Introduction

• Finance may be defined as the art and science of managing money.

• The major areas of finance are:

(1) Financial services and

(2) Managerial finance/Corporate Finance/ Financial Management.

 Financial services

• Financial services is concerned with the design and delivery of advice and
financial products to individuals, businesses, and governments within the areas:

o banking and related institutions,

o personal financial planning

o Investments

o real estate

o insurance and so on.

Corporate Finance
• Corporate Finance is all financial activities for a business.

• It is typically its department but can occasionally be rolled up into accounting,

investments, or general management.

• Financial activities for a business would include budgeting current capital, capital for

future years, funding and refinancing projects, and assets to ensure that the company

has the best deal possible in the current market.

• Corporate finance also includes finding ways to raise additional funds, which could be

through bond issues, finance offerings, or new investors.

 Financial Management

Financial management or corporate finance is concerned with the duties of the financial

managers in the business firm.

• Financial managers actively manage the financial affairs of any type of business, namely:

• financial and non-financial

• private and public

• large and small

• profit-seeking and not-for-profit.

 Duties of a Financial Manager
o Budgeting

o Financial forecasting

o Cash management

o Credit administration

o Investment analysis

o Funds management and so on.

• In recent years, the changing regulatory and economic environments coupled with the
globalization of business activities have increased the complexity as well as the importance of
the financial managers’ duties.

• As a result, the financial management function has become more demanding and complex.
 Functions of Financial Management

1.Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programs and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.

2.Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short-term and long-term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.

3.Choice of sources of funds: For additional funds to be procured, a company has many
choices like-Issue of shares and debentures
Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.

5.Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
1. Dividend declaration - It includes identifying the rate of dividends and other benefits
like bonus.
2. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.

6.Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
 FINANCE AND RELATED DISCIPLINES

• Financial management, as an integral part of overall management, is not a

independent area.

• It draws heavily on related disciplines and fields of study, such as

• Economics,

• Accounting,

• Marketing, production, and quantitative methods.

 Finance and Economics
• The relevance of economics to financial management can be described in the light

of the two broad areas of economics:

• Macroeconomics and

• Microeconomics.
Macroeconomics:

• Macroeconomics is concerned with the overall institutional environment in which the firm
operates.

• It looks at the economy as a whole.

Macroeconomics:

• Macroeconomics is concerned with the institutional structure of the banking system,

money and capital markets, financial intermediaries, monetary, credit and fiscal policies
and economic policies dealing with, and controlling level of, activity within an economy.

• Since business firms operate in the macroeconomic environment, it is important for

financial managers to understand the broad economic environment.
 Specifically, they should:

• Recognise and understand how monetary policy affects the cost and the
availability of funds;

• Be versed in fiscal policy and its effects on the economy;

• Be ware of the various financial institutions/financing outlets;

• Understand the consequences of various levels of economic activity and changes

in economic policy for their decision environment and so on.
• Microeconomics deals with the economic decisions of individuals and organisa
tions.
• It concerns itself with the determination of optimal operating strategies.
• In other words, the theories of microeconomics provide for effective operations of
business firms.
• They are concerned with defining actions that will permit the firms to achieve
success.
• The concepts and theories of microeconomics relevant to financial management
are, for instance, those involving;
o supply and demand relationships and profit maximization strategies,
o issues related to the mix of productive factors, ‘optimal’ sales level and product
pricing strategies,
o measurement of utility preference, risk and the determination of value, and
o the rationale for depreciating assets.
 Finance and Accounting

• Accounting function is a necessary input into the finance function.

• That is, accounting is a sub function of finance.

• Accounting generates information/data relating to operations/activities of the firm.

• The end-product of accounting constitutes financial statements such as the balance sheet,
the income statement (profit and loss account) and the statement of changes in financial
position/sources and uses of funds statement/cash flow statement.

• The information contained in these statements and reports assists financial managers in
assessing the past performance and future directions of the firm and in meeting legal
obligations, such as payment of taxes and so on.
 Finance and Other Related Disciplines

• Apart from economics and accounting, finance also draws—for its day-to-day
decisions—on supportive disciplines such as marketing, production and quantitative
methods.

• For instance, financial managers should consider the impact of new product
development and promotion plans made in marketing area since their plans will require
capital outlays and have an impact on the projected cash flows.

• Similarly, changes in the production process may necessitate capital expenditures which
the financial managers must evaluate and finance.

• And, finally, the tools of analysis developed in the quantitative methods area are helpful
in analysing complex financial management problems.
• The marketing, production and quantitative methods are, thus, only indirectly

related to day to-day decision making by financial managers and are supportive in

nature

• while economics and accounting are the primary disciplines on which the

financial manager draws substantially.

Impact of Other Disciplines on Financial Management
 SCOPE OF FINANCIAL MANAGEMENT

• Financial management provides a conceptual and analytical framework for financial

decision-making.

• The finance function covers both the acquisition of funds as well as their allocations.

• Thus, apart from the issues involved in acquiring external funds, the main concern of
financial management is the efficient and wise allocation of funds to various uses.

• Defined in a broad sense, it is viewed as an integral part of overall management.

• The financial management framework is an analytical way of viewing the financial
problems of a firm.

The main contents of this approach are:

1. What is the total volume of funds an enterprise should commit?

2. What specific assets should an enterprise acquire?

3. How should the funds required be financed?

• Alternatively, the principal contents of the modern approach to financial

management can be said to be:

i. How large should an enterprise be, and how fast should it grow?

ii. In what form should it hold assets? and

iii. What should be the composition of its liabilities?

• The three questions posed above cover between them the major financial

problems of a firm.

• In other words, the financial management, according to the new approach, is

concerned with the solution of three major problems relating to the financial

operations of a firm, corresponding to the three questions of investment,

financing and dividend decisions.

• Thus, financial management, in the modern sense of the term, can be broken

down into three major decisions as functions of finance:

1) The investment decision,

2) The financing decision, and

3) The dividend policy decision.

 Financing Decision

• The investment decision is broadly concerned with the asset-mix or the

composition of the assets of a firm.

• The concern of the financing decision is with the financing-mix or capital structure

or leverage.

• The financing decision of a firm relates to the choice of the proportion of these

sources to finance the investment requirements.

 Investment decision

• The investment decision relates to the selection of assets in which funds will be

invested by a firm.

• The assets that can be acquired fall into two broad groups:

• (i) long-term assets that yield a return over a period of time in future,

• (ii) short-term or current assets, defined as those assets which in the normal

course of business are convertible into cash without diminution in value, usually

within a year.
 Dividend Policy Decision

• The third major decision area of financial management is the decision relating to
the dividend policy.

• The dividend decision should be analysed in relation to the financing decision of a

firm.

• Two alternatives are available in dealing with the profits of a firm:

(i) They can be distributed to the shareholders in the form of dividends or

(ii) they can be retained in the business itself.

• The decision as to which course should be followed depends largely on a

significant element in the dividend decision, the dividend-payout ratio,

• The dividend-payout ratio is, what proportion of net profits should be paid out to

the shareholders.

• The final decision will depend upon the preference of the shareholders and the

investment opportunities available within the firm.

• The modern approach to the scope of financial management has broadened its scope
which involves the solution of three major decisions, namely,

• Investment decisions

• Financing decisions

• Dividend decisions.

• These are interrelated and should be jointly taken so that financial decision making is
optimal.

• The conceptual framework for optimum financial decisions is the objective of financial
management.

• In other words, to ensure an optimum decision in respect of these three areas, they should
be related to the objectives of financial management.
Decisions, Return, Risk, and Market Value
 OBJECTIVES OF FINANCIAL MANAGEMENT

(i) Profit (total)/Earning Per Share (EPS) maximization approach, and

(ii) Wealth maximization approach.

(iii) Proper Utilization of Financial Resources

(iv) Improved Efficiency

(v) Proper Estimation of Financial Requirements

(vi) Meeting Financial Commitments with Creditors

(vii) Creating Reserves

(viii)Maintenance of Liquidity
 Profit/EPS Maximisation Decision Criterion

• According to this approach, actions that increase profits (total)/EPS should be

undertaken and those that decrease profits/EPS are to be avoided.

• In specific operational terms, as applicable to financial management, the profit

maximisation criterion implies that the investment, financing and dividend policy

decisions of a firm should be oriented to the maximisation of profits/EPS.

• The term ‘profit’ can be used in two senses.

• As an owner-oriented concept:

• It refers to the amount and share of national income which is paid to the owners
of business, that is, those who supply equity capital.

• As a variant, it is described as profitability.

• It is an operational concept and signifies economic efficiency.

• In other words, profitability refers to a situation where output exceeds input, that
is, the value created by the use of resources is more than the total of the input
resources.
Wealth Maximisation Decision Criterion

• This is also known as value maximization or net present worth maximization.

• In current academic literature value maximization is almost universally accepted

as an appropriate operational decision criterion for financial management
decisions as it removes the technical limitations which characterize the earlier
profit maximization criterion.

• Its operational features satisfy all the three requirements of a suitable operational
objective of financial course of action, namely, exactness, quality of benefits and
the time value of money.
• The value of an asset should be viewed in terms of the benefits it can produce.

• The worth of a course of action can similarly be judged in terms of the value of
the benefits it produces less the cost of undertaking it.

• The wealth maximization criterion is based on the concept of cash flows

generated by the decision rather than accounting profit which is the basis of the
measurement of benefits in the case of the profit maximisation criterion.

• The second important feature of the wealth maximization criterion is that it

considers both the quantity and quality dimensions of benefits. At the same time,
it also incorporates the time value of money.
 ORGANISATION OF
FINANCE FUNCTION
• The responsibilities for financial management are spread throughout the
organization in the sense that financial management is, to an extent, an integral part
of the job for the managers involved in planning, allocation of resources, and control.

• For instance, the production manager (engineer) shapes the investment policy
(proposal of a new plant);

• the marketing manager/analyst provides inputs in forecasting and planning;

• the purchase manager influences the level of investment in inventories;

• and the sales manager has a say in the determination of receivables policy.
 EMERGING ROLE OF FINANCE MANAGERS IN INDIA

• Reflecting the emerging economic and financial environment in the post-liberalization era, the role/
job of financial managers in India has become more important, complex, and demanding.

• The key challenges are, inter-alia, in the areas:

• Financial structure,

• Foreign exchange management

• Treasury operations

• Investor communication

• Management control and

• Investment planning.
 AGENCY PROBLEM

• In proprietorships, partnerships, and cooperative societies, owners are actively

involved in management.

• But in companies, particularly large public limited companies, owners typically

are not active managers.

• Instead, they entrust this responsibility to professional managers who may have

little or no equity stake in the firm.

There are several reasons for the separation of ownership and management in such
companies:
• Most enterprises require large sums of capital to achieve economies of scale. Hence it
becomes necessary to pool capital from thousands or even hundreds of thousands of
owners. It is impractical for many owners to participate actively in management.

• Professional managers may be more qualified to run the business because of their
technical expertise, experience, and personality traits.

• Separation of ownership and management permits unrestricted change in owners through

share transfers without affecting the operations of the firm. It ensures that the ‘know-how'
of the firm is not impaired, despite changes in ownership.

