90,000) Rs 4,500
Investment cost (0.05 ´ Rs 4,50,000) 22,500
(b) He sells his holdings in firm Y for Rs 22,500 and creates a personal

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leverage by borrowing Rs 30,000 (0.05 ´ Rs 6,00,000). The total

amount with him is Rs 52,500. Income required for break even is:
Dividend income (Y firm) 4,500
Add interest on personal borrowings (0.10 X Rs 30,000) 3,000
7,500
(c) He purchases five per cent equity shares of the firm X for Rs 50,000
as the total value of the firm is Rs 10,00,000.
Dividend of the firm X (0.15 ´ Rs 50,000) 7,500
Amount of investment 50,000
The investor, thus, can reduce his outlay by Rs 2,500 through the use of leverage.

Yes, there are limits to the arbitrage process; this process will come to an end when the
values of both firm become identical.

18. Traditional Approach :

It takes a mid-way between the NI approach and the NOI approach.
Assumptions
(i) The value of the firm increases with the increase in financial leverage, upto a certain
limit only.
(ii) Kd is assumed to be less than Ke.

(Part-I) (Part-II)
Traditional viewpoint on the Relationship between Leverage, Cost of Capital and the
Value of the Firm

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Illustration12. Traditional Theory - Optimum Cost of Capital

SS Ltd has a PBIT of Rs.3 Lakhs. Presently the company is financed by equity capital of
Rs. 20 Lakhs with Equity Capitalization Rate of 16%. It is contemplating to redeem a
part of its Capital by introducing Debt Financing. It has two options—to raise debt to the
tune of 30% or 50% of the total funds.
It is expected that for debt financing upto 30% will cost 10% Equity Capitalization Rate
will rise to 17%. However, if the Firm opts for 50% debt, it will cost 12% and Equity
Shareholders expectation will be 20%.
From the above, compute the Overall Cost of Capital of the different options and
comment thereon.
Solution :

Inference : Traditional Theory lays down that as debt content increases, rate of interest
on debt increases & Equity Shareholders expectations also arise. Hence Value of Firm &
WACC will be affected. By suitably altering Debt content the firm should achive
maximum Firm Value & minimum WACC.
19. LEVERAGE
Leverage results from the use of fixed-cost assets or funds to magnify returns to
the firm’s owners. Generally, increases in leverage result in increased return and risk,
whereas decreases in leverage result in decreased return and risk. The amount of leverage

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in the firm’s capital structure—the mix of long-term debt and equity maintained by the
firm—can significantly affect its value by affecting return and risk. Unlike some causes
of risk, management has almost complete control over the risk introduced through the use
of leverage. Because of its effect on value, the financial manager must understand how to
measure and evaluate leverage, particularly when making capital structure decisions.
The three basic types of leverage can best be defined with reference to the firm’s income
statement, as shown in the general income statement format in given table.
• Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT. (EBIT is a descriptive label for
operating profits.)
• Financial leverage is concerned with the relationship between the firm’s EBIT and its
common stock earnings per share (EPS).
• Total leverage is concerned with the relationship between the firm’s sales revenue and
EPS.
We will examine the three types of leverage concepts in detail in sections that follow.
First, though, we will look at breakeven analysis, which lays the foundation for leverage
concepts by demonstrating the effects of fixed costs on the firm’s operations.
General income statement and showing the leverage

20. OPERATING LEVERAGE

Operating leverage results from the existence of fixed operating costs in the firm’s
income stream. Using the structure presented in above table we can define operating

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leverage as the potential use of fixed operating costs to magnify the effects of changes in
sales on the firm’s earnings before interest and taxes.

EBIT at various sales levels

Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100% increase in
earnings before interest and taxes (from $2,500 to $5,000).

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Case 2 A 50%decrease in sales (from 1,000 to 500 units) results in a 100% decrease in
earnings before interest and taxes (from $2,500 to $0).
we see that operating leverage works in both directions. When a firm has fixed operating
costs, operating leverage is present.
An increase in sales results in a more-than-proportional increase in EBIT; a decrease in
sales results in a more-than-proportional decrease in EBIT.
Measuring the Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) is the numerical measure of the firm’s
operating leverage. It can be derived using the following equation:
DOL = Percentage change in EBIT/ Percentage change in sales
Whenever the percentage change in EBIT resulting from a given percentage
change in sales is greater than the percentage change in sales, operating leverage exists.
This means that as long as DOL is greater than 1, there is operating leverage.

Because the result is greater than 1, operating leverage exists. For a given base level of
sales, the higher the value the greater the degree of operating leverage.
21. FINANCIAL LEVERAGE
Financial leverage results from the presence of fixed financial costs in the firm’s
income stream. We can define financial leverage as the potential use of fixed financial
costs to magnify the effects of changes in earnings before interest and taxes on the firm’s
earnings per share. The two fixed financial costs that may be found on the firm’s income
statement are (1) interest on debt and (2) preferred stock dividends. These charges must
be paid regardless of the amount of EBIT available to pay them

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EPS at various EBIT levels

Case 1 A 40% increase in EBIT (from $10,000 to $14,000) results in a 100% increase in
earnings per share (from $2.40 to $4.80).
Case 2 A 40% decrease in EBIT (from $10,000 to $6,000) results in a 100% decrease in
earnings per share (from $2.40 to $0).
The effect of financial leverage is such that an increase in the firm’s EBIT results in a
more-than-proportional increase in the firm’s earnings per share, whereas a decrease in
the firm’s EBIT results in a more-than-proportional decrease in EPS.
Measuring the Degree of Financial Leverage (DFL)
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial
leverage. Computing it is much like computing the degree of operating leverage. The
following equation presents one approach for obtaining the DFL.9
DFL = Percentage change in EPS/ Percentage change in EBIT

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Whenever the percentage change in EPS resulting from a given percentage change in
EBIT is greater than the percentage change in EBIT, financial leverage exists. This means
that whenever DFL is greater than 1, there is financial leverage.
22. TOTAL LEVERAGE
We also can assess the combined effect of operating and financial leverage on the
firm’s risk by using a framework similar to that used to develop the individual concepts
of leverage. This combined effect, or total leverage, can be defined as the potential use
of fixed costs, both operating and financial, to magnify the effect of changes in sales on
the firm’s earnings per share. Total leverage can therefore be viewed as the total impact
of the fixed costs in the firm’s operating and financial structure.
Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in
the coming year and must meet the following obligations: variable operating costs of $2
per unit, fixed operating costs of $10,000, interest of $20,000, and preferred stock
dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of
common stock outstanding.
Total Leverage Effect

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the above table presents the levels of earnings per share associated with the expected
sales of 20,000 units and with sales of 30,000 units.
The table illustrates that as a result of a 50% increase in sales (from 20,000 to 30,000
units), the firm would experience a 300% increase in earnings per share (from $1.20 to
$4.80). Although it is not shown in the table, a 50% decrease in sales would, conversely,
result in a 300% decrease in earnings per share. The linear nature of the leverage
relationship accounts for the fact that sales changes of equal magnitude in opposite
directions result in EPS changes of equal magnitude in the corresponding direction. At
this point, it should be clear that whenever a firm has fixed costs—operating or financial
—in its structure, total leverage will exist.
Measuring the Degree of Total Leverage (DTL)

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The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage.
It can be computed much as operating and financial leverage are computed.
The following equation presents one approach for measuring DTL:11
DTL = Percentage change in EPS/ Percentage change in sales
Whenever the percentage change in EPS resulting from a given percentage change in
sales is greater than the percentage change in sales, total leverage exists. This means that
as long as the DTL is greater than 1, there is total leverage.

Because this result is greater than 1, total leverage exists. The higher the value, the
greater will be the degree of total leverage.
23. The Relationship of Operating, Financial, and Total Leverage
Total leverage reflects the combined impact of operating and financial leverage on
the firm. High operating leverage and high financial leverage will cause total leverage to
be high. The opposite will also be true. The relationship between operating leverage and
financial leverage is multiplicative rather than additive. The relationship between the
degree of total leverage (DTL) and the degrees of operating leverage (DOL) and financial
leverage (DFL) is given by Equation
DTL= DOLX DFL

Illustration13.
Calculate operating leverage and financial leverage under situations A, B and C, and
financial plans I, II and III respectively from the following information relatng to the
operations and capital structure of XYZ Company for producing additional 800 units.

Also, find out the combination of operating and financial leverages which gives the
highest value and the least value. How are these calculations useful to the finance
manager of the company?
Selling price per unit, Rs 30
Variable cost per unit, 20
Fixed costs:

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Situation A Rs 2,000
Situation B 4,000
Situation C 6,000
Capital structure:
Financial plan
Particulars I II III
Equity Rs 10,000 Rs 15,000 Rs 5,000
Debt (0.12) 10,000 5,000 15,000

Determination of DOL in situations A, B and C.

Particulars Situations
A B C
Sales revenue (800 X Rs 30) Rs 24,000 Rs 24,000 Rs
24,000
Less variable costs (800 X Rs 20) 16,000 16,000 16,000
Contribution 8,000 8,000 8,000
Less fixed costs 2,000 4,000 6,000
EBIT 6,000 4,000 2,000
DOL (contribution/EBIT) 1.33 2 4

Determination of DFL in various situations and under alternative financial plans

Particulars Alternative financial plans
I II III
Situation A:
EBIT Rs 6,000 Rs 6,000 Rs 6,000
Less interest 1,200 600 1,800
EBT 4,800 5,400 4,200
DFL (EBIT/(EBIT – I) 1.25 1.11 1.43
Situation B:
EBIT 4,000 4,000 4,000

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Less interest 1,200 600 1,800

EBT 2,800 3,400 2,200
DFL 1.43 1.18 1.82
Situation C:
EBIT 2,000 2,000 2,000
Less interest 1,200 600 1,800
EBT 800 1,400 200
DFL 2.5 1.43 10

Determination of combined leverage in situations A, B and C and under financial

plans, I, II and III.
Particulars Situation A ` Situation B Situation C
I II III I II III I II III
DOL 1.33 1.33 1.33 2 2 2 4 4 4
DFL 1.25 1.11 1.431.43 1 .18 1.82 2.5 1.43 10
DCL 1.66 1.48 1.90 2.86 2.36 3.64 10 5.72 40
(i) Situation A (with fixed costs = Rs 2,000) under financial plan II (equity = Rs 15,000)
gives the lowest DCL (1.48).
(ii) Situation C (with fixed costs = Rs 6,000) under financial plan III (debt = Rs 15,000)
gives the highest DCL (40).

Illustration14.
The following figures relate to two companies: (Rupees in lakh)
Particulars P Ltd Q Ltd
Sales 500 1,000
Variable costs 200 300
Contribution 300 700
Fixed costs 150 400
EBIT 150 300
Interest 50 100
Profit before tax 100 200

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You are required to: (i) calculate the operating, financial and combined leverage for the
two companies; and (ii) comment on the relative risk position of the firms.

(b) (i) Find out operating leverage from the following data:
Sales, Rs 50,000
Variable costs, 60 per cent
Fixed costs, Rs 12,000
(ii) Find the financial leverage from the following data:
Net worth, Rs 25,00,000
Debt/Equity, 3:1
Interest rate, 12 per cent
Operating profit, Rs 20,00,000

(a) Determination of operating, financial and combined leverage (Rupees in lakh)

P Ltd Q Ltd
Sales 500 1,000
Less variable cost 200 300
Contribution 300 700
Fixed cost 150 400
EBIT 150 300
Less interest 50 100
EBT 100 200
DOL (contribution/EBIT) 2 2.33
DFL (EBIT/EBIT – I) 1.5:1 1.5

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DCL (DOL ´ DFL) 3 3.5

Q Ltd has higher operating as well as total risk.
Illustration15.
The MM Industries, a well established firm in plastics, is considering the purchase of one
of the two manufacturing companies up for sale. The financial manager of the company
has developed the following information about the two companies. Both companies have
total assets of Rs 15, 00,000 at the end of March.

Operating statements for the year ending March 31

Particulars M Ltd N Ltd

Sales revenue Rs 30,00,000 Rs30,00,000

Less: Cost of goods sold 22,50,000 22,50,000
Less: Selling expenses 2,40,000 2,40,000
Less: Administrative expenses 90,000 1,50,000
Less: Depreciation 1,20,000 90,000
EBIT 3,00,000 2,70,000
Cost of goods sold 9,00,000 18,00,000
Selling expenses 1,50,000 1,50,000
Total variable costs 10,50,000 19,50,000

(a) Prepare operating statements for both the companies assuming that sales
increase by 20 per cent. However, the total fixed costs are likely to remain
unchanged and the variable costs are a linear function of sales.
(b) Calculate the degree of operating leverage by both the methods you know.
(c) If the Royal Industries wishes to buy a company which has lower degree of
business risk, which one would it be?
(i) Operating statement of M Ltd. and N Ltd.
Particulars M Ltd N Ltd
Sales revenue Rs 36,00,000 Rs 36,00,000
Less:Cost of goods sold 24,30,000 26,10,000

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selling expenses 2,70,000 2,70,000

administrative expenses 90,000 1,50,000
depreciation 1,20,000 90,000
EBIT 6,90,000 4,80,000
Cost of goods sold break-up
Variable costs 10,80,0001 21,60,0002
Fixed costs 13,50,000 4,50,000
24,30,000 26,10,000
1)30 per cent of sales
2)60 per cent of sales
(ii) DOL(X) = (D EBIT ÷ EBIT)/(D Sales ÷ Sales) = (Rs 3,90,000 ÷ Rs 3,00,000)
(Rs 6,00,000 ÷ Rs 30,00,000) = 6.5.
DOL(Y) = (Rs 2, 10,000 ÷ Rs 2,70,000)/(Rs 6,00,000 ÷ Rs 30,00,000) = 3.88.
Alternatively,
DOL(X) = (Sales – VC)/ (Current EBIT) = (Rs 30, 00,000 – Rs 10,50,000)/3,00,000
= 6.5.
DOL(Y) = Rs 30, 00,000 – Rs 19, 50,000)/2, 70,000 = 3.88.
(iii) MM Industries Ltd should purchase N Ltd.

24. EBIT-EPS Indifference Point

Illustration16.
Calculate the level of EBIT at which the EPS indifference point between the following
financing alternatives will occur-
1. Equity share Capital of Rs.6,00,000 and 12% Debentures Rs.4,00,000 [or]
2. Equity Share Capital of Rs.4,00,000, 14% Preference Share Capital of Rs.2,00,000 and
12% Debentures of Rs.4,00,000.
Assume that Corporate Tax rate is 35% and par value of Equity Share is Rs.10 in
each case.
Solution : Let the PBIT at the indifference point level be Rs.X

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For indifference between the above alternatives,EPS should be equal, Hence we have

On Cross Multiplication,
1.30X - 62,400 = 1.95X - 1, 77,600.
0.65X = 1, 15,200 or X = PBIT = Rs. 1, 77,231
Illustration17.
Financial BEP, EBIT EPS Indifference Point and Interpretation
ABC Ltd. wants to raise Rs.5, 00,000 as additional capital. It has two mutually exclusive
alternative financial plans. The current EBIT is Rs.17, 00,000 which is likely to remain
unchanged.
The relevant Information is -

What is the indifference level of EBIT? Identify the financial break-even levels and plot
the EBIT-EPS lines on graph paper. Which alternative financial plan is better?
Solution :

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1. Computation of EBIT - EPS Indifference Point

For indifference between the above alternatives, EPS should be equal.

