UNIT-1 Introduction to finance [REVIEW QUESTION]

Q-1. Nature and Functions of financial management

a. Nature of financial management

 Financial management is integral part of overall management

 Financial considerations are involving in all business activities

 Financial management is pervasive throughout the organization

 Financial decisions are directed at increasing / maximizing / optimizing the value of

the firm.

 Financial decision essentially involves risk – return and trade – off.

 Decision on investment involves choosing of types of assets which generate the

returns.

 Financial management affects the survival, growth and vitality of the firm.

 Financial management is said to be the life blood of the business

 Finance functions i.e., investment, raising of capital, distribution of profit, are

performed in all firms.

 Financial management is a concern of every concern financial management is a sub

– system of the business system that has other sub–systems.

 Financial management of a business is influenced by the external, legal and

economic environment

 Financial management is related to other discipline like accounting, economics,

taxation, operation research, mathematics, statistics, etc.

 There are some procedural finance functions like record keeping, credit appraisal
and collection, inventory

 The nature of finance function is influenced by the special characteristic of the

business

 Finance assumes low profile importance

b. Functions of financial management

Financial management functions are classified into three categories. They are;

i. Investment decision

ii. Financial decision

iii. Dividend decision

iv. Other functions

i. Investment decision
Investment decision relates to the selection of assets in which funds will be invested by a firm.

a. Long – term assets

b. Short – term assets

c. Capital budgeting

d. Working capital management

ii. Financing decision

Finance decision relates to financing mix or capital structure or leverage. Capital structure deals to the optimum
combination of debt and equity.

Capital structure = Debt + Equity

Financing decision involves;

 Capital structure theory

 Capital structure decision

iii. Divided policy decision

Dividend is the monetary benefit of the shareholders. Dividend is declared by the part of profits. It is very most
important to decide;

 Whether to pay dividend to shareholders

 Whether to retain the dividend by the organization for further development and expansion.

iv. Other functions

 Determining financial needs

 Determining source of funds

 Financial analysis

 Optimum capital structure

 Cost volume profit analysis

 Profit planning and control

 Fixed assets management

 Project planning and evaluation

 Capital budgeting

 Working capital management

 Dividend policies

Q-2. Objectives of financial management

According to Robert W Johnson

  Planning and control

 Raising of funds

 Investing funds

 Meeting special problems

According to grunwald nemmars

 Investment of funds

 Providing liquid assets

 Generating earnings

 Maximizing market value of the firm

According to Van Horne & Wachowicz

 Investment function

 Finance function

 Dividend function

According to Earnest W. Walker

 Financial planning

 Financial co – ordination

 Financial control

Weston & Brigham

 Financial planning and control

 Fixed asset and working capital management

 Capital structure decisions

 Individual financing episodes

The financial functions are classified into two dimensions.

They are;

a. Managerial functions

 Planning

 Organizing

 Directing

 Co – ordination

 Control
 b. Operative function

 Investment and asset management

 Financing and liability management

 Dividend payout management

 Internal financing

C. Treasurer function

 Assets management

 Capital budgeting

 Bank – institutional relationship

 Credit management

 Dividend disbursement

 Investor’s relations

 Insurance

 Risk – management

 Tax analysis

4. Controller function

 Accounting

 Data processing

 Budgeting

 Internal control

 Government reporting

i. Investment and asset management function

Investment and asset management deals the following aspects;

 The total amount to be committed in assets

 The proportion of fixed to current assets

 The mix of fixed assets to be acquired

 The timing, sourcing and acquisition of fixed assets

 The evaluation of capital investment as to risk and return features

 The mix of current assets

 The management of each item of current assets to optimize liquidity and return
  The effecting of a health portfolio of assets

Investment function is, concerned capital budgeting and current asset management. Capital budgeting deals with
fixed assets management. Investment appraisal, capital rationing and acquisition, maintenance, replacement and
renewal of fixed assets come under fixed assets management.

Inventory management, receivable management, marketable securities management, cash management and
working capital administration come under current assets management.

ii. Financing and liability management function

The financing function refers to raising necessary funds for backing up the investment function. Financing
function is dealing the capital structure of the business and covers the following.

 Determination of total capital to be raised

 Determination of debt – equity ratio

 The proportion of debt to equity capital

 The mix of long term and short term capital

 Determination of the level of fixed change funds like bonds, debentures, loans etc.

 Determination of the source of borrowing

 Determination of the securities / charges to be given

 Determination of the extend of lease financing

 Determination of the degree of sensitivity of earnings per share to earnings before interest and
taxation

 Determination of the method of raising capital – public issue or private placement, underwriting and
brokerage, rights issue and the like

 The legal restriction, if any, on the scale, form, timing and other aspects of raising capital.

Finance function also affects the liquidity, solvency, profitability, capital structure, control of business and so
on.

iii. Dividend payout management function

The following questions are common for dividend payout ratio.

1. How the profits are to be utilized, is the concern of the dividend function?

2. How much of the profits to be distributed as dividend to the share- holders?

3. What should be the pay-out ratio?

4. What should be the retention ratio?

5. Is dividend payment is necessary?

Shareholders expect a return on their shareholding for they can invest / spend the dividend income; for
maintaining or enhancing the value of the shares in the market, for dividend declaration has a financial signaling
effect and so on.
Retaining the profits and gouging back the same in the business itself may become necessary because the
company can invest more profitably than the shareholders, the company can get established and can modernize,
diversify and expand using the retained profits; the shareholders are expecting capital gain rather than current
income and because the cost of raising new capital form the public is costlier and time consuming.

Q-3. Role of a financial management / Manager

 Anticipating financial management

 Acquiring financial resources

 Allocation of fund in business

 Expected events

 Financial implications

 Forecasting expected funds

 Business needs

 Different sources of funds

 Balancing of assets

 Profitability

 Liquidity

 Over – financing

 Under – financing

 Leverage

 Owner’s view point

Q-4. Return and Risk

Returns

Everything held constant, individuals generally prefer current consumption to future consumption. In order to
motivate individuals to invest, a potential investment must offer a positive rate of return. This will result in the
investor having greater future wealth and therefore greater future consumption opportunities than the current
consumption opportunities. It is an incentive for the investor to postpone consumption.

Three major factors which determine the return investors require in order investing. They are:

i. The time preference for consumption as measured by the risk-free real rate of return.

ii. The expected rate of inflation

iii. The risk associated with the investment.

Required return may thus be stated as follows;

Required return = (Risk- free real rate + Expected inflation + Risk premium)
The first two factors (The risk–free real rate of return and Rate of inflation) are common to all investments.
Only the third factor, risk premium is unique to each investment.

Risk

The risk of an investment refers to the volatility of its rate of return. The volatility in the return results in the
possibility that the realized returns will be less than the returns that were expected. The source of such risk is the
failure of dividends or interest and or the security’s price to materialize as expected.

Investment risk is associated with the variability of rates of return. The more variable return, the more risky the
investment. The standard deviation is commonly used as the measure of risk.

a. Systematic Risk

Systematic risk refers to that portion of risk affecting all the securities. It may arise due to economic, political
and sociological factors. These factors cause the prices of almost all the securities to rise or fall.

This will result in the security prices to move in the same direction as the stock market index (for instance the
Sensex). Systematic risk is also referred to as market risk or undiversifiable risk. Elements of systematic risk
are:

1. Market – risk

2. Interest – rate risk

3. Purchasing power risk

1. Market Risk

Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is
called as market risk. The basis for the changes in investors expectations may be political, social or economic.
For instance, the change of government or government policies may affect the security prices across the board.

Variability in return may also arise due to the market psychology. The emotional reaction of investors may
result in the security prices to overreact. It also is a cause for market risk.

2. Interest Rate Risk

The variation in the returns caused by fluctuations in the general level of interest rates is referred to as the
interest rate risk. As the interest rate goes up, the market price of existing fixed income securities falls, and vice
versa. The root cause for this fluctuation is that as the rate of interest on government securities rises or falls the
rates of return demand on other alternative investments such as bonds and equity shares rise or fall. While the
changes in the interest rates have a direct impact on the prices of bonds, they affect equity prices indirectly.

3. Purchasing Power Risk:

While market risk and interest rate risk are associated with the uncertainties in the amount of money to be
received by an investor, purchasing power risk is the uncertainty of the purchasing power of the money to be
received. It refers to the impact of inflation or deflation on an investment. Rising prices on goods and services
are normally associated with inflation or deflation on an investment.

Rising prices on goods and services are normally associated with inflation and falling prices on goods and
services are referred to as deflation. Generally, purchasing power risk is identified with inflation, because
declining prices is very rare.

The wholesale price index (WPI) and consumer price index (CPI) are the commonly used measures of inflation.
Rational investors should include inflation rate in their estimate of expected return.
b. Unsystematic Risk

Unsystematic risk is that portion of total risk that is unique to a firm or an industry, above and beyond the
systematic risk. Unsystematic risk may also be referred to as diversifiable risk. The two major elements of
unsystematic risk are:

a. Business Risk

b. Financial Risk

a. Business Risk

Business risk arises due to the variations in the operating income and the dividends. Factors such as
management capability, consumer preferences, competition, labour strikes and so on cause the business risk.

Business risk can be divided into two broad categories: internal and external. Internal business risk is associated
with the efficiency with which a firm conducts its business.

External business risk is associated with the external environment within which a firm has to operate. The
external factors may be the cost of capital, the business cycle, demographic factors, government policies,
economic factors, monetary and credit policies, political – legal factors and so on.

b. Financial Risk

The way in which a company finances its activities influences the return to the equity shareholders. This can be
ascertained from the capital structure of the firm. The use of debt finance creates payment of fixed interest and
hence it affects the residual profit available to the equity shareholders.

The use of debt capital, called financial leverage, increases the variability of equity returns, affects the
expectations of return by the equity shareholders and increases their risk.

Q-5. Shares and Bonds

Shares

Shares are instruments to raise capital. Share capital is the back bourn of the company’s financial structure.
Share capital represents ownership of the company (Equity). shareholders collectively own the company.

They enjoy the reward of ownership and bear the risk of the company. Share capital is also termed as the
venture capital on account of the risk involved in it. Shareholders’ liability is limited to their capital subscription
and contribution.

In India, under the companies Act 1956, shares which are not preference shares are called equity shares. The
equity shareholders get dividend. Dividend is the only monetary benefit received by the shareholders from the
company.

Normally equity shareholders get dividend after the payment of dividend to the preference shareholders.
Similarly, in the event of the winding up of the company, capital is returned to them after the return of capital to
the preference shareholders i.e., the least is bear by the shareholders.

The equity shareholders enjoy a statutory right to vote in the general body meeting and thus exercise their voice
in the management and affairs of the company. They have an unlimited interest in the company’s profit and
assets.

If the profit of the company is substantial, the equity shareholders may get good dividend. The equity
shareholders return of income, i.e., dividend is of fluctuating character and its magnitude directly depends upon
the amount of profit made by a company in a particular year.
Now a days equity capital is raised through global equity issues. Global depository receipts (GDRs), American
depository receipts (ADRs), etc. are certain instruments used by Indian companies to overseas capital market to
get equity capital.

