Financial Management b.com s3

8/8/2019 Financial Management b.com s3

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Financial Management III Semester B.Com

St.Berchmans [2010-11] [email protected]

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENTFINANCIAL MANAGEMENTFINANCIAL MANAGEMENTFINANCEFINANCEFINANCEFINANCE---- MeaningMeaningMeaningMeaning

Finance is defined as the provision of money at the time when it is required. The finance can

be basically classified into two:1. Public finance2. Private finance

Public finance deals with requirements, receipts and disbursements of funds in the

government institutions likes states, local self governments and central government.

Private finance concerned with requirements, receipts and disbursements of funds in the

case of individuals, a profit seeking business organisation and a non- profit business

organisation.

Private finance can be again classified into business finance, personal finance and financeof non profit organisation.

Business FinanceBusiness FinanceBusiness FinanceBusiness Finance

Business finance can be defined as an activity of or process which is concerned with

acquisition of funds, use of funds and distribution of profits of a business firm. Business

finance can be again divided into 3 ie, sole trader finance, partnership finance and

corporate finance.

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENTFINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

Financial management refers to that part of the management activity which is concerned

with the planning and controlling of firms financial resources.

Importance of financial managementImportance of financial managementImportance of financial managementImportance of financial management

1. Helps in financial planning and successful completion of an enterprise.2. Helps in acquisition of funds as and when required at the minimum possible cost3. Helps in proper use and allocation of funds4. Helps in taking sound financial decisions5. Helps in improving the profitability through financial control6. Helps in increasing the wealth of the investors and nation7. Helps in promoting and mobilising individual corporate savings

Finance functionFinance functionFinance functionFinance function

It is the most important of all business functions, because the need for money is continuous.

AIMS OF FINANCE FUNCTIONAIMS OF FINANCE FUNCTIONAIMS OF FINANCE FUNCTIONAIMS OF FINANCE FUNCTION

1. Acquiring Sufficient Funds.1. Acquiring Sufficient Funds.1. Acquiring Sufficient Funds.1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial

needs of enterprise and then finding out suitable sources for raising them. The sources

should commensurate with the needs of the business. If funds are needed for longer periods

then long-term sources like share capital, debentures, term loans may be explored. A


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concern with longer gestation period should rely more on owners funds instead of interest-

bearing securities because profits may not be there for some years.

2. Proper Utilisation of Funds.2. Proper Utilisation of Funds.2. Proper Utilisation of Funds.2. Proper Utilisation of Funds. The funds should be used in such a way that maximum

benefit is derived from them. The return from their use should be more than their cost. It

should be ensured that funds do not remain idle at any point of time. The funds committed

to various operations should be effectively utilised. Those projects should preferred which

are beneficial to the business.

3. Increasing Profitability.3. Increasing Profitability.3. Increasing Profitability.3. Increasing Profitability. The planning and control of finance function aims at increasing

profitability of the concern. It is true that money generates money. To increase profitability,

sufficient funds will have be invested. Finance function should be so planned that the

concern neither suffers from inadequacy of fund nor wastes more funds than required. A

proper control should also be exercised so that scarce resources are r. frittered away on

uneconomical operations. The cost of acquiring funds also influences profitability of

business.

4. Maximising Firms Value4. Maximising Firms Value4. Maximising Firms Value4. Maximising Firms Value. Finance function also aims at maximising the value of the firm.

A concerns value is linked with its profitability. Besides profits, the type of sources used for

raising funds, the cost of funds, the condition of money market, the demand for products

are some other considerations which also influence a firms value.

SCOPE OF FINANCIAL MANAGEMENTSCOPE OF FINANCIAL MANAGEMENTSCOPE OF FINANCIAL MANAGEMENTSCOPE OF FINANCIAL MANAGEMENT

1.1.1.1. Estimating FiEstimating FiEstimating FiEstimating Financial Requirements.nancial Requirements.nancial Requirements.nancial Requirements.The first task of a financial manager is to estimate short-term and long-term financial

requirements of his business. For this purpose, he will prepare a financial plan for present

as well as for future. The amount required for purchasing fixed assets as well as needs of

funds for working capital will have to be ascertained. The estimations should be based on

sound financial principles so that neither there are inadequate nor excess funds with the

concern. The inadequacy of funds will adversely affect the day-to-day working of the

concern whereas excess funds may tempt a management to indulge in extravagant

spending or speculative activities.

2. Deciding Capital StructureDeciding Capital StructureDeciding Capital StructureDeciding Capital Structure.The capital structure refers to the kind and proportion of different securities for raising

funds. After deciding about the quantum of funds required it should be decided which type

of securities should be raised. It may be wise to finance fixed assets through long-term

debts. Even here if gestation period is longer, then share capital may be most suitable. Long-

term funds should be employed to finance working capital also, if not wholly then partially.

Entirely depending upon overdrafts and cash credits for meeting working capital needs maynot be suitable. A decision about various sources for funds should be linked to the cost of


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raising funds. If cost of raising funds is very high then such sources may not be useful for

long. A decision about the kind of securities to be employed and the proportion in which

these should be used is an important decision which influences the short-term and long-

term financial planning of an enterprise.

3. Selecting a Source of Finance.Selecting a Source of Finance.Selecting a Source of Finance.Selecting a Source of Finance.After preparing a capital structure, an appropriate source of finance is selected. Various

sources from which finance may be raised, include : share capital, debentures, financial

institutions, commercial banks, public deposits, etc. If finances are needed for short periods

then banks, public deposits and financial institutions may be appropriate; on the other

hand, if long-term finances are required then share capital and debentures may be useful. If

the concern does not want to tie down assets as securities then public deposits maybe a

suitable source. If management does not want to dilute ownership then debentures should

be issued in preference to shares. The need, purpose, object and cost involved may be the

factors influencing the selection of a suitable source of financing.

4.4.4.4. Selecting a Pattern of Investment.Selecting a Pattern of Investment.Selecting a Pattern of Investment.Selecting a Pattern of Investment.When funds have been procured then a decision about investment pattern is to be taken.

The selection of an investment pattern is related to the use of funds. A decision will have to

be taken as to which assets are to be purchased. The funds will have to be spent first on

fixed assets and then an appropriate portion will be retained for working capital. Even in

various categories of assets, a decision about the type of fixed or other assets will be

essential. While selecting a plant and machinery, even different categories of them may beavailable. The decision-making techniques such as Capital Budgeting, Opportunity Cost

Analysis etc. may be applied in making decisions about capital expenditures. While

spending on various assets, the principles of safety, profitability and liquidity should not be

ignored. A balance should be struck even in these principles. One may not like to invest on a

project which may be risky even though there may be more

profits.

5. Proper Cash Management.Proper Cash Management.Proper Cash Management.Proper Cash Management.Cash management is also an important task of finance manager. He has to assess various

cash needs at different times and then make arrangements for arranging cash. Cash may be

required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills ;

(d) meet day- to-day expenses. The usual sources of cash may be: (a) cash sales , (b)

collection of debts, (c) short-term arrangements with banks etc. The cash management

should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash

will damage the creditworthiness of the enterprise. The idle cash with the business will

mean that it is not properly used. It will be better if Cash Flow Statement is regularlyprepared so that one is able to find out various sources and applications. If cash is spent on


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avoidable expenses then such spending may be curtailed. A proper idea on sources of cash

inflow may also enable to assess the utility of various sources. Some sources may not be

providing that much cash which we should have thought. All this information will help in

efficient management of cash.

6. Implementing Financial Controls.Implementing Financial Controls.Implementing Financial Controls.Implementing Financial Controls.An efficient system of financial management necessitates the use of various control devices.

Financial control devices generally used are, : (a) Return on investment, (b) Budgetary

Control, (c) Break Even Analysis., (d) Cost Control, (e) Ratio Analysis (i) Cost and Internal

Audit. Return on investment is the best control device to evaluate the performance of

various financial policies. The higher this percentage better may be the financial

performance. The use of various control techniques by the finance manager will help him

in evaluating the performance in various areas and take corrective measures whenever

needed.