Hence, we have

On Cross Multiplication, 15X - 30 Lakhs = 16X - 41.6 Lakhs; or X = 11.6 Lakhs

Hence EBIT should be Rs.11.60 Lakhs and at that level, EPS will be Rs.1.50 under both
alternatives.
2.Computation of Financial Break-Even Point
The Financial BEP for the two plans are
Plan I EBIT = Rs.2, 00,000(i.e. 10% interest on Rs.20, 00,000)
Plan II EBIT = Rs.2,60,000(i.e. 10% interest on Rs.20,00,000 and 12% interest on
Rs.5,00,000)
3.Graphical Depiction of Indifference Point and Financial BEP

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4. Interpretation of Graph:
(a) The horizontal intercepts identify the Financial Break Even levels of EBIT for each
plan.
(b) The point at which EPS lines of both plans interest is called Indifference Point. Its
horizontal intercept gives the level of EBIT at that point. The vertical intercept gives the
value of EPS at that point.
(c) Below the indifference point, one plan will have EPS over the other. Above that point,
automatically the other plan will have higher EPS over the former. This is interpreted as
under--

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Conclusion: In the given case Indifference Point of EBIT = Rs.11.60 Lakhs but the
current EBIT is Rs.17 lakhs. The new EBIT after employing additional capital of Rs.5
Lakhs will be (17/ 50×55)=Rs.18.70 Lakhs. Since this is above the indifference point of
Rs. 11.60 Lakhs, the option with the higher debt burden should chosen. Hence, the firm
should prefer Plan II for financing.
Note: As an exercise, students may recalculate the EPS for both plans with EBIT of
Rs.18.70 Lakhs, EPS will be Rs.2.61 and Rs.2.68 respectively. Hence Plan II is better on
account of higher EPS.
Illustration18.
Companies U and L are identical in every respect except that the former does not use debt
in its capital structure, while the latter employs Rs 6 lakh 10 per cent debt. Assuming that
(a) all the MM assumptions are met, (b) the corporate tax rate is 35 per cent, (c) the EBIT
is Rs 1,20,000, and (d) the equity capitalisation of the unlevered company is 0.20, what
will be the value of the firms, U and L? Also, determine the weighted average cost of
capital for both the firms.

Value of unlevered firm, Vu = EBIT (1 – t)/Ke = Rs 2,00,000 (1 – 0.35)/0.20 = Rs

6,50,000
Value of levered firm, Vl = Vu + Bt = Rs 6,50,000 + [Rs 6,00,000 (0.35)] = Rs 8,60,000
K0 of levered firm = 0.20 (Ke = Ko)
K0 of levered firm
EBIT Rs 2,00,000
Less interest 90,000
Net income after interest 1,10,000
Less taxes 38,500
NI for equityholders 71,500
Total market value (V) 8,60,000
Market value of debt (B) 6,00,000
Market value of equity (V – B) 2,60,000
Ke = (NI ÷ S) = Rs 71,500/Rs 2,60,000 0.275

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Ko = Ki(B/V) + Ke(B/V) = 0.0975 (Rs 6,00,000/Rs 8,60,000) + 0.275 (Rs 2,60,000/Rs

8,60,000) 0.1511
Illustration19.
The AXX Ltd needs Rs 5, 00,000 for construction of a new plant. The following three
financial plans are feasible:
(i) The company may issue 50,000 equity shares of Rs 10 per share.
(ii) The company may issue 25,000 equity shares at Rs 10 per share and
2,500 debentures of Rs 100 denomination bearing 8 per cent of
interest.
(iii) The company may issue 25,000 equity shares of Rs 10 per share and
2,500 preference shares of Rs 100 per share bearing, 10 per cent
rate of dividend.
If the company’s earnings before interest and taxes are Rs 40,000, Rs 80,000, and Rs
120,000 what are the earnings per share under each of the three financing plans? Which
alternative would you recommend and why? Assume corporate tax rate of 35 per cent and
P/E ratio of 10 times in equity plan, 9 times in equity + preference plan and 8 times in
equity + debt plan.

Determination of EPS at various levels of EBIT under alternative financing plans

EBIT

Particulars Rs 40,000 Rs 80,000 Rs 1,20,000

E E+D E+P E E+D E+P E E+D E+P

EBIT 40,000 40,000 40,000 80,000 80,000 80,000 1,20,000 1,20,000 1,20,000

(-)interest — 0,000 — — 20,000 — — 20,000 —

EBT 40,000 20,000 40,000 80,000 60,000 80,000 1,20,000 1,00,000 1,20,000

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(-) taxes 14,000 7,000 14,000 28,000 21,000 28,000 42,000 35,000 42,000

EAT 26,000 13,000 26,000 52,000 39,000 52,000 78,000 65,000 78,000

(-) Pref Div — — 5,000 — — 25,000 — — 25,000

EAESH* 26,000 13,000 1,000 52,000 39,000 27,000 78,000 65,000 53,000

No. Eq 50,000 25,000 25,000 50,000 25,000 25,000 50,000 25,000 25,000

EPS 0.52 0.52 0.04 1.04 1.56 1.08 1.56 2.6 2.12

P/E ratio 10 8 9 10 8 9 10 8 9

MPS 5.2 4.16 0.36 10.40 12.48 9.72 15.60 20.8 19.08

* Earnings Available For Equity Holders

Recommendation
(i) Equity plan is preferred when EBIT is Rs 40,000
(ii) In cases of EBIT levels of Rs 80,000 and Rs 1,20,000, equity + debt plan is
recommended.
Illustration20.
A growing company is confronted with a choice between 10 per cent debt issue and and
equity issue to finance its new investments. Its pre-expansion income statement is as
follows:
Sales (Production capacity of Rs 60,00,000 at current sales price) Rs 45,00,000
Fixed cost 5,00,000
Variable cost 30,00,000
EBIT 10,00,000
Interest at 8 per cent 1,00,000
Earning before taxes 9,00,000
Income tax 3,15,000
Net income 5,85,000
EPS 11.7

The expansion programme is estimated to cost Rs 5, 00,000. If this is financed through

debt, the rate on new debt will be 15 per cent and the P/E ratio will be 10. If expansion
programme is financed through equity, new shares can be sold at Rs 100 per share and

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the P/E ratio will be 12. The expansion will generate additional sales of Rs 12, 00,000.
No additional fixed costs would be needed to meet the expansion operation.
If the company is to follow a policy of maximising the market value of its shares, which
form of financing should be employed by it?
Market value of shares under different financing alternatives

Particulars 15% Debt Equity shares

Sales revenue Rs 57,75,000 Rs 57,75,000
Less fixed costs 5,00,000 5,00,000
Less Variable costs (2/3 of sales) 38,50,000 38,50,000
EBIT 14,25,000 14,25,000
Less interest 1,75,000 1,00,000
EBT 12,50,000 13,25,000
Less taxes 4,37,500 4,63,750
EAT 8,12,500 8,61,250
Number of equity shares (N) 50,000 55,000
EPS (EAT ÷ N) 16.25 15.66
P/E ratio (times) 10 12
Market price (EPS ´ P/E ratio) 162.50 187.92
Recommendation
Equity financing should be adopted by the company, as it maximises the MPS.
UNIT 3

1. INTRODUCTION:
Capital budgeting decisions are of paramount importance in financial decisions.
Capital Budgeting is the art of finding assets that are worth more than they cost to
achieve a predetermined goal i.e., ‘optimising the wealth of a business enterprise’.
Capital investment involves a cash outflow in the immediate future in anticipation of
returns at a future date. For making a rational decision regarding the capital investment
proposals, the decision maker needs some techniques to convert the cash outflows and
cash inflows of a project into meaningful yardsticks which can measure the economic

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worthiness of projects. The exercise involves ascertaining / estimating cash inflows and
outflows, matching the cash inflows with the outflows appropriately and evaluation of
desirability of the project. It is a managerial technique of meeting capital expenditure
with the overall objectives of the firm. It is a complex process as it involves decisions
relating to the investment of current funds for the benefit to be achieved in future. The
overall objective of capital budgeting is to maximize the profitability of the firm / the
return on investment.
2. CAPITAL EXPENDITURE
A capital expenditure is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of years in
future. The following are some of the examples of capital expenditure.
1) Cost of acquisition of permanent assets such as land & buildings, plant & machinery,
goodwill etc.
2) Cost of addition, expansion, improvement or alteration in the fixed assets.
3) Cost of replacement of permanent assets.
4) Research and development project cost etc.
Capital expenditure involves non-flexible long term commitment of funds.
3. CAPITAL BUDGETING – DEFINITION
“Capital budgeting” has been formally defined as follows.
1) “Capital budgeting is long-term planning for making and financing proposed capital
outlay”. - Charles T. Horn green
2) “The capital budgeting generally refers to acquiring inputs with long term returns”. -
Richards & Green law
3) “Capital budgeting involves the planning of expenditure for assets, the returns from
which will be realized in future time periods”. - Milton H. Spencer
The long-term activities are those activities that influence firms operation beyond the one
year period. The basic features of capital budgeting decisions are:
1. There is an investment in long term activities
2. Current funds are exchanged for future benefits
3. The future benefits will be available to the firm over series of years.
4. NEED FOR CAPITAL INVESTMENT

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The factors that give rise to the need for capital investments are:
1. Expansion
2. Diversification
3. Obsolescence
4. Wear and tear of old equipment
5. Productivity improvement
6. Learning – curve effect
7. Product improvement
8. Replacement and modernization
The firm’s value will increase in investments that are profitable. They add to the
shareholders’ wealth. The investment will add to the shareholders’ wealth if it yields
benefits, in excess of the minimum benefits as per the opportunity cost of capital.
5. CAPITAL BUDGETING – SIGNIFICANCE
1. Capital budgeting involves capital rationing. This is the available funds that have to be
allocated to competing projects in order of project potential. Normally the individuality
of project poses the problem of capital rationing due to the fact that required funds and
available funds may not be the same.
2. Capital budget becomes a control device when it is employed to control expenditure.
Because manned outlays are limits to actual expenditure, the concern has to investigate
the variation in order to keep expenditure under control.
3. A firm contemplating a major capital expenditure programme may need to arrange
funds many years in advance to be sure of having the funds when required.
4. Capital budgeting provides useful tool with the help of which the management can
reach prudent investment decision.
5. Capital budgeting is significant because it deals with right mind of evaluation of
projects. A good project must not be rejected and a bad project must not be selected.
Capital projects need to be thoroughly evaluated as to costs and benefits.
6. Capital projects involve investment in physical assets such as land, building plant,
machinery etc. for manufacturing a product as against financial investments which
involve investment in financial assets like shares, bonds or mutual funds. The benefits
from the projects last for few to many years.

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7. Capital projects involve huge outlay and last for years.

8. Capital budgeting thus involves the making of decisions to earmark funds for
investment in long term assets yielding considerable benefits in future, based on a careful
evaluation of the prospective profitability / utility of such proposed new investment.
6. CAPITAL BUDGETING PROCESS
The important steps involved in the capital budgeting process are
(1) Project generation,
(2) Project evaluation,
(3) Project selection and
(4) Project execution.
1. Project Generation. Investment proposals of various types may originate at different
levels within a firm. Investment proposals may be either proposals to add new product to
the product line or proposals to expand capacity in existing product lines. Secondly,
proposals designed to reduce costs in the output of existing products without changing
the scale of operations. The investment proposals of any type can originate at any level.
In a dynamic and progressive firm there is a continuous flow of profitable investment
proposals.
2. Project evaluation. Project evaluation involves two steps: i) estimation of benefits and
costs and ii) selection of an appropriate criterion to judge the desirability of the projects.
The evaluation of projects should be done by an impartial group. The criterion selected
must be consistent with the firm’s objective of maximizing its market value.
3. Project Selection. There is no uniform selection procedure for investment proposals.
Since capital budgeting decisions are of crucial importance, the final approval of the
projects should rest on top management.
4. Project Execution. After the final selection of investment proposals, funds are
earmarked for capital expenditures. Funds for the purpose of project execution should be
spent in accordance with appropriations made in the capital budget.
7. FACTORS INFLUENCING INVESTMENT DECISIONS
The main factors which, influence capital investment are :
1. Technological change. In modem times, one often finds fast obsolescence of
technology. New technology, which is relatively more efficient, takes the place of old

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technology; the latter getting downgraded to some less important applications. However,
in taking a decision of this type, the management has to consider the cost of new
equipment vis-a-vis the productive efficiencies of the new as well as the old equipments.
However, while evaluating the cost of new equipment, the management should not take
into, account its full accounting cost (as the equipment lasts for years) but its incremental
cost. Also, the cost of new equipment is often partly offset by the salvage value of the
replaced equipment.
2. Competitors 'strategy. Many a time an investment is taken to maintain the
competitive strength of the firm; If the competitors are installing new equipment to
expand output or to improve quality of their products, the firm under consideration will
have no alternative but to follow suit, else it will perish. It is, therefore, often found that
the competitors' strategy regarding capital investment plays a very significant role in
forcing capital decisions on a firm.
3. Demand forecast. The long-run forecast of demand is one of the determinants of
investment decision. If it is found that there is a market potential for the product in the
long run, the dynamic firm will have to take decisions for capital expansion.
4. Type of management. Whether capital investment would be encouraged or not
depends, to a large extent, on the viewpoint of the management. If the management is
modern and progressive in its outlook, the innovations will be encouraged, whereas a
conservative management discourages innovation and fresh investments.
5. Fiscal policy. Various tax policies of the government (like tax concessions on
investment income, rebate on new investment, method of allowing depreciation
deduction allowance) also have favourable or unfavourable influence on capital
investment.
6. Cash flows. Every firm makes a cash flow budget. Its analysis influences capital
investment decisions. With its help the firm plans the funds for acquiring the capital asset.
The budget also shows the timing of availability of cash flows for alternative investment
proposals, thereby helping the management in selecting the desired project.
7. Return expected from the investment. In most of the cases, investment decisions are
made in anticipation of increased return in future. While evaluating investment proposals,

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it is therefore essential for the firm to estimate future returns or benefits accruing from
the investment.
8. KINDS OF CAPITAL BUDGETING DECISIONS
The overall objective of capital budgeting is to maximise the profitability of a
firm or the return on investment. This objective can be achieved either by increasing the
revenues or by reducing costs. Thus, capital budgeting decisions can be broadly classified
into two categories:
(a) Those which increase revenue, and
(b) Those which reduce costs
The first category capital budgeting decisions are expected to increase revenue of
the firm through expansion of the production capacity or size of operations by adding a
new product line. The second category increases the earnings of the firm by reducing
costs and includes decisions relating to replacement of obsolete, outmoded or worn out
assets. In such cases, a firm has to decide whether to continue with the same asset or
replace it. Such a decision is taken by the firm by evaluating the benefit from replacement
of the asset in the form of reduction in operating costs and the cost/cash outlay needed for
replacement of the asset. Both categories of above decisions involve investment in fixed
assets but the basic diffemce between the two decisions lies in the fact that increasing
revenue investment decisions are subject to more uncertainty as compared to cost
reducing investment decisions. Further, in view of the investment proposals under
consideration, capital budgeting decisions may also be classified as.
(i) Accept / Reject Decisions
(ii) Mutually Exclusive Project Decisions
(iii) Capital Rationing Decisions.
(i) Accept / Reject Decisions; Accept / reject decisions relate to independent project
which do not compete with one another. Such decisions are generally taken on the basis
of minimum return on investment. All those proposals which yield a rate of return higher
than the minimum required rate of return or the cost of capital are accepted and the rest
are rejected. If the proposal is accepted the firm makes investment in it, and if it is
rejected the firm does not invest in the same.

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(ii) Mutually Exclusive project Decisions; Such decisions relate to proposals which
compete with one another in such a way that acceptance of one automatically excludes
the acceptance of the other. Thus, one of the proposals is selected at the cost of the other.
For example, a company may have the option of buying a new machine, or a second hand
machine, or taking an old machine on hire or selecting a machine out of more than one
brands available in the market. In such a case, the company may select one best
alternative out of the various options by adopting some suitable technique or method of
capital budgeting. Once one alternative is selected the others are automatically rejected.
iii) Capital Rationing Decisions: A firm may have several profitable investment
proposals but only limited funds to invest. In such a case, these various investments
compete for limited funds and, thus, the firm has to ration them. The firm effects the
combination of proposals that will yield the greatest profitability by ranking them in
descending order of their profitability.
9. INVESTMENT EVALUATION CRITERIA
The capital budgeting process begins with assembling of investment proposals of
different departments of a firm. The departmental head will have innumerable alternative
projects available to meet his requirements. He has to select the best alternative from
among the conflicting proposals. This selection is made after estimating return on the
projects and comparing the same with the cost of capital. Investment proposal which
gives the highest net marginal return will be chosen.
Following are the steps involved in the evaluation of an investment:
1) Estimation of cash flows
2) Estimation of the required rate of return
3) Application of a decision rule for making the choice
Features required by Investment Evaluation Criteria
A sound appraisal technique should be used to measure the economic worth of an
investment project. Porterfield, J.T.S. in his book, Investment Decisions and Capital
Costs, has outlined some of the features that must be had by sound investment evaluation
criteria.
• It should consider all cash flows to determine the true profitability of the project.