Advantages of equity share capital

 It contributes the ‘corpus’ of the company

 It is the ‘heart’ to the business

 It represents permanent capital

 No problem of refunding the capital

 It does not involves any fixed obligation for payment of dividend

 It does not create any charge on assets of the company

 The assets may be used as security for further financing

 It is the risk bearing capital

 It strengthens the credit worthiness

 Equity capital is now expanding

 Now global capital market can be accessed.

Disadvantages of equity share capital

 Cost of issue of equity share is high

 It attract only particular classes of investors who can take risk

 Cautious investors do not to subscribe for equity issue

 Underwriting commission, brokerage costs and other issues, so, are high for equity capital

 The cost of servicing is higher than the other classes of shares

 The expectation of the equity shareholders is also high

 The issuing of equity capital causes dilution of control of the equity holders

 In time of depression dividends on equity shares reach low

 Excessive reliance on financing through equity shares reduces the capacity of the company to trade on
equity.

Bonds

Bond is a fixed income security, which promises to give a certain fixed cash flow to the holder of the bond at
certain per- determined time period. Generally these returns are of two types.

They are;

1. Coupon

2. Face value
Q-6. Option

An option gives the holder or buyer of the option the right to do something – usually to buy or sell an underlying
at a previously agreed price at a given point in the future, without the concomitant obligation to do so.

In other words, a holder of an option has right to buy or sell an underlying without any obligation. Therefore, it
means that the seller has the obligation, but not the right as per the contract.

By contrast in a forward or futures contract the two parties are committed to fulfil the contract. This would mean
that both the buyer and the seller have individually the right and the obligation.

The status of right and obligations between the buyer and seller of an option can be depicted as shown in the
following terminology.

Terminology

 Buyer /Holder / Owner

 Seller / Writer

 Option premium

 Strike price

 Expiry date

 Call option

 Put option

 American option

 European option

 Intrinsic value

 Time value

 Volatility

 Break – even point

1. Buyer / Holder / Owner

This refers to the person who buys the option and as a result has the right to either buy / sell the underlying
without the attendant obligation to do so.

2. Seller / Writer

The person who sell the option and as a result has only the obligation to either buy / sell the underlying, having
surrendered his rights to the contract for a price known as the option premium.

3. Option premium

Amount paid by a buyer to seller for acquiring the right to buy or sell an underlying. It is usually paid upfront,
i.e., at the time of entering into the option contract.

4. Strike price
The price at which the right to buy or sell the underlying is exercisable – again agreed upfront. It is also known
as the exercise / agreed price.

5. Expiry date

The date on which the option contract expires or becomes invalid.

6. Call option

An option acquired to obtain the right to buy / call an underlying in the market.

7. American option

In this type of option, the right can be exercised by the buyer at any time during the life of the option contract.

8. European option

In this type of option, the right can be exercised by the buyer only at the end of the life of the option contract.

9. Intrinsic value

Given its throwaway feature, the value of an option never can fall below zero. The intrinsic value of an option is
different between the strike price and the spot rate of the underlying.

In other words, intrinsic value represents the gain to the holder on immediate exercise of an option

10. Time vale

The different between the total value of an option and its intrinsic value is the time value of the option. The time
value represents the additional amount of premium that the option buyer is willing to pay over the intrinsic value
for the unexpired life of the option.

11. Volatility

In risk management, risk is measured using standard deviation. Such standard deviation expressed in percentage
terms is known as volatility. In option, the value / price of the option is determined to great extent by the
volatility in the value / price of the underlying.

12. Break – even point

A break – even point is that where the cost and revenue are equal. Hence, at break – even point, the user has ‘no
loss – no profit situation.
Unit -2 Capital budgeting [REVIEW QUESTIONS]

Q-1. A Company has to choose one of the following two mutually executive projects. Investments required for
each project is Rs. 1,50,000. Both the projects have to be depreciated on straight line basis. Tax at the rate of
50% is to be provided.

Year Project A (Before depreciation) Rs.

1 42,000

2 49,000

3 70,000

4 80,000

5 20,000

Calculate pay-back-period and ARR.

Q-2. A company has an investment opportunity costing Rs. 2,10,000 with the following expected net cash flow
(after depreciation before tax)

Year Net cash flow [ADBT] [Rs.\]

1 7,000

2 8,000

3 10,000

4 9,000

5 8,000

6 10,000

7 10,000

Determine the pay-back period, and NPV, the cost of capital or discount factor is 12%.

Q-3. From the following information select the suitable proposal under payback period method

. Machine -1 Rs.. Machine -2 Rs..

Investment 60,000 60,000

Cash flow

i year 20,000 12,000

ii year 16,000 12,000

iii year 12,000 12,000

iv year 8,000 12,000

 v year 4,000 12,000

Solution

Machine – 1

Year Cash inflow Rs. Cumulative cash inflow Rs.

1 20,000 20,000

2 16,000 36,000

3 12,000 48,000

4 8,000 56,000

5* 4,000 60,000

Pay – back period = Investment / Cash inflow

= 5 Years.

Note

At the end of fifth year the machine – A get Rs. 60,000. Our investment is Rs. 60,000. Therefore, the pay- back
period is 5 years.

Machine – 2

Year Cash inflow Rs. Cumulative cash inflow Rs.

1 12,000 12,000

2 12,000 24,000

3 12,000 36,000

4 12,000 48,000

5* 12,000 60,000

Pay – back period = Investment / Cash inflo

= 60,000 / 12,000

= 5 Years.

Note
 At the end of fifth year the machine – A get Rs. 60,000. Our investment is Rs. 60,000. Therefore, the pay- back
period is 5 years.

Q-4. A company has an investment opportunity costing Rs. 2,10,000 with the following expected net cash flow
(after depreciation before tax)

Year Net cash flow [Rs.]

1 7,000

2 8,000

3 10,000

4 9,000

5 8,000

6 10,000

7 10,000

Determine the pay-back period.

Solution

Year Net cash flow (after Tax (50%) Rs. Cash flow after Before depreciation Cumulative cash
depreciation before tax) Rs. tax (PAT) Rs. after tax (PATBD) Rs. inflow Rs.

1 7,000 3,500 3,500 33,500 33,500

2 8,000 4,000 4,000 34,000 67,500

3 10,000 5,000 5,000 35,000 1,02,500

4 9,000 4,500 4,500 34,500 1,37,000

5 8,000 4,000 4,000 34,000 1,71,000

6* 10,000 5,000 5,000 35,000 2,06,000

7 10,000 5,000 5,000 35,000 2,41,000

Pay- back period = Investment / Cash inflow

= 6 years + (4,000 / 35,000) x 12

= 6 years + 1.37 months

= 6.137 years

Q-5. A Company proposing to expand its production can go either for an automatic machine costing
Rs.4,48,000 with an estimated life of 51/2 years or an ordinary machine costing Rs. 1,20,000 having an
estimated life of 8 years. The annual sales and costs are estimated as follows:

Automatic machine Ordinary machine

 Rs. Rs.

Sales 1,50,000 1,50,000

Costs

Material 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Compute the comparative profitability of the proposals under the pay-back method. Ignore income tax.

Solution

i. Automatic machine

Sales Rs.1,50,000

Less: Costs

Material 50,000

Labour 12,000

Variable overheads 24,000

---------------- 86,000

-----------------------

Profit 64,000

------------------------

Pay – back period = Investment / Cash inflow

= 4,48,000 / 64,000

= 7 years.

ii. Ordinary machine

Sales Rs.1,50,000

Less: Costs

Material 50,000

Labour 60,000

Variable overheads 20,000

---------------- 1,30,000

------------------
 Profit 20,000

Pay – back period = investment / cash inflow

= 1,20,000 / 20,000

= 6 years.

Q-6. Amala Ltd. is considering the purchase of a new machine which will carry out some operations at present
performed by labour. Two alternative models, X and Y are available for the purpose. From the following
information, prepare a profitability index using pay-back period and pay-back profitability for submission to
management.

Machine - X Machine – Y

Estimated life 5 6

Cost of machine Rs. 1,20,000 Rs. 2,25,000

Estimated additional costs

Maintenance (Per month) 750 1,000

Indirect materials (p.a) 2,000 3,000

Supervision (per quarter) 4,000 5,500.

Estimated savings in scrap (p.a) Rs. 18,000 Rs. 22,000

Estimated savings in direct wages p.a

Employees not required 10 15

Wages per employees Rs.7,200 Rs.7,200

Depreciation is calculated using straight line method. Taxation may be taken at 50% of profit.

Solution

Machine – X Machine – Y

Rs. Rs.

Estimated savings

Wages [7,200X10] 72,000 [7.200X16] 1,08,000

Scrap 18,000 22,000

---------------- ----------------------

90,000 1,30,000

Less: Additional costs:

Maintenance 9,000 12,000

Indirect materials 2,000 3,000

Supervision 16,000 22,000

------------------------ ---------------
63,000 93,000

Less : Depreciation 24,000 37,500

------------------------- -------------------------

PAD 39,000 55,500

Less: Tax 19,500 27,750

------------------ ----------------

PAT 19,500 27,750

Add: Depreciation 24,000 37,500

- --------------------- ------------------

PATBD / CFAT 43,500 65,250

i. Pay – back period (Machine - X)

= Investment / Cash inflow

= 1,20,000 / 43,500

= 2.26 years

i. Pay – back period (Machine - Y)

= Investment / Cash inflow

= 2,25,000 / 65,250

= 3.45 years

Q-7. Project A initially costs Rs. 50,000. It generates the following cash flows.

Year Cash inflows (Rs.) Present value of Re.1 at 10%

1 18,000 0.909

2 16,000 0.826

3 14,000 0.751

4 12,000 0.683

5 10,000 0.621

Taking the cut-off rate as 10%, suggest whether the project should be accepted or not.

Q-8. EMM PEE Ltd. is evaluating two mutually exclusively proposals of new capital investment. The following
information about the proposals is available.
 Project A (Rs.) Project B (Rs.)

