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Financial management – An overview

Financial management can be defined as the activity concerned with the planning, raising, controlling
and administering the funds used in the business. In simple terms, it is an activity concerned with
acquisition of funds use of funds and distribution of profits by a business organization.

Finance function

Finance function can be defined as the task of providing funds needed by the enterprise on the terms
that are most favourable to it keeping in view its objectives. Generally, finance function should answer
for the following three questions: -

a) How large and how fast should a company grow?

b) What will be the specific forms of its assets? And
c) What should be the composition of its liabilities?

Concepts of Profit Maximization and Wealth Maximization

There are two approaches Viz. 1) Profit maximization and 2) Wealth Maximization

Profit Maximization

According to this approach , actions that increase profits should be undertaken and those that decrease
profits are to be avoided. Under this approach, profit is considered as a test of economic efficiency.
More is the profit; more efficient is the firm is the conclusion under this approach. But this approach
does not consider the quality of profit but considers only the quantity of profit. The survival of the firm
depends upon its ability to earn profits.

Wealth Maximization

The concept of wealth maximization refers to the gradual growth of the value of assets of the firm in
terms of benefits it can produce. The wealth maximization attained by a company is reflected in the
market value of shares. In other words wealth maximization simply refers to maximizing wealth of the
share holders.

Example:

Company has 50,000 shares of Rs. 10 each, has an earning per share of Re.0.40, with a profit of Rs.
20000. Assume that the company has issued an additional capital of Rs. 50000 shares of Rs. 10 each for
its financial requirements. Now the profit will increase up to Rs. 30000 after taxes, resulting in a net
increase of Rs. 10000. Though the additional profit of Rs. 10000 is increased, the earnings per share
has come down to Re. 0.30. This does not add to the wealth of the shareholders. This is the reason why
the finance manager always concentrates on wealth maximization, cash flows and time value of money
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Functions of Finance Manager

1. Estimating the Financial needs

Financial manager has 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 estimation should be based on the sound financial principles so that neither there
are inadequate nor excess funds with the concern. Inadequacy of funds will adversely affect the
day-do –day working of the concern whereas excess funds may tempt management to spent on
speculative activities

2. Selection of right source of funds

After ascertaining total amount needed for the organization, it is the responsibility of the financial
manager to select the right type of source of funds at right time at right cost. Each source will have
its own cost. Careful selection should made in the light of duration, risk, cost and the purpose

3. Allocation of funds

After mobilizing funds, it is the responsibility of the finance manager to distribute the funds to
capital expenditure and revenue expenditure. Each investment must yield fair amount of return, so
that it should contribute to the goal of wealth maximization.

4. Analysis and interpretation of financial performance

An efficient system of financial management necessitates the use of various control devices to
interpret the financial performance of various operations. Financial control devices generally used
are: 1) ROI 2) Budgetary control 3) Break Even analysis 4) Ratio analysis 5) cost and internal audit.
ROI is the best control device to evaluate the performance of various financial policies. 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.

5. Analysis of CVP

It is another important tool of the financial management that helps the management to evaluate
different proposals of investments. It will help the management to know whether the organization is
moving in the right direction or not. Make or buy decision, continue or drop the product line are the
important decisions possible using CVP analysis.

6. Capital budgeting

It is the technique through which finance manager evaluates proposed investment in fixed assets. In
how many years the original investment can be recovered? At what percentage of returns business
should run? These are the issues answered by capital budgeting technique. PBP, IRR, ARR, NPV
are some of the modern techniques of evaluating the proposals.
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7. Working capital management

Working capital is the financial lubricant which keeps business operations going. Fate of large
investments mainly depends upon relatively small amount of working capital. Financial manager
must assess various cash needs at different times and then make arrangements for arranging cash.
Cash may be needed for 1) purchase of raw materials 2) making payments to creditors 3) meet wage
bills 4) met day – to –day expenses. usual sources of cash may be 1) cash sales and 2) collections
from debtors. Cash management should be such that neither there is shortage nor it is idle. Any
shortage of cash will damage the creditworthiness.

Profit planning guides the management in attaining the corporate goals. Profit may be earned
either through sales or through reducing cost. Cost reduction technique really helps in increasing
profits.

A judicial use of profit is essential for expansion and diversification plans and also in protecting the
interests of shareholders. Ploughing back of profits is the best policy of further financing. A balance
should be maintained in using funds for paying dividend and retaining earnings for financing
expensive plans.

8. Fair return to the investors

Organization should not ignore the interest of the shareholders. Equity holders normally expects
fair amount of divided and hence capital appreciation of their investment. If this is not done,
confidence of the investors will be lost. Hence it is advised the organization to maintain regular
dividend policy with growth

9. Maintaining liquidity and wealth maximization

This is considered the prime objective of an organization. Liquidity increases the borrowing
capacity. Expansion and diversification can be conducted conformably. Increased liquidity builds
the firm’s ability to meet short term obligations. Once the flow of funds is assured continuously, in
turn the overall profitability of the firm can be maximized. This wealth maximization takes place in
the form of growth of capital over the years.