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• It should provide for an objective and unambiguous way of separating good projects
from bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognise the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which
maximises the shareholders' wealth.
• It should be a criterion which is applicable to any conceivable investment project
independent of others.
10. TECHNIQUES OF INVESTMENT APPRAISAL
Traditional Cash Flow Criteria
1. Pay-back period
2. Accounting rate of return (ARR).
Discounted Cash Flow (DCF) Criteria
1. Net present value (NPV)
2. Internal rate of return (IRR)
3. Profitability index (PI)
4. Discounted payback period
11. TRADITIONAL CASH FLOW CRITERIA
I) Payback period Method: The basic element of this method is to calculate the
recovery time, by year wise accumulation of cash inflows (inclusive of depreciation) until
the cash inflows equal the amount of the original investment. The time taken to recover
such original investment is the “payback period” for the project. The formula for the
payback period calculation is simple. First of all, net-cash-inflow is determined. Then we
divide the initial cost (or any value we wish to recover) by the annual cash-inflows and
the resulting quotient is the payback period. As per formula:
Payback period = Original Investment / Annual Cash-inflows
If the annual cash-inflows are uneven, then the calculation of payback period takes a
cumulative form. We accumulate the annual cash-inflows till the recovery of investment
and as soon as this amount is recovered, it is the expected number of payback period

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years. An asset or capital expenditure outlay that pays back itself early comparatively is
to be preferred. “The shorter the payback period of the project more desirable for accept”.
Merits:
(1) No assumptions about future interest rates.
(2) In case of uncertainty in future, this method is most appropriate.
(3) A company is compelled to invest in projects with shortest payback period, if capital
is a constraint.
(4) It is an indication for th prospective investors specifying the payback period of their
investments.
(5) Ranking projects as per their payback period may be useful to firms undergoing
liquidity constraints.
Demerits:
(1) Cash generation beyond payback period is ignored.
(2) The timing of returns and the cost of capital is not considered.
(3) The traditional payback method does not consider the salvage value of an investment.
(4) Percentage Return on the capital invested is not measured.
(5) Projects with long payback periods are characteristically those involved in long-term
planning, which are ignored in this approach.

II) Accounting Rate of Return Method - It is also an important method. This method is
known as Accounting Rate of Return Method / Financial Statement Method/ Unadjusted
Rate of Return Method also. According to this method, capital projects are ranked in
order of earnings. Projects which yield the highest earnings are selected and others are
ruled out.
Merits:
(1) Like payback method it is also simple and easy to understand.

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(2) It takes into consideration the total earnings from the project during its entire
economic life.
(3) This approach gives due weight to the profitability of the project.
(4) In investment with extremely long lives, the simple rate of return will be fairly close
to the true rate of return. It is often used by financial analysis to measure current
performance of a firm.
Demerits
(1) One apparent disadvantage of this approach is that its results by different methods are
inconsistent.
(2) It is simply an averaging technique which does not take into account the various
impacts of external factors on over-all profits of the firm.
(3) This method also ignores the time factor which is very crucial in business decision.
(4) This method does not determine the fair rate of return on investments. It is left to the
discretion of the management.

Average profits = total profit over a life of the project / life period of the project

III) Discounted Payback Period

In Traditional Payback period, the time value of money is not considered. Under
discounted payback period, the expected future cash flows are discounted by applying the
appropriate rate, i.e., the cost of capital.
12. DISCOUNTED CASH FLOW TECHNIQUES
The discounted cash flow techniques using for evaluation of the investment
proposals based on time value and consider risk of the projects. It involves calculating the

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present value of the cash benefits discounted at a rate equal to the firm's cost of capital. In
other words, the "present value of an investment is the maximum amount a firm could
pay for the opportunity of making the investment without being financially worse off."
The financial executive compares the present values with the cost of the proposal. If the
present value is greater than the net investment, the proposal should be accepted.
Conversely, if the present value is smaller than the net investment, the return is less than
the cost of financing. Making the investment in this case will cause a financial loss to the
firm. There are four methods to judge the profitability of different proposals on the basis
of this technique
I) Net Present Value Method (NPV) - It gives explicit consideration to the time value of
money, this method is also known as Excess Present Value or Net Gain Method. To
implement this approach, we simply find the present value of the expected net cash
inflows of an investment discounted at the cost of capital and subtract from it the initial
cost outlay of the project. The rate using for discounting the cash flows —often called the
discount rate, required return, cost of capital, or opportunity cost—is the minimum return
that must be earned on a project to leave the firm’s market value unchanged.
The net present value (NPV) is found by subtracting a project’s initial investment (CF0)
from the present value of its cash inflows (CFt) discounted at a rate equal to the firm’s
cost of capital (k).
NPV = Present value of cash inflows - Initial investment

The Decision Criteria

When NPV is used to make accept–reject decisions, the decision criteria are as follows:
• If the NPV is greater than zero (NPV > 0), accept the project.
• If the NPV is less than zero (NPV < 0), reject the project.
If the NPV is greater than zero, the firm will earn a return greater than its cost of capital.
Such action should enhance the market value of the firm and therefore the wealth of its
owners.

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II) Internal Rate of Return (IRR)

The internal rate of return (IRR) is probably the most widely used sophisticated
capital budgeting technique. However, it is considerably more difficult than NPV to
calculate by hand. The (IRR) is the discount rate that equates the NPV of an investment
opportunity with zero. (Internal Rate of Return is discount rate applied in capital
investment decisions which brings the cost of a project and its expected future cash flows
into equality, i.e., NPV are zero.). It is the compound annual rate of return that the firm
will earn if it invests in the project and receives the given cash inflows. Mathematically,
the IRR is the value of k in that causes NPV to equal zero.
This 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
present 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. The interest rate that brings about this equality is
defined as the internal rate of return. 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.
Merits:
(i) The Time Value of Money is considered.
(ii) All cash flows in the project are considered.
Demerits
(i) Possibility of multiple IRR, interpretation may be difficult.
(ii) If two projects with different inflow/outflow patterns are compared, IRR will lead to
peculiar situations.
(iii) If mutually exclusive projects with different investments, a project with higher
investment but lower IRR contributes more in terms of absolute NPV and increases the
shareholders’ wealth.

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The Decision Criteria

When IRR is used to make accept–reject decisions, the decision criteria are as follows:
• If the IRR is greater than the cost of capital, accept the project.
• If the IRR is less than the cost of capital, reject the project.
These criteria guarantee that the firm earns at least its required return. Such an outcome
should enhance the market value of the firm and therefore the wealth of its owners.
III) Profitability Index Method - One major disadvantage of the present value method
is that it is not easy to rank projects on the basis of net present value particularly when the
costs of projects differ significantly. To compare such projects the present value
profitability index is prepared. The index establishes relationship between cash-inflows
and the amount of investment as per formula given below:

(or)

Decision Criteria
If P.I > 1, project is accepted
If P.I < 1, project is rejected
The PI signifies present value of inflow per rupee of outflow. It helps to compare projects
involving different amounts of initial investments. The higher profitability index, the
more desirable is the investment. Thus, this index provides a ready compatibility of
investment having various magnitudes. By computing profitability indices for various
projects, the financial manager can rank them in order of their respective rates of
profitability.
Merits
· Considers all cash flows.

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· Recognises the time value of money.

· Relative measure of profitability.
· Generally consistent with the wealth maximisation principle
Demerits
· Requires estimates of the cash flows which is a tedious task.
· At times fails to indicate correct choice between mutually exclusive projects.
IV) Terminal Value Method - This approach separates the timing of the cash-inflows
and outflows more distinctly. Behind this approach is the assumption that each cash-
inflow is re-invested in other assets at the certain rate of return from the moment it is
received until the termination of the project. Then the present value of the total
compounded sum is calculated and it is compared with the initial cash-outflow. The
decision rule is that if the present value of the sum total of the compounded re-invested
cash-inflows is greater than the present value of cash-outflows, the proposed project is
accepted otherwise not. The firm would be different if both the values are equal.
This method has a number of advantages. It incorporates the advantage of re-investment
of cash-inflows by compounding and then discounting it. Further, it is best suited to cash
budgeting requirements. The major practical problem of this method lies in projecting the
future rates of interest at which the intermediate cash inflows received will be re-
invested.
13. COMPARISON BETWEEN NPV AND IRR (NPV vs. IRR)
The Net Present value method and the Internal Rate of Return Method are similar
in the sense that both are modern techniques of capital budgeting and both take into
account the time value of money. In fact, both these methods are discounted cash flow
techniques. However, there are certain basic differences between these two methods of
capital budgeting:
(i) In the net present value method the present value is determined by discounting the
future cash flows of a project at a predetermined or specified rate called the cut off rate
based on cost of capital. But under the internal rate of return method, the cash flows are
discounted at a suitable rate by hit and trial method which equates the present value so
calculated to the amount of the investment. Under IRR method, discount rate is not
predetermined.

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(ii) The NPV method recognises the importance of market rate of interest or cost of
capital. It arrives at the amount to be invested in a given project so that its anticipated
earnings would recover the amount invested in the project at market rate. Contrary to this,
the IRR method does not consider the market rate of interest and seeks to determine the
maximum rate of interest at which funds invested in any project could be repaid with the
earnings generated by the project.
(iii) The basic presumption of NPV method is that intermediate cash inflows are
reinvested at the cut off rate, whereas, in the case of IRR method, intermediate cash flows
arc presumed to be reinvested at the internal rate of return.'
(iv) The results shown by NPV method are similar to that of IRR method under certain
situations, whereas, the two give contradictory results under some other circumstances.
However, it must be remembered that NPV method using a predetermined cut-off rate is
more reliable than the IRR method for ranking two or more capital investment proposals.
(a) Similarities of Results under NPV and IRR
Both NPV and IRR methods would show similar results in terms of accept or
reject decisions in the following cases:
(i) Independent investment proposals which do not compete with one another and which
may be either accepted or-rejected on the basis of a minimum required rate of return.
(ii) Conventional investment proposals which involve cash outflows or outlays in the
initial period followed by a series of cash inflows.
The reason for similarity of results in the above cases lies on the basis of decision-making
in the two methods. Under NPV method, a proposal is accepted if its net present value is
positive, whereas, under IRR method it is accepted if the internal rate of return is higher
than the cut off rate. The projects which have positive net present value, obviously, also
have an internal rate of return higher than the required rate of return.
(b) Conflict between NPV and IRR Results
In case of mutually exclusive investment proposals, which compete with one another
in such a manner that acceptance of one automatically excludes the acceptance of the
other, the NPV method and IRR method may give contradictory results. The net present
value may suggest acceptance of one proposal whereas, the internal rate of return may

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favour another proposal. Such conflict in rankings may be caused by any one or more of
the following problems:
(i) Significant difference in the size. (Amount) of cash outlays of various
proposals under consideration.
(ii) Problem of difference in the cash flow patterns or timings of the various
proposals and
(iii) Difference in service life or unequal expected lives of the projects.
NPV-IRR Conflict
Let us consider two mutually exclusive projects A & B.

When evaluating mutually exclusive projects, the one with the highest IRR may not be
the one with the best NPV.
The conflict between NPV & IRR for the evaluation of mutually exclusive projects in due
to the reinvestment assumption:
_ NPV assumes cash flows reinvested at the cost of capital.
_ IRR assumes cash flows reinvested at the internal rate of return.
The reinvestment assumption may cause different decisions due to:
_ Timing difference of cash flows.
_ Difference in scale of operations.
_ Project life disparity.
14. Which Approach Is Better?
It is difficult to choose one approach over the other, because the theoretical and
practical strengths of the approaches differ. It is therefore wise to view both NPV and
IRR techniques in each of those dimensions.
Theoretical View
On a purely theoretical basis, NPV is the better approach to capital budgeting as a
result of several factors. Most important is that the use of NPV implicitly assumes that
any intermediate cash inflows generated by an investment are reinvested at the firm’s cost
of capital. The use of IRR assumes reinvestment at the often high rate specified by the

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IRR. Because the cost of capital tends to be a reasonable estimate of the rate at which the
firm could actually reinvest intermediate cash inflows, the use of NPV, with its more
conservative and realistic reinvestment rate, is in theory preferable.
In addition, certain mathematical properties may cause a project with a non conventional
cash flow pattern to have zero or more than one real IRR; this problem does not occur
with the NPV approach.
Practical View
Evidence suggests that in spite of the theoretical superiority of NPV, financial
managers prefer to use IRR.7 The preference for IRR is due to the general disposition of
businesspeople toward rates of return rather than actual dollar returns. Because interest
rates, profitability, and so on are most often expressed as annual rates of return, the use of
IRR makes sense to financial decision makers. They tend to find NPV less intuitive
because it does not measure benefits relative to the amount invested. Because a variety of
techniques are available for avoiding the pitfalls of the IRR, its widespread use does not
imply a lack of sophistication on the part of financial decision makers.

15. RISK ANALYSIS IN CAPITAL BUDGETING

Meaning Of Risk and Uncertainty

Risk and uncertainty are quite inherent in capital budgeting decisions. Future is
uncertain and involves risk. Risk involves situations in which the probabilities of an event
occurring are known and these probabilities are objectively determinable. Uncertainty is a
subjective phenomenon. In such situation, no observation can be drawn from frequency
distribution. The risk associated with a project may be defined as the variability that is
likely to occur in the future returns from the project. A wide range of factors give rise to
risk and uncertainty in capital investment, viz. competition, technological development,
changes in consumer preferences, economic factors, both general and those peculiar to
the investment, political factors etc. Inflation and deflation are bound to affect the
investment decision in future period rendering the deeper of uncertainty more severe and
enhancing the scope of risk. Technological developments are other factors that enhance
the degree of risk and uncertainty by rendering the plants or equipments obsolete and the
product out of date. It is worth noting that distinction between risk and uncertainty is of

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academic interest only. Practically no generally accepted methods could so far be evolved
to deal with situation of uncertainty while there are innumerable techniques to deal with
risk. In view of this, the terms risk and uncertainty are used exchangeably in the
discussion of capital budgeting.
According to Luce R.D and H. Raiffa in their book, ‘Games and Decision’ (1957), the
decision situations with reference to risk analysis in capital budgeting decisions can be
broken into three types.
i) Uncertainty
ii) Risk and
iii) Certainty
The risk situation is one in which the probabilities of a particular event occurring are
known. The difference between risk and uncertainty lies in the fact that the variability is
less in risk than in the uncertainty.
In the words of Osteryang, J.S. ‘Capital budgeting’ risk refers to the set of unique
outcomes for a given event which can be assigned probabilities while uncertainty refers
to the outcomes of a given event which are too sure to be assigned probabilities.
Types of Uncertainties
Several types of uncertainties are important to the producer, as he formulates
plans and designs courses of actions for procuring resources at the present time for a
product forthcoming at a future date. The types of uncertainties can be classified as
(i) Price uncertainty (ii) Production uncertainty (iii) Production technology uncertainty
(iv) Political uncertainty (v) Personal uncertainty; and (vi) Peoples' uncertainty.
Two opportunities to adjust the present value of cash inflows for risk exist:
(1) The cash inflows (CFt) can be adjusted, or (2) the discount rate (k) can be adjusted.
Adjusting the cash inflows is highly subjective, so here we describe the more popular
process of adjusting the discount rate. In addition, we consider the portfolio effects of
project analysis as well as the practical aspects of the risk adjusted discount rate.
I) Risk-Adjusted Discount Rates
The approaches for dealing with risk that have been presented so far enable the
financial manager to get a “feel” for project risk. Unfortunately, they do not explicitly
recognize project risk. We will now illustrate the most popular risk adjustment technique