Investment cost 80,000 1,00,000

Economic life 4 years 5 years

Earnings before depreciation and

taxes

Year

1 24,000 28,000

2 28,000 32,000

3 32,000 36,000

4 44,000 34,000

5 ------- 4,000

The company’s cost of capital is 10% and tax rate is 50%. Advice the company as to which proposal would be
profitable using NPV techniques

Q-9. Apollo Ltd. is considering three alternatives for the purchase of a new machine i.e. A, B and C each
costing Rs. 20,000, earnings after taxes are expected to be as under;

Year Machine A Machine B Machine C

Cash flow

1 4,000 12,000 20,000

2 12,000 16,000 16,000

3 16,000 20,000 15,000

4 24,000 12,000 14,000

5 16,000 8,000 11,000

Year 1 2 3 4 5

P/V factor at 0.91 0.83 0.75 0.68 0.62

10%

Solution

Machine - A

Year Cash inflow Rs. P/V factor @ 10% NPV

1 4,000 0.91 3,640

 2 12,000 0.83 9,960

3 16,000 0.75 12,000

4 24,000 0.68 16,320

5 16,000 0.62 9,920

Net present value = 51,841 – 20,000 = 31,841

Machine – B

Year Cash inflow Rs. P/V factor @ 10% NPV

1 12,000 0.91 10,920

2 16,000 0.83 13,280

3 20,000 0.75 15,000

4 12,000 0.68 8,160

5 8,000 0.62 4,960

Net present value = 52,320 – 20,000 = 32,320

Machine – C

Year Cash inflow Rs. P/V factor @ 10% NPV

1 20,000 0.91 18,200

2 16,000 0,83 13,280

3 15,000 0.75 11,250

4 14,000 0.68 9,520

5 11,000 0.62 6,820

Net present value = 59,070 – 20,000 = 39, 070

Q-10. Three mutually exclusive projects X, Y and Z have been proposed. The projects are expected to each
require Rs. 2,00,000 have an estimated life of 5 years, 4 years, and 3 years respectively and hence no salvage
value. The company’s required rate of return is 10%. The anticipate cash flows after taxes (CFAT) for the three
projects are as follows CFAT (Rs.)

Year Project A Rs. Project B Rs. Project C Rs.

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

2 50,000 80,000 1,00,000

3 50,000 80,000 10,000

4 50,000 30,000 ------

5 1,00,000 --- ------

Rank each project applying the methods of pay-back, ARR, NPV, IRR and PI.

Solution

i. Pay – back period

Project - A

Year CFAT Rs. Cumulative CFAT Rs.

1 50,000 50,000

2 50,000 1,00,000

3 50,000 1,50,000

4 50,000 2,00,000

5 1,00,000 3,00,000

Pay-back period = Investment / Cash inflow

= 4 Years

Note

Investment of the machine = Rs. 2,00,000

Cumulative Cash flow for the first four years = Rs. 2,00,000

Therefore, pay-back period for the project A is 4 years

Project -B

Year CFAT Rs. Cumulative CFAT Rs.

1 80,000 80,000

2 80,000 1,60,000

3 80,000 2,40,000

4 30,000 2,70,000

Pay-back period = Investment / cash inflows

= 2 years + (40,000 / 80,000)

= 2.6 months

Note

At the end of 2nd year we get Rs. 1,60,000 and 3rd year Rs. 2,40,000. Our investment is Rs. 2,00,000.

Therefore, required amount for investment is Rs. 40,000, which is realised from 3rd year cash flow of Rs.
80,000. Pay-back period for the project B is 2.6 years.
Project - C

Year CFAT Cumulative CFAT

1 1,00,000 1,00,000

2 1,00,000 2,00,000

3 10,000 2,10,000

Pay- back period = Investment / Cash inflow

= 2 years

Note

At the end of 2nd year we get Rs. 2,00,000 Our investment is also Rs. 2,00,000. Therefore, pay-back period for
the project C is exactly 2 years.

Recommendations

1. Project C should be preferred first

2. Project B should be preferred second

3. Project A should be preferred third.

ii. ARR

ARR = Average income / Average investment x 100

Project – A

Average income = Total income / No. of years

= 3,00,000 / 5 = Rs. 60,000

Average investment = Investment / 2

= 2,00,000 / 2 = Rs. 1,00,000

ARR = 60,000 / 1,00,000 x 100 = 60%

Project – B

Average income = Total income / No. of years

= 2,70,000 / 4 = Rs. 67,500

Average investment = Investment / 2

= 2,00,000 / 2 = Rs. 1,00,000

ARR = 67,500 / 1,00,000 x 100 = 67.5%

Project – C

Average income = Total income / No. of years

= 2,10,000 / 3 = Rs. 70,000

Average investment = Investment / 2

= 2,00,000 / 2 = Rs. 1,00,000

ARR = 70,000 / 1,00,000 x 100 = 70%

Recommendations

1. Project C should be preferred first

2. Project B should be preferred second

3. Project A should be preferred third.

iii. NPV

Project – A

Year CFAT Rs. P / V Factor for 10% Present value

1 50,000 0,909 45,450

2 50,000 0.836 41,300

3 50,000 0.751 37,550

4 50,000 0.683 34,150

5 1,00,000 0.621 62,100

2,20,550

NPV = 2,20,550 – 2,00,000 = 20,550

Project - B

Year CFAT Rs. P/V factor for 10% Present value

1 80,000 0.909 72,720

2 80,000 0.826 66,080

3 80,000 0.751 60,080

4 30,000 0.683 20,490

2,19,370

NPV = 2,19,370 – 2,00,000 = 19,370

Project - C
 Year CFAT Rs. P/V factor for 10% Present value

1 1,00,000 0.909 90,900

2 1,00,000 0.826 82,600

3 10,000 0.751 7,510

1,80,010

NPV = 1,80,010 – 2,00,000 = - 18,990

Recommendations

1. Project A should be preferred first

2. Project B should be preferred second

3. Project C should be preferred third.

iv. IRR

Project – A

Year CFAT Rs. P / V Factor for Present value P/V factor for Present value
10% 22%

1 50,000 0,909 45,450 0.820 41,000

2 50,000 0.836 41,300 0.672 33,600

3 50,000 0.751 37,550 0.551 27,550

4 50,000 0.683 34,150 0.451 22,550

5 1,00,000 0.621 62,100 0.370 37,000

2,20,550 1,61,700

IRR = 10% + 20,550 / (2,20,550 – 1,61,700) x (22% - 10%)

= 10% + (20,550 / 58,850) x (12%)

= 10% + 0.3491 x (12%)

= 10% + 4.19% = 14.19%

Project - B

Year CFAT P/V factor for Present value P/V factor for Present value
10% 15%
Rs.

1 80,000 0.909 72,720 0.870 69,600

2 80,000 0.826 66,080 0.756 60,480

3 80,000 0.751 60,080 0.658 52,640

 4 30,000 0.683 20,490 0.572 17,.160

2,19,370 1,99,880

IRR = 10% + 19,370 / (2,19,370 – 1,99,889) x (15% - 10%)

= 10% +19,370/ 19,490 x 5%

= 10% + 4.969% = 14.969%

Project - C

Year CFAT P/V factor for Present vale P/V factor for Present value
10% 2%
Rs.

1 1,00,000 0.909 90,900 0.980 98,000

2 1,00,000 0.826 82,600 0.961 96,100

3 10,000 0.751 7,510 0.942 9,420

1,80,010 2,03,520

IRR = 10% + - 18,990 / (1,80,010 – 2,03,520) x (2% - 10%)

= 10% + -18, 990 / - 22,510 x ( -8%)

= 10% - 6.75% = 3.25%

Recommendations

1. Project B should be preferred first

2. Project A should be preferred second

3. Project C should be preferred third.

v. Profitability index [PI]

= P/V of CFAT / P/V of investment

Project – A

= 2,20,550 / 2,00,000 = 1.10

Project - B

= 2,19,370 / 2,00,000 = 1.09

Project – C

= 1,81,010 / 2,00,000 = 0.91

Q-11. Factors influencing capital investment decisions

Capital investment decisions are not governed by one or two factors, because the investment problem is not
simply one of replacing old equipment by a new one, but is concerned with replacing an existing process in a
system with another process which makes the entire system more effective. We discuss below some of the
relevant factors that affects investment decisions:

(i) Management Outlook: lf the management is progressive and has an aggressively marketing and growth
outlook, it will encourage innovation and favor capital proposals which ensure better productivity on quality or
both. In some industries where the product being manufactured is a simple standardized one, innovation is
difficult and management would be extremely cost conscious. In contrast, in industries such as chemicals and
electronics, a firm cannot survive, if it follows a policy of 'make-do' with its existing equipment. The
management has to be progressive and innovation must be encouraged in such cases.

(ii) Competitor’s Strategy: Competitors' strategy regarding capital investment exerts significant influence on
the investment decision of a company. If competitors continue to install more equipment and succeed in turning
out better products, the existence of the company not following suit would be seriously threatened. This reaction
to a rival's policy regarding capital investment often forces decision on a company'

(iii) Opportunities created by technological change: Technological changes create new equipment which may
represent a major change in process, so that there emerges the need for re-evaluation of existing capital
equipment in a company. Some changes may justify new investments. Sometimes the old equipment which has
to be replaced by new equipment as a result of technical innovation may be downgraded to some other
applications, A proper evaluation of this aspect is necessary, but is often not given due consideration. In this
connection, we may note that the cost of new equipment is a major factor in investment decisions. However the
management should think in terms of incremental cost, not the full accounting cost of the new equipment
because cost of new equipment is partly offset by the salvage value of the replaced equipment. In such analysis
an index called the disposal ratio becomes relevant.

Disposal ratio = (Salvage value, Alternative use value) / Installed cost

(iv) Market forecast: Both short and long run market forecasts are influential factors in capital investment
decisions. In order to participate in long-run forecast for market potential critical decisions on capital investment
have to be taken.

(v) Fiscal Incentives: Tax concessions either on new investment incomes or investment allowance allowed on
new investment decisions, the method for allowing depreciation deduction allowance also influence new
investment decisions.

(vi) Cash flow Budget: The analysis of cash-flow budget which shows the flow of funds into and out of the
company may affect capital investment decision in two ways. 'First, the analysis may indicate that a company
may acquire necessary cash to purchase the equipment not immediately but after say, one year, or it may show
that the purchase of capital assets now may generate the demand for major capital additions after two years and
such expenditure might clash with anticipated other expenditures which cannot be postponed. Secondly, the
cash flow budget shows the timing of cash flows for alternative investments and thus helps management in
selecting the desired investment project.

(vii) Non-economic factors: new equipment may make the workshop a pleasant place and permit more
socializing on the job. The effect would be reduced absenteeism and increased productivity. It may be difficult
to evaluate the benefits in monetary terms and as such we call this as non-economic factor. Let us take one more
example. Suppose the installation of a new machine ensures greater safety in operation. It is difficult to measure
the resulting monetary saving through avoidance of an unknown number of injuries. Even then, these factors
give tangible results and do influence investment decisions.
Others

 Availability of funds

 Future earnings

 Legal compulsion

 Degree of uncertainty

 Urgency

 Research and development

 Obsolescence

 Competitor’s activity

 Intangible factors

Q-12. Methods of capital budgeting

The importance of the capital budgeting is the equalizing of matching the available resources with the
acceptable projects.

There are many ways in practice all over the world in the sphere of capital expenditure decisions. Whichever
method is selected, it should;

 Provide a basis for difference between acceptable and non – acceptable projects

 Rank different proposals in order of priority

 Have a suitable approach

 Adopt criterion

 Recognizing the time value of money

The following are the familiar methods of capital budgeting

1. Traditional methods

 Pay – back period method

 Pay – back profitability method

 Accounting rate of return or Average rate of return method

2. Modern method

 Net present value

 Profitability index

 Internal rate of return

Unit – 3 Financing and Dividend decision [REVIEW QUESTIONS]

Q-1. Calculate operating, financial leverage and combined leverages.