7. Proper Use of Surpluses.Proper Use of Surpluses.Proper Use of Surpluses.Proper Use of Surpluses.The utilisation of profits or surpluses is also an important factor in financial management. A

judicious use of surpluses is essential for expansion and diversification plans and also in

protecting the interests of shareholders. The ploughing back of profits is the best policy of

further financing but it clashes with the interests of shareholders. A balance should be

struck in using funds for paying dividend and retaining earnings for financing expansion

plans, etc. The market value of shares will also be influenced by the declaration of dividend

and expected profitability in future. A finance manager should consider the influence ofvarious factors, such as : (a) trend of earnings of the enterprise, (b) expected earnings in

future, (c) market value of shares, (d) need for funds for financing expansion, etc. A

judicious policy for distributing surpluses will be essential for maintaining proper growth

of the unit.

OBJECTIVES OF FINANCIAL MANAGEMENTOBJECTIVES OF FINANCIAL MANAGEMENTOBJECTIVES OF FINANCIAL MANAGEMENTOBJECTIVES OF FINANCIAL MANAGEMENT

Financial management is concerned with the procurement and use of funds. Its main aim is

to use business funds in such a way that the firms value is maximised. The main objectiveof a business is to maximise the owners economic welfare and it can be achieved by;

1. Profit maximisation2. Wealth maximisation

Profit maximisationProfit maximisationProfit maximisationProfit maximisation

Profit earning is the main aim of every economic activity. Profit is a measure of efficiency of

a business enterprise. The accumulated profits enable a firm to face risks like fall in prices,

competition from other units, etc. There are so many arguments in favour and against profit

maximisation


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For:For:For:For:

When profit earning is the aim of business then the profit maximisation should bethe objective.

Profitability is the barometer of efficiency of a business organisation. Profits are the main sources of finance for the growth of the business. So it should

aim maximising profits

Profitability is essential for fulfilling social goals.Against:Against:Against:Against:

The term profit is vague and it cannot be defined. It ignores the time value of money and not considers the magnitude and timing of

earnings.

It does not consider the prospective earnings stream. The effect of dividend policy on the market price of share is not considered. Profit maximisation leads to exploiting workers and consumers Immoral and leads to malpractices and corruptive actions It leads to inequalities and lowers human values which are an essential part of an

ideal social system.

Wealth maximisationWealth maximisationWealth maximisationWealth maximisation

When the firm maximises the stockholders wealth, the individual stockholder can use this

wealth to maximise his individual utility. In other words by maximising stockholders

wealth the firm is operating consistently towards maximising stockholders utility.There are so many arguments in favour and against wealth maximisation, like;

For:

It serves the interest of all stakeholders of the business [shareholders, creditors,employees etc]

Consistent with the objective of owners economic welfare It implies the long term survival and growth of the business It considers the risk factor and time value of money The effect of dividend policy on market price of share is also considered It leads to maximising shareholders utility

Against:Against:Against:Against:

It is not socially desirable It does not give an idea about, what the firm should do to maximise the wealth It is not clear that whether the wealth of the shareholders or the wealth of the firm is

to be increased.

The objective faces difficulty when the management is separated from ownership


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FINANCIAL DECISIONSFINANCIAL DECISIONSFINANCIAL DECISIONSFINANCIAL DECISIONS

It refers to the decisions concerning the financial matters of a business firm. They can be

broadly classified as under;

1. Investment decisions2. Financing decisions3. Dividend decisions

Investment decisionsInvestment decisionsInvestment decisionsInvestment decisions

It refers to the determination of total amount of assets to be held in the firm, the proportion

of the assets and business risk associated with it. In other words it is a decisions related to

the investment in fixed assets and current assets and the proportion of these two in the

business firm. Investment decisions are broadly classified into;

a. Long term investment decisionsb. Short term investment decisions

Long term investment decisions are known as the capital budgeting and short term

investment decisions are known as working capital management.

Financing decisionsFinancing decisionsFinancing decisionsFinancing decisions

It means the selection of the sources of fund which will make the optimum capital

structure. At the time of raising of finance the financial managers has to strike a balance

between various sources so that the overall profitability of the business firm and wealth of

the shareholders are maximised.

Dividend decisionsDividend decisionsDividend decisionsDividend decisionsDividend refers to that part of the profit of the company, which is distributed among its

shareholders. A dividend decision includes whether all the profit are to be distributed or

retain all the profit in the business or retain a part of the profit and distribute the rest as

dividend.


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TIME VALUE OF MONEYTIME VALUE OF MONEYTIME VALUE OF MONEYTIME VALUE OF MONEYThe concept time value of money explains that the value of money received today is more

than the value of same amount of money received after a certain period. In other words

money received in the future is not as valuable as money received today. As per the timevalue of money concept, the sooner one receives, the money the better it is. The value of

current receipt of money is higher than the future receipt of money after one year. This

phenomenon is known as time preference of money.

Reasons for time preference of money

1. The future is uncertain and involves risk. Therefore an individual can never becertain of getting cash inflow in future and hence he will like to receive the money

today itself, instead of waiting for the future.

2.

For people the present needs are more urgent than the future needs.3. Opportunities available to invest the money received at the earlier days at the some

interest or otherwise to enhance the future earnings.

TechniquesTechniquesTechniquesTechniques oooof Time Valuef Time Valuef Time Valuef Time Value oooof Moneyf Moneyf Moneyf Money

There are 2 techniques to adjust time value of money;

1. Compounding technique2. Discounting technique.1.1.1.1. COMPOUNDING TECHNIQUECOMPOUNDING TECHNIQUECOMPOUNDING TECHNIQUECOMPOUNDING TECHNIQUE

The time preference for money encourages a person to receive money at present instead of

waiting for future. But he may like to wait if he duly compensated for the waiting time by

way of money at the end of a period. The future value of money at the end of a period can

be calculated by using the formula.

VVVV1111=V=V=V=V0000(1+i)(1+i)(1+i)(1+i)nnnn

Where;

V1= future value of money at the end.

V0= value of money at the beginning

i = interest rate

n= no. of years

Doubling PeriodDoubling PeriodDoubling PeriodDoubling Period

Doubling period means the length of period within which an amount is going to take

double at a certain rate of interest. Doubling period can be calculated be following either

Rule 72 or Rule 69

Rule 72Rule 72Rule 72Rule 72

Doubling period = 72/ Rate of interest

RuleRuleRuleRule 69696969

Doubling period = 0.35+(69/ Rate of interest)


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Multiple compoundingMultiple compoundingMultiple compoundingMultiple compounding

Multiple compounding period means the compounding the interest more than once in a

year like, half yearly or quarterly.

VVVVOOOO= V= V= V= V1111(1+i/m)(1+i/m)(1+i/m)(1+i/m)m x nm x nm x nm x n

where;

V1= future value of money at the end of a period

V0= value of money at the beginning

i = rate of interest

n= no. of years

m= frequency of compounding per year

Effective rate of interestEffective rate of interestEffective rate of interestEffective rate of interest

Effective rate of interest means the additional growth in the rate of interest due to multiple

compounding. It is because the actual rate of interest realised [effective rate of interest] in

multiple compounding is more than the normal rate of return.

EIR= (1+i/m)m-1

Where;

i = the normal rate of interest

m= frequency of compounding per year

Future value of series of paymentsFuture value of series of paymentsFuture value of series of paymentsFuture value of series of payments

VVVVnnnn= R= R= R= R1111(1+i)(1+i)(1+i)(1+i)nnnn----1111+ R+ R+ R+ R2222(1+i)(1+i)(1+i)(1+i)

nnnn----2222 + R+ R+ R+ R3333(1+i)(1+i)(1+i)(1+i)nnnn----3333

Where;Vn=future value of series of payments

R1= payment after first period

R2= payment after second period

R3= Payment after third period

i= rate of interest

n= no. of years

Compounded value of annuityCompounded value of annuityCompounded value of annuityCompounded value of annuity

An annuity is a series of equal payments lasting for some specified duration. When cashinflows occur at the end of each period the annuity is called a regular annuity or deferred

annuity.