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that employs the net present value (NPV) decision method. The rate of return must be
earned on a given project to compensate the firm’s owners adequately, that is, to maintain
or improve the firm’s share price. The higher the risk of a project, the higher the RADR,
and therefore the lower the net present value for a given stream of cash inflows. That is, a
risk discount factor (known as risk-premium rate) is determined and added to the
discount factor (risk free rate) otherwise used for calculating net present value. For
example, the rate of interest (rf) employed in the discounting is 10 per cent and the risk
discount factor (risk premium) (rp) for mildly risky, moderately risky and high risk (or
speculative) projects respectively then the total rate of discount (r) would, r = rf + rp
This approach uses Equation NPV but employs a risk-adjusted discount rate, as noted in
the following expression

Merits:
i) This technique is simple and easy to handle in practice.
ii) The discount rates can be adjusted for the varying degrees of risk in different years,
simply by increasing or decreasing the risk factor (r) in calculating the risk adjusted
discount rate.
iv) This method of discounting is such that the higher the risk factor in the remote future
is, automatically accounted for. The risk adjusted discount rate is a composite rate which
combines both the time and discount factors.
Demerits:
i) The value of discount factor must necessarily remain subjective as it is primarily based
on investor's attitude towards risk. .
ii) A uniform risk discount factor used for discounting al future returns is unscientific as-
it implies the risk level of investment remains same over the years where as in practice is
not so.
II) Certainty-Equivalent Co-efficient Approach.
This risk element in any decision is often characterized by the two Outcomes: the
'potential gain' at the one end and the 'potential loss' at the other. These are respectively
called the focal gain and focal loss. The risk level of the project under this method is

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taken into account by adjusting the expected cash inflows and the discount rate. Thus the
expected cash inflows are reduced to a conservative level by a risk-adjustment factor
(also called correction factor). This factor is expressed in terms of Certainty - Equivalent
Co-efficient which is the ratio of risk less cash flows to risky cash lows. Thus
Certainty -Equivalent Co-efficient = Risk less cash flow / Risky cash flows
This co-efficient is calculated for cash flows of each year. The value of the co-efficient
may vary-between 0 and 1, there is inverse relationship between the degree of risk, and
the value of co-efficient computed. These adjusted cash inflows are used for calculating
N.P.V. and the I.R.R. The discount rate to be used for calculating present values will be
risk free (i.e., the rate reflecting the time value of money). Using this criterion of the
N.P.V. the project would be accepted, if the N.P.V were positive, otherwise it would be
rejected. The I.R.R. will be compared with risk free discount rate and if it higher the
project will be accepted, otherwise rejected.
III) Sensitivity Analysis
This provides information about case flows under three assumptions: i)
pessimistic, ii) most likely and iii) optimistic outcomes associated with the project. It is
superior to one figure forecast as it gives a more precise idea about the variability of the
return. This explains how sensitive the cash flows or under the above mentioned different
situations. The larger is the difference between the pessimistic and optimistic cash flows,
the more risky is the project.
IV) Decision Tree Analysis
Decision tree analysis is another technique which is helpful in tackling risky
capital investment proposals. Decision tree is a graphic display of relationship between a
present decision and possible future events, future decisions and their consequence. The
sequence of event is mapped out over time in a format resembling branches of a tree. In
other words, it is pictorial representation in tree from which indicates the magnitude
probability and inter-relationship of all possible outcomes.
Elements of Decision Theory
Managerial Economics focuses attention on the development of tools for finding
out an optimal or best solution for the specified objectives in business. Any decision has
the following elements:

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1. The Decision Maker.

2. Objectives or goals sought to be achieved by the decision maker; for example,
maximisation of profit or sales revenue may be the objective of the business.
3. A set of choice alternatives.
4. A set of outcomes or pay-offs with each alternatives; that is net benefits from the
projects. Outcomes may be certain or uncertain. In case of former, the selection of any
alternative leads uniquely to a specific pay-off. In case of latter, any one of a number of
outcomes may be associated with any specific decision.
5. A number of states of the environment whose occurrence determines the possible
outcomes. For example, inflation and depression would be two alternative states, hi the
absence of risk and uncertainty, the outcome of a project is known. Therefore only one
state of the environment is possible. The study of Managerial Economics begins with
developing awareness of the environment within which managerial decisions are made.
6. Criteria derived from the general objectives which enable the decision taker to rank the
various alternatives in terms of how far their pay-offs lead to the achievement of the
decision maker's goals. This is known as the decision process.
7. Constraints on the alternatives when the decision maker may select. For example, the
government policy on monopoly control; top management directions regarding business
undertakings, diversification of business or diversifying an existing product line or to
refrain from certain types of business, etc.
16. CAPITAL RATIONING:
Capital rationing is a situation where a constraint or budget ceiling is placed on
the total size of capital expenditures during a particular period. Often firms draw up their
capital budget under the assumption that the availability of financial resources is limited.
Under this situation, a decision maker is compelled to reject some of the viable projects
having positive net present value because of shortage of funds. It is known as a situation
involving capital rationing.
Factors Leading to Capital Rationing - Two different types of capital rationing
situation can be identified, distinguished by the source of the capital expenditure
constraint.

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I. External Factors - Capital rationing may arise due to external factors like
imperfections of capital market or deficiencies in market information which might have
for the availability of capital. Generally, either the capital market itself or the
Government will not supply unlimited amounts of investment capital to a company, even
though the company has identified investment opportunities which would be able to
produce the required return. Because of these imperfections the firm may not get
necessary amount of capital funds to carry out all the profitable projects.
II. Internal Factors - Capital rationing is also caused by internal factors which are as
follows:
1. Reluctance to take resort to financing by external equities in order to avoid
assumption of further risk
2. Reluctance to broaden the equity share base due to fear of losing control.
3. Reluctance to accept viable projects its inability to control the firm in the scale of
operation resulting from inclusion of all the viable projects.

17. PRACTICE PROBLEMS WITH SOLUTIONS

1) Initial Investment = Rs. 1, 00,000
Expected future cash inflows Rs. 20,000, Rs. 40,000, Rs. 60,000, Rs. 70,000
Calculation of pay back period

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2) For each of the following projects compute (i) pay-back period and (ii) post payback
profitability
a) Initial outlay Rs.50,000, Annual cash inflow (after tax but before depreciation)
Rs.10,000 and Estimated life 8 Years
Solution
a) i) Pay-back period = Investment / Annual Cash Flow
= 50,000 / 10,000 = 5 Years
ii) Post pay back profitability= Annual cash inflow (estimated life–pay back period)
= 10,000 (8 – 5) = Rs. 30,000
3) X Ltd. is considering the purchase of a machine. Two machines are available E and F.
the cost of each machine is Rs. 60,000. Each machine has expected life of 5 years. Net
profits before tax and after depreciation during expected life of the machines are given
below:

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Machine E Machine F
Average profit after tax 42,500 x 1/5 = Rs. 8500 45,000 x 1/5 = Rs. 9000
Average investment 60,000 x ½ = Rs. 30000 60,000 x ½ = Rs. 30000
Average return on average 8500/30000 x 100 9000/30000 x 100
= 28.33% = 30%
Thus, machine F is more profitable.

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4) From the following information calculate the net present value of the two projects and
suggest which of the two projects should be accepted assuming a discount rate of 10%.

Solution
Calculation of Net Present Value for Project X

Present value of all cash inflows 24227

Less present value of initial investment 20000
(because all the investment is to be made in the first
year only, the present value is the same as the cost of
the initial investment)
Net present values = 4227

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Calculation of Net Present Value for Project Y

Present value of all cash inflows 34728

Less present value of initial investment 30000
(because all the investment is to be made in the first
year only, the present value is the same as the cost of
the initial investment)
Net present values = 4728
We find that net present value of Project Y is higher than that the net present value of
Project X and hence it is suggested that project Y should be selected.

5) Two mutually exclusive investment proposals are being considered. The following
information is available.

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Assuming cost of capital at 10%, advice the selection of the project.

Solution:
Calculation of Net Present Value of two Projects

As net present value of project is more than that of project X after taking into
consideration the probabilities of cash inflows. Project Y is more profitable.

6) Zenith Industrial Ltd. is thinking of investing in a project costing Rs. 20 lakhs. The
life of the project is five years and the estimated salvage value of the project is zero.
Straight line method of charging depreciation is followed. The tax rate is 50%. The
expected cash flows before tax are as follows :

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You are required to determine the : (i) Payback Period for the investment, (ii) Average
Rate of Return on the investment, (iii) Net Present Value at 10% Cost of capital, (iv)
Benefit-Cost Ratio (PI).

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7) A company is considering which of two mutually exclusive projects is should

undertake. The Finance Director thinks that the project with the higher NPV should be
chosen whereas the managing Director thinks that the one with the higher IRR should be
undertaken especially as both projects have the same initial outlay and length of life. The
company anticipates a cost of capital of 10% and the net after-tax cash flows of the
projects are as follows:

Required:
(a) Calculate the NPV and IRR of each project.
(b) Sate, with reasons, which project you would recommedn.
(c) Explain the inconsistency in the ranking of the two projects.

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(b) Both the projects are acceptable because they generate the positive NPV at the
company’s cost of Capital at 10%. However, the Company will have to select Project X
because it has a higher NPV. If the company follows IRR method, then Project Y should
be selected because of higher internal rate of return (IRR). But when NPV and IRR give
contradictory results, a project with higher NPV is generally preferred because of higher
return in absolute terms. Hence, Project X should be selected.
(c) The inconsistency in the ranking of the projects arises because of the difference in the
pattern of cash flows. Project X’s major cash flows occur mainly in the middle three
years, whereas Y generates the major cash flows in the first itself.
8) Projects X and Y are analysed and you have determined the following parameters.
Advice the investor on the choice of a project:

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Analysis: The major criterion i.e., IRR, Pay back and Profitability Index in which Project
X is ranking first and hence it could be selected.
9) A company is contemplating to purchase a machine. Two machine A and B are
available, each costing Rs. 5 lakhs. In comparing the profitability of the machines, a
discounting rate of 10% is to be used and machine is to be written off in five years by
straight line method of depreciation with nil residual value. Cash inflows after tax are
expected as follows :

Indicate which machine would be profitable using the following methods of ranking
investment proposals: (i) Pay back method: (ii) Net present value method; (iii)
Profitability index method; and (iv) Average rate of return method.

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Rank : Machine-A - I, Machine-B - II

Since Machine A has greater NPV compared to Machine B, Machine A is more
profitable.

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Machine B is more profitable.

10) A particulars project has a four-year life with yearly projected net profit of Rs. 10,000
after charging yearly Depreciation of Rs. 8,000 in order to write-off the capital cost of Rs.
32,000. Out of the Capital cost Rs. 20,000 is payable immediately (Year 0) and balance in
the next year (which will be the Yea 1 for evaluation). Stock amounting to Rs. 6,000 (to
be invested in Year 0) will be required throughout the project and for Debtors a further
sum of Rs. 8,000 will have to be invested in Year 1. The working capital will be recouped
in Year 5. It is expected that the machinery will fetch a redidual value of Rs. 2,000 a the
end of 4th year. Income Tax is payable @ 40% and the Depreciation equals the taxation
writting down allowances of 25% pre annum. Income Tax is paid after 9 months after the
end of the year when profit is made. The residual value of Rs. 2,000 will also bear Tax @
40%. Although the project is for 4 years, for computation of Tax and realisation of
working capital, the computation will be required up to 5 years. Taking Discount factor of
10%, calculate NPV of the project and give your comments regarding its acceptability.
Calculation of NPV of Project

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Suggestion: Since NPV is Rs. 10,910; it is suggested to accept the proposal.

11) Initial Investment Rs. 1, 00,000, Cost of Capital @ 12% p.a.

Expected Cash Inflows
Yr. 1 Rs. 25,000, Yr. 2 Rs. 50,000, Yr. 3 Rs. 75,000, Yr. 4 Rs. 1,00,000 and Yr. 5 Rs.
1,50, 000
Calculate Discounted Payback Period.

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12) A company has a machine in current use. It was purchased for Rs 1,60,000, and had a
projected life of 8 years with
Rs 10,000 salvage value. It has been depreciated @ 25 per cent on written down value
basis for 3 years to date, and can be sold for Rs 30,000.
A new machine can be purchased at a cost of Rs 2,60,000. It will have a
5-year life, salvage value of
Rs 10,000, and will be depreciated @ 25 per cent like other assets of the block. It is
estimated that the new machine will reduce labour expenses by Rs 15,000 per year and
net working capital requirement by Rs 20,000. The income tax rate of the company is 35
per cent and its required rate of return is 12 per cent on investment.

Determine whether the new machine should be purchased. The income statement for the
firm using the current machine for the current year is as follows:
Sales Rs 20,00,000
Labour Rs 7,00,000
Material 5,00,000
Depreciation 2,00,000
Total costs 14,00,000
Earnings before tax 6,00,000
Income tax 2,10,000
After tax profit 3,90,000
Incremental cash outflows
Cost of new machine Rs 2,60,000
Less sale value of existing machine 30,000
Less reduction in working capital 20,000
2,10,000

Determination of CFAT and NPV

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Partiuclars Years
1 2 3 4 5
Cost savings Rs 15,000 Rs 15,000 Rs 15,000 Rs 15,000 Rs 15,000
Less taxes (0.35) 5,250 5,250 5,250 5,250 5,250
EAT/CFAT 9,750 9,750 9,750 9,750 9,750
Tax shield on incremental
depreciation (Depreciation
´ 0.35) 20,125 15,094 11,320 8,490 5,493
Total CFAT 29,875 24,844 21,070 18,240 15,243
(X) PV factor (0.12) X 0.893 X 0.797 X 0.712 X 0.636 X 0.567
PV 26,678 19,801 15,002 11,601 8,643
Add PV of salvage value
(Rs 10,000 ´ 0.567) 5,670
Less PV of WC required
again (Rs 20,000 ´ 0.567) (11,340)
Total present value (t = 1 – 5) 76,055
Less incremental cash outflows 10,000
NPV 1,33,945)
Since NPV is negative, the new machine should not be purchased.
Working notes
(a) WDV of existing machine in the beginning of year 4:
Initial cost of machine Rs 1,60,000
Less depreciation charges (year 1 to 3):
Year 1 (Rs 1,60,000 X 0.25) Rs 40,000
2 ( 1,20,000 X 0.25) 30,000
3 ( 90,000 X 0.25) 22,500 92,500
67,500
(b) Depreciation base of new machine
WDV of existing machine Rs 67,500
Add cost of new machine 2,60,000
Less sale value of existing machine (30,000)

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2,97,500
(c) Base for incremental depreciation: (Rs 2,97,500 – Rs 67,500) = Rs 2,30,000.

13) One of three projects of a company is doing poorly and is being considered for
replacement. The projects (A, B and C) are expected to require Rs 2,00,000 each, have an
estimated life of 5 years, 4 years and 3 years respectively, and have no salvage value. The
required rate of return is 10 per cent. The anticipated cash flows after taxes (CFAT) for
the three projects are as follows:
CFAT
Year A B C

1 Rs 50,000 Rs 80,000 Rs 1,00,000

2 50,000 80,000 1,00,000
3 50,000 80,000 10,000
4 50,000 30,000 —
5 1,90,000 — —
(a) Rank each project applying the methods of pay back, average rate of return, net
present value, internal rate of return and profitability index.

(b) Explain why the five capital budgeting systems yield conflicting answers.

(c) What would be the profitability index if the internal rate of return equals the required
return on investment? What is the significance of a profitability index of less than
one?
(d) Recommend the project to be adopted and give reasons.