X Ltd Y Ltd

Sales 4,00,000 8,00,000

Less variable exp 1,60,000 2,40,000

Contribution 2,40,000 5,60,000

Less fixed exp 1,28.000 2,80,000

Operating profit [EBIT] 1,12,000 2,80,000

Less interest 48,000 1,20,000

Profit before tax 64,000 1,60,000

Q-2.. i. X ltd is expecting annual EBIT of Rs. 1.00 lakh. The company has Rs. 4.00 lakhs in 10% debentures.
The equity capitalization rate is 12.5%. the company desires to redeem debentures Rs. 1.00 lakh.

You are required to calculate value of the firm and overall cost of capital.

ii. A company is considering introducing a new product. The equipment to manufacture will cost Rs. 5,60,000.
The life of the equipment is 8 years. The selling price of the product is Rs. 12, variable cost Rs.6 and annual
fixed cost Rs. 4,50,000 [including depreciation of Es. 70,000 based on straight line method and overheads of Rs.
30,000\

Expected sales 1,00,000 unit per year. Assume tax rate of 45% and discount rate of 12%. Should the company
be introducing the new product.

Q-3. The current EBIT is Rs. 10,000. The firm has 5% bonus aggregating to Rs. 40,000, while the 10%
preference shares amount Rs. 20,000. What would be the earnings per share. Assuming the EBIT being 1) Rs.
6,000 2) Rs.14,000 3) Number of ordinary shares is 1,000.

Solution

1 (100%) 2 (- 40) 3 (+40%)

EBIT 10,000 6,000 14,000

Less: interest on bonds 2,000 2,000 2,000

EBT 8,000 4,000 12,000

Less: Taxes (50%) 4,000 2,000 6,000

EAT 4,000 2,000 6,000

Less: preference dividend 2,000 2,000 2,000

Earnings available to shareholders 2,000 Nil 4,000

EPS = Earnings available to shareholders / No. of equity shares

= 2,000 / 1,000 = Nil / 1,000 =4,000 / 1,000

= Rs. 2 = Nil = Rs.4

DFL = Percentage changes in EPS / Percentage change in EBIT

= 100% / 40% = 2.5

= -100% / - 40% = 2.5

Q-4. A company’s expected annual net operating income (EBIT) is Rs. 50,000. The company has Rs. 3,00,000,
12.5% debentures. The equity capitalization rate (Ke) of the company is 12.5%.

Calculate the value of the firm according to NI approach.

Solution

EBIT = 50,000

Less: Interest 12.5% (3,00,000 x 12.5 / 100) = 37,500

-------------------

Earnings available to shareholders 12,500

Equity capitalization rate (Ke) = 12.5%

Market value of Equity = (NI / Ke)

= 12,500 x 12.5%

= 12,500 x 100 / 12.5 = Rs.1,00,000

Market value of debt = (B) = Rs. 3,00,000

Value of the firm = (V = S+B) = [3,00,000 + 1,00,000] = Rs. 4,00,000

Q-5. The firms after – tax cost of capital of the specific sources is as follows;

Cost of debt = 8%

Cost of preference shares = 14%

Cost of equity funds = 17%

The firm decided to raise Rs. 5,00,000 for expansion of its plant. It estimates that Rs. 1,00,000 will be available
as retained earnings and the balance of the additional funds will be raised as follows;

1. Long term debt Rs. 3,00,000

2. Preference shares Rs. 1,00,000

Compute the weighted average cost of capital.

Solution

Sources of funds Amount Proportion Cost Weight

a b c d (b x d)

Debt 3,00,000 60% 8% 24,000

Preference shares 1,00,000 20% 14% 14,000

Equity shares 1,00,000 20% 17% 17,000

Total 5,00,000 100% 55,000

Weighted average cost of capital = 55,000 / 5,00,000 = 0.11 or 11%

Q-6. Factors affecting capital structure

 Internal factor

 External factor

 General factor

1. Internal factor

 Cost of capital

 Risk

 Dilution of value

 Acceptability

 Transformability

 Fluctuating needs

 Increasing owner’s profit

 Surrender operational control

 Future flexibility

2. External factor

 General level of business activity

 Level of interest rates

 Availability of funds in the money market

 Tax policy on interest and dividends

3. General factors

 Size of business

 Character of capital requirements

  Growth of the firm

 Age of the firm

 Operational characteristics

 Continuity of earnings

 Marketable securities

 Government influences

 Corporate tax

Q-7. Theories of capital structure

In order to achieve the goal of identifying an optimum debt – equity mix, it is necessary for the finance manager
to be conversant with the basic theories underlying the capital structure of corporate enterprises.

The decision about the financial structure is irrelevant as regards to maximization of shareholders’ wealth. The
major approaches available for studying capital structure theories are as under;

 Net income approach

 Net operating income approach

 Modigilani – miller approach

i. Net income approach (NI)

According to Durand, “the capital structure decision is relevant to the value of the firm” according to this
approach a firm can minimize the weighted average cost of capital and increase in the value of the firm as well
as market price of equity shares by using debt financing to the maximum possible extend.

In other words, a change in capital structure leads to have a change in leverage and it makes a change in the
overall cost of capital as well as the total value of the firm.

According this approach, higher debt content in the capital structure will result in decline in the overall or
weighted average cost of the capital. This will cause increase in the value of the firm and consequently increase
in the value of equity shares of the company. Reverse will happen in converse situation.

To prove the above theory, additionally the following three assumptions are made

 There is no tax.

 Cost of debt is less than cost of equity

 The use of debt does not create risk

The implication of the three assumptions underlying the NI approach is that as the degree of leverage
increases, the proportion of an inexpensive source of funds, i.e., debt in the capital structure increases.

As a result the weight average cost of capital tends to decline, leading to an increase in the total value of
the firm. Thus, with the cost of debt and cost of equity being constant, the increased use of debt will magnify the
shareholder’s earnings and thereby, the market value of the ordinary shares.

Financial leverage is, according to the NI approach, an important variable in the capital structure decision of
a firm. With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will
be the one at which value of the firm is the highest and the overall cost of capital is lowest. At that stage, the
market price per share would be maximum.

According to this approach, capital structure decision is relevant in the valuation of the firm

Assumptions

 There is no corporate tax

 The cost of debt is less than that of equity or equity capitalization rate

 The debt content does not change the risk perception of the investors

NI= V = S + B

ii. Net operating income approach

Net Operating Approach is just opposite of Net Income Approach. According to this approach, the
market value of the firm is not at all affected the Capital Structure changes. The market value of the firm is
ascertained by capitalizing the net operating income at the overall cost of capital (K), which is considered to be
constant. The market value of equity is ascertained by deducting the market value of the debt from the market
value of the firm.

Assumptions

 The overall cost of capital (K) remains constant for all degree of debt – equity mix or leverage.

 The market capitalizes the value of the firm as a whole and, therefore, the split between debt and equity
is not relevant

 The use of debt having low cost increases the risk of equity shareholders

 There are no corporate taxes

iii. Modigliani – Miller Approach (MM)

M & M approaches to the NOI approach, if taxes are ignored. However if corporate tax are ignored.
Therefore, if corporate taxes are assumed to exit, their hypothesis is similar to NOI approach.

The theory proves that the cost of capital is not affected by changes in the capital structure or says that
the debt – equity mix is irrelevant in determination of the total value of the firm.

The reason argued is that though the debt is cheaper to equity, with increased use of debt as a source of
finance, the cost of equity increases. The increase in cost of equity offsets the advantage of the low cost of debt.
Thus, although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The
theory emphasis the fact that a firm’s operating income is a determined of its total value.

In the opinion of Modigliani and miller, two identical firms in all respects expect their capital structure
cannot have different market values or cost of capital because of arbitrage process. In case two identical firms
except for their capital structure have different market values or cost of control arbitrage will take place and the
investor will engage in ‘personal leverage’ as against the corporate leverage.

There are three basic proportions of the MM approach, namely

 The overall cost of capital (Ko) and the value of the firm (V) are independent of its capital structure.
The Ko and V are constant for all degree of leverage
  The Ko is equal to the capitalization rate of pure equity stream plus a premium for financial risk equal
to the difference between the pure equity – capitalization rate (K o) and Kt times the ratio of debt to
equity.

 The cut – off rate for investment purposes are complexly independent of the way in which an
investment is financed

Assumptions

 Perfect capital market

 There are no corporate taxes

 Investors Act rationally

 Investors are free to buy and sell securities

 There are no transaction costs

 The expected earnings of all the firm is capitalized rate

 Risk to investor, depends upon the random fluctuations of expected earnings

 All earnings are distributed to the shareholders

 The dividend payout ratio is 100%

Q-8. Describe the MM [Modigliani Miller] theories of capital structure

M & M approaches to the NOI approach, if taxes are ignored. However if corporate tax are ignored. Therefore,
if corporate taxes are assumed to exit, their hypothesis is similar to NOI approach.

a. In the absence of taxes

The theory proves that the cost of capital is not affected by changes in the capital structure or says that the debt
– equity mix is irrelevant in determination of the total value of the firm.

The reason argued is that though the debt is cheaper to equity, with increased use of debt as a source of finance,
the cost of equity increases. The increase in cost of equity offsets the advantage of the low cost of debt. Thus,
although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The theory
emphasis the fact that a firm’s operating income is a determined of its total value.

In the opinion of Modigliani and miller, two identical firms in all respects expect their capital structure cannot
have different market values or cost of capital because of arbitrage process. In case two identical firms except
for their capital structure have different market values or cost of control arbitrage will take place and the
investor will engage in ‘personal leverage’ as against the corporate leverage.

There are three basic proportions of the MM approach, namely

 The overall cost of capital (Ko) and the value of the firm (V) are independent of its capital structure.
The Ko and V are constant for all degree of leverage

 The Ko is equal to the capitalization rate of pure equity stream plus a premium for financial risk equal
to the difference between the pure equity – capitalization rate (K o) and Kt times the ratio of debt to
equity.
  The cut – off rate for investment purposes are complexly independent of the way in which an
investment is financed

Assumptions

 Perfect capital market

 There are no corporate taxes

 Investors Act rationally

 Investors are free to buy and sell securities

 There are no transaction costs

 The expected earnings of all the firm is capitalized rate

 Risk to investor, depends upon the random fluctuations of expected earnings

 All earnings are distributed to the shareholders

 The dividend payout ratio is 100%

b. Arbitrage process theory

The ‘Arbitrage process’ is operational justification of MM hypothesis. The term Arbitrage refers to an act of
buying an asset or security in the market having lower price and selling it in another market at a higher price.

The consequence of such action is that the market price of securities of the two firms remains exactly similar in
all respects except in their capital structure. This, however, cannot exist for longer period in different markets.
Thus, arbitrage process restores equilibrium in value of securities.

The total value of the homogeneous firms which differ only in respect of leverage cannot be different because of
the operation of arbitrage. The investors of the firm whose value in higher will see their shares and instead buy
the shares of the firm whose value is lower. Investor will be able to earn the same return at lower outlay with the
same perceived risk or lower risk.