• Given economic uncertainties, investors would like to hold a diversified portfolio of

securities. Such diversification is achievable only when ownership and management are
separated.
Managers, shareholders, creditors, and other interested groups seek answers to
the following important questions about a firm:

1. What is the financial position of the firm at a given point of time?

2. How has the firm performed financially over a given period of time?

3. What have been the sources and uses of cash over a given period of time?
 Financial Statements
• A manager's primary goal is to maximize his firm's value.

• Value depends on the future stream of cash flows generated by the firm.

• How can a manager decide which actions are likely to increase cash flows?

• How can an investor estimate future cash flows?

• To answer these questions, it is essential to study the financial statements of

the firm
• To answer the above questions, the accountant prepares financial statements:

i. The balance sheet

ii. The profit and loss account,

iii. Cash flow statement

iv. Fund flow statement

v. Notes to accounts
• The balance sheet shows the financial position (or condition) of the firm at a

given point of time. It provides a snapshot and may be regarded as a static

picture.

• The profit and loss account reflects the performance of the firm over a period of

time.

• Finally, the cash flow statement displays the sources and uses of cash during

the period.
 Profit and loss account/ Income statement
• The Companies Act has prescribed a standard form for the balance sheet, but none for the
profit and loss account.

• However, the Companies Act does require that the information provided should be
adequate to reflect a true and fair picture of the operations of the company for the
accounting period.

• The profit and loss account, like the balance sheet, may be presented in the account form
or the report form.

• Typically, companies employ the report form.

• The report form statement may be a single-step statement or a multi-step statement.

• In a single step statement, all revenue items are recorded first, then the expense items are
shown, and finally the net profit is given.
Nature of Income Statement:
• The Income Statement is a financial statement that reports a company's revenues,
expenses, gains, and losses over a specific period, typically a fiscal quarter or year.
• It reflects the company's profitability during the reporting period.

Objectives of Income Statement:

• To show the company's ability to generate profit from its core operations by
subtracting expenses from revenue.
• To provide information about the company's revenue sources, such as sales,
interest, and investments.
• To assess the company's overall financial performance and profitability.
• To help investors and creditors evaluate the company's potential for future profitability.
1.Income Statement (Profit and Loss Statement):
•This statement shows a company's revenues, costs, and expenses during a specific period,
typically a year or quarter.

•It starts with the company's total revenue and then subtracts the cost of goods sold
(COGS) to determine the gross profit.

•Operating expenses (e.g., salaries, rent, utilities) are subtracted from the gross profit to
arrive at the operating income.

•After accounting for other income and expenses (e.g., interest, taxes), the net income or
net loss is calculated.
•The income statement provides insights into a company's profitability.
Format of Income statement

Particulars Amount
Sales xxxx
Less: Cost of Goods sold xxxx
Gross Profit xxxx
Less: Operating expenses xxxx
Operating profit xxxx
Add: Other income xxxx
Earnings Before Interest and xxxx
Taxes(EBIT)
Less: Interest xxxx
Earnings Before Tax (PBT) xxxx
Less: Taxes xxxx
Profit after tax xxxx
Example 1: The following is the financial information for ABC Ltd.
Sales 500000
Cost of goods sold 300000
Indirect expenses 100000
Provision for tax 65000.
Prepare the income statement of ABC Ltd.
Solution: Income statement of ABC Ltd.

Particulars Amount
Sales 500000
Less: Cost of Goods sold 300000
Gross Profit 200000
Less: Operating expenses 100000
Operating profit 100000
Add: Other income -
Earnings Before Interest and Taxe (EBIT) 100000
Less: Interest -
Earnings Before Tax (PBT) 100000
Less: Taxes 65000
Profit after tax 35000
Example 2: Following is the financial information of XYZ Ltd.

Sales 800000

Cost of goods sold 70% of sales

Indirect expenses 5% of sales

Provision for tax 50% of net profit.

Prepare the income statement of XYZ Ltd.

Solution:
Income statement of XYZ Ltd.,
Particulars Amount
Sales 800000
Less: Cost of Goods sold 5,60,000
(800000*70%)
Gross Profit 240,000
Less: Operating expenses (8,0000*5%) 40,000
Operating profit 2,00,000
Add: Other income -
Earnings Before Interest and Tax (EBIT) 2,00,000
Less: Interest -
Earnings Before Tax (PBT) 2,00,000
Less: Taxes (50% of net profit) 1,00,000
Profit after tax 1,00,000
 Balance sheet

• The balance sheet shows the financial condition of a business at a given point of

time.

• As per the Companies Act, the balance sheet of a company shall be in either

• the account form or

• the report form.

Balance sheet Forms
Nature of Balance Sheet:
• The Balance Sheet presents the financial position of a company at a specific
point in time.
• It lists the company's assets, liabilities, and shareholders' equity, following the
accounting equation: Assets = Liabilities + Equity.

Objectives of Balance Sheet:

• To provide a snapshot of the company's financial health and resources at a given
moment.
• To show what the company owns (assets), owes (liabilities), and what remains for
shareholders (equity).
• To assess the company's liquidity, solvency, and overall financial stability.
• To assist investors, creditors, and management in making informed decisions
about the company's financial position.
 Components of Balance sheet
Assets
• Accounts within this segment are listed from top to bottom in order of their liquidity
• This is the ease with which they can be converted into cash.
• They are divided into current assets, which can be converted to cash in one year or less;
and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
•Cash and cash equivalents are the most liquid assets and can include Treasury bills and
short-term certificates of deposit, as well as hard currency.
•Accounts receivable (AR) refer to money that customers owe the company. This may include
an allowance for doubtful accounts as some customers may not pay what they owe.
•Inventory refers to any goods available for sale, valued at the lower of the cost or market
price.
•Prepaid expenses represent the value that has already been paid for, such as insurance,
advertising contracts, or rent.
Long-term assets include the following:

•Long-term investments are securities that will not or cannot be liquidated in the next
year.

•Fixed assets include land, machinery, equipment, buildings, and other durable, generally
capital-intensive assets.

•Intangible assets include non-physical (but still valuable) assets such as intellectual
property and goodwill. These assets are generally only listed on the balance sheet if they
are acquired, rather than developed in-house. Their value may thus be wildly understated
(by not including a globally recognized logo, for example) or just as wildly overstated.
Liabilities

• A liability is any money that a company owes to outside parties, from bills it has to pay

to suppliers to interest on bonds issued to creditors to rent, utilities and salaries.

• Current liabilities are due within one year and are listed in order of their due date.

• Long-term liabilities, on the other hand, are due at any point after one year.
Current liabilities accounts might include:

•Current portion of long-term debt is the portion of a long-term debt due within the
next 12 months. For example, if a company has a 10 years left on a loan to pay for its
warehouse, 1 year is a current liability and 9 years is a long-term liability.

•Interest payable is accumulated interest owed, often due as part of a past-due

obligation such as late remittance on property taxes.

•Wages payable is salaries, wages, and benefits to employees, often for the most recent
pay period.

•Customer prepayments is money received by a customer before the service has been
provided or product delivered.
•Earned and unearned premiums is similar to prepayments in that a company has
received money upfront, has not yet executed on their portion of an agreement, and
must return unearned cash if they fail to execute.

•Accounts payable is often the most common current liability. Accounts payable is debt
obligations on invoices processed as part of the operation of a business that are often
due within 30 days of receipt.

•Dividends payable is dividends that have been authorized for payment but have not
yet been issued.
Long-term liabilities can include:

•Long-term debt includes any interest and principal on bonds issued

•Pension fund liability refers to the money a company is required to pay into its

employees' retirement accounts

•Deferred tax liability is the amount of taxes that accrued but will not be paid for another

year. Besides timing, this figure reconciles differences between requirements

for financial reporting and the way tax is assessed, such as depreciation calculations.
Shareholder Equity

• Shareholder equity is the money attributable to the owners of a business or its

shareholders.

• Retained earnings are the net earnings a company either reinvests in the business or

uses to pay off debt. The remaining amount is distributed to shareholders in the form

of dividends.
Example: The following is the financial information for ABC Ltd.
Prepare a balance sheet of ABC Ltd.,

Particulars Amount
Equity share capital 25,00,000
Non-current Assets 30,00,000
Reserves and surplus 5,00,000
Investments 5,00,000
Long term loans 15,00,000
Current assets 15,00,000
Current liabilities 5,00,000
Solution:
The balance sheet of ABC Ltd.,

Particulars Amount
i) Shareholders Funds: 50,00,000
a) Equity share capital 2500000
b) Reserves and surplus 5,00,000

ii) Non-current liabilities

a) Long term loans 15,00,000

iii) Current liabilities 5,00,000

Total
ii) Assets 50,00,000
i) Non-current assets 30,00,000
ii) Current assets 15,00,000
iii) Investments 5,00,000
Example: The following is the financial information for A Ltd. Prepare balance sheet
of ABC Ltd.

Particulars Amount
Equity share capital 10,00,000
Non-current Assets 15,00,000
Reserves and surplus 2,00,000
Long term loans 8,00,000
Current assets 9,00,000
Current liabilities 4,00,000
 Solution: Balance sheet of ABC Ltd.

Amount
Shareholders Funds:
a) Equity share capital 10,00,000
b) Reserves and surplus 2,00,000

ii) Non-current liabilities

a) Long term loans 8,00,000
iii) Current liabilities 4,00,000

Total 24,00,000
ii) Assets
Non-current assets 15,00,000
Current assets 9,00,000
24,00,000
 Statements of Cash flow

• From a financial point of view, a firm basically generates cash and spends cash.

• It generates cash when it issues securities, raises a bank loan, receives payments
from its customers, and so on.

• It spends cash when it redeems securities, pays interest and dividends, pays for the
purchase of materials and assets, and so on.

• The activities that generate cash are called sources of cash and the activities that
absorb cash are called uses of cash.
 Classified Cash Flow Statement

• To understand better how cash flows have been influenced by various decisions, it
is helpful to classify cash flows into three classes viz.,

• Cash flows from operating activities

• Cash flows from investing activities, and

• Cash flows from financing activities

Operating activities:

• It involves the production and selling of goods and services.

• Cash inflows from operating activities include:

• money received from customers for sales of goods and services.

• Cash outflows from operating activities include:

• payments to suppliers for materials,

• to employees for services, and

• to the government for taxes.

Investing activities:

• It involves acquiring and disposing of fixed assets, buying and selling financial
securities, and disbursing and collecting loans.

• Cash inflows from investing activities include:

• Receipts from the sale of assets (real as well financial),

• Recovery of loans, and collection of dividends and interest.

• Cash outflows from investing activities include:

• Payments for the purchase of assets (real and financial)

Financing activities:

• It involves raising money from lenders and shareholders, paying interest and
dividends, and redeeming loans and share capital.

• Cash inflows from financing activities include:

• receipts from issue of securities and from loans and deposits.