Calculation of NPV fro projects, A, B and C

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Year CFAT PV factor Total PV

A B C (at 0.10) A B C
1 Rs 50,000 Rs 80,000 Rs 1,00,000 0.909 Rs 45,450 Rs 72,720 Rs 90,900
2 50,000 80,000 1,00,000 0.826 41,300 66,080 82,600
3 50,000 80,000 1,00,000 0.751 37,550 60,080 7,510
4 50,000 30,000 — 0.683 34,150 20,490 —
5 1,90,000 — — 0.621 1,17,990 — —
3,90,000 2,70,000 2,10,000 2,76,440 2,19,370 1,81,010
NPV (Gross present value – Cash outflows):
(A) (Rs 2,76,440 – Rs 2,00,000) = Rs 76,440
(B) (Rs 2,19,370 – Rs 2,00,000) = Rs 19,370
(C) (Rs 1,81,010 – Rs 2,00,000) = Rs (18,990)
Pay back period: Project A = 4 years
Project B = 2.5 years
Project C = 2 years

Internal rate of return (IRR):

IRR will be calculated based on trial and error approach, it uses the different discount
rates for converting the future cash flows into present cash flows to equate the NPV to
zero.

Project A: In Project A, CFAT in the initial years are substantially smaller than the

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average CFAT; therefore, lower discount rates of 21 and 20 per cent are applied.

Project A
PV factor at Total PVat
Year CFAT (0.21) (0.20) (0.21) (0.20)
1 Rs 50,000 0.826 0.833 Rs 41,300 Rs 41,650
2 50,000 0.683 0.694 34,150 34,700
3 50,000 0.564 0.579 28,200 28,950
4 50,000 0.467 0.482 23,350 24,100
5 1,90,000 0.386 0.402 73,340 76,380
IRR(A) = 21 per cent 2,00,340 2,05,780
Project B
PV factor at Total PV at
Year CFAT (0.14) (0.15) (0.14) (0.15)
1 Rs 80,000 0.877 0.870 Rs 70,160 Rs 69,600
2 80,000 0.769 0.756 61,520 60,480
3 80,000 0.675 0.658 54,000 52,640
4 30,000 0.592 0.572 17,760 17,160
2,03,440 1,99,880
IRR(B) = 15 per cent
Project C
Year CFAT PV factor (at 0.03) Total PV
1 Rs 1,00,000 0.971 Rs 97,100
2 1,00,000 0.943 94,300
3 10,000 0.915 9,150
2,00,550
IRR(C) = 3 per cent

Ranking of the projects

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Name of the method A B C

PB 3 2 1
NPV 1 2 No rank
IRR 1 2 No rank
(ii) The profitability index (PI) would be 1 if the IRR equalled the required return on
investment.
The significance of a PI less than 1 is that NPV is negative and the project should not
be undertaken.
(iii) Project A should be adopted because its NPV is the highest among all the projects.

14) A company is considering a proposal to buy one of the two machines to manufacture
a new commodity. Each of the machines requires investments of Rs 50,000 and is
expected to provide benefits over a period of 12 years. The firm has made ‘pessimistic,’
‘most likely’ and ‘optimistic’ estimates of the returns associated with each of these
alternatives. These estimates are as follows:
Machine A Machine B
Cost Rs 50,000 Rs 50,000
Cash flow estimates:
Pessimistic 8,000 0
Most likely 12,000 10,000
Optimistic 16,000 20,000

Assuming 14 per cent cost of capital, which project do you consider more risky, and
why?

Computation of net present value

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Cash flow CFAT (t=1–12) PVfactor(0.14) TotalPV Cashoutlays NPV

estimates
Machine A
Pessimistic Rs 8,000 5.660 Rs 45,280 Rs 50,000 Rs(4,720)
Most likely 12,000 5.660 67,920 50,000 17,920
Optimistic 16,000 5.660 90,560 50,000 40,560
Machine B
Pessimistic Nil 5.660 Nil 50,000 (50,000)
Most likely 10,000 5.660 56,660 50,000 6,660
Optimistic 20,000 5.660 1,13,200 50,000 63,200

Project B is more risky because the NPV can be negative as high as Rs 50,000, while in
Project A, the NPV can be negative only by Rs 4,720.

15) A company is considering two mutually exclusive projects X and Y. Project X costs
Rs 30,000 and Project Y Rs 36,000. You have been given below the net present value
probability distribution for each project:
Project X Project Y
NPV estimate Probability NPV estimate Probability
Rs 3,000 0.1 Rs 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
(a) Compute the expected net present value of projects X and Y.
(b) Compute the risk attached to each project that is, standard deviation of
each probability distribution.
(c) Which project do you consider more risky and why?
(d) Compute the profitability index of each project.

(a) Expected NPV

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Project X Project Y
NPV Pi Expected NPV NPV Pi ExpectedNPV
(NPV X Pi ) (NPV X Pi )
Rs 3,000 0.1 Rs 300 Rs 3,000 0.2 Rs 600
6,000 0.4 2,400 6,000 0.3 1,800
12,000 0.4 4,800 12,000 0.3 3,600
15,000 0.1 1,500 15,000 0.2 3,000
Expected NPVx 9,000 Expected NPVy 9,000
(b) Standard deviation of each probability distribution
NPV NPVi (NPVi– NPV)2 Pi (NPVi– NPV)2Pi
Project X
Rs 3,000 Rs 9,000 Rs 360,00,000 0.1 Rs 36,00,000
6,000 9,000 90,00,000 0.4 36,00,000
12,000 9,000 90,00,000 0.4 36,00,000
15,000 9,000 3,60,00,000 0.1 36,00,000
1,44,00,000
Project Y
3,000 9,000 3,60,00,000 0.2 72,00,000
6,000 9,000 90,00,000 0.3 27,00,000
12,000 9,000 90,00,000 0.3 27,00,000
15,000 9,000 3,60,00,000 0.2 72,00,000
1,98,00,000

(c) Risk of the project is to be determined with reference to coefficient of variation

(V).
V = SD /NPV: Vx = Rs 3,795/9,000 = 0.42, Vy = Rs 4,450/9,000 = 0.49.
Project Y is more risky because of higher coefficient of variation.
(d) PI(X) = Rs 39,000/30,000 = 1.3, PI(Y) = Rs 45,000/36,000 = 1.25

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16) A company is considering a proposal to purchase a new machine. The machine has an
initial cost of Rs 50,000. The capital budgeting department has developed the following
discrete probability distribution for cash flows generated by the project during its useful
life of 3 years:
Period 1 Period 2 Period 3
CFAT Prob CFAT Prob CFAT Prob
Rs 15,000 0.2 Rs 20,000 0.5 Rs 25,000 0.1
20,000 0.4 23,000 0.1 30,000 0.3
25,000 0.3 25,000 0.2 35,000 0.3
30,000 0.1 28,000 0.2 50,000 0.3

(a) Assuming that the probability distributions of cash flows for future periods are
independent, the firm’s cost of capital is 10 per cent and the firm can invest in 5 per cent
treasury bills, determine the expected NPV.
(b) Determine the standard deviation about the expected value.

(a) Determination of expected NPV

Year 1 Year 2 Year 3
CF Pj CF X Pj CF Pj CF X Pj CF Pj CF X Pj
15,000 0.2 3,000 20,000 0.5 10,000 25,000 0.1 2,500
20,000 0.4 8,000 23,000 0.1 2,300 30,000 0.3 9,000
25,000 0.3 7,500 25,000 0.2 5,000 35,000 0.3 10,500
30,000 0.1 3,000 28,000 0.2 5,600 50,000 0.3 15,000
(CF1) = 21,500 (CF2) = 22,900 (CF3) = 37,000
PV factor(0.05) 0.952 0.907 0.864
PV 20,468 20,770 31,968
Total PV (Yr 1+2+3) 73,206
Less cash outflows 50,000
NPV (expected) 23,206

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(b) Period 1
(CFj1 – CF1)2 X Pj1 = (CFj1 – CF1)2Pj1
Rs 4,22,50,000 0.2 = Rs 84,50,000
22,50,000 0.4 = 9,00,000
1,22,50,000 0.3 = 36,75,000
7,22,50,000 0.1 = 72,25,000
(CFj1 – CF1)2 Pj1 = 2,02,50,000
= = 4,500
Period 2
(CFj2 – CF2)2 X Pj2 = (CFj2 – CF2)2Pj2
84,10,000 0.5 = 42,05,000
10,000 0.1 = 1,000
44,10,000 0.2 = 8,82,000
2,60,10,000 0.2 = 52,02,000
(CFj2 – CF2)2 Pj2 = 1, 02, 90,000
= 3,208
Period 3
(CFj3 –CF3)2 X Pj3 = (CFj3 – CF3)2Pj3
14,40,00,000 0.1 = 1,44,00,000
4,90,00,000 0.3 = 1,47,00,000
40,00,000 0.3 = 12,00,000
16,90,00,000 0.3 = 5,07,00,000
(CFj3 – CF3)2 X Pj3 = 8,10,00,000
= 8,10,00,000 = 9,000

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Standard deviation about the expected value

(4,500)2 (3,208)2 (9,000)2

= + +
(1+0.05)2 (1+0.05)4 (1+0.05)6

= (2,02,50,000) + 102,91,264
+ 8,10,00,000
1.102 1.216 1.340

= 1,83,75,681 + 84,63,211 + 6,04,47,761

8,72,86,653 = 9.343
=

Illustration17.
A company has made the following estimates of the CFAT associated with an investment
proposal. The company intends to use a decision tree to get a clear picture of the project’s
cash inflows. The project has an expected life of 2 years.
CFAT(t = 1 Probability
Rs 25,000 0.4
30,000 0.6
CFAT2
If CFAT1 = Rs 25,000 12,000 0.2
16,000 0.3
22,000 0.5
If CFAT1 = Rs 30,000 20,000 0.4
25,000 0.5
30,000 0.1
The equipment costs of Rs 40,000 and the company uses a 10 per cent discount rate for
this type of investment.
(a) Construct a decision tree for the proposed investment project.

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(b) What net present value will the project yield if the worst outcome is
realised? What is the probability of occurrence of this NPV?
(c) What will be the net present value if the best outcome occurs? What
is its probability?
(d) Will the project be accepted?

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UNIT 4

INTRODUCTION
Working capital refers to the investment by a company in short-term assets such as cash,
marketable securities, accounts receivables and inventories. A study of working capital is of
major importance to internal and external analysis because of its close relationship with
the current day to day operations of business.
Business needs funds for the purpose of its establishment and to carry out its day-to-
day operations. Long-term funds are required to create production facilities through
purchase fixed assets such as plant & machinery, land & buildings, furniture etc. investment
in these assets represents the part of firm's capital, which is blocked on a permanent or
fixed and is called fixed capital, Funds are also needed for short-term purpose for the
purchase of raw materials, payments of wages and other day-to-day expenses etc., these funds
are known as working capital.
Working capital is one of the most important requirements of any business concern.
Working capital can be compared with the -blood of human beings. As human cannot
survive without blood, in the same way on business cannot survive without working capital.
Working capital management deals with maintaining the levels of working capital
to optimum, because if a concern has inadequate opportunities if the working capital is more
than required the concern will loose money in form of interest on the block funds.
Therefore working capital management plays a very vital role in profitability of a
company.
DEFINITION AND MEANING:
Working capital is defined as excess of current assets over current liabilities.
Management of working capital includes management of all current-assets and current
liabilities. The interaction between current assets and current liabilities is the main theme of
the theory of working capital management.

J.S.Mill: “The Sum of the current assets is the working capital of a business”

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Bonneviulle and Dewey: “Any acquisition of funds which increases the current assets,
increased working capital, for they are one and the same”.

C.W. Gerstenberg: “Working capital has ordinarily been defined as the excess of current
assets over current liabilities.”
Working capital is commonly used for the capital required for day to day working in a
business concern, such as purchasing raw material for meeting day to day expenditure on
salaries, wages, rent rates, advertising etc.
Current Working capital measures how much in assets a company has available to build
its business. The number can be positive or negative, depending on how much debt the
company
Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's
ability to fund operations, reinvest and meet capital requirements and payments.
Understanding a company's health is essential to making investment decisions. A good
way to judge a company's cash flow prospects is to look at its Working Capital
Management (WCM).
NEED FOR WORKING CAPITAL:
The basic objective of financial management is to maximize the shareholder wealth. This
is possible only when company earns sufficient profits. The amount of such profits
largely depends upon the magnitude of sales. However sales convert into cash
instantaneously. There is always time gap between sale for goods and their actual
realization working capital required in order to sustain the sales activities in this period.
In case adequate working capital is not available for this period the company will not be in a
position to purchase raw material, pay wages and other expenses required for, manufacturing the
goods. Therefore sufficient amount of working capital is to be maintained at nay point time.
ADEQUACY OF WORKING CAPITAL:
A firm must have -adequate working capital is as much as needed by the firm. It should neither
be excessive nor in adequate. Both the situation is harmful to the concern. Excessive working
capital is the firm as ideal funds which earns no profits for the firm inadequate working capital
means the firm does not have funds to perform operations which means ultimately results in
production interruptions and lowering down of the profitability. It will be interesting to understand

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the relationship between working capital, risk return in manufacturing concern it is

generally accepted that higher levels of working capital decrees the risk and have the
potential of increasing the profitability also.
ASSUMPTION:

There is a direct relationship risk and profitability, higher the risk higher the profitability,
while lower the risk lower the profitability. Current assets are less profitable than fixed assets...
Short-term funds are less expensive than long-term funds. On account of above principles, an
increasing in the ratio of current assets to total assets will be result in the decline of the
profitability of the firm, This is because investment in current assets as started above is less
profitable than in the fixed assets, However an increase in the ratio would decrease the risk
of the firm becoming technically insolvent. On the other hand a decrease in the ratio of
current assets to total assets would increase the profitability of the firm because
investment in fixed assets is more profitable then investment in current assets. However
this increases the risk of becoming insolvent on account of its possible inability in meeting its
commitments in time due to shortage of funds.

CONCEPT OF WORKING CAPITAL :

There are two concepts of working capital. They are:
 Gross Working Capital
 Net working Capita
GROSS WORKING CAPITAL:
It is the total of all the current assets, which include inventories, sundry debtors, and cash in
hand, and bank, advances, investments, short term deposits etc.,
NET WORKING CAPITAL:
It is the excess of current assets over current liabilities; this is as a matter of fact the
most commonly accepted definition. In other words it can also be defined as difference
between current assets and current assets and current liabilities.
It is that portion of a firm's current assets, which is financed with long-term funds.
Operating cycle:
Working capital is required for a business because of the time gap between the sales and
their actual realization in cash. The time gap is technically called an operating cycle of
the Business fig -3 illustrates the operating cycle of a firm working capital management

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involves management of different components of working capital such as account

receivable and i9nventories for determining the size and method of financing.
A brief description of various issues involved in the management of each of the
component of working capital is here below. Adequate cash balance have to maintained
so that no fund are blocked in idle cash which involves costs in terms if interest.
Adequate cash is required to meet business obligation as and when they raise. Cash
requirement also arise to meet unforced contingencies such as stake, increase in the price
of raw material, and fall in the collocation of the account receivable. The grater is the
possibilities of contingencies. The greater amount of fund required to maintain by the
firm.
Adequate cash is also required to take the advantages of unexpected Business
opportunities. The management of cash is aimed to meet the obligation as per the
payment schedule and to minimize the amount of idle cash balance. Inventories include
raw material, work in progress and finished good inventories. The maintenance of these
levels of inventories depend upon the nature of business.
Adequate inventories protect the firm from the losses on account of shortage or delay in
production price variations and defer ratio of stock. Accounts receivable constitute a
significant portion of the hotel current assets of a business. Accounts receivable are the
results of goods or credit intended increase the scale volume and thereby increase in the
profits of the business. Management of accounts receivable is aimed to ensure liquidity.
Higher level of accounts receivable to be bad debt and inverse the collection cost.

Working capital can be divided into categories on the basis of time.

 Permanent working capital / fixed working capital
 Temporary working capital / variable working capita

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Cash
Raw material

Work in
progress
Account
receivable

Finished
Sales goods

OPERATING CYCLE

ESTIMATION OF WORKING CAPITAL:

Since working capital is excess of current assets over current liabilities, the forecast for
working capital requirements can be made only after estimating the amount of different
constituent's working capital.
I. Inventories
 Stock of raw materials
 Work - in – process
 Finished goods
II. Sundry debtors
III. Cash and bank balances
IV. Sundry creditors
V. Outstanding expenses

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INVENTORIES:
The terms inventories include stock of raw materials, work - in - process and finished
goods. The estimation of each of them will be made as follows:

 STOCK OF RAW MATERIALS: The average amount of raw materials to be kept in

stock will depends upon the quantity of raw material required for production during a
particular period and the average time taken in obtaining a fresh delivery.
 WORK- IN-PROCESS: The cost of work - in - process includes raw materials, wages
and overheads. In determining the amount of work in process, the time period for which
the good will be in the course of production process, is most important.
 FINISHED GOODS: The finished goods are kept in warehouse and according to the orders of
the customers, goods will be delivered.