They would, therefore, be better off. The behavior of the investors will have the effect of’

 Increasing the share prices – purchased

 Lowering the share price – sold

The essence of the arbitrage arguments of MM is that the investors are able to substitute personal leverage or
home – made leverage for corporate leverage, that is, the use of debt by the firm itself.

According to MM approach, the value of the firm can be calculated as follows;

Value of unlevered firm (Vu)

= EBIT / Overall cost of capital x (1 – t)

Q-9. Explain the forms and dividend policy

1. Regular dividend policy

 Payment of dividend at the rate is termed as regular dividend. The investors such as low-income peoples
prefer to get regular dividends. (Retired persons, Widows and other economically weaker persons)

A regular dividend offers the following advantages

 It establishes policy offers the following advantages

 It creates confidence amongst the shareholders

 It establishes the market value of shares

 It aids in long – term financing and renders financing easier

2. Stable dividend policy

The term stability of dividends means consisting or lack of variability in the stream of dividend payments. It
means payment of certain minimum amount of dividend regularly. A stable dividend policy may be established
in any of the following three forms.

 Constant dividend per share

Some companies follow a policy of paying fixed dividend per share irrespective of the level of
earnings year after year. A policy of constant dividend per share is most suitable to concern whose
earnings are expected to remain stable over a number of years.

 Constant payout ratio

The constant payout ratio means payment of a fixed percentage of net earnings as dividends every
year. the amount of dividend in such a policy fluctuates in direct promotion to the earnings of the
company.

 Stable rupee dividend plus extra dividend

Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the
year of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to
year.

3. Irregular dividend policy

Some companies follow irregular dividend payments on account of the following.

 Uncertainty of earnings

 Unsuccessful business operations

 Lack of liquid resources

 Fear of adverse effect of regular dividends

4. No dividend policy

A company may follow a policy of paying no dividends presently because of its unfavourable working
capital position or on account of requirements of funds for future expansion and growth.

Forms of dividend

1. Cash dividend
 A cash dividend is a usual method of paying dividends. Payments of dividend in cash result in outflow of
funds, reduces the company’s networth. The shareholders get an opportunity to invest the cash in any manner
they desire.

2. Scrip or bond dividend

A scrip dividend promises to pay the shareholders at a future specific date. In case a company does not
have sufficient funds to pay dividends in cash, it may issue notes or bonds for amounts due to the shareholders.
A scrip dividend bears interest and is accept as a collateral security.

3. Property dividend

It is paid in the form of some assets other than cash. Property dividend is distributed under exceptional
circumstances and is not popular, in our country.

4. Stock dividend

Stock dividend means the issue of bonus shares to the existing shareholders. If a company does not have
liquid resources it is better to declare stock dividend. Stock dividend amounts to capitalization of earnings and
distribution of profits among the existing shareholders without affecting the cash position of the firm.

Normally, the issue of bonus shares does not affect the wealth of shareholders. Earnings per share and
market price per share will fall proportionately to the bonus issue.

Q-10. Factors influencing dividend decision

1. Legal position

Section 205 of the Companies Act, 1956 which lays down the sources from which dividend can be paid,
provides for payment of dividend

 Out of past profits

 Out of money provided by the central / state Government, apart from current profits

Concerning declaration of dividend based on two important concepts.

 Profit available for distribution

 Profit available for dividend

2. Magnitude and Trend in EPS

EPS is the basis for dividend. The size of the EPS and trend in EPS in recent years set how much can
be paid as dividend. A high and steadily increasing EPS enables a high and steady increasing in DPS. When
EPS fluctuates a different dividend policy has to be adopted.

3. Taxability

According to section 205 (3) of the company Act, 1956 no dividend shall be payable except in cash.
Income Tax Act defines the term dividend so as to include any distribution of property or right having monetary
value.

4. Liquidity

Distribution of dividend results in out flow of cash and as such a reduction in working capital position.
Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront
with a week liquidity position. Under this situation while one company may prefer not to pay dividend since the
payment may impair liquidity, another company following a stable dividend policy may wish to declare
dividends even by restoring to borrowings for dividend payment in cash.

5. Working capital position.

Distribution of dividend results in out flow of cash and as such a reduction in working capital position.
The company borrows money for the sake of pursuing regular dividend policy. They may be adequate profit and
sufficiency of cash for payment of dividend. The payment of dividend depends on the policy of management.
The company may require funds to finance an expansion programme, and the directors may decide to skip the
payment of dividend, and instead retain the earnings and invest them in the expansion programme. But if the
management follows dividend policy, it may pay dividend and prefer to finance the expansion programme
through borrowings. This will be very much so, if the company enjoys an enviable record of perennial dividend
payments.

6. Impact of shareholders

The impact of dividends on market price of shares, through cannot be precisely measured, still one could
gauge the influence of dividend on the market price of shares. The dividend policy pursued by a company
naturally depends on how for the management is concerned about the market price of shares. Normally, an
increase in dividend payout results in a hike in the market price of shares. This is the significance as it has a
bearing on new issues. Established concerns may follow a stable dividend policy, instead of varying dividend
rates frequently. The market price of shares of former companies is higher than that of companies with
fluctuating dividend payments.

7. Control consideration

The directors wish to retain control, they may desire to finance growth programmes by retained earnings,
since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating
group. So, low dividend payout is favour by board.

8. Types of shareholders

The shareholders of the company prefer current dividend rather than capital gain a high payment is
desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require
periodical income or they have better investment avenues than the company. Retired persons, economically
weaker section and similarly placed investors prefer current income i.e., dividend. If on the other hand, majority
of the shareholders are moneyed people, and want capital gains, the low payout ratio is desirable. This is known
as clientele effect on dividend decision.

9. Industry norms

The industry norms have to be adhered to the extent possible. If most firms in the industry adopt a high
payout policy, perhaps others also have to adopt such a policy.

10. Age of the company

Newly formed companies adopt a conservative dividend policy that they can get stabilized and think of
growth and expansion.

11. Investment opportunities for the company

If the company has better investment opportunities and it is difficult to raise fresh capital quickly and at
cheap costs, it is better to adopt a conservative dividend policy. (r > K)

12. Restrictive covenants imposed by debt financiers

 Debt financiers, especially term leading financial institutions, may impose restrictive conditions on the rate,
timing and form of dividends declared. So, that consideration is also significant.

13. Floating cost, cost of fresh equity and access capital market

When floating cost and cost of fresh equity are high and capital market conditions are congenial for a
fresh issue, a low payout ratio is adopted.

14. Financial signaling

Dividends are the best medium to sell shareholders of better days ahead of the company. When a
company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on
stable growth path. Share prices immediately react positively.

Unit-4 Working capital requirement - REVIEW QUESTIONS

Q-1. YAMAHA Ltd. willing to purchase a business and has consulted you and one point on which you are
asked to advice them is average amount of working capital which will be required in the first year’s working.

You are given the following estimates and are instructed to add 10% to your computed figures to allow for
contingencies.

Figures for the year Rs.

1. Average amount locked – up in stocks

Stock of finished goods 7,500

Stock of stores and materials 12,000

2. Average credit given

Sales in India - 6 weeks 4,68,000

Sales in outside India – 1.5 weeks 1,17,000

3. Lag in payment of wages and other outgoings

Wages – 1.5 weeks 3,90,000

Stores, materials, etc – 1.5 months 72,000

Rent , royalties, etc – 6 months 15,000

Clerical staff – 0.5 month 93,600

Manager – 0.5 month 7,200

Miscellaneous expenditure – 1.5 months 72,000

4. Payment in advance

Sundry expenses – one quarter prepaid 12,000

5. Undrawn profit on the average throughout the year 16,500

Set up your calculations for the average amount of working capital required

Q-2. From the following estimates the average amount of working capital requirement

Particulars Rs.

1. Average amount locked – up in stocks

Stock of finished goods and W.I.P 0,000

Stocks of stores, materials, etc. 16,000

2. Average credit given

Local sales 2 weeks credit 2,08,000

Outside sales 6 weeks 6,24,000

3. Time available for payment

For purchase 4 weeks 1,56,000

For wages 2 weeks 5,20,000

Add 10% to allow for contingencies

Q-3. From the following information, you are required to estimate the net working capital M/S Arjun chemicals
Ltd.

Cost per unit

Rs.

Raw materials 40

Direct labour 15

Overheads 30

-----------------

85
 --------------

Additional information

1. Selling price per unit Rs. 100 per unit

2. Output 5,200 units

3. Raw material in stock – Average 4 weeks

4. Work-in-progress (Assume 50% completion stage with full material consumption) – 4 weeks

5. Finished goods in stock – Average 4 weeks

6. Credit allowed to customers (Debtors) – Average 8 weeks

7. Credit allowed by Suppliers – Average 4 weeks

8. Cash at bank is expected to be Rs. 5,000

Assume that production is sustained evenly during the 52 weeks of the year. All sales are on credit basis.

Q-4. A proforma cost sheet of a company provides the following particulars

Particulars Amt/unit

Elements of cost Rs.

Raw materials 80

Direct labour 30

Overheads 60

-------------

170

Profit 30

------------

Selling price 200

-------------

The following particulars are available

1. Output 52,000 units

2. Raw material in stock – Average one month

3. Work-in-progress (Assume 50% completion stage with full material consumption) – 2 weeks

4. Finished goods in stock – Average 4 weeks

5. Credit allowed to customers (Debtors) – Average 8 weeks

6. Credit allowed by Suppliers – Average 4 weeks

7. Cash at bank is expected to be Rs. 3,65,000

Assume that production is sustained evenly during the 52 weeks of the year. All sales are on credit basis.

Q-5. Cost sheet of the company provides the following information: elements of cost on sales, raw materials –
40%, labour – 10%, and overheads – 30%.

The following particulars are also available

1. Raw materials remain in stock for 8 weeks

2. Processing time 4 weeks

3. Finished goods are in stock for 4 weeks

4. Period of credit allowed to debtors 8 weeks

5. Lag in payment of wages – 4 weeks

6. Period of credit allowed by creditor’s 6 weeks

7. Selling price Rs. 100 per unit

8. Production in units 6,500 p.a

Prepare an estimate of working capital.

Q-6. The following are the projection of good limited for the financial year 2022-23. Based on the details
estimate the working capital requirement.

Annual sales – Rs. 14,40,000

Cost of production [includes depreciation of Rs. 1,20,000]- 12,00,000

Raw material purchased – Rs. 7,50,000

Monthly expenses-Rs. 30,000

Opening stock of raw materials- Rs. 1,40,000

Closing stock of raw materials – 1,25,000

The company has a policy of holding inventory of raw materials for 1.5 months. Work in progresses for 1
month, and finished goods for 4 weeks. The firm enjoys a credit period of 1 month on purchases and has a
collection period of 15 days. The company balso receives an advance of Rs, 15,000 on sales orders. The
minimum cash balance desired is Rs. 40,000.