VVVVnnnn= R [= R [= R [= R [((((1+i)1+i)1+i)1+i)nnnn----1111+( 1+i)+( 1+i)+( 1+i)+( 1+i)nnnn----2222+( 1+i)+( 1+i)+( 1+i)+( 1+i)nnnn----3333]]]]

or

Vn= R [ACFVn= R [ACFVn= R [ACFVn= R [ACFi,ni,ni,ni,n]]]]

Where;

Vn= future value of annuity

R= equal paymentsn= No .of years


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ACF= annuity compound factor

Compounded value of annuityCompounded value of annuityCompounded value of annuityCompounded value of annuity duedueduedue

If the cash inflow occurs at the beginning of each period the annuity is called annuity due.

Vn=Vn=Vn=Vn= R [ACFR [ACFR [ACFR [ACFi,ni,ni,ni,n]( 1+i)]( 1+i)]( 1+i)]( 1+i)

Where;

Vn= future value of annuity

R= equal payments

n= No .of years


ACF= annuity compound factor

2.2.2.2. DISCOUNTING TECHNIQUEDISCOUNTING TECHNIQUEDISCOUNTING TECHNIQUEDISCOUNTING TECHNIQUEThe present value is exact the opposite of compound value or future value. While the future

value shows how much sum of money becomes at future period, present value shows what

the present value of some future sum of money. The present value of money to be received

in future will always be less. The present value of a future sum of money can be calculated

as follows;

VVVV0000= V= V= V= Vnnnn//// ((((1+i)1+i)1+i)1+i)

or

VVVV0000= V= V= V= Vnnnn X DFX DFX DFX DFi,ni,ni,ni,n

Where;V0= present value of money

Vn= future value of money


DF= discount factor

N= no.of years

Present value of series of paymentsPresent value of series of paymentsPresent value of series of paymentsPresent value of series of payments

VVVV0000= [R= [R= [R= [R1111/(1+i)] +[R/(1+i)] +[R/(1+i)] +[R/(1+i)] +[R2222/(1+i)/(1+i)/(1+i)/(1+i)2222] +[R] +[R] +[R] +[R3333/(1+i)/(1+i)/(1+i)/(1+i)

3333] +[R] +[R] +[R] +[R4444/(1+i)/(1+i)/(1+i)/(1+i)4444]]]]

Where;Vn=future value of series of payments

R1= payment after first period

R2= payment after second period

R3= Payment after third period

i= rate of interest

n= no. of years

Present value of annuityPresent value of annuityPresent value of annuityPresent value of annuity

An annuity is a series of equal payments lasting for some specified duration.VVVV0000==== R [ADFR [ADFR [ADFR [ADFi,ni,ni,ni,n]]]]


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0

Where;

Vn=future value of series of payments

R= series of equal payments

i= rate of interest

n= no. of years

Present value of annuity duePresent value of annuity duePresent value of annuity duePresent value of annuity due

If the cash inflow occurs at the beginning of each period the annuity is called annuity due.

VVVV0000==== R [ADFR [ADFR [ADFR [ADFi,ni,ni,ni,n]( 1+i)]( 1+i)]( 1+i)]( 1+i)

Where;

Vn=future value of series of payments

R= series of equal payments

i= rate of interest

n= no. of years

ADF= annuity discounting factor


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1

WORKINGWORKINGWORKINGWORKINGCAPITALCAPITALCAPITALCAPITALMANAGEMENTMANAGEMENTMANAGEMENTMANAGEMENTWorking capital management is concerned with the problems that arise in

attempting to discuss in details various tools and techniques which can be gainfully

employed to solve the problem of determining optimum level of working capital.Working capitalWorking capitalWorking capitalWorking capital ---- MeaningMeaningMeaningMeaning

Working capital is defined as the "excess of current assets over current liabilities

and provisions". That is, the amount of surplus of current assets which remain after

deducting current liabilities from total current assets which is equal to the amount

invested in working capital, consisting of work-is-progress, raw materials and stocks,

consumable items, amounts owing by customers and cash at the or bank in hand.

Shubin defines working capital as the amount of funds necessary for the cost of

operating the enterprise. Working capital in a going concern is a revolving fund; consist ofcash receipts from sales which are used to cover the cost of operation.

In accounting working capital is the difference between inflow and out flow of

funds. In other words it is the net cash flow. It is also known as circulating capital,

fluctuating capital and revolving capital.

Need for Working CapitalNeed for Working CapitalNeed for Working CapitalNeed for Working Capital

Working Capital is significant because of:

a. Adequate working capital is required to continue uninterrupted businessoperations

b. It is essential to run the day to day business activitiesc. Greater volume of working capital required to invest in current assets for the

success of sales activities

d. To ensure the maximizing the wealth of the firme. To enable to increase the rate of return on investmentf. To meet the short-term obligations of a business enterprise To increase the

operational efficiency of a firm

g. To utilize the maximum available resourcesConcepts of working capitalConcepts of working capitalConcepts of working capitalConcepts of working capital

There are two concepts of working capital

a. Balance sheet andb. Operating cycle concept

BalanceBalanceBalanceBalance sheet conceptsheet conceptsheet conceptsheet concept

There are two variations of working capital under this concept:

1. Gross working capital2. Net working capital

Gross Working Capital: The term Gross Working Capital refers to the total of all current


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assets. In other words, the firm's investments in total current or circulating assets. Current

assets represent short term securities, sundry debtors, bills receivable, stock (inventories)

etc. The Gross concept of working capital is very suited to company organization where

ownership is separated from management and control.

Advantages of Gross Working Capital:Advantages of Gross Working Capital:Advantages of Gross Working Capital:Advantages of Gross Working Capital:

This concept has the following advantages:

(1) It provides the amount of working capital at the right time.(2) It enables a firm to realize the greatest return on its investment.(3) It helps in the fixing of various financial responsibilities.(4) It helps to the top executives to make plan and control funds and to maximize the

return on investment.

(5) It enables a firm to operate its business more efficiently.Net Working Capital : The net concept of working capital is qualitative, indicating the firms

ability to meet its operating expenses and current liabilities. The term net working capital

refers to the difference between current assets and current liabilities.

Net working capital = current assets current liabilities.

Current assetsCurrent assetsCurrent assetsCurrent assets are those assets which in the ordinary course of business can be, or will be

turned in to cash within one year undergoing a diminution in the value or without

disrupting the operations of the firm. Current assets= cash+ marketable securities+

accounting receivables+notes and bills receivables +stock

Current liabilitiesCurrent liabilitiesCurrent liabilitiesCurrent liabilities are those liabilities which are intended at their inception to be paid in theordinary course of business, within a year, out of the current assets or earnings of the

concern. Current liability= accounts payable+ bills payable+ outstanding expenses+ shortter

loans

Positive or negative working capital:Positive or negative working capital:Positive or negative working capital:Positive or negative working capital: the working capital of a firm may be positive or

negative working capital. If the value of current liabilities is more than current assets then it

is negative working capital.

Difference between gross concept and net concept of working capitalDifference between gross concept and net concept of working capitalDifference between gross concept and net concept of working capitalDifference between gross concept and net concept of working capital

Net Working CapitalNet Working CapitalNet Working CapitalNet Working Capital Gross Working CapitalGross Working CapitalGross Working CapitalGross Working Capital

Net working capital is the concept ofqualitative nature.

It is indicating the firm's ability tomeet its operating expenses and

current liability.

It expressed as current assets minuscurrent liability.

It is a concept very popular in

Gross concept of working capital isquantitative nature.

It is pointing out the total amountavailable for financing the current

assets.

It indicating the total sum ofCurrent assets.

It is a concept very popular in


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accounting system.

Net concept suitable for sole Traderand partnership firms.

It is useful to find out the truefinancial position of a company.

financial management circles.

Gross concept suitable forcompanies

It can not reveal the true financialposition of a company.

Operating cycle conceptOperating cycle conceptOperating cycle conceptOperating cycle concept

Working capital refers to that part of a firms capital which is required for financing short

term or current assets. The operating cycle concept of working capital is based on operating

cycle of firm. The term operating cycle otherwise known as "Cash Cycle". In order to earn

sufficient profits, a firm has to depend on its sales activities apart from others. Sales are not

always converted into cash immediately, i.e., there is a time lag between the sale of a

product and the realization of cash. The continuing flow from cash to supplier to investors,

to account receivable and back in cash. This time gap is technically termed as operating

cycle.

In case of a manufacturing firmmanufacturing firmmanufacturing firmmanufacturing firm, the duration of time required to complete the

following sequence of events is called the operating cycle.