II.SUNDRY DEBTORS: Debtors are those persons who will be purchase goods on credit basis.
The sundry' debtors will-be calculated on the basis of credit sales.
III.CASH AND BANK BALANCES: The amount of money to be kept as cash in hand or cash at
bank can be estimated on the basis of past experience.
IV.SUNDRY CREDITORS: The lag in payment to suppliers of raw materials, goods, etc., and
likely credit purchase to be made during the period will be help in estimating the amount of
creditors.
V.OUTSTANDING EXPENSES: The time lag in payment of wages and other expenses will be
help in estimation of outstanding expenses.

SOURCES OF WORKING CAPITAL

There are mainly two types of sources of working capital, they are as follows:
PERMANENT OR FIXED OR LONG-TERM WOKI N G CAPITAL:
 SHARES: Issue of shares is the most important share for raising the permanent or
long-term capital. A company can issue various types of shares, preference share and
deferred share.
 DEBENTURES: A debenture is an instrument issued by the company
acknowledging its debts to its holder it is also an important method of raising long
term permanent working capital

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 PUBLIC DEPOSITS: Public deposits are the fixed deposits accepted by a business
enterprise directly popular in the absence of banking facilities.
 LOANS FROM FINANCIAL INSTITUTION : Financial Institutions such as commercial
Banks, industrial finance corporations of India, state financial corporations.

TEMPORARY OR VARIABLE FOR SHORT-TERM WORKING CAPITAL:

 TRADE CREDIT: Trade credit ref ers to the credit extended by the suppliers
of goods in the normal coerce of business. As present day commerce is built
upon credit, the trade credit arrangement of a firm with its suppliers is an
important source of short-term finance.
 I NDIGENOUS BUSINESS: Private money-lenders and other is country banks used
to be the only sources of finance prior to the establishment of commercial
banks. They used to change very higher rates of interest and exploited the
customers to the largest extent possible.
 DEFERRED INCOMES: Deferred incomes are incomes received advances before
supplying goods or services. They represent funds received by a firm for which
it has to supply goods or services in future.
 COMMERCIAL PAPER: Commercial paper represents unsecured promissory notes
issued by firms to raise short-terms funds. It is an important money market
instrument in advanced countries like U.S.A. In India, the reserve bank of India
introduced commercial paper in the Indian Money Market on the
recommendations of the working capital upon money market (Vague -
Committee)
FACTORS DETERMINING THE WORKING CAPITAL

The working capital requirements of a concern depends upon a large number of

factors such as nature and size of the business, scale of it’s operations etc. However the

following are the important factors generally influencing the working capital

requirements.

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1) Nature of the business: The working capital requirements of a firm are basically

influenced by the nature of it’s business. Firms engaged in trading and financing activities

make very heavy investment in current assets as compared to the investment in fixed

assets, whereas in the case of rail and road transport and other public utility services steel,

Aluminum, Automobile industries, working capital forms a relatively low proportion of

total assets.

1) Operating Cycle: The operating cycle implies the stages of process through which the

raw materials are processed to get the final product. If the process is lengthy and takes

long time to get the finished products, the requirement of working capital will be much

larger than that of a unit which has a relatively low operating cycle. The shortest

manufacturing process will minimize the investment in the form of work in progress.

Operating cycle of a manufacturing firm

3) Seasonal Elements: The requirements of working capital to a company is influenced by

the demand for the product. If the firm’s product is seasonal demand oriented, not only
the amount of working capital fluctuates from one season to other, but also the
composition of working capital changes over the time. During the season cash and bank
balances are converted into inventory. The working capital level will increase and cash
balances may reduce.

4 Growth and expansion of business: The working capital requirements of the firm will
increase as it grows in terms of sales or fixed assets. Current assets are closely related
with that of sales. The requirements of working capital for a growing firm will be more. A
growing company has to maintain proper balance between fixed and current assets in
order to sustain it’s growing production and sales. This will in turn increase the
investment in current assets to support the increased sale of operations.

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5) Firm’s credit policy: The Credit policy of the firm affects working capital by
influencing the debtor balances. The credit terms of a company may also depend upon the
industry credit norms. If a company follows a liberal credit policy, without following
norms of credit, it will result in more credit sales, increased book debts and increased
investment in working capital.

6) Turnover of Current Assets: Turnover of current assets refers to the speed at which the
components of current assets can be converted into cash. The greater the turnover is,
greater will be the cash flow and lesser will be the level of working capital. If the
turnover is low, the company can witness heavy pilling up of various components of
current assets and increased level of working capital.

7) Availability of Credit: The level of working capital of a company also depends upon
the credit facility available to it. The firm will need less working capital, if liberal credit
terms are available. The availability of credit facility from Commercial Banks also
influences working capital needs of the firm. Generally, if a firm gets credit facility
easily, on favourable conditions, it can operate with less working capital than a firm
without such facility.

8) Dividend policy: Dividends are paid to shareholders of the company out of the profits.
The payments of dividend result in cash out flow. Further, a desire to maintain an
established dividend policy may affect the company by reducing the cash balances. It will
cause changes in the level of working capital. Often changes in working capital also bring
an adjustment in the dividend policy. Shortage of working capital therefore, acts as a
powerful reason for reducing or skipping a cash dividend.

9) Taxation: Taxation is a short-term liability payable in cash. Advance payment of tax

may have to be paid on the basis of anticipated profits. Higher the tax, greater is the strain
on the working capital of the company.
10) Government Regulations and Restrictions: Regulations and restrictions by the
Government and Reserve bank of India through such controls, as credit control, import
regulations, influence the working capital of companies.

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INVENTORY MANAGEMENT:-
Management of inventories means an optimum investment in inventories, it should neither be
too low to effect the production adversely nor too high to block the funds. Unnecessary
investment in inventories is unprofitable for business. Inventories are one of the major
elements, which help the firm in obtaining the desired level of sales. Inventories mean the
stock of the product of a company and components of the products, which include raw
materials, work - in - process and finished goods. Inventories constitute about 60 percent
of current assets of public limited companies in India.
The term inventory refers to the stockpile of the product, a firm is offering
for sale and the components that make up the product. In other words, inventory is
composed of assets that will be sold future in the normal course of business
operations.
The manufacturing companies hold inventories in the form of
1) Raw materials inventory(pre-production)
2) Work in process inventory(in process) and
3) Finished goods inventory.
Raw material inventory consists of those basic inputs that are converted
into finished products through the manufacturing process. Raw material
inventories are those units which are have been purchased and stored for future
production.
Work in process inventories are semi-manufactured products. They
represent products that need more work before they become finished products for
sales.
Finished goods inventories and those completely manufactured products
which are ready for sale.

NEED TO HOLD INVENTORIES:-

There are three general motives for holding inventories.

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1) Transaction motive:- emphasizes the need to maintain inventories to

facilitate smooth production and sales operation.
2) Precautionary:- motive necessitates holding of inventories to guard
against the risk of unpredictable changes in demand and supply forces and
other factors.
3) Speculative motive:- influences the decision to increase or reduce
inventory levels to take a advantage of price fluctuations.
OBJECTIVES OF INVENTORY MANAGEMENT:-
In the context of inventory management, the firm is faced with the problem
of meeting two conflicting needs:-
1) To maintain a large size of inventory for efficient and smooth production
and sales operations.
2) To maintain a minimum investment in inventories to maximize profitably.
3) To ensure continuous supply of materials, spares and finished goods so that
production should not suffer of any time and the customers demand should
also be met.
4) To avoid both over-stocking and under-stocking of inventory.
5) To maintain investments in inventories at the optimum level as required by
the operational and sales activities.
6) To minimize losses through deterioration, pilferage wastage and damages.
Inventories represent the investment of a firm’s funds. Thus a firm should always
avoid a situation of over investment or under investment in inventories.
Major Problems of over investment.
1) Unnecessary tie ups of the firm’s funds and loss of profits
2) Excessive carrying costs
3) Risk of liquidity
Consequences of under investment.
1) Production hold-ups
2) Failure of meet delivery commitments.

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Thus an effective inventory manager should

 Ensure a continuous supply of raw material to facilitate uninterrupted
production.
 Maintain sufficient finished goods inventory for smooth sales operation and
efficient customer service.
 Maintain sufficient stock of raw material in periods of short supply and
anticipate price changes.
 Control investment in inventories and keep it at an optimum level.

RECEIVABLES MANAGMENT
The term receivable is defined as “debt owned to the firm by customer
arising from sale of goods or services in the ordinary course of business.” When a
firm makes an ordinary sale of goods or services and does not receive payment,
the firm grants trade credit and creates accounts, receivables which would be
collected in the future.
Receivable management is also called trade credit management. Thus
accounts receivable represent an extension of credit to customers, allowing them a
reasonable period of them in which to pay for the goods which they have received.
A firm’s investment in account receivables depends upon
a) Volume of credit sales, and
b) The collection period.
The volume of credit sales is a function of the firm’s total sales and the
percentage of credit sales to total sales. Total sales depend on market size, firm’s
market share product quality, intensity of competition, economic conditions, etc.
The financial manager hardly has any control over these variables. The
percentage of credit sales to total sales is mostly influenced by the nature of
business and industry norms.

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The term credit policy is used to denote a combination of these decision

variables.
1) Credit standard
2) Credit terms, and
3) Collection efforts on which the financial manager had influence.
Credit standards are criteria to decide the types of customers to whom
goods could be sold on credit.
Credit terms specify duration of credit and terms of payment by customers.
Credit efforts determine the actual collection period.
The average collection period ratio represents the average number of days
for which firm has to wait before its receivables are converted in to cash. It
measures the quality of debtors generally, the shorter the average collection period
the better is the quality of debtors as a short collection period implies quick
payment of debtors similarly a higher collection period implies as inefficient
collection performance which in turn adversely affects the liquidity or short-term
paying capacity of a firm out of its current liabilities moreover longer the average
collection period larger are the chances of bad debtors. But a precaution i.e.,
needed while interpreting a very short collection period because a very low
collection period may imply a firm’s conservative policy to sell on credit or its
inability to allow credit to its customer and thereby losing sales and profits.
Turnover ratio. If possible stock figures at the beginning and at the end of every
month should be taken and added up and thus should be divided by 13 to get a
proper average. In questions the stock figures are not given for different months.
Rather inventory in the beginning and at the end of the year is given; so the
average of these two figures should be taken.

OPTIMUM COLLECTION POLICY

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Optimum collection policy is one which maximizes the firm’s value. The
value of the firm is maximized when the incremental rate of return or marginal
rate of return of an investment is equal to the incremental cost of funds used to
finance the investment. The incremental rate of return can be calculated as
incremental profit divided by the incremental investment in receivables.

The incremental cost of fund is the rate of return required by the supplies of
fund, given the risk of investment rate. Higher the risk of investment, higher the
required rate of return. As the firm loosens its credit policy, its investment in
accounts receivable become more risky because of increase in slow paying and
defaulting accounts.

To analyse accounts receivable ageing schedule is prepared. According to

section 211 of the Indian companies Act 1956, the form of ‘Balance Sheet’ and
contents should be as prescribed. It states that a provision can be maintained on
accounts receivables, and more than 6 months and not exceeding the doubtful or
bad debts.
LN Polyesters limited is adopting ageing basis as required by the Act.

CASH MANAGEMENT:

Cash is the most important current asset for the operation of the business.
Cash is the basic input needed to keep the business running on a continuous basis,
it is also the ultimate output expected to be realized by selling the service or
product manufactured by the firm. The firm should keep sufficient cash, neither
more nor less. Cash shortage will disrupt the firm’s manufacturing operations
while excessive cash will simply remain idle, without contributing anything
towards the firm’s profitability.

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Thus a major function of the financial manager is to maintain a sound cash

position.

Cash management is concerned with managing of

1. Cash flows into and out of the firm.
2. Cash flows within the firm, and
3. Cash balances held by the firm at a point time by financing deficit of investing
surplus cash.

FACTS OF CASH MANAGEMENT:

In order to resolve the uncertainty about flow prediction and lack of
Synchronization between cash receipts and payments the firm should develop
appropriate for cash management. The firm should evolve strategies regarding the
following four facets of cash management.

1) Cash planning: Cash inflows and out flows should be planned to project
cash surplus or deficit for each period of the planning period. Cash budget
should be prepared for this purpose.

2) Optimum cash level: The firm should decide about the appropriate level of
cash balances. The cost of excess cash and danger of cash deficiency should
be matched to determine the optimum level of cash balances.

3) Managing the cash flows: The flow of cash should be properly managed.
The cash inflows should be accelerated while, as far as possible,
decelerating the cash outflows.

4) Investing surplus cash: The surplus cash balances should be properly

invested to cash profits. The firm should decide about the division of such

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cash balances between bank deposits, marketable securities and inter

corporate lending.

MOTIVES FOR HOLDING CASH

1) The transaction Motives:
The transaction motive requires a firm to hold cash to conduct its business
in the ordinary course. The firm needs cash primarily to make payments for
purchases, wages and salaries other operating expenses, taxes, dividends,
etc..Profitability will be increased only when the operating needs are met
promptly.

2) The Precautionary Motives:

The precautionary motive is the need to hold cash to meet contingencies in

future. The precautionary motive provides a cushion or buffer to withstand some
unexpected emergency.

Stronger the ability of the firm to borrow at short notice, less the need of
precautionary balances. These balances may be kept in cash and marketable
securities.

3) The speculative Motive:

The speculative motive relates to the holding of cash for investing in profit
making opportunities as and when they arise. Changes in security price may
provide such opportunities to make profits.

The firm will hold cash when it is expected that interest rates will rise and
security prices change.

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Illustration 1.
The cost sheet of POR Ltd. provides the following data :
Cost per unit
Raw materials Rs. 50
Direct Labor 20
Overheads (including depreciation of Rs. 10) 40
Total cost 110
Profits 20
Selling price 130
Average raw material in stock is for one month. Average materials in work-in-progress is
for half month. Credit allowed by suppliers; one month; credit allowed to debtors; one
month. Average time lag in payment of wages; 10 days; average time lag in payment of
overheads 30 days. 25% of the sales are on cash basis. Cash balance expected to be Rs.
1,00,000. Finishedgoods lie in the warehouse for one month.
You are required to prepare a statement of the working capital needed to finance a level
of the acitivity of 54,000 units of output. Production is carried on evenly throughout the
year and wages and overheads accrue similarly. State your assumptions, if any, clearly.
Solution :
As the annual level of acitivity is given at 54,000 units, it means that the monthly
turnover would be 54,000/12=4,500 units. The working capital requirement for this
monthly turnover can now be estimated as follows :

Estimation of Working Capital Requirements

1 Current Assets : Amount(Rs.) Amount (Rs.)
Minimum Cash Balance 1,00,000
Inventories :
Raw Materials (4,500×Rs. 50) 2,25,000
Work-in-progress :
Materials (4,500×Rs. 50)/2 1,12,500
Wages 50% of (4,500×Rs. 20)/2 22,500
Overheads 50% of (4,500×Rs. 30)/2 33,750
Finished Goods (4,500×Rs. 100) 4,50,000
Debtors (4,500×Rs. 100×75%) 3,37,500
Gross Working Capital 12,81,250 12,81,250
II Current Liabilities :
Creditors for Materials (4,500×Rs. 50) 2,25,000
Creditors for Wages (4,500×Rs. 20)/3 30,000
Creditors for Overheads (4,500×Rs. 30) 1,35,000
Total Current Liabilities 3,90,000 3,90,000
Net Working Capital 8,91,250
Working Notes :
1. The Overheads of Rs. 40 per unit include a depreciation of Rs. 10 per unit, which is a
non-cash item. This depreciation cost has been ignored for valuation of work-in-progress,
finished goods and debtors. The overhead cost, therefore, has been taken only at Rs. 30
per unit.