Q-7. Factors determining working capital requirement

The working capital needs of a firm are determined and influenced by various factors. A wide variety of
considerations may affect the quantum of working capital required and these considerations may vary from time
to time. The working capital needed at one point of time may not be good enough for some other situation. The
determination of working capital requirement is a continuous process and must be undertaken on a regular basis
in the light of the changing situations. Following are some of the factors which are relevant in determining the
working capital needs of the firm:

1. Basic Nature of Business:

The working capital requirement is closely related to the nature of the business of the firm. In case of a retail
shop or a trading firm, the amount of working capital required is small enough. Most of the transactions are
undertaken in cash and the length of the operating cycle is generally small. The trading concerns usually have
smaller needs of working capital, however, in certain cases, large inventories of goods may be required and
consequently the working capital may be large. In case of financial concerns (engaged in financial business)
there may not be stock of goods but these firms do have to maintain sufficient liquidity all the times.

In case of manufacturing concerns, different types of production processes are performed. One unit of raw
material introduced in the production schedule may take a long period before it is available as finished goods for
sale. Funds are blocked not only in raw materials but also in labor expenses and overheads at every stage of
production. The operating cycle is usually a longer one and sales are made generally on credit terms. So, in
case of manufacturing concerns, there is a requirement of substantial working capital.

2. Business Cycle Fluctuations:

Different phases of business cycle i.e., boom, recession, recovery etc. also affect the working capital
requirement. In case of boom conditions, inflationary pressure appears and business activities expand. As a
result, the overall need for cash, inventories etc. increases resulting in more and more funds blocked in these
current assets. In case of recession period however, there is usually a dullness in business activities and there
will be an opposite effect on the level of working capital requirement. There will be a fall in inventories and
cash requirement etc.

3. Seasonal Operations:
If a firm is operating in goods and services having seasonal fluctuations in demand, then the working capital
requirement will also fluctuate with every change. In a cold drink factory, the demand will certainly be higher
during summer season and therefore, more working capital is required to maintain higher production, in the
form of larger inventories and bigger receivables. On the other hand, if the operations are smooth and even
through out the year then the working capital requirement will be constant and will not be affected by the
seasonal factors.

4. Market Competitiveness:

The market competitiveness has an important bearing on the working capital needs of a firm. In view of the
competitive conditions prevailing in the market, the firm may have to offer liberal credit terms to the customers
resulting in higher debtors. Even larger inventories may be maintained to serve an order as and when received;
otherwise the customer may go to some other supplier. Thus, the working capital tends to be high as a result of
greater investment in inventories and receivable. On the other hand, a monopolistic firm may not require larger
working capital. It may ask the customers to pay in advance or to wait for some time after placing the order.

5. Credit Policy:

The credit policy means the totality of terms and conditions on which goods are sold and purchased. A firm has
to interact with two types of credit policies at a time. One, the credit policy of the supplier of raw materials,
goods etc., and two, the credit policy relating to credit which it extends to its customers. In both the cases,
however, the firm while deciding its credit policy, has to take care of the credit policy of the market. For
example, a firm might be purchasing goods and services on credit terms but selling goods only for cash. The
working capital requirement of this firm will be lower than that of a firm which is purchasing cash but has to sell
on credit basis.

6. Supply Conditions:

The time taken by a supplier of raw materials, goods etc. after placing an order, also determines the working
capital requirement. If goods are received as soon as or in a short period after placing an order, then the
purchaser will not like to maintain a high level of inventory of that good. Otherwise, larger inventories should
be kept e.g., in case of imported goods. It is often seen that the shopkeepers may not be keeping stock of all
items, but whenever there is a demand, they procure from the wholesaler/producer and supply it to their
customers.
Thus, the working capital requirement of a firm is determined by a host of factors. Every consideration is to be
weighted relatively to determine the working capital requirement. Further, the determination of working capital
requirement is not once a while exercise, rather a continuous review must be made in order to assess the
working capital requirement in the changing situation. There are various reasons which may require the review
of the working capital requirement e.g., change in credit policy, change in sales volume etc.

Q-8. Factors affecting size of working capital

 Nature of business

 Manufacturing cycle

 Time lag between production and sales

 Policies relating to production

 Credit period and terms

 Rapidity of turnover

 Cyclical fluctuations

 Regularity in supply of raw materials

 Seasonal business

 Intensity of competition

 Operating efficiency

 Dividend policy

 Nature of raw materials used

 Fluctuation in the price of raw materials

 Wage rates

 Finished goods

 Fuel price

 Pressure on working capital

Unit-5 Long-term financing [ REVIEW QUESTIONS]

Q-1. New issue market and Stock exchange

The New Issue Market and Stock Exchange are inter-linked and work in conjunction with each other. They
cannot be described as two separate markets because of the kind of functions they perform. Although they differ
from each other in the sense that the New Issue Market deals with ‘new securities’ issued for the first time to the
public and the stock exchange deals with those securities which have already been issued once to the public,
they are complementary in nature because of this particular function. The ‘new issues’ first placed with the NIM
have a regular and continuous Buying and selling in the stock exchange when secondary purchases have to be
made by the investor.

The NIM, therefore, functions as a ‘direct’ link between the companies which require a provision for funds and
the investing public. The Stock Exchange provides capital to firms ‘indirectly.’ The transactions relating to
purchase and sale of securities, while providing both liquidity and marketability, do not involve firms in the
transfer of stocks form one person to another. The stock exchange is, thus, an important medium to transfer of
resources for those shares which have already been issued. It also plays a role in the transfer of securities with
the companies whose shares are being dealt with as the process of registration of shares must be conducted
when they are transferred.

The second factor which makes the role of the NIM and Stock Exchange complementary to each other is the
infrastructural facilities provided for the ‘ selling and Buying’ of securities. The NIM does not have a physical
existence but the service as is provided in India is taken up entirely by the brokers and commercial banks. The
New Issue Shares, in the private corporate sector, are subscribed to go through the application forms supplied by
the brokers before the date of commencement of the issue. On the opening day of the issue, these forms can also
be collected from the authourised banks.

The authorised bankers also undertake the function of collection of forms and receiving the amount on
application. The NIM thus does not have a physical form or existence, but there are agencies which provide the
facilities which are conducive to the sale of the new issues.

The stock exchange unlike the New Issue Market provides all the facilities in the form of a market. It is a well-
established organization with professional brokers, financial literature, information about companies and the
daily stock exchange lists are supplied for information to the investors. This is also a place where dealers of
security meet regularly at an appointed time announced by the market. The Bombay Stock Exchange is well
organized with proper electronic gadgets to receive information about stock prices from other parts of the
country. It also gives the daily changes in prices of stocks.

Another related factor between the NIM and Stock Exchange is the relative strength and public confidence in
their joint participation in the sale, purchase and transfer of securities. In India, NIM and the Stock Exchange are
connected to each other even at the time of the New Issue. The usual practice by the firms issuing securities is to
register themselves on a stock exchange by applying for listing of shares. Listing of shares provides the firm
with an added prestige and the investing publics are encouraged with this service.

The advantage of listing on a recognized stock exchange is that it widens the market for the investor. It provides
the investor with the facility of sale of his shares, thus offering him a ‘market’ for immediate liquidity of funds.
Secondly, the working of the stock exchange and NIM provides a greater protection for the investing public as
the companies applying for stock exchange registration are bound by the statutory rules and regulations of the
market.

Further, the securities market is closely connected to each other because of the sensitive nature of the
movements of stock prices. Stock prices are to a great extent affected by environmental such as political
stability, economic and social conditions, industrial pattern, monetary and fiscal policies of the government. The
long-term and short-term changes in these factors have an effect on the day-to-day changes in prices of stocks.

The New Issue Market depends on the stock exchange to find out these price movements and the general
economic outlook to forecast the climate for investing and the success of new issues floated in the NIM. Thus,
the prices of shares in the NIM are sensitive to changes in the stock market and act and react accordingly and in
the same direction. The general outlook in the market will show a “downswing” in the trading activity of
securities.

Q-2. Role of the New Issue Market

The New Issue Market has three functions to perform. These may be put together and referred to as the
‘performing’ role of the NIM.

These functions as described by Briston are;

(a) Origination

(b) Underwriting

(c) Distribution.
The interplay of these functions helps to transfer resources from the sources of surplus funds to those who
require these funds, i.e. the ultimate users of these funds.

a. Origination

Origination is the work which begins before an issue is actually floated in the market. It is the stage where initial
‘Spade Work’ is conducted to find out the investment climate and to be sure that if the issue is floated, it will be
subscribed to by the public. The factors which have to be carefully analysed are regarding the soundness of the
project. Soundness of the project refers to its technical feasibility backed by its economic and financial viability.
It is also concerned with background factors which facilitate the success of an issue.

The underlying conditions are;

i) The Time of Floating of an Issue: This determines to mood of the investment market. Timing is crucial
because it has a reflection on the subscription of an issue. Periods of Buoyancy (PoB) will clearly show over-
subscription to even ordinary quality issues and are marked by the general lack of public support during
depression.

ii) Type of Issue: This refers to the kind of securities to be issued weather equity, preference, debentures or
convertible securities. These have significance with the existing trends in the investment market. Sometimes,
there is a sudden spurt of new issue of shares market with government support and tax incentives. Investors are
keen buyers of such an issue.

The success of one encourages issues of these kinds to be floated. In these times, the market will have little
support from even sound and good issues of other types of securities. The kind of marketability of the issue is an
important analysis at the time of origination.

iii) Price: The encouragement of the public to a particular issue will largely depend on the price of an issue.
Well established firms of some group connections may be able to sell their shares at a premium at the time of a
new issue, but relatively unknown firms will have to be cautious of the price. Price of Shares of these firms
should be fixed at par. There is a danger of fixing prices at a discount as these may undervalue the firm and
bring down their reputation.

The functions of the NIM at the time of origination are, therefore, based on preliminary investigation and are
mainly advisory in nature. Since 1981, the function of origination has been taken over in India by certain
specialized divisions of commercial banks. Commercial banks have created a special cell called the ‘merchant
banking’ division through which they advise the companies about the viability of the project. Merchant Banking
was first started in 1969 in India by Grindlays Banks. They look the entire function of working out the necessary
inputs and details for floating an issue including the function of origination of only those firms in whom they
believed that success could be achieved.

The Merchant Banking Divisions of Commercial Banks in India do not undertake to achieve the success of
floatation of an issue. This division began its operations with the view of the country. They do not help out only
superior firms but try to conduct their services towards the less superior firms also. The impact of the Merchant
Banking Division of the banks is slowly being felt in the market for industrial securities. Origination coupled
with the function of underwriting ensures success of an issue.

Underwriting is kind of guarantee undertaken by an institution or firm of brokers ensuring the marketability of
an issue. It is a method whereby the guarantee makes a promise to the stock issuing company that he would
purchase a certain specified number of shares in the event of their not being invested by the public. Subscription
is thus guaranteed even if the public does not purchase the shares for a commission from the issuing company.
These are;

(a) Life Insurance Corporation of India (LIC)

(b) Unit Trust if India (UTI)

(c) Development Banks like Industrial Development Bank of India (IDBI), Industrial Finance Corporation of
India (IFCI), Industrial Credit and Investment Corporation of India (ICICI)

(d) General Insurance Companies (GIC)

(e) Commercial Banks (CB)

(f) Brokers.