(1) Conversion of cash into raw materials(2) Conversion of raw materials into work-in-progress(3) Conversion of work-in-progress into finished goods(4) Conversion of finished goods into accounts receivable and(5) Conversion of accounts receivable into cash.

In the case of nonnonnonnon----manufacturing firmmanufacturing firmmanufacturing firmmanufacturing firm, the operating cycle will include the length of time

required to convert:

(a) Cash into inventories;(b) Inventories into accounts receivable;(c) Accounts receivable into cash.


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In the case of service and financial concernsservice and financial concernsservice and financial concernsservice and financial concerns may not have any inventory at all. So the

operating cycle include the length of time taken for direct conversion of cash. The

following formula is used to express the duration of working capital cycle

O =R+W+F+DO =R+W+F+DO =R+W+F+DO =R+W+F+D----CCCC [[[[where]

O==== total period of the operating cycle in number of days

R= number of days for holding stock of raw materials and stores

W= number of days for holding stock of work in progress with regard to cost of production

F= number of days for holding stock of finished goods with regard to cost of production

D= debtors collection period

C= credit payment period.

KindsKindsKindsKinds of Wof Wof Wof Working Capitalorking Capitalorking Capitalorking Capital

The Working Capital includes the following broad classifications

1. On the basis of Concepta. Gross Working Capitalb. Net Working Capital

i. Positive Net Working Capitalii.

Negative Net Working Capital

2. On the basis of Timea. Permanent Working Capital

i. Regular working capitalii. Reserve working capital

b. Temporary Working Capitali. Seasonal working capital

ii. Special working capitalPermanent Working Capital:Permanent Working Capital:Permanent Working Capital:Permanent Working Capital: The minimum amount of current assets why are kept by a

firm over the entire year to ensure uninterrupted course of operation. The minimum level


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of current asset is referred to as permanent working capital. It is termed as Regular

Working Capital or Core Working Capital or Fixed Working Capital. Permanent working

capital is classified as regular working capital and reserve working capital. Regular

working capital ensures the circulation of current assets from cash to stock, from stock to

debtors and debtors to cash and so on. Reserve working capital is the excess amount over

the requirement for regular working capital which may be provided for contingencies

situations.

Permanent Working Capital has following characteristics;

a. Continue to exist for a longer period of time in the business.b. Constantly changes in the business from one asset to another.c. Required to meet permanent obligations along with other fixed assets.d. Grows the size or volume of business operations.e. Classified on the basis of the time factor.f. Minimum level of working capital always required to be maintained.

Temporary Working Capital:Temporary Working Capital:Temporary Working Capital:Temporary Working Capital: Any amount over and above the permanent level of working

is Temporary or Fluctuating or Variable Working Capital. In other worlds, it represents

additional current assets required to meet fluctuations during the operating year. As it

fluctuates according to the level of operation, it is termed as Fluctuating working

Capital. Temporary working capital is classified as Seasonal working capital and special

working capital. Seasonal working capital is for meeting the seasonal requirements and

special working capital for meeting special situations like, launching new marketingcampaigns etc.

Temporary working capital has following characteristics;

a. It is an extra working capital needed to changing production and sales activities.b. It is created to meet `liquidity requirements.c. Temporary working capital is fluctuating during the operating period.d. It fluctuates according to the level of operations.e. It is needed for shorter period.

Reasons for change in working capital.Reasons for change in working capital.Reasons for change in working capital.Reasons for change in working capital.1. Change in the level of sales activities2. Change in the level of operating activities3. Policy change initiated by management4. Technological changes5. Cyclical change in the economy6. Changes in the operating cycle7. Sources of change is seasonally in sales activity.

Dangers of Excess Working CapitalDangers of Excess Working CapitalDangers of Excess Working CapitalDangers of Excess Working CapitalThe success and otherwise of a business depends on the adequacy of the said capital


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maintaining a desired level. Both excessive or inadequate working capital poses a serious

problem to a company which may even lead to its doom. Excessive working capital means

idle fund which earn no profits for the firm. Inadequate working capital impairs firm's

profitability and liquidity . When working capital is excessive, a firm faces the following

1) It leads to unnecessary purchase and accumulation of inventories.

(2) Excessive working capital results in imbalance between liquidity and profitability(3) It is an indication of defective credit policy(4) A company may not be tempted to overtrade and lose heavily.(5) Excessive working capital leads to operational inefficiency because large volume of

funds not being used productively.

(6) This makes management complacent which degenerates into managerialinefficiency.

(7) High liquidity may induce a firm to undertake great production which may nothave a matching demand.

Dangers of Inadequate Working CapitalDangers of Inadequate Working CapitalDangers of Inadequate Working CapitalDangers of Inadequate Working Capital

When working capital is inadequate, a firm faces the following problems.

(1) Inadequate working capital causes stagnates growth and expansion(2) It may not able to utilize production facilities fully(3) It becomes difficult to take advantages of profitable business opportunities(4) It may not able to efficiently utilized fixed assets. This leads to low profitability(5) A firm may not able to take advantages of cash discount facilities.(6) Inadequate working capital causes paucity of funds. This leads to damage credit-

worthiness of the firm

(7) It may not able to meet short term obligation(8) Inadequate working capital causes unable to pay its dividends and interest(9) A firm may not able to meet its day to day commitments. This leads to firm, loses its

reputation.

FactorsFactorsFactorsFactors determindetermindetermindetermininginginging thethethethe Working CaWorking CaWorking CaWorking Capitalpitalpitalpital

The total working capital requirement is determined by a wide variety of factors. Itshould be however, noted that these factors affect different enterprises differently. The

following is the description of the factors which generally influence the working

capital requirements of the firms.

Internal factors.Internal factors.Internal factors.Internal factors.

1. Nature of Enterprise.2. Size of business3. Manufacturing cycle4. Firms credit policy5. Access to money market


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6. Expansion and growth of business7. Profit margin and dividend policy8. Depreciation policy9. Operating efficiency of the firm10.Co-ordination activities of the firm

External factorsExternal factorsExternal factorsExternal factors

1. Business cycle fluctuations2. Technological developments3. Seasonal fluctuations4. Environmental factors5. Taxation policy

Internal FactorsInternal FactorsInternal FactorsInternal Factors

(1) Nature of Enterprise:Nature of Enterprise:Nature of Enterprise:Nature of Enterprise: The working capital requirements of a firm basicallyinfluenced by the nature of its firm. For example, trading and financial firms

require a large amount of investment in working capital but a significantly smaller

amount of investment in fixed assets. But in the case of manufacturing concern

have to invest substantially in working capital and a normal amount in fixed assets.

In contrast public utilities have a very limited need for working capital, while a

merchandising department depends generally on inventory and receivable need a

large amount of working capital. Needs for working capital are thus determined by

the nature of an enterprise or business.(2)(2)(2)(2) Size of Business.Size of Business.Size of Business.Size of Business. The size of the firm is also an important factor to requirements of

working capital. Because a smaller firm needs smaller amount of working, capital on the

basis of its production activities and vise versain the opposite case.

(3)(3)(3)(3) Manufacturing Cycle:Manufacturing Cycle:Manufacturing Cycle:Manufacturing Cycle: Time span required for conversion of raw materials intofinished goods is to block period. The period in reality extends a little before and after the

work-in-progress. This cycle determine the need of working capital.

(4)(4)(4)(4) Firm's Credit Policy:Firm's Credit Policy:Firm's Credit Policy:Firm's Credit Policy: The level of working capital is also determined by credit policywhich relates to sales and purchases. The credit policy influences the requirement ofworking capital in two ways (a) Through credit terms granted by the firm to

customers/ buyers of goods; (b)Credit terms available to the firm from its creditors.

(5)(5)(5)(5) Access to Money Market:Access to Money Market:Access to Money Market:Access to Money Market: Working capital requirements of a firms are condition--- bythe firms access to different sources of money market. Thus, firm with readily available credit

from banks and trade credit facilities at liberal terms will be able to get by W-= less

working capital than a firm without such facilities.