• Cash outflows from financing activities include:

• payment of interest on various forms of borrowings,

• payment of dividends,

• retirement of borrowings, and

• redemption of capital.
Components of Cash flow
 Format of Cash flow from operating activities

Particulars Amount
Cash sales XXXX
Cash received from customers XXXX
XXXX
Less: Cash expenses XXXX
Cash paid to customers XXXX

Cash paid to suppliers XXXX

Cash expenses (wages, salaries, rent, rates and XXXX XXXX

taxes etc.)
Net cash flow from operating activities XXXX
Example1 From the following information calculate cash flow from operating
activities
Purchases:
Cash - 600000
Credit- 200000
Expenses:
Wages paid – 100000
Salary paid – 50000
Sales:
Cash sales- 900000
Credit- 100000
 Solution: Cash flow from operating activities

Particulars Amount
Cash sales 900000
Cash received from customers -
9,00000
Less: Cash purchases 6,00,000
Cash paid to suppliers -

Cash expenses (wages and salaries) 1,50,000 7,50,000

Net cash flow from operating activities 1,50,000
Cash flow from investing activities
Example 2: From the following information prepare cash flow from investing activities.

Particulars Amount (2022) Amount (2023)

Plant and machinery 850,000 10,00,000
Long-term Investments 40,000 1,00,000
Land 2,00,000 1,00,000

Additional information:
Depreciation charged on Plant and machinery 50,000
Plant and machinery with a book value of 60,000 was sold for 40,000
Land was sold at a profit of 60,000
No investment was sold during the year.
Solution: Cash flow from investing activities

Particulars Amount
Cash payment to acquire Plant and machinery (2,60,000)

Cash received from sale of Plant and machinery 40,000

Cash payment to acquire investments (60,000)

Cash received from sale of land (100000+60000 1,60,000
(profit))
Net cash flow from investing activities (1,20,000)
Example: Following is the financial information of XYZ. Prepare Cash flow from
financing activities.

Particulars Amount (2022) Amount (2023)

Equity share capital 5,00,000 6,00,000
14% Debentures 1,00,000 -
redeemed
12% Debentures - 2,00, 000

Additional information:
Interest paid on debentures 19000
Dividends paid 50,000
Calculate cash flow from financing activities.
Answer: Net cash flow from financing activities

Particulars Amount
Cash proceeds from issue of debentures (including 200000
premium)

Cash repayment of debentures (100000)

Interest paid on debentures (19,000)

Dividend paid (50,000) (69000)

Net cash flow from financing activities 31,000
Example:
Following is the financial information of ABC Ltd. Prepare the cash flow statement
Net profit before tax for the year 2013 was Rs. 500
Particulars Amount Particulars Amount (Rs.)
(Rs.)
Balance on 50 Payment to Suppliers 2000
1.1.2022
Issue of equity 300 Purchase of fixed assets 200
shares
Receipts from 2800 Overhead expenses 200
customers
Sale of fixed assets 100 Wages and salaries 100

Taxation 250
Dividend 50
Repayment of Bank 300
Loan
Balance on 31.12.2022 150

3250 3250
Particulars Amount Amount
A. Cash flow from operating activities

Net profit before tax 500

Tax paid (250)
Net cash from operating activities 250

A. Cash flow from investing activities

Purchase of fixed assets (200)

Sale of fixed assets 100
Net cash used in investing activities (100)

A. Cash flow from financing activities :

Issue of equity shares 300

Repayment of bank loan (300)
Dividend paid (50)
Net cash used in financing activities (50)

Net increase in cash (A+B+C) 100

Solution: Cash flow statement

Particulars Amount Amount

A. Cash Flow from Operating Activities
Profit for the Year (Difference between Closing and Opening Surplus, i.e., 130,000
Balance in Statement of Profit and Loss) (` 2,30,000 - ` 1,00,000)
Add: Decrease in Current Asset (trade receivables) (12,00,000-11,50,000) 50,000
180,000
Less:
Increase in Inventories (900,000-800,000) (100000)
Decrease in Trade Payables (7,00,000-4,50,000) (250000) (350,000)
Cash Used in Operating Activities (170,000)
 Cash flow from investing activities

B. Cash Flow from investing Activities

Cash Payment for Land Purchased 160,000

Cash Used in Investing Activities (160,000)

C. Cash Flow from financing Activities

Cash Proceeds from Issue of Shares 5,00,000
Cash Flow from Financing Activities 5,00,000
Net Increase in Cash and Cash Equivalents (A+B+C) (5,00,000-1,70,000- 1,70,000
1,60,000)
Add: Cash and Cash Equivalents in the Beginning 3,00,000
Cash and Cash Equivalents at the End 4,70,000
 Role of Finance in Business

• Raising capital
• Working capital Management
• Investing capital
• Safeguard investment
• Financial Planning
• Risk mitigation
• Other functions
 Unit 2- Capital Budgeting
• Capital Budgeting is the process of evaluating and
selecting long-term investments that are
consistent with the goal of shareholders’ (owners)
wealth maximization.

• Capital budgeting decisions pertain to fixed/long-term

assets which are in operation and yield a return, over a
period of time, usually, exceeding one year.

• They, therefore, involve a current outlay or series of

outlays of cash resources in return for an anticipated
flow of future benefits.
• These benefits may be either in the form of:

o increased revenues or

o reduced costs.

Capital expenditure management, therefore, includes:

• The addition

• Disposition

• modification, and

• replacement of fixed assets.

Importance of Capital Budgeting

• Capital budgeting decisions are of paramount

importance in financial decision-making.

1. In the first place, such decisions affect firm’s

profitability.

2. Secondly, a capital expenditure decision has its

effect over a long time span and inevitably affects
the company’s future cost structure.

3. Finally, capital investment involves costs and the

majority of the firms have scarce capital
resources.
Rationale of capital budgeting
• The rationale underlying the capital budgeting decision is efficiency.

• Thus, a firm must replace worn and obsolete plants and machinery,
acquire fixed assets for current and new products and make
strategic investment decisions.

• This will enable the firm to achieve its objective of maximising profits
either by way of increased revenues or cost reductions.

• The quality of these decisions is improved by capital budgeting.

• Capital budgeting decisions can be of two types:

• (i) those which expand revenues, and

• (ii) those which reduce costs.

 • Capital budgeting process refers to the total process
of generating, evaluating, selecting, and following up
on capital expenditure alternatives.

Types of • The firm allocates or budgets financial resources to

new investment proposals.
capital
• Basically, the firm may be confronted with 3 types of
budgeting capital budgeting decisions:
decisions • (i) the accept-reject decision;

• (ii) the mutually exclusive choice decision; and

• (iii) the capital rationing decision.

 • This is a fundamental decision in capital budgeting.

• If the project is accepted, the firm will invest in it; if the

proposal is rejected, it does not.

• In general, all those proposals that yield a rate of return greater

than a certain required rate of return or cost of capital are
accepted and the rest are rejected.

Accept-reject • By applying this criterion, all independent projects are accepted.

Decision • Independent projects are projects that do not compete with one
another in such a way that the acceptance of one precludes the
possibility of acceptance of another.

• Under the accept-reject decision, all independent projects that

satisfy the minimum investment criterion should be
implemented.
 • Mutually exclusive projects are those that compete
with other projects in such a way that the
acceptance of one will exclude the acceptance of
the other projects.
• The alternatives are mutually exclusive and only one
may be chosen.
• Example: a company intends to buy a new folding
Mutually Exclusive machine.

Project Decisions
• There 3 three competing brands, each with a different
initial investment and operating costs.
• The 3 machines represent mutually exclusive
alternatives, as only one of these can be selected.
• It may be noted here that the mutually exclusive project
decisions are not independent of the accept-reject
decisions.
 • In a situation where the firm has unlimited funds, all independent
investment proposals yielding returns greater than some predetermined
Capital level are accepted.

Rationing • However, this situation does not prevail in most of the business firms in

Decision actual practice.

• They have a fixed capital budget.

• A large number of investment proposals compete for these limited funds.

The firm must, therefore, ration them.

• The firm allocates funds to projects in a manner that it maximizes long-

run returns.

• Thus, capital rationing refers to a situation in which a firm has more

acceptable investments than it can finance.
• It is concerned with the selection of a group of investment proposals out of many

investment proposals acceptable under the accept-reject decision.

• Capital rationing employs ranking of the acceptable investment projects.

• The projects can be ranked on the basis of a predetermined criterion such as the

rate of return.

• The projects are ranked in the descending order of the rate of return.
Capital budgeting techniques
• The methods of appraising capital expenditure proposals can be
classified into two broad categories:

• Traditional, and

• Modern Approach

• (i) Traditional Approach:

• This approach includes:

• Average Rate of Return / Accounting Rate of Return (ARR)

method

• Pay Back Period method

(ii) Modern Approach
• This approach is popularly known as the
adjusted approach.
It includes:
(i) Net Present Value (NPV) method,
(ii) Internal Rate of Return (IRR) method,
(iii) Net Terminal Value method, and
(iv) Profitability Index.
 Average Rate of Return (ARR)
• The average rate of return (ARR) method of evaluating proposed capital
expenditure is also known as the Accounting Rate of Return method.

• It is based on accounting information rather than cash flows.

• There is no unanimity regarding the definition of the rate of return.

• There are several alternative methods for calculating the ARR.

• The most common usage of the average rate of return (ARR) expresses it as
follows:

• ARR = Average annual profits after taxes/ Average investment over the life
of the project* 100
• The average profits after taxes are determined by adding up the after-tax profits

expected for each year of the project’s life and dividing the result by the number of

years.

• The average investment is determined by dividing the net investment by two.

• This averaging process assumes that the firm is using straight-line depreciation, in

which case the book value of the asset declines at a constant rate from its purchase

price to zero at the end of its depreciable life.

• This means that, on average, firms will have one-half of their initial purchase price in the books.

• Consequently, if the machine has salvage value, then only the depreciable cost (cost-salvage

value) of the machine should be divided by two to ascertain the average net investment, as the

salvage money will be recovered only at the end of the life of the project.

• If any additional net working capital is required in the initial year which is likely to be released

only at the end of the project’s life, the full amount of working capital should be taken in

determining relevant investment to calculate ARR.

Example 1: From the following information calculate the average investment

• Initial investment (purchase of machine) is Rs 11,000

• Salvage value, Rs 1,000

• Working capital, Rs 2,000

• Service life (years) 5 and that the straight-line method of depreciation is adopted,
Answer:

• Average investment= working capital+ salvage value+1/2(cost of machine-

salvage value)

• Average investment= Rs 2,000 + Rs 1,000 + 1/2 (Rs 11,000 – Rs.1,000)

= Rs 8,000.

Note: Depreciation is a non-cash item, so it is not included.

Example 2
From the following financial information. Calculate the Average Rate of Return
(ARR).
Year Book value of the Profit after tax
investment
1 90000 20000
2 80000 22000
3 70000 24000
4 60000 26000
5 50000 28000
Answer:
ARR= Average annual profits after taxes/ Average investment over the life of the
project* 100

Average annual profits after taxes

= (20,000 + 22,000 + 24,000 +26,000 +28,000) /5
= 24000

Average investment over the life of the project

= 90,000 + 80,000 + 70,000 + 60,000 + 50,000/5
= 70000

ARR= 24000/70000*100
ARR= 34%
Example 3 Determine the Average Rate of Return from the following data of two
machines, A and B.