Financial Plan
The basic purpose of the financial plan is to make sure that adequate funds are raised at the minimum
cost and that they are used wisely.

Factors affecting financial plan

1. Nature of the industry

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The nature of industry decides the quantum of capital and the sources of its procurement. Capital
intensive industries require a larger amount of capital in comparison to the labor-intensive
industries. Moreover, industries having stability and regularity in earnings may collect capital form
the market very easily in comparison to those having instability or irregularity in their income.

2. Amount of risks

The amount of risks involved in the process of production also affects the planning. The industries
would depend more upon the ownership securities such as shares in case of greater amount of risks
and uncertainties are involved whereas the other industries having lesser amount of risk may
depend upon debts and thus earning higher profits for equities. Amount of risks also affects the
liquidity of cash

3. Standing of the concern

Certain individual characteristics of the unit such as age, size, goodwill of the industry, area of
operation, credit rating in the market, past performance etc. effect the financial planning. Large
concerns or companies with good credit rating in the market may collect their finance (equity,
debenture or public deposit) very easily whereas the new companies get difficulties in raising their
capital and loan from the market

4. Availability of sources

There are a number of sources from which funds can be raised. Various alternative sources of
finance must be appraised of in the light of their cost, availability, regularity etc. at the time of
formulating financial plan

5. Attitude of management

Management may would like to establish control over the industry. In such a case, they would not
like to issue equity shares or if they issue thy would purchase a majority of such shares themselves
or would prefer debt financing. Such management would not like to issue new equity shares even
for its expansion programmes. Ploughing back of profits is always preferred in such units

6. Future expansion plans

The future plans of a concern should be considered while formulating a financial plan. The plans for
expansion and diversification in near future will require a flexible financial plan. The sources of
funds should be such which will facilitate rising required funds without any difficulty
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7. Magnitude of external capital requirement

It would be good policy for the industry to finance its expansion or diversification programmes
though internal sources such as ploughing back of profits, reserves and surpluses etc., but short term
finances may be obtained from external sources by issuing redeemable preference shares or
debentures.

8. Government control

Government policies regarding issue of shares and debentures, payment of dividend and interest
rates, entering foreign collaborations etc. will influence a financial plan. The legislative restrictions
on using certain sources, limiting dividend and interest rates, etc. will make it difficult to raise
funds. So government controls should be considered properly while selecting a financial plan

9. Flexibility

Flexibility and not the rigidity should be the main principle to be followed in the financial plan. If
there is no flexibility in the plans, it would be very difficult later on, to carry on its expansion
programmes due to lack of funds

10. Capital structure

The capital structure of the company should be diversified but balanced. A fair rate of dividend
should also be maintained

Characteristic features of a good financial Plan

1. Simplicity

It should be easily understandable by all concerned and free from complications and suspicion.
There must be no confusion in the minds of the investors about the nature of the securities
issued by the organization

2. Foresight

The planners should always keep in mind not only the needs of today but also the needs of
tomorrow so that a sound capital structure may be formed.

3. Flexibility

The capital structure of a company should be flexible enough to meet the capital requirements of
the company. The financial plan should be chalked out in such a way that both increase and
decrease in capital may be feasible.
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4. Intensive use

Every ‘paisa’ should be used properly for the prosperity of the enterprise. Wasteful use of capital
is as bad as inadequate capital. It must be seen that there is neither over-capitalization nor under-
capitalization.

5. Liquidity

Reasonable amount of current assets must be kept in the form of liquid cash so that business
operations may be carried on smoothly without any shocks due to shortage of funds.

6. Economy

It means that cost of raising capital should be the minimum. Dividend or interest should not be a
burden to the company
7. Provision for anticipated contingencies

A sound financial plan should provide for the future contingencies caused by business cycles

Risk, Return and Value of firm

Financial decisions involve alternative course of action. The alternative course of action will have
different risk-return implications. In general the financial manager is required to answer the following
questions :-
a) What is the expected return
b) What is the amount of risk involved
c) How would the decision influence the market value of the firm

Capital budgeting
Decisions Return

Capital Structure
Decisions
Market value
of firm
Dividend
Decisions

Working capital Risk

Decisions

Relationship between risk, return and valuation of firm

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Sources of finance

Equity shares  Dividend is the cost to the company. No Tax benefits. Not repayable during the life
time of the company

Preference shares  Fixed rate of Dividend is the cost to the company. No Tax benefits. Repayment
depends on the type of Preference share

Debentures  Fixed rate of interest is the cost of capital. Tax benefit is available. Repayment depends
on the type of debenture.