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2. In the valuation of work-in-progress, the raw materials have been taken at full
requirements
for 15 days; but the wages and overheads have been taken only at 50% on the
assumption that on an average all units in work-in-progress are 50% complete.
3. Since, the wages are paid with a time lag of 10 days, the working capital provided by
wages has been taken by dividing the monthly wages by 3 (assuming a month to consist
of 30 days).

Illustration 2.
Grow More Ltd. is presently operating at 60% level, producing 36,000 units per annum.
In view of favourable market conditions, it has been decided that from 1st January 2000,
the Company would operate at 90% capacity. The following informations are available :
(i) Existing cost-price structure per unit is given below :
Raw materials Rs. 4.00
Wages 2.00
Overheads (Variable) 2.00
Overheads (Fixed) 1.00
Profits 1.00
(ii) It is expected that the cost of raw material, wages rate expenses and sales per
unit will remain unchanged in 2000.
(iii) Raw materials remain in store for 2 months before these are issued to
production. These units remain in production process for 1 month.
(iv) Finished goods remain in godown for 2 months.
(v) Credit allowed to debtors is 2 months. Credit allowed by creditors is 3 months.
(vi) Lag in wages and overhead payments is 1 months. It may be assumed that
wages and overhead accrue evenly throughout the production cycle.
You are required to :
(a) Prepare profit statement at 90% capacity level; and
(b) Calculate the working requirements on an estimated basis to sustain the increased
production level.
Assumption made if any, should be clearly indicated.
Solution :
Statement of Profitability at 90% Capacity
Units (at 90% capacity) 54,000
Sales (54,000×Rs. 10) (A) Rs. 5,40,000
Cost :
Raw materials (54,000×Rs. 4) 2,16,000
Wages (54,000×Rs. 2) 1,08,000
Variable overhead (54,000×Rs. 2) 1,08,000
Fixed overhead (Rs. 1×36,000) 36,000
Total cost (B) 4,68,000
Net Profit (A–B) 72,000

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Statement of Working Capital Requirement

A. Current Assets : (Rs.) (Rs.)
Stock of raw materials (2 months×4,500×Rs. 4) 36,000
Work-in-progress :
Materials (1 month×4,500×Rs. 4) 18,000
Wages (1/2 month) 4,500
Overheads (1/2 month) 6,000 28,500
Finished goods (2 month) 78,000
Debtors [2 months × (4,68,000/12)] 78,000
Total Current Assets 2,20,500
246
B. Current Liabilities
Sundry creditors (goods)-3 months 54,000
Outstanding wages (1 month) 9,000
Outstanding overhead (1 month) 12,000
Total Current liabilities 75,000
Working capital requirment 1,45,500
Working Note :
Overhead and Wages — The work in progress period is one month. So, the wages and
overheads included in work-in-progress, are on an average, for half month or 1/24 of a
year.
Wages = Rs 1,08,000
24
= Rs 4,500
Overhead = Rs 1,08,000 – 36,000
24
= Rs 6,000
The valuation of finished goods can also be arrived at as follows:
Number of units = 4,500×2 = 9,000
Variable cost = Rs. 8 per unit
Fixed Cost (Rs. 36,000/12)×2 = Rs. 6,000
Total cost of finished goods (9,000×8) + 6,000 = Rs. 78,000
As the decision to increase the operating capacity from 60% to 90% is already taken, it
has been assumed hat the opening balance of raw materials, work in progress and
finished goods have already been brought to the desired level. Consequently, good
purchased during the period will be only for the production requirement and not for
increasing the level of stock.

Illustration 3
The management of Royal Industries has called for a statement showing the working
capital to finance a level of acitivity of 1,80,000 units of output for the year. The cost
structure for the company’s product for the above mentioned activity level is detailed
below :

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Cost per unit

Raw material Rs. 20
Direct labour 5
Overheads (including depreciation of Rs. 5 per unit) 15
40
Profit 10
Selling price 50
Additional information :
(a) Minimum desired cash balance is Rs. 20,000
(b) Raw materials are held in stock, on an average, for two months.
(c) Work-in-progress (assume 50% completion stage) will approximate to half-a-
month’sproduction.
(d) Finished goods remian in werehouse, on an average, for a month.
(e) Suppliers of materials extend a month’s credit and debtors are provided two
month’s credit; cash sales are 25% of total sale.
7 (f) There is a time-lag in payment of wages of a month; and half-a-month in the
case of overheads.
From the above facts, you are required to prepare a statement showing working capital
requirements.
Solution :
Statement of Total Cost
Raw material (1,80,000×Rs. 20) Rs. 36,00,000
Direct labour (1,80,000×Rs. 5) 9,00,000
Overheads (excluding depreciation) (1,80,000×Rs. 10) 18,00,000
Total Cost 63,00,000
Statement of Working Capital Requirement
1. Current Assets: Amt. (Rs.)
Cash balance 20,000
Raw materials (1/6 of Rs. 36,00,000) 6,00,000
Work-in-progress (Total cost¸24×50%) 1,31,250
Finished goods (Total cost¸12) 5,25,000
Debtors (75%×Rs. 63.00,000)×1/6 7,87,500
Total current assets 20,63,750
2. Current liabilities :
Creditors (Rs. 36,00,000)×1/12 3,00,000
Direct labour (Rs. 9,00,000)×1/12 75,000
Overheads (Rs. 18,00,000)×1,24 (excluding dep.) 75,000
Total current liabilities 4,50,000
Net working capital requirement 16,13,750
Note : Depreciation is a non-cash item, there for, it has been excluded from total cost as
well as working capital provided by overheads. Work-in-progress has been assumed to be
50% complete in respect of materials as well as labour and overheads expenses.

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Illustration 4.

XYZ Ltd. sells its products on a gross profit of 20% of sales. The following information
is extracted from its annual accounts for the year ending 31st March, 2009.
Sales (at 3 months credit) Rs. 40,00,000
Raw material 12,00,000
Wages (15 days in arreas) 9,60,000
Manufacturing and General expenses (one month in arrears) 12,00,000
Administration expenses (one month in arrears) 4,80,000
Sales promotion expenses (payable half yearly in advance) 2,00,000

The company enjoys one month’s credit from the suppliers of raw materials and
maintains 2 months stock of raw materials and 1½ months finished goods. Cash balance
is maintained at Rs. 1,00,000 as a precautionary balance. Assuming a 10% margin, find
out the working capital requirement of XYZ Ltd.
Solution :
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.)

Debtors (40,00,000×3/12×80%) 9at cost of goods sold) 8,00,000

Raw maetrial stock (2/12 of 12,00,000) 2,00,000
Finished goods stock (1½ months of cost of production)
(Cost of production being 80% of sales of 40,00,000) 4,00,000
Advance payment of sales promotion 1,00,000
Cash 1,00,000
Total Current assets 16,00,000

2. Current liabilities :

Sundry creditors (1/12 of 12,00,000) 1,00,000

Wages (arrears for 15 days) (1/24 of 9,60,000) 40,000
Manu, and Gen. exp. (arrears for 1 month)(1/12 of 12,00,000) 1,00,000
Administrative exp. (arrears for 1 months) (1/12 of 4,80,000) 40,000
Total Current liabilities 2,80,000

Excess of Current Assets and Current Liabilities 13,20,000

Add 10% margin 1,32,000
Net working capital requirement 14,52,000

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Illustration 5.
Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods sold is as
follows:
Rs. (Per Unit)
Raw material 100
Manufacturing expenses 30
Selling, administration and financial expenses 20
Selling price 200
The duration at various stages of the operating cycle is expected to be as follows:
Raw material stage 2 months
Work-in-progress stage 1 month
Finished stage 1/2 month
Debtors stage 1 month49
Assuming the monthly sales level of 2,500 units, estimate the gross working capital
requirement is the desired cash balance is 5% of the gross working capital requirement,
and work-in - progress in 25% complete with respect to manufacturing expenses.
Solution :

Statement of Working Capital Requirement

1. Current Assets : Amt. (Rs.) Amt. (Rs.)
Stock of Raw Material (2,500×2×100) 5,00,000
Work-in-progress :
Raw Materials (2,500×100) 2,50,000
Manufacturing Expenses 25% of (2,500×300) 18,750 2,68,750
Finished Goods :
Raw Materials (2,500×½×30) 1,25,000
Manufacturing Expenses (2,500×½×30) 37,500 1,62,500
Debtors (2,500×150) 3,75,000
13,06,250
Cash Balance (13,06,250×5/95) 68,750
Working Capital Requirement 13,75,000
Note : Selling, administration and financial expenses have not been included in valuation
of closing stock.

Illustration 6.
Calculate the amount of

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Determine the working capital requirements from the following particulars:

Annual budget for: Amount (Rs lakhs)
Raw materials 360
Supplies and components 120
Manpower 240
Factory expenses 60
Administration 90
Sales 1,190

You are given the following additional information:

(i) Stock-levels planned: Raw materials, 30 days, supplies and components,
90 days.
(ii) 50 per cent of the sales is for cash; for the remaining 20 days credit is
normal
(iii) Finished goods are held in stock for a period of 7 days before they are
released for sale
(iv) Goods remain in process for 5 days
(v) The company enjoys 30 days credit facilities on 20 per cent of the
purchases
(vi) Cash/bank balanced had been planned to be kept at the rate of half
month’s budgeted expenses
you may make assumptions as considered necessary and relevant in this
connection

Statement showing determination of net working capital

Current assets:

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Cash balance (Rs 150 lakh1 X 1/24) Rs 6,25,000

Raw materials (Rs 360 lakh X 30/360) 30,00,000
Supplies and components (Rs 120 lakh X 90/360) 30,00,000
Work-in-process (Rs870 lakh2 X 5/360) 12,08,333
Finished goods (Rs 870 lakh X 7/360) 16,91,667
Debtors (Rs 435 lakh3 X 20/360) 24,16,667
Total 1,19,41,667
Current liabilities:
Creditors4 (Rs 480 lakh X 0.2 X 30/360) 8,00,000
NWC 1,11,41,667

(B) Current liabilities

(i) Lag in payment of expenses:
Wages (Rs 19,50,000 X 1.5)/52 Rs 56,250
Rent, etc. (Rs 1,00,000/2) 50,000
Directors’ and managers’ salaries (Rs 3,60,000 ÷ 12) 30,000
Travellers’ and office salaries (Rs 4,55,000 X 2)/52 17,500
Travellers’ commission (Rs 2,00,000 X 3/12) 50,000
Other overheads (Rs 6,00,000 X 2/12) 1,00,000 3,03,750
(ii) Payment to creditors (Rs 26,00,000/52 X 6) 3,00,000
Total 6,03,750
(C) NWC (A – B) 5,71,250

* Cost of sales figure is not available

The company should arrange for Rs 5,71,250 to meet its working capital needs.
Overdraft limit of Rs 1,50,000 has not been taken into account for two reasons. First, the
NWC should be financed from permanent or long-term sources. Secondly, some amount
(not stated here) would also be required by the company as a precautionary margin.

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(iii)
Debtors:
Year 1 (Rs 4,32,000/12) 36,000
Year 2 (Rs 6,75,000/12) 56,250
Cost of goods sold (cash) Rs 4,00,000 Rs 6,29,000
Add variable expenses @ Rs 4 per
unit sold 20,000 34,000
Add total fixed selling expenses
(Rs 12,000 X Rs. 1) 12,000 12,000

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Cost of sales (cash) 4,32,000 6,75,000

Minimum desired cash balance 10,000
10,000
Total 1,71,000 2,44,750

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UNIT - V
DIVIDEND DECIDIONS

1. INTRODUCTION
A business organization always aims at earning profits. The utilization of profits
earned is a significant financial decision. The main issue here is whether the profits
should be used by the owners or retained and reinvested in the business itself. This
decision does not involve any problem so far as the sole proprietary business is
concerned. In case of a partnership the agreement often provides for the basis of
distribution of profits among partners. The decision-making is somewhat complex in the
case of joint stock companies only. The decisions regarding dividend is taken by their
Board of directors and is meeting of the company. Disposal of profits in the form of
dividends can become a controversial-issue because of conflicting interests if various
parties like the directors, employees, shareholders, debenture holders, lending
institutions, etc. even among the shareholders there may be conflicts as they may belong
to different income groups. While some may be interested in regular income, others may
be interested in capital appreciation and capital gains. Hence, formulation of dividend
policy is a complex decision. It needs careful consideration of various factors, one thing,
however, standout. Instead of an ad hoc approach, it is more desirable to follows a
reasonably long term policy regarding dividends.

2. DIVIDEND POLICY
The objective of corporate management usually is the maximization of the market
value of the enterprise i.e., its wealth. The market value of common stock of a company
is influenced by its policy regarding allocation of net earnings into plough back and
payout while maximizing the market value of shares, the dividend policy should be so
oriented as to satisfy the interests of the existing shareholders as well as to attract the
potential investors and the appreciation in the market price of share.

3. FACTORS AFFECTING THE SHAPING OF DIVIDEND POLICY

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Normally dividend policy of any organization is influenced by many factors,

namely known as Nature of business, management policy and philosophy and other
factors. Those factors are discussed in detail in the following lines
3.1 Nature of Business
This is an important determinant of the dividend policy of a company. Companies
with unstable earnings adopt dividend policies, which are different from those which
have steady earnings. Consumer good industries usually suffer less from uncertainties of
income and therefore, pay dividends with greater regularity than the capital goods
industries. Industries with stable income are in a position to formulate consistent dividend
rate. Mining companies on the other hand, with long gestation period and multiplicity of
hazards, may not be able to declare dividends payments. If earnings fluctuate and losses
are caused during depression, the continued payment of dividends may become a risky
proposition.
A company with ‘wasting assets such as timber, oil or mines-which get depleted over
time may well pursue a policy of gradually returning capital to its owners because its
resources are going to be exhausted. Such a company may offer dividends, which
include, in part a return of the owner investment.
Generally speaking large and mature companies pay a reasonable good but not a
excessive rate of dividend. Excessive dividends may be paid only by mushroom
companies. A healthy company with an eye on future follows a somewhat cautious policy
and build up reserves. A company which believes in publicity gimmicks may follow a
more liberal; dividend policy to its future detriment. A firm with a heavy programme of
investments in research and development would see to it that adequate reserves are built
up for the purpose.

3.2 Attitude and Objectives of Management

While some organization may be niggardly in dividend payments. Some others may
be liberal. A large number of firms may be found within these two extremes. Niggardly
organizations prefer to conserve cash. Though such an approach may easily meet their
future needs for funds, it deprives the stockholders of a legitimate return on their
investment. Liberal organizations on the other hand feel that stockholders are entitles to

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an established rate of dividend as long as their financial condition is reasonably sound.

Within these two extremes, a number of corporations adopt several variations.
The attitude of the management affects the dividend policies of a corporation in
another way. The stockholders who control the management of the company may be
interested in empire building they may consider ploughing back earnings as the most
effective technique for achieving their objectives of building up the corporation is
perhaps the largest in the field.
3.3 Composition of shareholdings
There may be marked variations in dividend policies on account of the variations in
the composition of the shareholding. In the case of a closely held company, the personal
objectives of the directors and of a majority of shareholders may govern the decision.
Widely held companies have scattered shareholders. Such companies may take the
dividend decision with a greater sense of responsibility by adopting a more formal and
scientific approach.
The tax burden on business corporations is a determining factor in formulation of
their dividend policies. The director’s of a closely held company may take into
considerations the effect of dividends upon the tax position of their important
shareholders. Those in the high-income brackets may be willing to sacrifice additional
income in the form of dividends in favour of appreciation in the value of shares and
capital gains. However when the stock is widely held, stockholders are enthusiastic about
collecting their dividends regularly and do not attach much importance to tax
considerations.
Thus a company, which is closely held by a few shareholders in the high income-tax
brackets, is likely to payout a relatively low dividend. The shareholders in such a
company are interested in taking their income in the form of capital gains rather than in
the form of dividends, which are subject to higher personal income taxes. On the other
hand, the shareholders of a large and widely held company may be interested in high
dividend payout.