(6)(6)(6)(6) ExpaExpaExpaExpansion and Growth of Business:nsion and Growth of Business:nsion and Growth of Business:nsion and Growth of Business: It is obvious that, as business expands it willrequire more working capital in terms of sales or fixed assets. In the case of growth andexpansion, there will be an increase in investment. With the increase in fixed assets for


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increasing sales the requirement of working capital will be expanded not only for

financing increased volume of raw materials but also to finance maintenance of

inventory stock and grant credit to customers.

(7)(7)(7)(7) Profit Margin and Dividend Policy:Profit Margin and Dividend Policy:Profit Margin and Dividend Policy:Profit Margin and Dividend Policy: Magnitude of working capital in a firm dependupon its profit margin and dividend policy. As a matter of fact, a high net profit margin

reduces the working capital requirements of the firm because it contribute towards

working capital pool. Similarly, distribution of high proportion of profits in the form of

dividend result in a drain on cash resources and thus reduces company's working capital to

that extend. Where the management follows constructive dividend policy and retain

larger portion of the net profits, the company's working capital position is strong.

(8)(8)(8)(8) Depreciation Policy:Depreciation Policy:Depreciation Policy:Depreciation Policy: The depreciation policy influences the level of working capital byaffecting the tax liability and retained earnings of the enterprise. Since depreciation is tax

deductible expense item, this will affect the firm's tax liability and retained earnings and

thus strengthen the firm's working capital position.

(9)(9)(9)(9) Operating Efficiency of Firm:Operating Efficiency of Firm:Operating Efficiency of Firm:Operating Efficiency of Firm: The operating efficiency of management is also animportant determinant of the level of working capital management can contribute to a

sound working capital position through operating efficiency. Efficiency of operations

accelerates the pace of the cash cycle and improves the working capital turnover.

(10)(10)(10)(10)CoCoCoCo----ordination Activities of Firm:ordination Activities of Firm:ordination Activities of Firm:ordination Activities of Firm: In addition, absence of co-ordination inaction and distribution policies in a company results in a high demand for working capital.

Where production and distribution activities are co-ordinate, pressure on working capitalwill be minimized.

External FactorsExternal FactorsExternal FactorsExternal Factors

(1)(1)(1)(1) Business Cycle FluctuBusiness Cycle FluctuBusiness Cycle FluctuBusiness Cycle Fluctuations:ations:ations:ations: This is another factor which determines the need level.Barring exceptional cases, there are variations in the demand for goods/services handled by

any organization. Economic boom/recession have their influence on the transactions and

consequently on the quantum of working capital required.

(2)(2)(2)(2) Technological Development:Technological Development:Technological Development:Technological Development: Changes in technologies may lead to improvements inprocessing raw materials, minimizing wastages, greater productivity, more speed ofproduction. All these improvements may enable the firm to reduce investments in

inventory. Thus changes in technology affect the requirements of working capital. If the

firm decides to go for automation, thus world reduce the requirements for working capital. If

the firm adopts a labour intensive process, the requirement for working capital will be

larger

(3)(3)(3)(3) Seasonal Fluctuations:Seasonal Fluctuations:Seasonal Fluctuations:Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variableworking capital. Often the demand for products may be of a seasonal nature. Yet

inventories have got to be purchased during certain seasons only. The size of workingcapital in one period may therefore, be bigger than that in another.


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(4)(4)(4)(4) Environment Factors:Environment Factors:Environment Factors:Environment Factors: Political stability in its wake bring in stability in money marketand trade world. Risk ventures are possible with enhanced need for working capital

finance.

(5)(5)(5)(5) Taxation Policy:Taxation Policy:Taxation Policy:Taxation Policy: Taxes must be paid out of profits. Tax liability is unavoidable andadequate provision should be made for it in working capital planning. If the tax liability

increases, it will impose an additional strain on working capital. The finance manager must

do tax planning in order to avail the benefits of all sorts of tax concessions and incentives.

Working Capital Financing MixWorking Capital Financing MixWorking Capital Financing MixWorking Capital Financing Mix

There are three basic approaches for determining the working capital financing mix. They

are;

1. Hedging or matching approach2. Conservative approach3. Aggressive approach1.1.1.1. Hedging ApproachHedging ApproachHedging ApproachHedging Approach

This approach suggests that the permanent working capital requirement should be financed

with funds from long term sources while the temporary working capital should be financed

with short term funds.

2.2.2.2. Conservative approachConservative approachConservative approachConservative approachAs per this approach, the entire estimated investments in current assets should be financed

from long term sources and the short term sources should be used only for emergency

requirements. In this finance mix liquidity is greater, risk is minimum and cost is relativelyhigh.

3.3.3.3. Aggressive approachAggressive approachAggressive approachAggressive approachThis approach suggests that, the entire estimated requirements of current assets should be

financed from short term sources and even a part of fixed assets requirements be financed

from short term sources. This finance mix is more risky, less costly and more profitable.

Principles of working capital management policyPrinciples of working capital management policyPrinciples of working capital management policyPrinciples of working capital management policy

The following are the sound principles of a sound working capital management policy;

1. Principle of risk variation2. Principles of cost of capital3. Principle of equity position4. Principle of maturity of payment.

Principle of risk variation:Principle of risk variation:Principle of risk variation:Principle of risk variation:

There is inverse relationship between risk and profitability. A firm can prefer to minimize

risk by maintaining a higher level of current assets or working capital or maximize risk by

reducing working capital. As per the risk varies according to the level of working capital,

the management should keep a suitable balance between profitability and risk.PrincPrincPrincPrinciples of cost of capitaliples of cost of capitaliples of cost of capitaliples of cost of capital::::


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Different sources of working capital have different cost of capital and different degree of

risk. The higher the risk, lower the cost and lower the risk, higher the cost. A sound working

capital management policy should maintain a proper balance between cost and risk

associated with it.

Principle of equity positionPrinciple of equity positionPrinciple of equity positionPrinciple of equity position

As per this principle, the amount of working capital invested in each component should be

adequately justified by a firms equity position. Every rupee invested in current assets

should contribute to the net worth of the firm.

Principle of maturity of payment.Principle of maturity of payment.Principle of maturity of payment.Principle of maturity of payment.

A firm should make effort to relate maturities of payment to its flow of internally generated

funds. Maturity patterns of various current obligations is an important factor in risk.

EstimationEstimationEstimationEstimation of Working Capital Requirementsof Working Capital Requirementsof Working Capital Requirementsof Working Capital Requirements

The term working capital as already point out, usually means the excess of current

assets over current liabilities. In reality such excess of current assets over current

liability may be either more or less than the working capital requirement of the company.

Assessing the requirements of working capital to be employed during the immediate future

period of operations. The working capital requirements can be determined by the following

three techniques

(1) Percentage of Sales Method.(2) Estimation of Components of Working Capital Method.(3) Operating Cycle Approach (or) Cash Working Capital Method.

1. Percentage of Sales Method:1. Percentage of Sales Method:1. Percentage of Sales Method:1. Percentage of Sales Method: This is simple and traditional method. According to percentage

of sales method, the requirement of working capital can be determined or the basis of

sales, amount of working capital required and prior year's experiences. In this method, the

working capital is calculated and expressed it as a percentage to sales This method is much

useful in planning short term working capital requirements However, the basic

criticism of this method is that it assumes a linear relationship between sales and working

capital. Therefore, this method is not universally accepted

2. Estimation of Components of2. Estimation of Components of2. Estimation of Components of2. Estimation of Components of Working Capital Method:Working Capital Method:Working Capital Method:Working Capital Method: The second method is useful inestimating working capital requirements on the basis of the components current assets and

current liabilities. These components include inventories, Account: receivables,

Accounts payables, Marketable investments, Short Term Obligations etc This method is

widely discussed in the chapter of cash management of this book. It practically suitable for

long term forecasting. Symbolically, it can be expressed as:

Working Capital = Current Assets - Current Liabilities

3. Operating Cycle (or) Cash Working Capital Method.3. Operating Cycle (or) Cash Working Capital Method.3. Operating Cycle (or) Cash Working Capital Method.3. Operating Cycle (or) Cash Working Capital Method. Operating cycle method otherwise

known as 'cash working capital method'. In estimating the working capital cycle require fora business, the volume of cash needed to finance the entire process the cycle is to be taken in


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to consideration. Accordingly, this method suggests that actual level of working capital

requirement of a firm in a period can be appropriately determined with reference to the

length of net operating cycle and the volume of cash needed to meet the operation expenses

for the period. In other words, the operating cycle refers u the period

The following formula is used to express the duration of working capital cycle

O =R+W+F+DO =R+W+F+DO =R+W+F+DO =R+W+F+D----CCCC

where

O==== total period of the operating cycle in number of days

R= number of days for holding stock of raw materials and stores

W= number of days for holding stock of work in progress with regard to cost of production

F= number of days for holding stock of finished goods with regard to cost of production

D= debtors collection period

C= credit payment period.