Bank Loan  Fixed rate of interest is the cost of capital. Tax benefit is available.

Public deposit Fixed rate of interest is the cost of capital. Tax benefit is available.

Retained Earnings Free source of finance. Opportunity cost should be properly calculated.

Leverage Analysis

Leverage refers to the utilization of fixed cost/ interest bearing securities to maximize the wealth of
equity shareholders.
Master table for calculating the leverages

Amount
Rs.

Sales *******
Less: Variable Cost *******
Contribution *******
Less: Fixed Cost *******
Operating profit or EBIT *******
Less: Interest *******
Earnings Before Tax (EBT) *******
Less: Tax *******
Earnings After Tax (EAT) *******
Less: Preference Divided *******
Earnings available to equity holders *******
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Financial Leverage

FL= EBIT
EBT
Operating Leverage
OL= Contribution
EBIT
Degree of Operating Leverage

Degree of OL = % change in Income

% Change in Sales

Combined Leverage

CL= FL x OL

Or EPS= EAESH
CL= EBIT No. Equity Shares
EBT
Or
CL= EBIT x Contribution = Contribution
EBT EBIT EBT
It is true that capital structure cannot affect the total earnings of a firm but it can affect the share of
earnings available for equity shareholders.

Types of leverages

1.Financial Leverage
2.Operating Leverage
3.Combined Leverage.

Financial Leverage

Financial leverage is a tool with which a financial manager can maximize the returns to the equity
shareholders. He should choose proper capital structure. The proper blend of debt to equity should be
maintained. The use more and more fixed interest bearing securities to maximize the wealth of the
equity shareholders is called Financial Leverage or Trading on Equity. When the amount of debt is
relatively larger in relation to capital stock, a company is said to be trading on their equity

Operating Leverage

Costs can be classified into 1) Fixed cost and 2) Variable cost. Variable cost varies depending upon the
volume of operation. Fixed cost remains constant irrespective of the level of activity. Reducing variable
cost can increase operating profit of an organization.
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Operating leverage results from the presence of fixed costs that help in magnifying net operating
income fluctuations flowing from small variations in revenue. The changes in sales are related to
changes in revenue. The fixed costs do not change with the change is sales. Any increase in sales, fixed
costs remaining the same, will magnify the operating revenue. The operating leverage occurs when a
firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining
the same, the % change in operating revenue will be more than the percentage change in sales. The
occurrence is known as operating leverage.

The degree of operating leverage depends upon the amount of fixed elements in the cost structure.
Thus, the operating leverage has impact on fixed cost, variable cost and contribution. Operating
leverage simply explains whether the firm has better operating efficiency or not.

Problems on Financial Leverage

Financial plans
Debt ( Int. @ 10% p.a.)
Equity Shares ( Rs. 10 each)
Plan I Plan II
Rs.4,00,000 Rs. 1,00,000
Rs.1,00,000 Rs. 4,00,000
Rs.5,00,000 Rs. 5,00,000

The earnings before interest and tax are assumed as Rs. 50,000, Rs.75,000 and 1,25,000. The tax be
taken at 50%

(1) When EBIT is Rs. 50,000

Plan I Plan II
Rs Rs.
Earnings before interest and tax(EBIT) 50,000 50,000
Less : Interest on debts 40,000 10,000
Earnings before tax(EBT) 10,000 40,000
Less: Tax @ 50% 05,000 20,000
Earnings after tax 05,000 20,000
No. of equity shares 10,000 40,000
Earning per share (EPS) 5,000 =0.50 P. 20,000 = 0.50 P.
10,000 40,000

(2) When EBIT 1s Rs. 75,000

Plan I Plan II
Rs Rs.
Earnings before interest and tax(EBIT) 75,000 75,000
Less: Interest on debts 40,000 10,000
Earnings before tax (EBT) 35,000 65,000
Less: Tax @ 50% 17,500 35,500
Earnings after tax 17,500 32,500
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No. of equity shares 10,000 40,000

Earning per share (EPS) 17,500 =1.75 P. 32,500 = 0.81 P.

10,000 40,000

(3) When EBIT is Rs. 1,25,000

Plan I Plan II
Rs Rs.
Earnings before interest and tax(EBIT) 1,25,000 1,25,000
Less : Interest on debts 40,000 10,000
Earnings before tax(EBT) 85,000 1,15,000
Less: Tax @ 50% 42,500 57,500
Earnings after tax 42,500 57,500

No. of equity shares 10,000 40,000

Earning per share (EPS) 42,500 = 4.25 P. 20,000 =1.44 P.