The methods adopted by these groups and their pattern of underwriting show a definite type of institutional role.

LIC and UTI both have emerged as the most important institutional underwriters in the capital market in India.
Their underwriting pattern is marked by the policy of the underwriting firm, i.e. buying industrial securities
from the new issue market with the view of holding the securities on their own portfolio. Both the institutions
show a marked performance for underwriting shares in large and well established firms and those belonging to
established industrial centers like Maharashtra, Gujarat, West Bengal and Tamil Nadu Their pattern was marked
by the absence of underwriting in ‘small’ and ‘new’ enterprises. Since 1980, Life Insurance Corporation has
withdrawn to a great extent from the sphere of underwriting. Unit Trust of India has become the most
dominating underwriter in the NIM.

The pattern of underwriting of Development Banks is somewhat different to the institutional investors like LIC
and UIT. They are gap fillers and are looked upon as engines of economic development while they also
underwrite ‘firms’, they have given special attention to the growth of issues in backward states and those
industries which are useful for the development of the economic status of the country, or those industries which
fall in the priority list. The thrust of the Development Bank is also towards encouragement of small and new
issues which do not have adequate support from other institutions.

The Development Banks of the nature of state orientation that is, the State Financial Corporations underwrite
issues which are floated in the State of their origin. Their aim is to under-write that issue which will contribute
to the industrialization of their own state.

The General Insurance Companies are bound by Section 27B of the Insurance Act of 1938. The Act directs
them to make investments in a particular manner. Although their investment policy resembles LIC to a great
extent, yet their underwriting pattern shows certain differences in approach, General Insurance Companies have,
unlike the LIC, underwritten in companies which are fairly ‘new’ and are not established in the industrial sector.
They have also not shown preference to ‘group’ issues of well-known family industrial houses. Their
contribution in small issues can also be identified.

The Commercial Banks, to be great extent, have remained away from the underwriting sphere. They are better
known for their function as agents engaged in the distribution of shares for a commission. Even if they have
undertaken issue, it has been on an ad-hoc basis. They have not believed in an underwriting firm. They may
keep the shares in their own portfolio or off-load them in the stock market for a price. They, therefore, do not
have a particular direction in underwriting. They are also known to underwrite small amounts only.

They brokers do not underwrite a ‘firm’. They guarantee shares only with the view of earning commission from
the company floating its shares. They are known to off-load their shares later again to make a profit. The
broker’s policy can thus be identified with the ‘profit motive’ in underwriting industrial securities.

The New Issue Market has a third function besides the function of origination and underwriting. The third
function is that of distribution of shares. Distribution means the function of sale of shares and debentures to the
investors. This is performed by brokers and agents. They maintain regular lists of clients and directly contact
them for purchase and sale of securities.

Q-3. Mechanics of Floating New Issues

The objectives of the New Issue Market are to centre its activities towards the floatation of New Issues.

The methods by which the new issues are placed in the market are:

(a) Public Issues

(b) Offer for Sale

(c) Placement

(d) Right Issues.

(a) Public Issues: The most popular methods for floating shares in the New Issue Market is through a legal
document called the ‘Prospectus’. The issuing company makes an offer to be public directly of a fixed number
of shares at a specific price. Two features are noticeable in floatation through the prospectus method:
(i) It is almost always underwritten by strong public financial institutions in India. This adds prestige to the
firm’s shares. It also encourages the public as such underwriting gives a financial backing to the issuing
company.

(ii) The securities of issuing companies are usually offered at their par value. If the issuing company is sure of
full subscription, only then it offers shares at a premium. New companies rarely offer shares at a premium and
existing well-known established companies sometimes offer shares at a premium.

Offer to the public is made through prospectus. The contents of the prospectus are;

(a) Name of the company.

(b) Address of the Registered Office of the company.

(c) Activities of the company, existing business functions and its proposal for the future .

(d) Location of the Industry.

(e) Names of the Directors of the firm.

(f) Minimum subscription.

(g) Dates when subscription is opened and date of closing offer.

(h) Institutions underwriting the issue, their names, address and amounts underwritten.

(i) A statement made by the company that it will apply to the stock exchange for the quotation of its shares.

Sale through prospectus is a direct method of floatation of shares. Intermediaries are not involved but it is an
expensive method of flotation of shares. The company has to incur expenses on administration, advertisement,
printing, prospectus, paper announcements, bank’s commission, underwriting commission, agents’ fees, legal
charges, stamp duty, document fees, listing fees and registration charges.

(b) Offer for Sale: This is a method of flotation of shares through an ‘intermediary’ and ‘indirectly’ through an
‘issuing house’. It involves sale of securities through two distinct steps.

1. The first step is a direct sale by the issuing company to issuing house and brokers.

2. The second step is also a second sale of these securities involving the issue house and the public.

The price of the shares is obviously at a higher rate to the public than for which the ‘issuing house’ (or
intermediary) purchases form the ‘issuing company’. The profit charged by the issuing house is called a ‘turn’.
This method is not used in India. It is widely used for floatation as described in the public offer method. In
India, offer for sale method is sometimes used when a foreign company floats its shares. Offer for sale as used
in Indian terminology has a different meaning. It is used not for selling securities to the public but to comply
with certain stock exchange regulations at the time of listing of shares.

In India, the existing shareholders make an offer to the public for subscription so that the securities become
widely distributed to the public, i.e. to the extent of 49+. This offer would grant a stock exchange quotation.
Offer for sale even in this sense is not used often in India as a method of flotation of securities.

(c) Placement: This is another method of flotation not used normally in the Indian capital market. In the London
Stock Exchange, this is operative and is used for an issuing house to sell shares to its own clients. ‘The Issuing
Houses’ or ‘Intermediaries’ purchase shares from companies issuing their shares. Subsequently, the issuing
house sells these shares for a profit. The issuing houses maintain their own list of clients and through customer
contacts sell shares.
The main disadvantage of this method is that the issues remain relatively unknown. A small number of investors
buy a large number of shares and are in this way able to corner the shares of firms.

This method is useful when small companies are issuing their shares. They can avoid the expenses of issue and
also have their shares placed.

Timing is crucial from the point of view of floatation of shares. In a depressed market condition, when these
issues are not likely to get proper public response through prospectus placement method, this is an excellent
process for the floatation of shares.

(d) Right Issues: Shares floated through ‘right issues’ are a measure for distribution of shares normally used for
established companies which are already listed in the stock exchange. Sometimes, this method of floatation is
used by new companies also.

Right issues are an inexpensive mode of floatation of shares. This is an offer made to existing shareholders
through a formal letter of information. In India, according to Section 81 of the Companies Act, 1956

(a) One year after the company’s first issue

(b) or Two years after its existence, right shares must be issued first to existing shareholders.

The shares can also be offered to the public after the rights of the existing shareholders have been satisfied.
These shares are issued in proportion to the shares held by the existing shareholders. This right can be taken
away by the company by passing a special resolution to this effect.

Q-4. Types of capital

a. Equity capital

b. Preference capital

c. Debentures capital

a. Equity capital

Equity shareholders are the real owners of the business. They received the tail profits of the company after
having paid the preference shareholders and other creditors of the company. Their liability is restricted to the
amount of share capital they contributed to the company.

Equity capital provides the issuing firm the advantage of not having any fixed obligation for dividend payment
but offers permanent capital with limited liability for repayment

However, the cost of equity capital is higher than other capital.

Firstly, since the equity dividends are not tax-deductible expenses

Secondly, the high costs of issue

In addition to this since the equity shareholders enjoy voting rights, excess of equity capital in the firms’ capital
structure will lead to dilution of effective control.

b. Preference capital

Preference shares have some attributes similar to equity shares and some to debentures. In simple, preference
shares are shares, which are having priority to declaration of dividend and insolvency.
Like in the case of equity shareholders, there is no obligation payment to the preference shareholders; and the
preference dividend is not tax deductible. However, similar to the debenture holders, the preference shareholders
earn a fixed rate of return for their dividend payment.

In addition to this, the preference shareholders have preference over equity shareholders to the post-tax earnings
in the form of dividends; and assets in the event of liquidation.

Types of preference capital

a. Cumulative preference shares

b. Non-cumulative preference shares

c. Redeemable preference shares

d. Irredeemable preference shares or perpetual preference shares

e. Convertible preference shares

f. Non- convertible preference shares

g. Participating preference shares

h. Non- participating preference shares

i. Cumulative convertible preference shares

c. Debentures capital

Debenture means acknowledgement of debt. In other words, a debenture is a marketable legal contract whereby
the company promises to pay its owner, a specified rate of interest for a defined period of time and to repay the
principal at the specified date of maturity.

Debentures are usually represented by a trustee and this trustee is responsible for ensuring that the borrowing
company fulfils the contractual obligation embodied in the contract.

i. Debentures redemption reserve (DRR)

If the company issues debentures with a maturity period of more than 18 months, then it has to create a
debenture redemption reserve, which should be at least half of the issue amount before the redemption
commences. The company can also attach call and put option.

ii. Types of debentures

a. Convertible debentures (CDs)

b. Non- convertible debentures (NCDs)

c. Fully convertible debentures (FCDs)

d. Partly convertible debentures (PCDs)

e. Registered debentures

f. Bearer debentures

g. Secured debentures
h. Unsecured debentures

i. Redeemable debentures

j. Irredeemable debentures

k. equitable debentures

l. Legal debentures

m. Preferred debentures

n. Fixed rate debentures

o. Floating rate debentures

p. Zero coupon debentures

q. Foreign currency convertible debentures

a. Convertible debentures

These debentures are converted into equity shares and will be redeemed at before or end of the maturity period.

b. Non- convertible debentures (NCDs)

These debentures cannot be converted into equity shares and will be redeemed at end of the maturity period.

c. Fully convertible debentures (FCDs)

These debentures can be converted into equity shares after a specified period of time at one stroke or in
installment.

d. Partly convertible debentures (PCDs)

These are debentures, a portion of which will be converted into equity shares after a specified period of time.

e. Registered debentures

Registered debentures are recorded in a register of debenture – holders with full details about the number, value
and type of debentures held by the debenture holders.

f. Bearer debentures

The debentures which are payable to the bearer are called bearer debentures The name of the debenture holders
are not recorded in the register of debenture holders.

g. Secured debentures

The debentures which are secured by mortgage or change on the whole or part of the assets of the company are
called secured debentures..

h. Unsecured debentures

Unsecured debentures are those which do not carry any charge on the assets of the company. These are, also,
known as ‘naked debentures’.

i. Redeemable debentures
The debentures which are repayable after a certain period are called redeemable debentures.

j. Irredeemable debentures

The debentures which are not redeemed during the life time of the company are called irredeemable debentures.

k. Equitable debentures

Equitable debentures are those which are secured by deposit of the title of the property with a memorandum in
writing to create a charge.

l. Legal debentures

Legal debentures are those in which the legal ownership of the property of the corporation is transferred by a
deed to the debenture holders, as security loan.

m. Preferred debentures

Preferred debentures are those which are paid first in the event of winding up of the company.

n. Fixed rate debentures

Those debentures carry a fixed rate of interest.

o. Floating rate debentures

Those debentures carry floating rate of interest.

p. Zero coupon debentures

Such debentures are not carry periodical interest coupons.

q. Foreign currency convertible debentures

Those debentures are issued in overseas market in the currency of the country where the floatation takes place.