Additional information:
Depreciation has been charged on a straight line basis.
Solution:

ARR = (Average income/Average investment)* 100

ARR= Average income of Machines A and B

= (Rs 36,875/5) = Rs 7,375

Average investment = Salvage value + 1/2 (Cost of the machine – Salvage value)

= Rs 3,000 + 1/2 (Rs 56,125 – Rs 3,000)

= Rs 29,562.50

ARR (for machines A and B)

= (Rs 7,375/Rs 29563.50) = 24.9%

Example 3:

Anand Ltd. is willing to purchase a new machine for Rs. 70,000.

The usable life of the machine is 5 years, at the end of its usable life, the
machine can be sold for Rs. 20000/.

The machine will provide a cash inflow of Rs. 20,000 every year.

Annual expenses on operating the machine (working capital) is Rs.5,000.

i) Calculate ARR of the investment in the machine.

ii) Do you accept the project if the minimum expected ARR from the
investment is 20%? Justify.
Solution:

ARR= Average annual profits after taxes/ Average investment over the life of the project*
100

Average annual profits after taxes= 20,000

Average investment = working capital + salvage value+1/2 (cost of machine-salvage value)

=5,000+ 20,000+1/2 (70,000-20,000)

=5,000+20,000+1/2 (50,000)

= 25,000+1/2(50,000)

= 25,000+25,000

Average investment = Rs. 50,000

ARR= Average annual profits after taxes/ Average investment over the life of the

project* 100

ARR= 20,000/50,000

i) ARR = 40%

ii) Yes, the company accepts the project because the actual ARR (40%) is higher than

the minimum expected (20%) ARR.

Accept-reject Rule:
• With the help of the ARR, the financial decision maker can decide whether to accept or reject
the investment proposal.

• As an accept-reject criterion, the actual ARR would be compared with a predetermined or a

minimum required rate of return or cut-off rate.

• A project would qualify to be accepted if the actual ARR is higher than the minimum
desired ARR. Otherwise, it is liable to be rejected.

• Alternatively, the ranking method can be used to select or reject proposals. Thus, the
alternative proposals under consideration may be arranged in descending order of
magnitude, starting with the proposal with the highest ARR and ending with the proposal
having the lowest ARR.

• Obviously, projects having higher ARR would be preferred to projects with lower ARR.
 Evaluation of ARR:
• In evaluating the ARR, as a criterion to select/reject investment projects, its merits
and drawbacks need to be considered.

• The most favourable attribute of the ARR method is its easy calculation. Only
the figure of accounting profits after taxes is required, which should be easily
obtainable.

• Moreover, it is simple to understand and use.

• In contrast to this, the discounted flow techniques involve tedious calculations and
are difficult to understand.

• Finally, the total benefits associated with the project are considered while
calculating the ARR.
 Drawbacks of ARR

(i) The Considerations of Accounting Income:

• The principal shortcoming of the ARR approach arises from the use of accounting
income instead of cash flows.

• The cash flow approach is markedly superior to accounting earnings for project
evaluation.

• The earnings calculations ignore the reinvestment potential of a project’s benefits

while the cash flow takes into account this potential and, hence, the total benefits
of the project.
(ii) Ignorance of the time value of money:
• The second principal shortcoming of ARR is that it does not take into account the time value
of money.

• The timing of cash inflows and outflows is a major decision variable in financial decision-
making.

• Accordingly, benefits in the earlier years and later years cannot be valued at par.

• To the extent the ARR method treats these benefits at par and fails to take account of the
differences in the time value of money, it suffers from a serious deficiency.

• Thus, in Example the ARR in the case of both machines, A and B is the same, although
machine B should be preferred since its returns in the early years of its life are greater.

• Clearly, the ARR method of evaluating investment proposals fails to consider this.
(iii) Size of the investment:

• Thirdly, the ARR criterion of measuring the worth of investment does not

differentiate between the size of the investment required for each project.

• Competing investment proposals may have the same ARR, but may require

different average investments.

(iv) Benefits from the sale of equipment:

• This method does not take into consideration any benefits that can accrue to the
firm from the sale or abandonment of equipment that is replaced by the new
investment.

• The ‘new’ investment, from the point of view of correct financial decision making,
should be measured in terms of incremental cash outflows due to new investments,
that is, new investment minus sale proceeds of the existing equipment ± tax
adjustment.

• However, the ARR method does not make any adjustment in this regard to
determine the level of average investments. Investments in fixed assets are
determined at their acquisition cost.
 Pay Back Method

• The payback method (PB) is the second traditional method of capital budgeting.

• It is the simplest and, perhaps, the most widely employed, quantitative method for
appraising capital expenditure decisions.

• This method answers the question:

• How many years will it take for the cash benefits to pay the original cost of an
investment, normally disregarding salvage value?

• Cash benefits here represent CFAT ignoring interest payment.

• Thus, the payback method (PB) measures the number of years required for the
CFAT to pay back the original outlay required in an investment proposal.
Payback Period= investment/Constant annual cash inflow

Example 1:

• An investment of Rs 40,000 in a machine is expected to produce CFAT of Rs 8,000

for 10 years. Calculate the payback period.

Answer:

Payback period = investment/Constant annual cash inflow

Payback period = Rs 40,000/Rs 8,000

Payback period = 5 years

Example 2: Due to increased demand, the management of Rani Beverage Company is
considering purchasing new equipment to increase production and revenues. The useful
life of the equipment is 10 years and the company’s maximum desired payback period is
4 years. The inflow and outflow of cash associated with the new equipment is given
below:
The initial cost of equipment is Rs. 37,500
Annual cash inflow: Sales Rs. 75,000

Annual cash outflow: Cost of ingredients Rs. 45,000

Salaries expenses Rs. 13,500
Maintenance expenses Rs. 1,500

Noncash expenses: Depreciation Rs. 5,000

Should Rani Beverage Company purchase the new equipment? Use payback method for
your answer.
Computation of net annual cash inflow: = 75,000 – (45,000 + 13,500 + 1,500)

= 15,000

payback-period-formula

Payback period = 37,500 / 15,000

= 2.5 years

Depreciation is a non cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the payback period of
the equipment is 2.5 years which is shorter than the maximum desired payback period of the
company.
• When a project’s cash flows are not uniform (mixed stream) but vary from year to
year.
• In such a situation, PB is calculated by the process of cumulating cash flows till
the time when cumulative cash flows become equal to the original investment
outlay.
Example: The initial investment of a company on project A and B is Rs 56,125.
Calculate payback period
Answer: Calculation of payback period
Answer:

• The initial investment of Rs 56,125 on machine A will be recovered between

years 3 and 4.

• The payback period would be a fraction more than 3 years.

• The sum of Rs 48,000 is recovered by the end of the third year.

• The balance of Rs 8,125 (56,125- 48,000) is needed to be recovered in the fourth

year.

• In the fourth year cash inflow is Rs 20,000.

• The payback fraction is, therefore, 0.406 (Rs 8,125/Rs 20,000).

• The payback period for machine A is 3.406 years.

• Similarly, for machine B the payback period would be 2 years and a fraction of a

year. As Rs 42,000 is recovered by the end of the second year, the balance of Rs

14,125 needs to be recovered in the third year.

• In the third year, cash inflow is Rs 18,000. The payback fraction is 0.785 (Rs

14,125/Rs 18,000).

• Thus, the PB period for machine B is 2.785 years.

 Accept-Reject Criterion

• The payback period can be used as a decision criterion to accept or reject

investment proposals.

• One application of this technique is to compare the actual payback with a

predetermined payback, that is, the payback set up by the management in terms of
the maximum period during which the initial investment must be recovered.

• If the actual payback period is less than the predetermined pay back, the project
would be accepted; if not, it would be rejected.

• Alternatively, the payback can be used as a ranking method.

• When mutually exclusive projects are under consideration, they may be ranked
according to the length of the payback period.

• Thus, the project having the shortest payback may be assigned rank one,
followed in that order so that the project with the longest payback would be
ranked last.

• Projects with shorter payback periods will be selected.

The payback method has certain merits.

• It is easy to calculate and simple to understand.

• Moreover, the payback method is an improvement over the ARR approach.

• Its superiority arises because it is based on cash flow analysis.

• Thus, though the average cash flows for both the machines under the ARR method
were the same, the payback method shows that the payback period for machine B is
shorter than for machine A.

• The payback period approach shows that machine B should be preferred as it

refunds the capital outlay earlier than machine A.
Demerits:

• The first major shortcoming of the payback method is that it completely ignores
all cash inflows after the payback period.

• This can be very misleading in capital budgeting evaluations.

• Another deficiency of the payback method is that it does not measure correctly
even the cash flows expected to be received within the payback period as it
does not differentiate between projects in terms of the timing or the magnitude of
cash flows.

• It considers only the recovery period as a whole.

• This happens because it does not discount the future cash inflows but rather
treats a rupee received in the second or third year as valuable as a rupee received
in the first year.

• In other words, to the extent the payback method fails to consider the pattern of
cash inflows, it ignores the time value of money.
• Another flaw of the payback method is that it does not consider the project’s

entire life during which cash flows are generated.

• As a result, projects with large cash inflows in the latter part of their lives may be

rejected in favour of less profitable projects that generate a larger proportion of

their cash inflows in the earlier part of their lives.

• To conclude the discussion of the traditional methods of appraising capital

investment decisions, there are two major drawbacks of these techniques.

• They do not consider the total benefits in terms of

• (i) the magnitude and

• (ii) the timing of cash flows.

• For these reasons, the traditional methods are unsatisfactory as capital

budgeting decision criteria.

 The two essential ingredients of a theoretically sound appraisal method,

therefore, are

• (i) It should be based on a consideration of the total cash stream.

• (ii) It should consider the time value of money as reflected in both the magnitude

and the timing of expected cash flows in each period of a project’s life.

• The time-adjusted (also known as discounted cash flow) techniques satisfy these

requirements and to that extent, provide a more objective basis for selecting and

evaluating investment projects.

• The second commendable feature of these techniques is that they take into

account all benefits and costs occurring during the entire life of the project.
 Net Present Value
(NPV)
Time Value of Money

Money received earlier is more valuable than that received later.

The estimated future cash inflows and outflows of a project

should not be treated at their face value ignoring their “timing”.

Income expected at the end of the first year of a project is

definitely more valuable than the income which may be earned in
the 8th year of a project.
Example: If we deposit Rs.100 in Jan 1, 2015 @ 10 %
interest. What is the value after one year?
FV = Rs.100 + Interest (Rs.100 X 10/100 ) = Rs. 110
Formula :
FV = PV (1 + r/100)n

= 100 ( 1 + 10/100)1 = Rs.110

Example: If we receive Rs.110 at the end of first year, what will

be the value today? Assume the rate of interest is 10%.
Formula:

FV Rs.110
PV = ---------- = -------------- = Rs.100
(1 + r/100)n ( 1 + 10/100)1
(This is called discount factor)
 1
Discount factor = ----------- where r = discounting rate
(1 + r)n n = no. of years

For example

Discounting factor at 10% rate for a period of 2 years

1 1
Discount factor = ----------- = ------ = 0.826
(1 + 0.1)2 1.21

0.826 means that say Rs.1000 receivable after 2 years is equal to

Rs.826 today. ( 1000 / 1.21 = Rs.826)
(OR) Rs.826 invested today at 10% will bring Rs.1000 after 2 yrs.
 Net Present Value (NPV)
• Net present value method (also known as discounted
cash flow method) is a popular capital budgeting
technique that takes into account the time value of
money.