3.4 Investment Opportunities

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Many companies retain the earnings to facilitate planned expansion. Companies with
low credit ratings may feel that they may not be able to sell their securities for raising
necessary finance they would need for future expansion. So, they may adopt a policy for
retaining larger portion of earnings.
In the context of opportunities for expansion and growth, it is wise to adopt a
conservative dividend policy if the cost of capital involved in external financing is greater
than the cost of internally generated funds.
Similarly, if a company has lucrative opportunities for investing its funds and can
earn a rate, which is higher than its cost of capital, it may adopt a conservative
3.5 Desire for financial solvency and liquidity.
Companies may desire to build up reserves by retaining their earnings which would
enable them to weather deficit years of the downswings of business cycle. They may,
therefore, consider it necessary to conserve their cash resources to face future
emergencies. Cash credit limits, working capital needs, capital expenditure commitments,
repayments of long term debt etc. influence the dividend decision. Companies sometimes
prune dividends when their liquidity declines.
3.6 Regularity
A company may decide about dividends on the basis of its current earnings which
according to its thinking may provide the best index of what a company can pay, even
though large variations in earnings and consequently in dividends may be observed from
year to year. Other companies may consider regularity in payment of dividends as more
important that anything else they may use past profits to pay dividends regularly,
irrespective of whether they have enough current profits or not. The past record of
company in payment of dividends regularly builds up the morale of the stockholders who
may adopt a helpful attitude towards it in periods of emergency of financial crisis.
Regularity in dividends cultivates an investment attitude rather than speculative one
towards the share of the company.
3.7 Restrictions By Financial Institutions:
Sometimes financial institutions which grant long term loans to corporations put a
clause restricting dividend payment till the loan or a substantial part of it is repaid.
3.8 Inflation

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Inflation is also a factor, which may affect a firm’s dividend decision. In period of
inflation, funds generated from depreciation may not be adequate to replace worn out
equipment. Under these circumstances, the firm has to depend upon retained earnings as
a source of funds to make up for the shortfall. This is of particular relevance if the assets
have to be replaced in near future. Consequently, the dividend payout ratio will tend to be
low.
On account of inflation often the profits of most of the companies are inflated. A
higher payout ratio based on overstated profits may eventually lead to the liquidation of
the company. You are aware that inflation has become an integral part of the present
financial climate while shareholders may delight in immediate income; they will feel
sorry lithe company has to suffer in a few years on account of not retaining sufficient
earnings to support future growth or not being able to maintain its position in the market
place.
Inflation has another dimension. In an inflationary situation, current income becomes
more important and shareholders in general attach more value to current yield than to
distant capital appreciation. They would thus expect a higher payout ratio.
3.9 Other Factors:
Age of company has some effect on the dividend decision. Established companies
often find it easier to distribute higher earnings without causing an adverse effect on the
financial position of the company than a comparatively younger corporation which has
yet to establish itself.
The demand for capital expenditure, money supply, etc. undergoes great oscillations
during the different stages of a business cycle. As a result, dividend policies may
fluctuate from time to time.
In many instances, dividend policies result from tradition, ignorance and indifference
rather than from considered judgment. An industry or a company may have established
some satisfactory standard for the payment of dividends and this standard becomes a
convention of custom for that industry or company.

4. DIVIDEND THEORIES

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4.1 THE RELEVANCE CONCEPT

Another school of thought represents relevance concept which considers dividend
decision to be an active variable influencing the value of the firm. Gordon, Richardson,
Lintner and James E Walter are of the opinion that dividend decision is very important.
According to them, a Firms position in the stock market i.e. dividends communicate
information to the investors about the firms profitability Prof Walter strongly supports
doctrine that dividend policy almost always affects the value of the enterprise.
4.1.1 Walters Approach
Prof Walter recognizes that dividend policy cannot be separated from investment
policy of a company. He opines that the choice of dividend policies almost always affects
the value of the firm.
Professor James E Walter has been a proponent of relevance of dividends concept. He
argues that the choice of dividend policies almost always affects the value of enterprise.
His model is one of the earlier theoretical models on this concept and it is clearly shows
the importance of dividend policy in maximization of wealth of shareholders. Walters’
model is based on the following assumptions.
 The firm finances all its investments retained earnings and debt or new
equity is not issued.
 The firm’s internal rate of return, r and its cost of capital k are
constant.
 All earnings are either distributed as dividends or reinvested internally
immediately.
 Beginning earnings and dividends never change. The value of the
earnings per share E and the dividend per share D may be changed in
the model to determine results, but any given values of E and D are
assumed to remain constant forever in determining a given value.
 The firm has a very long or infinite life.
Walter’s formula for determining the market price per share is as follows.
D r (E-D)/K
P= --- + ------------------
K K

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Where:
P = Market price per share.
D = Dividend per share.
E = Earnings per share
r = Internal rate of return
K = Cost of Capitalization or (cost of capital)
The equation shows that the market price per share is the sum of the present value of
two sources of income i) the present value of an infinite stream of constant dividends,
D/K and all the present value of infinite stream of capital gains, [r(E-D)/K]/K
According to Walter’s model, the optimum dividend policy depends on the
relationship between the firm’s internal rate of return, and its cost of capital k. the
relationship works in different circumstances a follows.
A) Growth firms where r > K; firm having r > K may be referred to as growth
firms. The growth firms are assumed to have ample profitable investment
opportunities. These firms would reinvest retained earnings\s at a higher r than
K. hence, these firms will maximize the value per share if they follows a
continuous policy of retaining all earnings for internal investment,
B) Normal Firms where r =K: the firms having the rate of r equal to K are said to
be normal firms. After having exhausted such profitable opportunities these
firms earn on their investment a rate of return equal to the cost of capital only.
Hence, for such normal of average firms, the dividend policy has no effect on
the market value per share
C) Declining firms where r < K declining firms are these firms which do not
have any profitable investment opportunity, hence they earn less than the cost
of capital (the expectation of share holders in case of the earnings are retained
and reinvested in the business ) for such firms 100% payment ratio will e an
optimum ratio. The shareholders will be better if its 100% earnings are
distributed among them so that they may spend or invest it in alternative
investments.
Thus in Walters model, the dividend policy of the firm depends on the availability of
investment opportunities and the relationship between the firms internal rate of return r

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and its cost of capital, K . the firm should use earnings to finance investments if r < K and
would remain indifferent when r = K this dividend policy becomes a financing decision
also. When dividend policy is treated as a financing decision, the payment of cash
dividends is a passive residual.

4.1.2 Gordon’s approach:

J. Gordon has also put forth a model arguing for relevance of dividend decision to
valuation of firm. The model is founded on the following assumptions.
 The firm is an all-equity firm. i.e., the firm only uses retained earnings for
financing its investments programmes.
 ‘r' and K remain unchanged for all times to come.
 The firm has perpetual life.
 There are no corporate taxes.
 The retention ratio, b once decided upon, is constant. Thus the growth rate
g = br is constant.
Gordon is of the view that the investors always prefer dividend as current income to
dividend to be obtained in future because they are rational and would be non-chalant to
take risk. The payment of current dividends completely removes any possibility of risk.
They would lay less emphasis on future dividends as compared to the current dividend.
That is why when a firm retains its earnings; its share values receive set back. Investors’
preference for current dividend exists even in situation where r = K. this sharply contrasts
with Walter’s approach which holds that investors are indifferent between and retention,
when r = K.
Gordon has proved the following formula (which is a simplified version of the original
formula to determine the market value of a share.
E (1-b)
P= ---------
K-br
Where:
P = Price of shares.
E = Earnings per share

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b = retention ratio
1-b= percentage of earnings distribution as dividends
K = Capitalization rate or cost of capital.
br = Growth rate in r, i.e., rate of return on investment of an all equity firm.

4.2 IRRELEVANT CONCEPT OF DIVIDEND

The school of thought is associated with Solomon and Modigliani and miller. The
basic theme of irrelevance approach of dividend is that the dividend policy is a passive
variable which does not in any way influence share values.

4.2.1 Modigliani and millers approach of irrelevance of dividend

Modigliani - Miller’s thoughts for irrelevance of dividends are most comprehensive
and logical. According to them, dividend policy does not affect value of a firm and is
therefore, of no consequence. They are of the view that the sum of the discounted value
per share after dividend payments is equal to the market value per share before dividend
is paid. It is earning potentially and investment policy of a firm rather than its pattern of
distribution of remainings that affects value of the firm.
The basic assumptions of M-M approach are:
1) There exists perfect capital market where all investors are rational-information is
available to all at no cost, there are no transaction costs and floatation costs, there
is no such investor as could alone influence market value of shares.
2) There does not exist taxes. Alternatively, there is no tax differential between
income on dividend and capital gains
3) Firm’s investment policy is well planned and is fixed for all the time to come.
4) There is no uncertainty as to future investments and profits of the firm. Thus,
investors are able to predict future prices and dividends with certainty. This
assumption was dropped by M-M later.
M-M’s argument of irrelevance of dividend remains unchanged whether external
funds are obtained by means of share capital borrowings. This is for the fact that
investors are indifferent between debts and equity with respect to leverage and the real
cost of debt is the same as the real cost of equity. Besides, even under conditions of

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uncertainty, dividend decision will be of no relevance because of operation of arbitrage.

According to MM hypothesis the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price
of the share at the end of the period. This can be expressed by the following formulas:

D1+P1
Po = ----------
1+Ke
Where:
Po = existing price of a share
Ke = cost of capital
D1 = Dividend to be received at the end of the period
P1 = Market price of a share at the year end.
From the above equation the following equation can be derived to
determine the value of P1
P1 = P0 (1+Ke) –D1
A firm can finance its investment programme either by ploughing back its
earnings or by issue of new shares or by both. The number of new share to be
issued can be determined as follows.
M x P1 = I - (X-nD1)
Where
M = number of new issue is to be made
P = price at which new issue is to be made
I = investment amount required
X = total net profit of the firm during the period.
nD1 = total dividends paid during the period.

Criticism of M-M’s Hypothesis:

M-M Hypothesis if dividend irrelevance is based on some simplifying
assumptions, the most critical of which were:
 No floatation costs

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 No taxes, and
 No uncertainty
All the assumptions in the model are very far from reality. Fluctuations
costs do exists in real circumstances, tax differentials wok in actual life,
uncertainty is also there shareholders very much desire current dividends and
afford to ignore capital gains.

Illustration 1: The earnings per share of a company is Rs. 8 and the rate of capitalisation
applicable is 10%. The company has before it an option of adopting (i) 50%, (ii) 75%and
(iii) 100% dividend payout ratio. Compute the market price of the company’s quoted
shares as per Walter’s model if it can earn a return of (i) 15%, (ii) 10% and (iii) 5% on its
retained earnings.
Computation of market price of Company’s share by applying Walter’s formula

Where P = Market price per share

D = Dividend per share
Ra = Internal rate of return on investment
Rc = Cost of capital i.e.,10%or 0.10
E = Earnings per share i.e., Rs. 8
Now, we can calculate the market price per share based on different IRRS and dividend
payout rations.

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Illustration 2. Agile Ltd. belongs to a risk class of which the appropriate capitalisation
rate is 10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is
contemplating declaration of a dividend of Rs.6 per share at the end of the current fiscal
year which has just begun. Answer the following questions based on Modigliani and
Miller Model and assumption of no taxes:
(i) What will be the price of the shares at the end of the year if a diviend is not declared?
(ii) What will be the price if dividend is declared?
(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh and new
investments of Rs. 20 lakhs during the period, how many new shares must be issued?
Modigliani and Miller - Dividend Irrelevancy Model

Where,
D1 = Contemplated dividend per share i.e., Rs. 6
P1 = Market price of share at the year end (to be determined)
Po = Existing market price of share i.e., Rs. 100
Ke = Cost of equity capital or rate of capitalisation i.e., 10% or 0.10
a) If dividends are declared

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Therefore, whether dividends are paid or not, value of the firm remains the same as per
M.M. approach.
Illustration 3.
ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each. The shares
currently quoted at par. The company proposes declaration of a dividend of Rs.10 per
share at the end of the current financial year. The capitalisation rate for the risk class to
which the company belongs is 12%.
What will be the market price of the share at the end of the year, if
i) A dividend is not declared?
ii) A dividend is declared?
iii) Assuming that the company pays the dividend and has net profits of Rs.5,00,000 and
makes new investments of Rs.10 lakhs during the period, how many new shares must be
issued? Use the M.M. model.

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Illustration 4.
A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It
currently has 50,000 outstanding shares selling at Rs.100 each. The firm is contemplating
the declaration of Rs.8 dividend at the end of the current fiscal year which has just
started. Given the assumption of MM, answer the following questions.

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i) What will be the price of the share at the end of the year: (a) if a dividend is not
declared, (b) if its is declared?
ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000 and
makes new investments of Rs.10,00,000 during the period, how many new shares must
be issued?
iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a
dividend is not declared?

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Illustration 5
(i) From the following information supplied to you, ascertain whether the firm’s D/P ratio
is optimal according to Walter. The firm was started a year ago with an equity capital of
Rs. 20 lakh. Earnings of the firm Rs. 2,00,000.00, Dividend paid 1,50,000.00 and P/E

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ratio 12.50. Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected
to maintain its current rate of earnings on investment.
ii) What should be the P/E ratio at which the dividend payout ratio will have no effect on
the value of the share?
iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
Solution :
i. Ke = (EPS / market price) = 1 /(12.5) = 8 %
r = (200000 / 2000000) x 100 = 10 %
Payout ratio = (150000/200000) x 100 = 75%
It is the growth firm (r > Ke), as per WALTER’s model the optimum payout ratio is Zero.
So in the given case pay out ratio is not optimum.

Therefore Zero Payout is optimum.

i. The payment of dividend in case of normal firms(r = Ke) has no effect on the market

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value of the share.

Ke = r = 10%
P/E ratio = 10times i.e [ 1 / Ke]
ii. If P/E ratio = 8 , Ke= 12.5 %
r = 10%
When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio is
100%.
So in the given case it is 75% payout only, it is not optimum payout.

Illustration 6.
Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March. They
finance all investments from out of retained earnings. The opportunities for investments
are many. If such opportunities are not availed their earnings will stay perpetually at Rs.
800,000. Following figures are relevant.

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The returns to shareholders are expected to rise if the earnings are retained because of the
risk attached to new investments. As for the current year, dividend payments will be
made with or without retained earnings. What according to you, should be retained ?

Illustration 7.
The following information is available for ABC Ltd. Earnings per share : Rs. 4 Rate of
return on investments : 18 percent Rate of return required by shareholders : 15 percent
What will be the price per share as per the Walter model if the payout ratio is 40 percent?
50 percent? 60 percent?
Solution.
According to the Walter model, P = [D + (E – D) r/k] / k
Given E = Rs4, r = 0, and k = 0.15, the value of P for the three different payout

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ratios is as follow:
Payout ratio P
40 percent = [1.6 + (2.40) 0.18/0.15] / 0.15 = Rs.29.87
50 percent = [2.00 + (2.00) 0.18/0.15] / 0.15 = Rs29.33
60 percent = [2.40 + (1.60) 0.18/0.15] / 0.15 = Rs28.80

Illustration 8.
The EPS of a company is Rs 16. The market capitalisation rate applicable to the company
is 12.5 per cent. Retained earnings can be employed to yield a return of 10 per cent. The
company is considering a pay-out of 25 per cent, 50 per cent and 75 per cent. This of
these payout ratios would maximise wealth of shareholders as per Walter’s model.

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Illustration 9.
Xyz Ltd belongs to a risk-class for which the appropriate capitalisation rate is 10 per cent.
It currently has outstanding 25,000 shares selling at Rs 100 each. The firm is
contemplating the declaration of dividend of Rs 5 per share at the end of the current
financial year. The company expects to have a net income of Rs 2.5 lakh and has a
proposal for making new investments of Rs 5 lakh.

Show that under the MM assumption, the payment of dividend does not affect the value
of the firm. Is the MM model realistic with respect to valuation? What factors might mar
its validity ?

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