PLANNINGPLANNINGPLANNINGPLANNINGOFOFOFOFWORKINGWORKINGWORKINGWORKING CAPITALCAPITALCAPITALCAPITAL

Objectives of Working CapitalObjectives of Working CapitalObjectives of Working CapitalObjectives of Working Capital

The following are the main objectives of adequate working capital management

(1) Availability of adequate funds

(2) Minimum cost

(3) Matching (balance) between profitability and liquidity

(4) Flexibility(5) Optimum use of funds

(1)(1)(1)(1) Availability of Adequate Funds:Availability of Adequate Funds:Availability of Adequate Funds:Availability of Adequate Funds: A sound working capital financial plan must ensure the

supply of adequate amount of working capital needed by the business enterprises, both for

current and future needs.

(2) Minimum Cost:(2) Minimum Cost:(2) Minimum Cost:(2) Minimum Cost: The fund required by the firm should be made available at the lowest

cost. It is made possible through planning, considering in advance various cost factors and

trends of capital market and suggesting the best course of action.

(3) Matching (Balance) Between Profitability and Liquidity(3) Matching (Balance) Between Profitability and Liquidity(3) Matching (Balance) Between Profitability and Liquidity(3) Matching (Balance) Between Profitability and Liquidity: A judicious balance betweenprofitability and liquidity is one of the fundamental principles of successful finance

planning. Profitability and liquidity are inversely related. The working capital financial plan

must ensure sufficient amount of investment in those assets which are liquid cash and

near-cash assets.

(4) Flexibility:(4) Flexibility:(4) Flexibility:(4) Flexibility: The working capital financial plan should be dynamic in nature. In other

words, it should provide sufficient scope for change and re-adjustment in the financial

structure. Such changes become necessary due to changes in business conditions in future.

SOURCE OF WORKING CAPITALSOURCE OF WORKING CAPITALSOURCE OF WORKING CAPITALSOURCE OF WORKING CAPITALSource of working capital can be basically classified into following;


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1. Long term sourcea. Issue of shareb. Floating of debenturesc. Long term loansd. Public depositse. Private loansf. leasing

2. Medium and short terma. Internal

i. Depreciationii. Taxation provision

iii. Accrued expansesiv. Private loansv. Reserves and provisions

b. Externali. Bank credit

ii. Trade creditiii. Customers creditiv. Hire purchase and salev. Government assistance

vi. Accounts receivables.Long Term Source of Working CapitalLong Term Source of Working CapitalLong Term Source of Working CapitalLong Term Source of Working Capital

1. Issue of Shares:1. Issue of Shares:1. Issue of Shares:1. Issue of Shares: This is the most common method of raising the permanent working

capital. Every company generally uses this method. Shares may be defined as the share in

the capital of a company and des stock expect where a distinction between stock and share

is expressed or implied. Shares are of two types. Equity shares and preference shares.

2. Floating of Debentures:2. Floating of Debentures:2. Floating of Debentures:2. Floating of Debentures: It is also an important source of long term working capital. A

debenture is a document issued by a company as an evidence of a debt due from the

company with or without a charge on the asset of the company. Debenture includesdebenture stock, bonds and any other ties of a company whether constituting a charge on

the assets of the company or not.

3. Long Term Loans:3. Long Term Loans:3. Long Term Loans:3. Long Term Loans: Long term loans are one of the important sources of permanent

working capital. Financial institutions and commercial banks provide loans for augmenting

long term working capital needs and for meeting additional margin money requirements

for working capital arising out of increase in volume of operations, expansion,

diversifications etc.

4. Public Deposits/Loans :4. Public Deposits/Loans :4. Public Deposits/Loans :4. Public Deposits/Loans : The issue of public deposits is directly related to the image of thecompany seeking to invite deposits. Many companies accept deposits as permanent working


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capital from members, directors and the general public. This mode of raising funds is

becoming popular these days on account of bank credit becoming quiet costlier.

5. Sale of Unwanted Assets:.5. Sale of Unwanted Assets:.5. Sale of Unwanted Assets:.5. Sale of Unwanted Assets:. Considerable amount of working capital can be raised by the

sale of unwanted or unutilized assets of land, building, machinery, furniture, scrap and

loose tools etc.

6. Private Loans:6. Private Loans:6. Private Loans:6. Private Loans: Lending private institutions and private banks are granting permanent

working capital at a fixed rate of interest against securities to meet the operational

expenses.

7. Equipment Leasing:7. Equipment Leasing:7. Equipment Leasing:7. Equipment Leasing: Companies can get the permanent working capital assistance by

offering equipment leasing facilities. Financial institutions and commercial banks provides

facilities for leases indigenously procured imported machinery and equipment for a period

of 5 to 8 years with a 90% principal amortization through lease rentals over the period

Medium anMedium anMedium anMedium and Short Term Sources of Working Capitald Short Term Sources of Working Capitald Short Term Sources of Working Capitald Short Term Sources of Working Capital

Internal sourcesInternal sourcesInternal sourcesInternal sources

1. Depreciation:Depreciation:Depreciation:Depreciation: Depreciation means decrease in the value of asset due to wear lapse oftime, obsolescence, exhaustion and accident. Depreciation reserves a good source of

funds for working capital. It is as a non-cash expense, and it represent any cash

outlay with the result that part of the profits adjusted for depreciation can be used

by management to increase any of the current assets or pay dividend etc.

2. Taxation Provision:Taxation Provision:Taxation Provision:Taxation Provision: Provision for taxation is one of the internal sources of mediumand short-term working capital. According to Income Tax Act, firms are liable topay income tax on the assessable net profit as per rate prescribed for the same by

Finance Act from time to time. Normally, there is a time lag between the creation of

the provision for taxes and their actual payment. And in the period the resources as

against this provision which remain within the enterprise may be used as a source of

working capital

3. Accrued Expenses:Accrued Expenses:Accrued Expenses:Accrued Expenses: Accrued expenses otherwise known as outstanding expenses Thefirm can postpone the payment of expenses for shorter periods. This constitute as an

internal source of medium and short-term working capital.4. Private loans:Private loans:Private loans:Private loans: Lending private institutions and private banks are granting medium

and short-term working capital at a fixed rate of interest against securities to meet

the operational expenses.

5. Reserves and Provisions:Reserves and Provisions:Reserves and Provisions:Reserves and Provisions: It is provided for meeting prospective losses or liabilities.creation of reserve and provision to increase the working capital in the business and

strengthen its financial position. Sometimes, the amount is not kept in the business

as additional working capital but is invested in purchase of outside securities, then it

is called reserve fund.External SourcesExternal SourcesExternal SourcesExternal Sources


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1. Bank CreditBank CreditBank CreditBank Credit: Bank credit is one of the important external sources of medium and short-

term sources of working capital. It is arranged by which a banker allow his customer to

borrow money up to a certain limit. Cash credit arrangements are usually made against the

security of commodities hypothecated or pledged with the bank.

2. Trade Credit:2. Trade Credit:2. Trade Credit:2. Trade Credit: Trade credit is a form of medium and short-term financing common to all

type of business firm. It is the largest source of temporary working capital. Most buyers are

not required to pay for goods on delivery. Trade credit is also granted by the seller of raw

materials and goods to manufactures and/ or wholesaler. It generally takes the form of

discount for cash payment on delivery and net for future payment. This credit may take the

form of (a) Open account credit arrangement (b) Acceptance credit arrangement. In the

case of an open account credit arrangement, the buyer does not sign a formal debt

instrument as an evidence of the amount due by him to the seller while in the case of

acceptance.