• It uses net present value of the investment project as

the base to accept or reject a proposed investment in
projects like purchase of new equipment, purchase of
inventory, expansion or addition of existing plant
assets and the installation of new plants etc.
 Net Present Value
NPV = PV of cash inflows - PV of the cash outflows
that occur as a result of undertaking an investment project.

3 possibilities of NPV :
Net present value (NPV)

• The NPV method is one of the discounted cash flow

methods of capital budgeting.

• It recognises the time value of money and that

cash inflows arising at different periods of time
differ in value and are not comparable unless their
equivalent present values are found.

NPV = P.V of Cash inflows - P.V of Cash outflows

Accept when NPV > Zero

Reject when NPV < Zero
Net present value (NPV)

The NPV method is used for evaluating the desirability

of investments or projects.
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
𝟏
+ 𝟐
+ 𝟑
+ n
− 𝐈𝐨
(1 + r) (1 + r) (1 + r) (1 + r)

where:
C = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of
return on investment
n = the project/investment's duration in years.
PVIF
PVIF
 Net Present Value
Example 1
The management of Fine Electronics Company is considering
to purchase an equipment. The equipment will cost
Rs.6,000 and will increase annual cash inflow by Rs.2,200.
The useful life of the equipment is 6 years. After 6 years it
will have no salvage value. The management wants a 20%
return on all investments.

Compute net present value (NPV) of this investment project.

Should the equipment be purchased according to NPV
analysis?
 Net Present Value
Solution:
(1) Computation of net present value:

net-present-value-cash-inflow

Rs.

Rs.

Rs. Rs.

Rs.

* Value from present value

 Net Present Value
Example 2

Smart Manufacturing Company is planning to reduce its

labor costs by automating a critical task that is currently
performed manually. The automation requires the
installation of a new machine. The cost to purchase and
install a new machine is Rs.15,000. The installation of
machine can reduce annual labor cost by Rs.4,200. The life
of the machine is 15 years. The salvage value of the machine
after fifteen years will be zero. The required rate of return of
Smart Manufacturing Company is 25%.

Should Smart Manufacturing Company purchase the

machine?
 Net Present Value
Solution:
(1) Computation of net present value:

net-present-value-cost-reduction

Rs.

Rs.

Rs. Rs.

Rs.
 Net present value method – uneven cash flow

Example:
A project requires an initial investment of Rs. 2,25,000 and
is expected to generate the following net cash inflows:

Year Cash inflow

1 Rs. 95,000
2 Rs. 80,000
3 Rs.60,000
4 Rs.55,000

Compute net present value of the project if the minimum

desired rate of return is 12%.
 Solution
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈𝐨
(1 + r) 𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 95000/(1 +0.12 )1 + 80,000/(1 +0.12 )2 + 60000/(1

+0.12 )3 + 55000/(1 +0.12 )4 - 225000
= 84821.43+ 63775.51+ 42723.86+ 34947.71-
225000
= 226268.51- 225000
NPV = 1268.51
Example: From the following information calculate NPV
The cost of capital for the firm is 10 percent.
Solution:

𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
𝟏
+ 𝟐
+ 𝟑
+ n
− 𝐈𝐨
(1 + r) (1 + r) (1 + r) (1 + r)
 Example:

A firm has initial investment of Rs.1,00,000.

Following are the cash inflows for different years.
Find out NPV by using 10% discount rate.

Year Cash in flow

1 50,000

2 40,000
3 30,000
4 10,000
 Solution
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈0
(1 + r) 𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 50000/(1 +0.10 )1 + 40,000/(1 +0.10 )2 + 30000/(1

+0.10 )3 + 10000/(1 +0.10 )4 - 100000
=45454.55 + 33057.85 + 22539.01. + 6830.68 -
100000
= 107882.09- 100000
NPV = 7882.09
Example:
From the following information calculate NPV and suggest which
of the two projects should be accepted assuming discount rate at
10%

Particulars Project X Project Y

Initial Investment 40,000 60,000
Estimated life 5 years 5 years
Scrap value 2000 4000
The profits before depreciation and after taxes are as
follows
Year Project X Project Y
1 10,000 40,000
2 20,000 20,000
3 20,000 10,000
4 6,000 6,000
5 4,000 4,000
 Solution: NPV of Project X

𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈𝐨
(1 + r) 𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 10000/(1 +0.10 )1 + 20,000/(1 +0.10 )2 + 20000/(1 +0.10 )3 +

6000/(1 +0.10 )4 + 4000/(1 +0.10 )5 + 2000/(1 +0.10 )5 - - 40000
= 9090.91+ 16,528.93+ 15,026.17+ 4,095.60+ 2,484.10+ 1,242.05

= 48,467.76- 40000
NPV = 8467.05
 Solution: NPV of Project Y
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈𝐨
(1 + r)𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 40000/(1 +0.10 )1 + 20,000/(1 +0.10 )2 + 10000/(1 +0.10 )3 +

6000/(1 +0.10 )4 + 4000/(1 +0.10 )5 + 4000/(1 +0.10 )5 - -
60000
= 36,363.64+ 16,528.93+ 7,513.37+ 4098.08+ 2483.69+
2483.69- 60000

69,471.40- 60000
NPV = Rs. 9471.40
• Overall, the NPV of Project X is Rs. 8467.05
and the NPV of Project Y is Rs. 9471.40.
• Moreover, the NPV is positive in both cases.
• However, project Y is preferable over project X
due to the high NPV.
Example:
A firm’s cost of capital is 10%. It is considering two mutually
exclusive projects A and B. The details are given below:

Cash flow Project A Project B

0 1,40,000 1,40,000
1 20,000 1,20,000
2 40,000 80,000
3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000

Calculate the NPV of projects A and B

 Solution: NPV of Project A

𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈𝐨
(1 + r)𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 20000/(1 +0.10 )1 + 40,000/(1 +0.10 )2 + 60000/(1

+0.10 )3 + 90000/(1 +0.10 )4 + 1,20,000/(1 +0.10 )5 -
140000
=18181.81+33057.85+45078.88+61471.21+74511.02

= 232,300.77-140000
NPV = 92300.77
 Solution: NPV of Project B

𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
NPV= + + + − 𝐈𝐨
(1 + r) 𝟏
(1 + r)𝟐
(1 + r)𝟑
(1 + r)n

= 1,20,000/(1 +0.10 )1 + 80,000/(1 +0.10 )2 + 40,000/(1 +0.10 )3 +

20,000/(1 +0.10 )4 + 20,000/(1 +0.10)5 – 1,40,000
=1,09,090.90+66115.70+30052.59+13660.26+12418.50– 1,40,000

= 2,31,337.95- 1,40000
NPV = 91,337.95
 Merits of NPV

• It recognizes the time value of money.

• It considers the total benefits arising out of the

proposal.

• It is the best method for the selection of

mutually exclusive projects.

• It helps to achieve the maximization of

shareholders’ wealth.
 Demerits of NPV
• It is difficult to understand and calculate.
• It needs the discount factors for calculation of
present values.
• It is not suitable for projects having different
effective lives.
Internal Rate of Return (IRR)

• IRR is ‘that rate of return at which the present values

of cash inflows and cash outflows are equal.

• Thus, at IRR the total discounted cash inflows equals

the total of discounted cash outflows.

• It is also known as “TRIAL AND ERROR METHOD”

• IRR is a metric used in financial analysis to estimate

the profitability of potential investments.
• IRR calculations rely on the same formula as NPV
does.
 Internal Rate of Return
The formula to calculate IRR as follows:
𝑪−𝑶
IRR= 𝑨 + 𝑿 (B-A)
𝑪−𝑫

A=Discount factor at lower trail rate

B=Discount Factor at higher trail rate
C=Present value of Cash inflow at lower trail rate
D= Present value of Cash inflow at higher trail rate
O = Original Investment / Initial Cash outlay
Decision rule of Internal Rate of Return (IRR)

Accept when IRR > Cut-off rate

Reject when IRR < Cut-off rate

Example:
A firm whose cost of capital is 10% considering two projects X
and Y, the details of which are as follows:
Particulars Machine X Machine Y
1 40,000 90,000
2 60,000 80,000
3 80,000 60,000
4 1,00,000 20,000
5 1,20,000 16,000

The original investment is Rs.2,00,000 for both projects.

Compute the IRR for the two projects.
Project X by 20% and 29% and Project Y by 9% and 15% trail rates.
 IRR of Project X :

Present Value (PV) =1/(1+r)n

Yea CIF Disc factor Disc factor PVCIF @ PVCIF @

r @ 20% @ 29% 20%` 29%`
1 40,000 0.833 0.775 33,320 31,000
2 60,000 0.694 0.601 41,640 36,060
3 80,000 0.579 0.466 46,320 37,280
4 1,00,000 0.482 0.361 48,200 36,100
5 1,20,000 0.402 0.280 48,240 33,600
Total Present value of Cash in flows 2,17,720 1,74,040
Solution:
𝐶−𝑂
IRR= 𝐴 + 𝑋 (B-A)
𝐶−𝐷
A= 20%
C= 2,17720
O= 200000
D= 174040
B= 29%
 𝐶−𝑂
IRR= 𝐴 + 𝑋 (B-A)
𝐶−𝐷

2,𝟏𝟕,𝟕𝟐𝟎−𝟐,𝟎𝟎,𝟎𝟎𝟎
IRR= 20 + 𝟐,𝟏𝟕,𝟕𝟐𝟎−𝟏𝟕𝟒𝟎𝟒𝟎
𝑋 (29-20)

𝟏𝟕,𝟕𝟐𝟎
IRR= 20+ 𝟒𝟑,𝟔𝟖𝟎
𝑋 (29-20)

IRR=20+𝟎. 𝟒𝟎𝟔 𝑿 (𝟗)

IRR=20+𝟑. 𝟔𝟓𝟒

IRR of project X =23.654%

 IRR Project of Y :

PV=1/(1+r)n

Yea CIF Disc factor Disc factor PVCIF @ PVCIF @

r @ 9% @ 15% 9%` 15%`
1 90,000 0.917 0.870 82530 78300
2 80,000 0.842 0.750 67360 60000
3 60,000 0.772 0.658 46320 39480
4 20,000 0.708 0.572 14160 11440
5 16,000 0.650 0.497 10400 7952
Total Present value of Cash in flows 220770 197172
Solution:
A= 9%
C=220770
O= 200000
D= 197172
B= 15%
𝐶−𝑂
IRR= 𝐴 + 𝑋 (B-A)
𝐶−𝐷
 𝐶−𝑂
IRR= 𝐴 + 𝑋 (B-A)
𝐶−𝐷

2,20770−200000
IRR= 9 + 𝟐,𝟐𝟎𝟕𝟕𝟎−𝟏𝟗𝟕𝟏𝟕𝟐
𝑋 (15-9)

20770
IRR= 9+ 𝟐𝟑𝟓𝟗𝟖
𝑋 (15-9)

IRR=9+0.8801 X (6)