Q-5 Leasing

A lease is a contract in which the owner of the asset, called lessor, allows the use of the asset to another party,
called lessee, for a specified period of time, referred as the lease period, in exchange for periodic payments,
called lease rentals.

Most of us have entered into lease agreements of some sort at some time or the other. For example the hiring of
a taxi for a day.

In simple words, leasing is an asset – based financing mechanism. Leasing separates ownership and usage. One
who uses the asset is called lessee and the one who owns the asset is called a lessor.

Asset

Lessor ---------------------------------- Lessee

(Owner of the asset) Rentals (User of the asset)

The lessor owns the asset but does not use it, which the lessee uses the asset but does not own it. Normally
assets are owned by the firms because they have to be put them to use for making economic gains.
Under a lease, assets are not owned by the firms. Leasing provides the unique advantage of separating
ownership and usage.

Advantages of leasing

 Financial benefits

 Flexibility of lease

 Risk of obsolescence

 Need for maintenance

 Specialized services

Advantages to lessor

 Lease is an additional financial product involving ownership and risk taking for a reward in terms of
rentals

 Lease improve profitability due to attached tax benefits to the lessor

 It is a marketing strategy for capital intensive goods like plant and machinery

 It provides a competitive edge foe sale of the product by the manufacturer

 Lease arrangement is a simple documents

 Less formalities than bank borrowing

 As a financial technique it is more rewarding and attractive to lessor

 It is flexible

 It can be opened and closed quickly

Advantages of lessee

 Leasing provides 100% finance

 Leasing preserves and improves the cash position

 It is flexible and can be adjusted to the cash flow forecast

 It achieves gearing and provides a hedge against inflation

 It helps the tax planning

 It is off balance sheet method of financing

 It is straight forward, simple and efficient

Q-6. Types of leases

Lease can be classified in two categories:

1. Financial lease

2. Operating lease
3. Amortization of lease

1. Financial lease

Financial lease is a financing mode. Used as one of the means of financing the equipment, the lease agreement
normally provides for an operator to accompany the equipment.

Types of financial lease

 Leveraged lease

 Sale and lease back

 Cross border leases

 Foreign to foreign lease

2. Operating lease

Operating lease includes the other benefits for the lessee. The lessor does so because he / she is responsible for
the running and maintenance of the equipment, or the lessee may not have the necessary skills to operate the
equipment. Such lease is known as an operating lease.

For example, hiring a taxi with its driver.

3. Amortization of lease

Amortization of lease refers to the issue of whether the full cost of the asset and profit thereon is recovered in a
single lease agreement. If the entire cost and profit are recovered through lease rentals, the lease is classified as
fully amortized.

In simple words, when the lease rents cover the capital cost and profit, the lease is said to be fully amortized

Q-7. Operating leverage and financial leverage

Operating lease Financial lease

Not fully amortized Fully amortized

Maintenance by lessor Maintenance by lessee

Insurance by lessor Insurance by lessee

Rest with lease only cancelled Generally non-cancellable

Lessor reserves the right to offer lease to another Lessee usually has a right to renew
party

High risk with the lessor Transferred substantially to the lessee

Lessor repossesses the asset Lessee normally buys the asset

Q-8. Hire purchase

Another popular means of acquiring an asset is hire purchase. The hirer pays a fixed installment periodically
over the hire purchase period, just as the lessee pays lease rents in a lease transaction.

The similarity between hire purchase and lease possibly end here. In the treatment of taxes, ownership, and cash
flows, the hire purchase transaction becomes different from a lease transaction.

Hire purchase transactions are extremely popular in the automobile industry. Normally, some part of the
equipment cost has to be paid in advance by the hirer while the finance company contributes major portion.

In a hire purchase system, the asset is procured by the finance company which lets it out for use by the hirer for
a specified period, and lets the purchase take place at the end of the hire period, subject to full and timely
payment of all the installments. The asset is purchased in the name of the hirer to enable him to claim
depreciation.

The hirer becomes the complete and legal ownership of the asst only upon payment of the final installment.
Each installment is treated as hire charges, to facilitate recovery of asset in case of defaults.

Each payment of hire purchase is like repayment of a loan along with interest. The amount of each installment is
bifurcated into principal and interest. The hirer can claim only the interest portion as expenses and not the
principal.

Comparison of lease and hire purchase

Lease Hire purchase

Owner ship

With lessor Remains with hirer and transferred upon payment of

final installment

Ownership at the end

Lessee has no right to own the leased asset Hirer has right own upon payment of final
installment

Depreciation

Claimed by lessor Claim by hirer

Tax deductibility

To the lessee for the entire amount of lease rent Tax deductibility only on the interest portion of
installment

Extent of finance

Entire capital cost is borne by lessor Some portion of the capital cost is contributed by
hirer

Claim on salvage value

With the lessor With hirer

Q-9. Venture capital financing

Venture capital is risk money, which is used in risky enterprise either as equity or debt capital. It may be in new
sunshine industries or older risk enterprise. The funds which finance such risky ventures are called venture
finance or funds.

Venture capital was born and popularized in the USA in the sixties. In developed countries, this capital came
from pension funds, insurance companies and even large scale banks. Some large companies with excess funds
may provide this capital to achieve diversification, market expansion and a ‘window on technology’ or to share
in the results of research and development of others.

In India, as the majority of the above institution are in the public sector, only the government or public financial
institution can provide the funds for venture capital.

Indian position

In India, most project financing schemes require at least 25% of the project cost to be contributed by the
promoters, while the latter can raise barely 5% to 10%.

At present, there are a few agencies such as IFCI’s subsidiary company, Risk Capital and Technology
Foundation of India, which provides finance to bridge the shortfall in the promoter’s contribution, but they
cannot fulfill the requirement of a great many budding entrepreneurs.

As a result of promoters not being able to bring in those vital initial inputs of money, many of their good
projects are hanging fire. Venture capital finance could remedy this situation as well.

A beginning was made in this direction by the setting of venture capital divisions under the control of ICICI,
IFCI, IDBI, UTI, and TDICI.

Need for Growth of Venture Capital Finance

 There is need for encouragement of risk capital in India

 This will widen the industrial base of, high – tech industries and promote the growth of
technology.

 Extending the investment range of such funds to embrace unquoted stocks

 Introducing more genuine investors

 Improve market liquidity

 Improve equity cult

 Move towards a freer and less regulated market

 Stimulate the entry of the private sector into risk capital formation

Q-10. Private equity

Private equity is a pooled investment vehicle used for making investments in various equity (and to a lesser
extent debt) securities according to one of the investment strategies associated with private equity. Private
equity is typically limited partnerships with a fixed term of 10 years (often with annual extensions). At
inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn
over the term of the fund.

A private equity is raised and managed by investment professionals of a specific private equity firm (the
general partner and investment advisor). Typically, a single private equity firm will manage a series of distinct
private equity funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully
invested.

A private equity fund typically makes investments in companies (known as portfolio companies). These
portfolio company investments are funded with the capital rose from Leveraged Portfolios, and may be partially
or substantially financed by debt. Some private equity investment transactions can be highly leveraged with debt
financing.

Private equity applicable to the following firms

• Private equity firms

• Venture capital firms

• Portfolio companies

Q-10. Financial markets

Financial markets are the markets in which securities are bought and sold. Securities market plays an extremely
important role in an economy. An efficient and integrated financial market is an important infrastructure that
facilities savings, investments and consequent economic growth.

Functions of financial markets

The primary role of financial markets is to allocate the resources in an economy. They perform the following
three important functions:

a. Facilitating price discovery

Financial markets facilitate continual interaction among a large number of buyers and sellers. Thereby the
prices of financial securities are established. The fairness in the pricing of a security depends on the efficiency
of the market.

b. Providing Liquidity:

The most important function of financial markets is to provide liquidity for the securities. Liquidity refers to the
ease and convenience with which a financial security can be sold or bought at a reasonable price. In the absence
of financial markets the investors would not like to hold securities.

c. Reduce the cost of transaction

The two major costs associated with buying and selling an asset are search costs and information costs. Search
costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset
and implicit costs such as the effort and time one has to put in to find out a buyer or seller. Information costs
refer to costs incurred in evaluating the merits of an asset.

Types of Financial Markets

Financial markets may be classified in several ways. The following three types of classifications are discussed.

i. By maturity of claims
ii. By the type of financial claim
iii. By the type of issue
On the basis of maturity of claims, the market may be classified into money market and capital market.

Money market
Money market is the market for short-term securities with a maturity period of one year or less. Short-term
securities are always debt securities and hence the money market is the market for short-term debt securities.

Capital market

Capital market on the other hand is the market for long-term securities. Long term securities include the debt
securities with a maturity of more than one year and equity stocks.

The second way of classifying financial markets is by the type of financial claim. A financial claim may be a
fixed claim or a residual claim. Debt securities have a fixed claim and equity shares have a residual claim.
Hence, the market may be classified into debt market and equity market.

The third way of classifying a financial market is on the basis of type of issue i.e. new issues or outstanding
issues. The market for the new issues is referred to as primary market and the market for the outstanding issues
is referred to as secondary market. In a primary market a company is the seller and the transaction leads to
raising capital for the company. Companies generally engage in two types of primary market transactions:
Public issues and Private placements. A public issue, as the name suggests, involves selling securities to the
general public. Whereas, private placement is a negotiated sale involving a specific buyer.

Public issues can be made after the consent of Securities and Exchange Board of India (SEBI) and as per the
SEBI regulations. The cost of public issues is considerable. Private placements are made to large financial
institutions such as LIC, GIC or mutual funds. The cost of private placements is significantly less.

In a secondary market transaction one owner of equity or debt securities sells his holdings to another. Therefore,
a secondary market provides the means for transferring ownership in financial securities.

Q-11. Functions of SEBI

The ever-expanding investors’ population led to a horde of malpractices on the part of the companies, brokers,
merchant bankers, investment consultants and various other agencies involved in new issue. This led to an
erosion of investor confidence and multiplied their grievances. The Government and stock exchanges were
helpless because the existing legal frame work was just not enough.

Later, the Government realizing this problem, SEBI was constituted in April, 1988, and given legal status in
1992, as a supervisory body to regulate and promote the securities market.

 Promote fair dealings

 Provide a degree of protection to the investors

 Regulate and develop a code of conduct

Powers of SEBI

 Power to call for periodical returns from stock exchange

 Power to call upon the stock exchange to furnish relevant information

 Power to appoint any person to make inquiries into the affairs of the exchange to furnish the relevant
information

 Power to amend bye-laws of stock exchange

 Power to compel a public company to list its shares in any stock exchange