3. Discounting Bills:3. Discounting Bills:3. Discounting Bills:3. Discounting Bills: Companies can get the medium and short-term working capital

assistance by discounting their bill of exchange, promissory notes from banks. These

documents are discounted by the banks at a price lower than their face value.

4. Accounts Receivable Financing:4. Accounts Receivable Financing:4. Accounts Receivable Financing:4. Accounts Receivable Financing: Under this arrangement, the account receivable of a

business concern are bought by a financing company or money may be advanced on

securing of accounts receivable. Normally, 60% of the value of accounts receivable pledged

is advanced by the finance companies. If there are any bad debts, it is to be borne by the

business concern itself.5. Government Assistance:5. Government Assistance:5. Government Assistance:5. Government Assistance: Government undertakes a variety of promotional activities

including provides subsidies and short-term working capital assistance for the acquisition

and installation of energy conversion equipment. It extends the facility of granting loans,

tax concessions for projects involving the development and use of indigenous technology

and for adopting and development of imported technology, as well as high risk, high return

ventures.

6. Customer Credit:6. Customer Credit:6. Customer Credit:6. Customer Credit: This is also known as installment credit as it is usually allowed by

retailers for selling consumer durable goods. Some portion of the cost price of the asset ispaid at the time of delivery and the balance is paid in number of installments along with the

interest. Sometimes, installment credit is granted by financial companies or banks which

have special arrangements with the suppliers.

7. Loans from Directors:7. Loans from Directors:7. Loans from Directors:7. Loans from Directors: A business firm may resort to miscellaneous source of finance in

periods of pressing working capital needs. Specialized financial institutions also provide

finance to their client units in times of need. The cost of these funds is nominal.

8. Hire Purchase8. Hire Purchase8. Hire Purchase8. Hire Purchase and Sale:and Sale:and Sale:and Sale: Financial institutions and commercial banks grant loans as

medium and short-term working capital to companies engaged in leasing and financing orindustrial plant and machinery or durable customer goods.


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COST OF CAPITALCOST OF CAPITALCOST OF CAPITALCOST OF CAPITALCost of capital is the rate of return the firm requires from investment in order to

increase the value of the firm in the market place. In economic sense, it is the cost of raisingfunds required to finance the proposed project, the borrowing rate of the firm. Thus under

economic terms, the cost of capital may be defined as the weighted average cost of each type

of capital.

There are three basic aspects about the concept of cost

1. It is not a cost as such: The cost of capital of a firm is the rate of return which itrequires on the projects. That is why; it is a hurdle rate.

2. It is the minimum rate of return: A firms cost of capital represents the minimumrate of return which is required to maintain at least the market value of equityshares.

3. It consists of three components. A firms cost of capital includes three componentsa. Return at Zero Risk Level:Return at Zero Risk Level:Return at Zero Risk Level:Return at Zero Risk Level: It relates to the expected rate of return when a

project involves no financial or business risks.

b. Business Risk Premium:Business Risk Premium:Business Risk Premium:Business Risk Premium: Business risk relates to the variability in operatingprofit (earnings before interest and taxes) by virtue of changes in sales.

Business risk premium is determined by the capital budgeting decisions for

investment proposals.

c. Financial Risk Premium:Financial Risk Premium:Financial Risk Premium:Financial Risk Premium: Financial risk relates to the pattern of capitalstructure (i.e., debt-equity mix) of the firm, In general, a firm which has

higher debt content in its capital structure should have more risk than a firm

which has comparatively low debt content. This is because the former should

have a greater operating profit with a view to covering the periodic interest

payment and repayment of principal at the time of maturity than the latter.

Significance of Cost of CapitalSignificance of Cost of CapitalSignificance of Cost of CapitalSignificance of Cost of Capital

The cost of capital is significant because of the following cases;

1.1.1.1. Capital Budgeting Decisions: The concept of cost of capital can serve as a discountrate for selecting the capital expenditure projects. The capital budgeting decision


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after all is the matching of the costs of the use of funds with the returns of the

employment of funds. Thus the financial manager can arrive at the break-even

point in the capital structure the point at which the rate of return of a given project

equals the cost of procuring funds for that project.

2.2.2.2. Capital Structure Decisions: The concept of cost of capital is an importantconsideration in capital structure decisions. It helps to devise an optimal capital

structure with an ideal debt-equity mix based on minimum costs

Classification of cost of capitalClassification of cost of capitalClassification of cost of capitalClassification of cost of capital

Cost of capital can be brought as under:

Explicit Cost and Implicit Cost Future Cost and Historical Cost Specific Cost and Combined Cost Average Cost and Marginal Cost

1. Explicit Cost and Implicit Cost1. Explicit Cost and Implicit Cost1. Explicit Cost and Implicit Cost1. Explicit Cost and Implicit Cost

The explicit cost of any source of finance may be defined as the discount rate that

equates the present value of the cash inflows (that are incremental to the taking of the

financing opportunity) with the present value of its expected cash outflows. In other words,

the explicit cost is the internal rate of return the firm pays for financing.

The implicit cost may be defined as the rate of return associated with the best

investment opportunity for the firm and its shareholders that will be forgone if the projects

presently under consideration by the firm were accepted. When the earnings are retainedby a firm, the implicit cost is the income which the shareholders could have earned if such

earnings would have been distributed and invested by them.

In short, the explicit cost arises when the capital is raised and implicit cost of capital

arises whenever funds are used.

2. Future Cos2. Future Cos2. Future Cos2. Future Cost and Historical Costt and Historical Costt and Historical Costt and Historical Cost

If future cost is the expected cost of funds for financing a project, historical cost is

the cost which has already been incurred for financing a particular project. In financial

decision making process, the relevant cost is future cost.3. Specific Cost and Combined Cost3. Specific Cost and Combined Cost3. Specific Cost and Combined Cost3. Specific Cost and Combined Cost

The cost of each component of capital, i.e., equity shares, preference shares,

debentures, loan, etc., is called the specific cost of capital. The firm should consider the

specific cost, while determining the average cost of capital.

When specific costs are combined to find out the overall cost of capital, it is called

the combined cost or composite cost. In other words, the combined or composite cost of

capital is inclusive of all costs of capital from all sources (i.e., equity shares, preference

shares, debentures and other loans). This concept of capital is used as a basis for accepting


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or rejecting the proposal in capital investment decisions although various proposals are

financed through various sources.

4. Aver4. Aver4. Aver4. Average Cost and Marginal Costage Cost and Marginal Costage Cost and Marginal Costage Cost and Marginal Cost

Average cost of capital is the weighted average of the cost of each component of

funds invested by the concern. But the weights are in proportion of the shares of each

component of capital in the total investment.

Marginal cost of capital is the cost of additional amount of capital which is raised by

a firm

Approaches of cost of capitalApproaches of cost of capitalApproaches of cost of capitalApproaches of cost of capital

1. Traditional Approach

As per this approach, the cost of capital of a firm relates to its capital structure. In other

words, the cost of capital of the firm is the weighted average cost of debt and the cost of

equity. However, the raising of funds by way of debentures is cheaper. This is mainly due to

the following facts:

a. Usually, interest rate is less than dividend rates.b. Interest is allowed as an expense while taxable profit of the company is computed.

But dividend is not allowed as an expense.

The main argument in favour of this approach is that the weighted average cost of capital

will go up with every increase in the debt content in the total capital employed. However,

the debt content in the total capital employed must be maintained at a proper level as the

cost of debt is a fixed burden. Moreover, when the debt content goes up beyond a certainlevel, the investors consider the company too risky and their expectations from equity

shares will go up.

2. Modigliani and Miller Approach2. Modigliani and Miller Approach2. Modigliani and Miller Approach2. Modigliani and Miller Approach

Under this approach, the total cost of capital of a company is constant and

independent of its capital structure. In other words, a change in the debt-equity ratio does

not affect the total cost of capital.

The main arguments of MM approach are:

The total market value of the firm and its cost of capital are independent of its capitalstructure. The total market value of the firm can be calculated by capitalising the

expected stream of operating earnings at a discount rate considered appropriate for its

risk class.

The cut-off rate for investment purposes is completely independent of the way inwhich investment is financed.

Assumptions of MM ApproachAssumptions of MM ApproachAssumptions of MM ApproachAssumptions of MM Approach

1. Perfect Capital MaPerfect Capital MaPerfect Capital MaPerfect Capital Market:rket:rket:rket: Trading of securities takes place in perfect capital market.This indicates that:

a. Investors have full-fledged freedom to buy and sell securities.