IRR=9+5.28

IRR of project X =14.28%

 Profitability Index
• The Profitability Index is also known as Benefit-
cost ratio.
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index = -1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

Where
PVCIF= present value of cash inflows
PVCOF= present value of cash outflows
Decision rule of Profitability Index

Profitability Index Decision

>1 Accept
<1 Reject
=0 Indifferent
Example: Let us consider a project which is being
evaluated by a firm that has a cost of capital of
12 percent.
Initial investment: Rs. 100,000
Cash flow:
Year 1: 25000
Year 2: 40000
Year 3: 40000
Year 4: 50000
Calculate Profitability Index
Solution:
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability index= -1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

Present value of cash inflow:

25,000/(1+0.12)1 +40,000/(1 +0.12 )2 +40,000/(1
+0.12 )3 +50,000/(1 +0.12 )4
=25000/1.12+40000/1.25+40000/1.40+50000/1.
57
= 22321.42+32000+28571.42+31847.13
= 114739.99
 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability index= -1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
Rs.114739.99
= -1
𝑹𝒔.1,00,000
= 1.14-1
Profitability index = 0.14
Example:
Beta Ltd., is considering the purchase of a new machine. Two
alternative machines A and B suggested each costing Rs.
4,00,000. Earnings are expected to be as follows:

Year Machine A Machine B

1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The cost of capital is 10%.
You are required to compare the Profitability of the
two machines and state the best out of two.
Solution: Profitability index of project A
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability index= -1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
Present value of cash inflow:
40,000/(1+0.10)1+120,000/(1+0.10)2+1,60,000/(
1+0.10)3+2,40,000/(1+0.10)4+1,60,000/(1+0.10)5
=40000/1.1+120000/1.21+160000/1.33+240000
/1.46+160000/1.61
=36363.63+99173.55+120300+164383.56+9937
8.88
=519599.62
 519599.62
Profitability index= - 1
𝟒𝟎𝟎𝟎𝟎𝟎
= 1.29-1
= 0.29
Solution: Profitability index of project B
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability index= -1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

Present value of cash inflow:

120,000/(1+0.10)1+160,000/(1+0.10)2+2,00,000/
(1+0.10)3+1,20,000/(1+0.10)4+80,000/(1+0.10)5
=109090.90+132231.40+150375.93+82191.78+4
9689.44
= Rs.523579.45
 523579.45
Profitability index= -1
400000
= 1.30-1
= 0.30

Project B is better compared to project A due to

its high profitability index value.
Unit III- Funding of Capital Projects
 Bonds
•Bonds are fixed-income securities that are issued by corporations
and governments to raise capital.

•The bond issuer borrows capital from the bondholder and makes
fixed payments to them at a fixed (or variable) interest rate for a
specified period.
 Basic Idea of Bonds

•Think of bonds as an IOU (I owe you). When a company or government

needs money, it can either sell stock (giving up ownership) or issue bonds
(borrowing money). If you buy a bond, you’re giving them a loan.

•In return, they promise to pay you interest at a fixed rate, called the
coupon rate. At the end of the bond's life (called maturity), they pay back
the original amount you invested, known as the principal.
 Features

•Issuer: The company, government, or organization that’s borrowing money by issuing the bond.

•Principal: The original amount of money you lend when you buy the bond, also called the face value.

•Coupon Rate: The interest rate the bond pays you, usually given as a percentage of the principal. For example, a $1,000
bond with a 5% coupon rate pays $50 each year.

•Maturity Date: The date when the issuer has to pay back the principal to you. Bonds can have short, medium, or long
terms to maturity.

•Yield: The amount of return you get from a bond. It can be a little tricky to calculate if you buy the bond at a different
price than the face value, but the yield tells you the return as a percentage of the bond’s current price.
 Types of Bonds
•Government Bonds: Issued by governments (e.g., U.S. Treasury Bonds, Indian Government Bonds) and are generally
considered low-risk.

•Corporate Bonds: Issued by companies to raise capital for business. They are usually higher risk than government
bonds, but they often pay a higher coupon rate.

•Municipal Bonds: Issued by states, cities, or local governments, typically to fund public projects like schools, roads, or
hospitals.

•High-Yield or “Junk” Bonds: These are riskier corporate bonds from companies with lower credit ratings but offer a
higher yield to attract investors.
 Features of Bonds

•Fixed Income: Bonds are often called “fixed-income” investments because they pay a set interest rate, giving
predictable income.
•Credit Risk: This is the risk that the issuer won’t be able to pay the interest or repay the principal. Government
bonds are usually low-risk, while corporate bonds depend on the financial strength of the company.
•Interest Rate Risk: Bond prices and interest rates move in opposite directions. If interest rates go up, the price
of existing bonds goes down because new bonds will be issued with higher interest rates, making the older ones
less attractive.
•Liquidity: Bonds are generally less liquid than stocks, meaning they can be harder to buy and sell quickly
without affecting the price.
 Importance of Bonds in Finance

•Diversity and Stability: Bonds help investors diversify their portfolio and reduce risk, as they
usually aren’t as volatile as stocks. Bonds provide stability, especially for people close to retirement.
•Income Generation: Bonds offer regular income through interest payments, which is attractive to
investors seeking stable returns.
•Predictability: Since most bonds pay a fixed interest rate and have a set maturity date, they’re
more predictable than stocks, making them safer for conservative investors.
 Comparing Bonds with Other Investments

•Bonds vs. Stocks: Stocks represent ownership in a company, while bonds are a loan to the
company or government. Stocks can have higher returns but are riskier, whereas bonds provide
steady income with lower risk.
•Bonds vs. Savings Accounts: Bonds generally offer a higher return than savings accounts but
come with risks, such as interest rate changes and credit risk.
•Bonds vs. Mutual Funds: Bond funds pool money to buy different bonds, offering diversification,
but they may have higher fees and less predictable returns than holding individual bonds.
 Evaluating Bonds: What to Look For

•Interest Rates: If interest rates rise, existing bonds may lose value.

•Credit Ratings: Agencies like Moody’s or S&P rate bonds. AAA-rated bonds are safer, while lower-

rated (like BB or lower) have higher risk but could yield higher returns.

•Maturity: Short-term bonds have less risk but usually pay lower interest. Long-term bonds pay

more but are more sensitive to interest rate changes.

 Debenture
A debenture is a type of debt instrument, similar to a bond, but with a few differences.
When a company wants to borrow money, instead of going to a bank, it can issue
debentures to investors. By buying a debenture, you’re effectively lending money to the
company, which will repay you with interest.
 Basic Idea of a Debenture

•Like a bond, a debenture is an IOU from the company to the investor. However,

debentures are typically unsecured. This means there’s no physical asset (like

property or equipment) backing the loan, so it’s riskier than a secured bond.

•If the company runs into trouble and can’t pay its debts, debenture holders might

have to wait to be paid back because other secured creditors have priority.
 Key Terms
•Issuer: The company issuing the debenture and borrowing the money.
•Principal: The amount of money you lend by buying the debenture, often called the face
value.
•Coupon Rate: The interest rate paid on the debenture, similar to a bond. This is usually a
fixed amount paid out at regular intervals.
•Maturity Date: The date when the company has to repay the principal. Debentures can
have short, medium, or long terms.
•Yield: The return you earn on the debenture, usually expressed as a percentage of its
purchase price.
 Types of Debentures
•Convertible Debentures: These can be converted into company stock after a certain period. If
the company does well, this can increase the debenture’s value, as you get to own shares in the
company.
•Non-Convertible Debentures (NCDs): These cannot be converted into stock, but they often offer
a higher interest rate as compensation.
•Secured Debentures: Although most debentures are unsecured, some companies do issue
secured debentures backed by assets.
•Unsecured Debentures: These are not backed by assets, meaning they rely entirely on the
company’s promise to repay.
Features of Debentures
•Fixed Income: Debentures usually have a fixed interest rate, providing steady income, like
bonds.
•Higher Risk for Unsecured: Since most debentures are unsecured, there’s more risk than with
secured bonds, especially if the issuing company is struggling financially.
•Priority in Repayment: In case of liquidation, debenture holders are paid after secured creditors
but before shareholders.
•Flexibility with Convertibles: Convertible debentures offer the potential for capital growth by
allowing conversion into shares if the company performs well.
 Importance of Debentures in Finance

•Capital Raising for Companies: Debentures allow companies to raise money without
giving up ownership, unlike issuing shares.

•Income for Investors: They provide a predictable income stream through interest
payments, which can be attractive for income-seeking investors.

•Growth Potential with Convertibles: Convertible debentures offer both income and the
chance to share in the company’s growth if converted to stock.
Comparing Debentures with Other Debt
Instruments
•Debentures vs. Bonds: Bonds are generally secured by assets, while most debentures are unsecured. Bonds
may be less risky, but debentures might offer higher interest rates as compensation for the risk.

•Debentures vs. Loans: Unlike traditional bank loans, debentures are more flexible, often allowing companies
to structure interest payments and offer the conversion feature.

•Debentures vs. Stocks: Stocks represent ownership in a company, and their returns depend on the company’s
success. Debentures, on the other hand, are loans to the company, offering fixed income but no ownership.
 Examples

•Example 1: A company issues a 5-year unsecured debenture with a face value of $1,000 and a 6% coupon rate.
If you buy it, you’ll receive $60 each year in interest. After 5 years, you get your $1,000 back (assuming the
company is doing well and can repay it).

•Example 2: A tech startup issues convertible debentures at an 8% interest rate, giving investors the option to
convert them into stock in 3 years. If the company grows fast, the conversion option could allow investors to
profit from owning shares instead of sticking with the debenture’s fixed interest.
Debentures offer a way for companies to raise funds without giving up ownership, and for

investors, they provide regular interest income. However, they carry different risks than bonds,

so it’s essential to consider the creditworthiness of the issuer and any features like convertibility

before investing.
 Evaluating Debentures: What to Look For

•Credit Rating: Since debentures are often unsecured, checking the company’s credit rating (e.g., by Moody’s, S&P) is
important to assess their financial health.

•Interest Rate (Coupon): Compare the coupon rate with other investment options, especially in relation to the
debenture’s risk level.

•Conversion Option: If it’s a convertible debenture, assess the company’s growth potential and whether the stock
conversion could be valuable.

•Maturity Date: Think about your time horizon and when you’d like your money back, as debentures can have varying
terms to maturity.
 Shares

•Shares represent ownership in a company. When you buy a share, you’re purchasing a small piece of
the company, meaning you have a claim on its profits and assets. If the company does well, the value
of your share can go up, and you might receive a portion of the profits as dividends.

•Types: Shares are typically divided into Equity Shares (common shares) and Preference Shares.

•Ownership and Voting Rights: Most shares (especially equity shares) come with voting rights,
allowing shareholders to participate in decisions like electing board members or approving major
business changes.
 Equity Shares (Common Shares)
• Equity shares, also known as common shares, are the primary type of shares issued by a company. They give
you ownership in the company and are the most common way for investors to become shareholders.
•Features:
• Voting Rights: Equity shareholders usually have voting rights in the company’s annual meetings.
• Dividends: Equity shareholders may receive dividends, but these are not guaranteed and depend on
the company’s profits and board decisions.
• High Risk, High Reward: Equity shareholders bear more risk than preference shareholders because they
are the last to get paid if the company goes bankrupt. However, if the company does well, they stand to
gain the most from any increase in share value.
• Residual Claim on Assets: If the company is liquidated, equity shareholders get paid only after all debts
and preference shareholders are paid.
Importance of Equity shares in Finance

•Capital Growth: Equity shares offer the potential for high capital growth if the
company performs well.
•Ownership: Equity shareholders collectively own the company and help decide
its direction through voting rights.
•Example: If you buy 100 equity shares of a tech company and it grows rapidly,
the value of your shares may increase significantly. You might also receive
dividends if the company decides to distribute profits.
 Preference Shares

•Preference shares (or preferred shares) represent a special class of ownership in a company. They have some unique benefits
over equity shares, but generally, they don’t come with voting rights.

•Features:
• Fixed Dividends: Preference shareholders usually receive fixed dividends, making them more predictable than equity
shares. These dividends are paid before any dividends to equity shareholders.
• Priority in Payments: In case of bankruptcy, preference shareholders are paid back before equity shareholders but after
debt holders.
• Limited or No Voting Rights: Unlike equity shares, preference shares often don’t carry voting rights.
• Convertible/Non-Convertible: Some preference shares can be converted to equity shares after a certain period, called
convertible preference shares.
 Types of Preference Shares

•Cumulative Preference Shares: If the company skips a dividend payment one year, it accumulates

and must be paid out later before any dividends go to equity shareholders.

•Non-Cumulative Preference Shares: If a dividend is missed, it’s not carried forward.

•
 Importance in Finance

•Income Stability: For investors who want steady income, preference

shares offer a fixed dividend and lower risk compared to equity
shares.
•Priority Claims: Preference shareholders have priority over equity
shareholders in receiving dividends and claim on assets if the
company goes bankrupt.
Example:

If you hold 200 preference shares of a company that pays a fixed dividend
of 5%, you’ll receive 5% of the face value of those shares as a dividend
every year, regardless of company performance, as long as the company
remains financially stable.
Comparison Between Equity Shares and Preference
Shares
•Risk: Equity shares are riskier because they’re the last to get paid if the company fails, while preference shares
are safer as they get paid before equity shareholders.
•Dividends: Equity shareholders may get variable dividends (or none at all) depending on company profits,
whereas preference shareholders get fixed dividends.
•Voting Rights: Equity shares usually have voting rights, allowing shareholders a say in company decisions.
Preference shares often don’t have voting rights.
•Growth Potential: Equity shares offer more potential for price appreciation (or growth), while preference
shares provide more stable income.
•Convertibility: Some preference shares can be converted to equity shares, offering flexibility if the investor
wants a chance to participate in company growth.
 Importance of Shares (Equity and Preference) in
Finance
•Ownership and Control: Shares are a way for investors to own a piece of the company. Equity shareholders
can participate in the company’s management decisions, adding a level of control.

•Capital for Companies: Companies issue shares to raise capital for growth, expansion, or other purposes. By
issuing preference shares, they attract investors looking for regular income.

•Investment Diversity: By offering both equity and preference shares, companies cater to different types of
investors. Risk-tolerant investors may prefer equity shares, while conservative investors may opt for
preference shares for stable income.
•Example 1 - Equity Shareholder: You buy equity shares in an energy company. If the company discovers a
profitable new technology, the value of your shares might rise, and you could profit by selling them. However,
if the company performs poorly, your shares could decrease in value.

•Example 2 - Preference Shareholder: You buy preference shares in a financial institution that pays a fixed
dividend of 7% each year. Regardless of the company's performance, you get a predictable dividend every
year as long as the company can afford it.
 Summary

Feature Equity Shares Preference Shares

Higher risk, last in line for

Risk Level Lower risk, paid before equity shareholders
payments

Dividends Variable, based on profits Fixed, generally guaranteed

Voting Rights Usually has voting rights Usually no voting rights

Growth Potential Higher growth potential More stable, income-focused

Convertible Option Not applicable Some can be converted to equity shares

•Equity shares give ownership, potential for high returns, and voting rights, but they carry more risk.

•Preference shares provide stable income with fixed dividends and have priority in payments over equity
shareholders, though they don’t usually include voting rights.

Shares, both equity and preference, are important for companies to raise funds and for investors as ways to
grow wealth or earn steady income. Investors choose based on their risk tolerance, need for income, and
desire for involvement in company decisions.
 Cost of Capital
• The cost of capital is an important element, as a basic input information, in
capital investment decisions.

• In the NPV method of discounted cash flow technique, the cost of capital is
used as the discount rate to calculate the NPV.

• The profitability index or benefit-cost ratio method similarly employs it to

determine the present value of future cash inflows .

• When the internal rate of return method is used, the computed IRR is
compared with the cost of capital.
• The cost of capital, thus, constitutes an integral part of investment
decisions.

• It provides a yardstick to measure the worth of the investment proposal

and, thus, performs the role of accept-reject criterion.

• This underlines the crucial significance of the cost of capital.

• It is also referred to as cut-off rate, target rate, hurdle rate, minimum

required rate of return, standard return, etc.
• The cost of capital, as an operational criterion, is related to the firms’ wealth
maximization objective.

• The accept-reject rules require that a firm should avail of only such
investment opportunities as promise a rate of return higher than the cost of
capital.

• Conversely, the firm would be well advised to reject proposals whose rates of
return are less than the cost of capital.

• If the firm accepts a proposal having a rate of return higher than the cost of
capital, it implies that the proposal yields returns higher than the minimum
required by the investors and the prices of shares will increase and, thus, the
shareholders’ wealth.
• By virtue of the same logic, the shareholders’ wealth will decline on the
acceptance of a proposal in which the actual return is less than the cost of
capital.

• The cost of capital, thus, provides a rational mechanism for making optimum
investment decisions .

• In brief, the cost of capital is important because of its practical utility as an

acceptance -rejection decision criterion.

• The considerable significance of the cost of capital in terms of its practical

utility notwithstanding , it is probably the most controversial topic in
financial management. There are varying opinions as to how this can be
computed.
•

•
• Obviously, each source of funds or each component of capital has its cost.

• For example, equity capital has a cost, so also preference share capital and so
on. The cost of each source or component is called specific cost of capital.

• When these specific costs are combined to arrive at overall cost of capital, it
is referred to as the weighted cost of capital (WACC).

• The terms, cost of capital, weighted cost of capital, composite cost of capital
and combined cost of capital are used interchangeably.

• In other words, the term, cost of capital, as the acceptance criterion for
investment proposals, is used in the sense of the combined cost of all
sources of financing .
Measurement of specific costs

• The term cost of capital, as a decision criterion, is the overall cost.

• This is the combined cost of the specific costs associated with specific sources
of financing .

• The cost of the different sources of financing represents the components of

the combined cost.

• The computation of the cost of capital, therefore, involves two steps:

• (i) the computation of the different elements of the cost in terms of the cost of
the different sources of finance (specific costs), and

• (ii) the calculation of the overall cost by combining the specific costs into a
composite cost.
• The first step in the measurement of the cost of capital of the firm is the
calculation of the cost of individual sources of raising funds .

• Apart from its relevance to the measurement of the combined cost, the
specific cost will also indicate the relative cost of pursuing one line of
financing rather than another.

• From the viewpoint of capital budgeting decisions, the long-term

sources of funds are relevant as they constitute the major sources of

financing of fixed assets.

• In calculating the cost of capital, therefore, the focus is on long-term funds .

• In other words, the specific costs have to be calculated for

(i) Long-term debt (including debentures);

(ii) Preference shares;

(iii)Equity capital;

(iv)Retained earnings
Cost of debt

• Cost of debt is the after-tax cost of long-term funds through

borrowing.

• In practice, the corporates are normally likely to have multiple debt

issues most likely subject to different interest rates.

• To determine the overall cost of debt, cost of each debt issue is to be

separately computed.

• The weighted average of costs of all debt issues would be the cost of
debt of the firm as a whole.
Cost of preference share

• Cost of preference share capital is the annual preference share

dividend divided by the net proceeds from the sale of preference
shares.

• Therefore, the stipulated dividend on preference shares, like the

interest on debt, constitutes the basis for the calculation of the cost of
preference shares.

• The cost of preference capital may be defined as the dividend expected

by the preference shareholders.
Cost of equity

• The cost of equity capital is the rate at which investors discount the
expected dividends of the firm to determine its share value.

• Conceptually, the cost of equity capital may be defined as the minimum

rate of return that a firm must earn on the equity-financed portion of an
investment project in order to leave unchanged market price of the
shares.
Cost of retained earnings
• It is true that a firm is not obliged to pay a return (dividend or interest) on
retained earnings .

• However, the retention of earnings has implications for the firm's

shareholders . If earnings were not retained, they would have been paid out
to the ordinary shareholders as dividends .

• In other words, retention of earnings implies withholding of dividends from

holders of ordinary shares .

• When earnings are, thus, retained, shareholders are forced to forego

dividends . The dividends foregone by the equity holders are, in fact, an
opportunity cost.

• Thus, retained earnings involve opportunity cost.

• In other words, the firm is implicitly required to earn on the retained
earnings at least equal to the rate that would have been earned by the
shareholders if they were distributed to them.

• This is the cost of retained earnings.

• Therefore, the cost of retained earnings may be defined as opportunity

cost in terms of dividends foregone by/withheld from the equity
shareholders.
 Cost of debt
𝐼
𝑘𝑖 =
𝑆𝑉
𝐼
𝑘𝑑 = (1-T)
𝑆𝑉

𝑘 𝑖 = BEFORE-TAX COST OF DEBT

𝑘 𝑑 = TAX-ADJUSTED COST OF DEBT
I= ANNUAL INTEREST PAYMENT

SV= SALE PROCEEDS OF THE BOND/DEBENTURE

T= TAX RATE
EXAMPLE:

A COMPANY HAS 10 PER CENT PERPETUAL DEBT OF RS 1,00,000. THE TAX

RATE IS 35 PER CENT. DETERMINE THE COST OF CAPITAL (BEFORE TAX AS
WELL AS AFTER TAX) ASSUMING THE DEBT IS ISSUED AT (I) PAR, (II) 10 PER
CENT DISCOUNT, AND (III) 10 PER CENT PREMIUM.
 Cost of preference
𝐷𝑝
𝑘𝑝 =
𝑃0 (1−𝑓 )

𝑘 𝑝 = COST OF PREFERENCE
𝐷𝑝 = CONSTANT ANNUAL DIVIDEND PAYMENT
𝑃0 = EXPECTED SALES PRICE OF PREFERENCE SHARES
𝑓 = FLOTATION COSTS AS A PERCENTAGE OF SALES PRICE
EXAMPLE:
A COMPANY ISSUES 11 PER CENT IRREDEEMABLE PREFERENCE SHARES OF
THE FACE VALUE OF RS 100 EACH. FLOTATION COSTS ARE ESTIMATED AT 5
PER CENT OF THE EXPECTED SALE PRICE.
WHAT IS THE KP, IF PREFERENCE SHARES ARE ISSUED AT
(I) PAR VALUE,
(II) 10 PER CENT PREMIUM, AND
(III) 5 PER CENT DISCOUNT? (B) ALSO, COMPUTE KP IN THESE SITUATIONS
ASSUMING 13.125 PERCENT DIVIDEND TAX.
 COST OF EQUITY
𝐷1
𝑘𝑒 = +G
𝑃0

𝑘 𝑒 = COST OF EQUITY
𝐷1 = CONSTANT ANNUAL DIVIDEND PAYMENT
𝑃0 = NET PROCEEDS PER SHARE/CURRENT MARKET PRICE
G= GROWTH IN EXPECTED DIVIDENDS
EXAMPLE:

EXAMPLE 11.7 SUPPOSE THAT DIVIDEND PER SHARE OF A FIRM IS EXPECTED

TO BE RE 1 PER SHARE NEXT YEAR AND IS EXPECTED TO GROW AT 6 PER
CENT PER YEAR PERPETUALLY. DETERMINE THE COST OF EQUITY CAPITAL,
ASSUMING THE MARKET PRICE PER SHARE IS RS 25.
SOLUTION:
Computation of overall cost of capital

• The term cost of capital means the overall composite cost of capital

defined as weighted average of the cost of each specific type of fund.