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b. As investors are completely knowledgeable and rational persons, they canknow at once all information and changes.

c. The buying and selling of securities does not involve costs such as brokerscommission, transfer fees, etc.

d. The investors can borrow against securities on the same basis as the firmscan do so.

2. Homogeneous Risk Classes:Homogeneous Risk Classes:Homogeneous Risk Classes:Homogeneous Risk Classes: In case the firms expected earnings have identical riskfeatures, they should be considered to belong to a homogeneous class.

3. Same ExpectationsSame ExpectationsSame ExpectationsSame Expectations: All investors have the same expectations of the net operatingincome (EBIT) of firm which is used for its evaluation. There is 100 per cent

dividend payout, i.e., all the net earnings of the firm are distributed to the

shareholders,

4. No Corporate Taxes:No Corporate Taxes:No Corporate Taxes:No Corporate Taxes: At the formulation stage of hypothesis, Modigliani and Millerassume that there are no corporate taxes, However, they have removed this

assumption later on.

Computation of Cost Of CapitalComputation of Cost Of CapitalComputation of Cost Of CapitalComputation of Cost Of Capital

Computation of the cost of capital involves: (i) computation of specific costs and (ii)

computation of composite cost.

I.I.I.I. Computation of Specific Costs:Computation of Specific Costs:Computation of Specific Costs:Computation of Specific Costs: It is the computation of the cost of each specificsource of finance such as debt, preference capital and equity capital.

1.1.1.1. Cost of Debt:Cost of Debt:Cost of Debt:Cost of Debt: It is the rate of return which is expected by lenders. This is actually theinterest rate specified at the time of issue. Debt may be issued at par, at premium or

discount. It may be perpetual or redeemable.

Debt Issued at Par: The cost of debt issued at par is the explicit interest rate adjusted further

for the tax liability. It is computed in accordance with the following formula:

Debt Issued at Premium or Discount: When the debentures are issued at a premium (more

than the face value) or at a discount (less than the face value) the cost of debt should be

computed on the basis of net proceeds realised on account of issue of such debentures.

Cost of Redeemable Debt: When debentures


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are redeemed after the expiry of a fixed period, the cost of debt before tax can be computed

with the help of the following

Formula

2.2.2.2. Cost of Preference Share CapitalCost of Preference Share CapitalCost of Preference Share CapitalCost of Preference Share CapitalEven though it is not legally binding on the part of the company to pay preference dividend,

it is generally paid as and when the company earns enough profits. The failure to pay

preference dividend is a matter of serious concern on the part of the equity shareholders.

They may even lose control of the company as the preference shareholders will enjoy the

right to take part in the general meeting with equity shareholders under certain conditions

if the company fails to pay preference dividend. The accumulation of arrears of preference

dividend may adversely affect the right to equity shareholders.

Cost of Redeemable Preference Shares:

The cost of redeemable preference shares is the discount rate which equates the net

proceeds of sale of preference shares with the present value of future dividend and

repayment of principal. But the cost of preference share capital is not adjusted for taxes as it

is not a charge against profit but an appropriation of profit.


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3.3.3.3. Cost of Equity CapitalCost of Equity CapitalCost of Equity CapitalCost of Equity CapitalCost of equity capital may be defined as the minimum rate of return that a firm must earn

on the equity financed portion of an investment project in order to leave unchanged the

market price of its stock.

a.a.a.a. Dividend Price (DIP) MethodDividend Price (DIP) MethodDividend Price (DIP) MethodDividend Price (DIP) MethodAccording to this approach, the cost of equity capital is computed against a required rate of

return in terms of future dividends. Thus cost of capital is defined as the discount rate that

equates the present value of all expected future dividends per share with the net proceeds of

the sale (or the current market price) of a share. In other words, the cost of equity capital

will be that rate of expected dividends which will maintain the present market price of

equity shares

b. Dividend Price Plus Growth MethodIn this approach, the cost of equity capital is calculated on the basis of the expected

dividend rate plus the rate of growth in dividend. But the rate of growth is ascertained on

the basis of the amount of dividends paid by the company for the last few years.

c. Earning Price ApproachThis method is based on the assumption that the shareholders capitalise a stream of future

earnings for evaluating their shareholdings. Thus the cost of capital relates to that earning

percentage which can keep the market price of the equity shares constant. This approachrecognises both dividend and retained earnings.


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d.d.d.d. Realised Yield ApproachRealised Yield ApproachRealised Yield ApproachRealised Yield ApproachUnder this approach, the cost of equity capital should be ascertained on the basis of return

actually realised by the investors on their investment (i.e., on equity shares). Thus in this

approach, the past records in a given period regarding dividends and the actual capital

appreciation in the value of the equity shares held by the shareholders should be taken to

calculate the cost of equity capital.

4. Cost of Retained EarningsCost of Retained EarningsCost of Retained EarningsCost of Retained EarningsGenerally, the companies do not distribute the whole of the profits earned by them by way

of dividend among their shareholders. A part of such profits is retained by them for future

expansion of the business. This portion of profit is known as retained earnings or ploughing

back of profit. The cost of retained earnings is the earnings foregone by the shareholders. In

other words, the opportunity cost of retained earnings may be taken as the cost of retained

earnings. It is equal to the income what a shareholder could have earned otherwise by

investing the same in alternative investment.

The following adjustments are required for determining the cost of retained

earnings.a. Income Tax Adjustment: The dividends receivable by the shareholders are subject to

income tax. Thus the dividends actually received by them are the amount of net

dividend (i.e., gross dividends less income tax).

b. Brokerage Cost Adjustment: The shareholders cannot utilise the whole amount ofdividend received from the company for the purpose of investment as they have to

incur some expenses by way of brokerage, commission, etc. for purchasing new

shares against the dividend.

II. Composite or Weighted Average Cost of CapitalII. Composite or Weighted Average Cost of CapitalII. Composite or Weighted Average Cost of CapitalII. Composite or Weighted Average Cost of Capital

The term cost of capital is used to denote the overall composite cost of capital or

weighted average of the cost of each specific type of funds i.e., weighted average cost. Inother words, the composite or weighted average cost of capital is the combined specific


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costs used to find out the overall cost of capital. The computation of weighted average cost

of capital involves the following steps:

a. Calculate the cost of each specific source of funds.b. Assign proper weights to specific costs.c. Multiply the cost of each source by the appropriate weight.d. Divide the total weighted cost by the total weights to get the overall cost of capital.

Assignment of WeightsAssignment of WeightsAssignment of WeightsAssignment of Weights

This involves the determination of the proportion of each source of funds in the total capital

structure of the company. For this purpose, the following three possible weights may be

used.

Book Value Weights used for actual or historical weights. Market Value Weights used for current weights. Marginal Value Weights used for proposed future financing.

Book Value WeightsBook Value WeightsBook Value WeightsBook Value Weights

Under this method, the relative proportions of various sources to the existing capital

structure are used to assign weights. The advantages of these weights are as follows:

1. Book values are easily available from the published annual report of a company.2. All companies set their targets of capital structure in terms of book values rather

than market value,

3. The analysis of capital structure on the basis of debt equity ratio also depends onbook value.

Market Value WeightsMarket Value WeightsMarket Value WeightsMarket Value Weights

Theoretically, the use of market value weights for computing the cost of capital is more

appealing due to the following facts:

1. The market values of the securities are approximate to the actual amount to beobtained from the sale of such securities.

2. The cost of each specific source of finance is computed in accordance with theprevailing market price.

However, there are some practical difficulties for using market value weights. They are as1. Frequent fluctuation in the market value of securities is a common phenomenon.2. Market values of securities are not readily available like book values. But book

values are available from the published records of the company.

3. The book value and not the market value is the base for analysing the capitalstructure of the company in terms of debt-equity ratio.

Marginal Value WeightsMarginal Value WeightsMarginal Value WeightsMarginal Value Weights


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Under this method, weights are assigned to each source of funds in proportions of financing

inputs the firm intends to employ. This method is based on a logic that the firm is with the

new or incremental capital and not with

Financial Management b.com s3

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