• The overall cost of capital should take into account the relative

proportions of different sources and hence the weighted average.

• The computation of the overall cost of capital (represented symbolically
by ko ) involves the following steps:

1. Assigning weights to specific costs.

2. Multiplying the cost of each of the sources by the appropriate weights.

3. Dividing the total weighted cost by the total weights.

Example:
A firm’s after-tax cost of capital of the specific sources is as follows:
(a) Cost of debt 8 percent, cost of preference shares (including dividend
tax) is 14, cost of equity funds is 17
The following is the capital structure:
(a) Debt rs 3,00,000, preference capital 2,00,000, equity capital 5,00,000

Calculate the weighted average cost of capital using book value weights.
Solution: calculation of WACC

Sources of Amount Proportion Cost Weighted cost

funds
Debt 300000 0.3 0.08 (0.30*0.08)
(300000/10,00000) 0.024

Preference 200000 0.2 0.14 (0.2*0.14)

(200000/10,00,000) 0.028
Equity 500000 0.5 0.17 (0.5*0.17)
(500000/10,00,000) 0.085
Total 10,00,000 1.0 0.137

Weighted average cost of capital = 13.7 percent

 Unit-IV Working Capital Finance for Projects

• Working capital management is concerned with the problems that arise in attempting to manage the
current assets, liabilities, and the interrelationship between them.

• The term current assets refer to those assets which in the ordinary course of business can be, or will
be, converted into cash within one year without undergoing a diminution in value and without
disrupting the operations of the firm.

• The major current assets are cash, marketable securities, accounts receivable and inventory.

• Current liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary
course of business, within a year, out of the current assets or earnings of the concern.
• The basic current liabilities are accounts payable, bills payable bank overdraft,
and outstanding expenses.

• The goal of working capital management is to manage the firm’s current assets and
liabilities in such a way that a satisfactory level of working capital is maintained.

• This is so because if the firm cannot maintain a satisfactory level of working

capital, it is likely to become insolvent and may even be forced into bankruptcy.

• The current assets should be large enough to cover its current liabilities in order to
ensure a reasonable margin of safety.

• Each of the current assets must be managed efficiently in order to maintain the
liquidity of the firm while not keeping too high a level of any one of them.
Concepts and There are two concepts of working
capital:
Definitions of 1. Gross working capital and
Working Capital 2. Net working capital
 • The term gross working capital
also referred to as working
capital
• It means the total current
Gross assets.
working • Gross working capital means
the current assets, which
capital represent the proportion of
investment that circulates
from one form to another in
the ordinary conduct of
business
 • The term net working capital can be

Net defined in two ways:

(i) the most common definition of net
working capital (NWC) is the
working difference between current
assets and current liabilities; and

Capital (ii) (ii) alternate definition of NWC is

that portion of current assets
which is financed with long-term
funds.
 • There are three alternative policies related to the total amount
Policies of investments made in current assets:

Related to • Relaxed
• Aggressive
Current Assets • Moderate.
Investment • These policies differ in respect of the total amount of current
assets carried to support any given level of sales.
 • This refers to the policy where the
firms carry relatively large amounts
of cash and cash equivalents,
Relaxed inventories, and receivables.
• They use liberal credit policy
Current implying a relatively longer time-
span of credit period extended to
Assets debtors, as a means of promoting
Investment sales.
• In view of the relatively higher
Policy amount of investment in current
assets, the current assets turnover
ratio of such firms tends to be
relatively low.
 • This refers to the policy where the
firm’s holdings of cash and cash
equivalents, inventories and
receivables are minimized.

Aggressive • Since there is a relatively lower amount

of current assets to support given level
Current Assets of sales, the current assets turnover
ratio tends to be high.
Investment Policy • Under such a policy, the firm would
hold a minimum level of safety stocks
of cash and inventories and would
pursue a tight/strict credit policy for
credit sales.
• It provides the highest expected return
on investment. At the same time, it
entails the greatest risk
Moderate Current Assets Investment
Policy

• This falls between the above two extreme policies in terms of current
assets carried as well as expected return and risk.
 • One of the most important decisions, involved in
the management of working capital is how
current assets will be financed.
• There are, broadly speaking, two sources from
which funds can be raised for current asset
Determining financing;

Financing • (i) short-term sources (current liabilities), and

• (ii) long-term sources, such as share capital,
Mix long-term borrowings, internally generated
resources like retained earnings and so on.
• What proportion of current assets should be
financed by current liabilities and how much by
long-term resources? Decisions on such
questions will determine the financing mix.
Approaches to • There are three basic approaches to determine
an appropriate financing mix:
determine an • (a) Hedging approach, also called the
Matching approach;
appropriate • (b) Conservative approach, and
financing mix • (c) Trade-off between these two
 • The term ‘hedging’ is often used in the
sense of a risk-reducing investment
strategy involving transactions of a
simultaneous but opposing nature so that
the effect of one is likely to
counterbalance the effect of the other.
Hedging • Concerning an appropriate financing mix,

Approach the term hedging can be said to refer to

the process of matching the maturities
of debt with the maturities of financial
needs.
• This approach to the financing decision to
determine an appropriate financing mix is
also called the Matching approach.
• According to this approach, the maturity of the source of funds should match the
nature of the assets to be financed.

• For the purpose of analysis, the current assets can be broadly classified into two
classes:

1. Those which are required in a certain amount for a given level of operation and,
hence, do not vary over time.

2. Those that fluctuate over time.

• The hedging approach suggests that long-term funds should be used to finance the
fixed portion of current assets requirements in a manner similar to the financing
of fixed assets.

• The purely temporary requirements, that is, the seasonal variations over and above
the permanent financing needs should be appropriately financed with short-term
funds (current liabilities).

• This approach, therefore, divides the requirements of total funds into permanent
and seasonal components, each being financed by a different source.
Conservative Approach
• This approach suggests that the
estimated requirement of total
funds should be met from long-term
sources;
• the use of short-term funds should
be restricted to only emergency
situations or when there is an
unexpected outflow of funds.
• In other words, it is a strategy by
which the firm finances all funds
requirements, with long-term funds
for emergencies or unexpected
outflows
A Trade-off Between the Hedging and Conservative Approaches

• It refers to a proper Trade-off Between the Hedging and Conservative Approaches

 Need for Working Capital

• The need for working capital (gross) or current assets cannot be overemphasized.

• Given the objective of financial decision making to maximsie the shareholders’

wealth, it is necessary to generate sufficient profits.

• The extent to which profits can be earned will naturally depend, among other
things, upon the magnitude of the sales.

• A successful sales programme is necessary for earning profits by any business

enterprise.

• However, sales do not convert into cash instantly; there is invariably a time lag
between the sale of goods and the receipt of cash.
 • There is a need for working capital in the form of
current assets to deal with the problem arising
out of the lack of immediate realization of cash
against goods sold.
• Therefore, sufficient working capital is necessary
Operating or to sustain sales activity.
• Technically, this is referred to as the operating
cash cycle or cash cycle.
• The operating cycle can be said to be at the heart
of the need for working capital.
• ‘The continuing flow from cash to suppliers, to
inventory, to accounts receivable and back
into cash is what is called the operating cycle’
The term cash cycle refers to the length of time necessary to complete the following
cycle of events:

1. Conversion of cash into inventory

2. Conversion of inventory into receivables

3. Conversion of receivables into cash

Permanent and Temporary Working Capital

• Permanent (fixed) working capital:

• Permanent (fixed) working capital is a certain minimum level of working
capital on a continuous and uninterrupted basis.
• Temporary (fluctuating/ variable) working capital:
• Temporary (fluctuating/ variable) working capital is the working capital
needed to meet seasonal as well as unforeseen requirements.
Permanent and Temporary Working Capital
 sources of working capital financing

• Trade credit
• Bank credit
• Commercial papers
• Certificate of deposits
 Trade Credit
• Trade credit refers to the credit extended by the supplier of goods and services in
the normal course of transaction/business/sale of the firm.
• According to trade practices, cash is not paid immediately for purchases but after
an agreed period of time.
• Thus, deferral of payment (trade credit) represents a source of finance for credit
purchases.
• There is, however, no formal/specific negotiation for trade credit. It is an informal
arrangement between the buyer and the seller.
• There are no legal instruments/ acknowledgements of debt which are granted on
an open account basis.
• Such credit appears in the records of the buyer of goods as sundry
creditors/accounts payable.
 Merits
• Trade credit, as a source of short-term/working capital finance, has certain

advantages.

• It is easily, almost automatically, available.

• Moreover, it is a flexible and spontaneous source of finance.

• The availability and magnitude of trade credit is related to the size of operations

of the firm in terms of sales/purchases.

 Bank Credit
• Bank credit is the primary institutional source of working capital finance in India. It
represents the most important source for financing of current assets.
Forms of Credit:
Working capital finance is provided by banks in five ways:
(i) cash credits/overdrafts
(ii) loans
(iii) purchase/discount bills
(iv) letter of credit and
(v) working capital term loans.
 Letter of Credit
• Letter of credit is an indirect form of working capital financing and banks assume
only the risk, the credit being provided by the supplier himself.

• The purchaser of goods on credit obtains a letter of credit from a bank.

• The bank undertakes the responsibility to pay the supplier if the buyer fails to
meet his obligations.
 COMMERCIAL PAPERS

• Commerical paper is a form of financing consisting of short-term unsecured

promissory notes issued by a firm with high credit rating.

• It is a simple instrument and hardly involves any documentation between the

issuer and the investor.

• It is additionally flexible in terms of maturities of the underlying promissory note,

which can be tailored to match the cash flow of the issuer.

• Further, a well-rated company can diversify its sources of finance from banks to
the short-term money market at a cheaper cost.
 • General Nature of Business
• Production Cycle
• Business Cycle
• Production Policy
• Credit Policy
• Growth and Expansion
Determinants • Vagaries in the Availability of Raw Material

of Working • Profit Level

• Level of Taxes
Capital • Dividend Policy
• Price Level Changes
• Operating Efficiency
Example:
Solution