10,000 40,000

2 . A limited company has equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
wishes to raise further Rs. 3,00,000 for expansion programmes. The company plans the following
financing schemes:

1) all common stock

2) Rs. 1,00,000 in common stock and Rs. 2,00,000 in debt @ 10% p.a
3) All debt at 10%
4) Rs. 1,00,000 in common stock and Rs. 2,00,000 in preference capital with a dividend rate of 8%

The company has EBIT of Rs. 1,50,000. Tax may be taken at 50%

Plan I Plan II Plan III Plan IV

EBIT 1,50,000 1,50,000 1,50,000 1,50,000

Less: Interest - 20,000 30,000 -
1,50,000 1,30,000 1,20,000 1,50,000
Less: Tax @ 50% 75,000 65,000 60,000 75,000
Earning after tax 75,000 65,000 60,000 75,000
Less: Pref. Dividend @ 8% - - - 16,000
Earnings available for equity 75,000 65,000 60,000 59,000
No. equity shares 8,000 6,000 5,000 6,000
EPS Rs. 9.375 Rs.10.83 Rs. 12.00 Rs.9.83
(4) (2) ( 1) (3)

Impact of Leverage on Loss.

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The leverage will have an adverse impact on earning if the firm suffers losses. This impact is discussed
as below:

Taking the above figures if company suffers a loss of Rs. 70,000, discuss the impact of leverage under
all the four plans

Plan I Plan II Plan III Plan IV

Loss before interest and tax -70,000 -70,000 -70,000 -70,000

Less: Interest - -20,000 -30,000 -
Loss after interest -70,000 -90,000 -100,000 -70,000
No. equity shares 8,000 6,000 5,000 6,000

Loss Per share Rs.8.75 Rs.15 Rs.20 Rs.11.67

3. The Indo American Company Ltd. had the following capital structure on 31-3-2003

7 % Debentures Rs. 12,00,000

8 % Bank Loan Rs. 2,00,000
9 % Preference shares @ Rs. 10 each Rs. 14,00,000
38,000 Equity shares of Rs. 50 each Rs. 19,00,000
Retained Earnings Rs. 13,00,000
60,00,000
The present earnings before interest and taxes are Rs. 9,00,000. The company is contemplating an
expansion programmes requiring an additional investment of Rs. 10,00,000.

Company hopes to maintain the same rate of earnings. The company has the following alternatives:-

1) The issue debentures @ 8%

2) To issue preference shares at 10%
3) To issue equity shares at a premium of Rs. 10 per share

Examine the alternatives assuming income tax @ 55%

Comparative Statement of EPS in Different Alternatives

Earnings on 60,00,000 capital = 9,00,000

Therefore, earnings on 10,00,000 = 9,00,000 x 10,00,000 = 1,50,000
60,00,000
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Particulars Present Alternative Alternative Alternative

I II III
Earnings (EBIT) 9,00,000 9,00,000 9,00,000 9,00,000
[On present cap.
of Rs. 60,00,000]
Earnings (EPS)
[On new cap. of
Rs. 10,00,000] - 1,50,000 1,50,000 1,50,000

Total Earnings 9,00,000 10,50,000 10,50,000 10,50,000

Less: Interest
a) B.L 16000
b) Deb. 84000 1,00,000 1,00,000 1,00,000 1,00,000
c) Int. on proposed
Debt - 80,000 - -
EBT 8,00,000 8,70,000 9,50,000 9,50,000
Less: Tax @ 55% 4,40,000 4,78,500 5,22,500 5,22,500
PAT 3,60,000 3,91,500 4,27,500 4,27,500
Less: Pref. Div.
a) on 14 Lks. @
9% 1,26,000 1,26,000 1,26,000 1,26,000
b) on proposed
pref. @ 10% 1,00,000

Earnings  equity 2,34,000 2,65,500 2,01,500 3,01,500

No. shares 38000 38,000 38,000 54,667

EPS Rs. 6.16 Rs. 6.99 Rs. 5.30 Rs. 5.52

Total No. of Equity shares : Existing Shares  38000

Add: New equity
10,00,000 16667
60 54,667
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WORKING CAPITAL ANALYSIS

The prime objective of management is to make profit, whether or not this is accomplished, in most
business depends largely on the manner in which the working capital is administered

The fate of large scale investment in fixed capital is often determined by a relatively small amount of
current assets

Inadequate working capital is disastrous; whereas redundant working capita is a criminal waste

Without working capital, fixed assets are like a gun which can not shoot as there are no cartridges

Meaning of Working Capital

Capital needed for day-to-day operation of a business is termed as working capital

There are two concepts of working capital

1) Gross Working Capital
2) Net Working Capital

Gross working capital refers to the firm’s total investment in current assets. Net working capital refers
to the excess of current assets over current liabilities of the firm. However, for all practical purposes, it
means net working capital only.

Factors Influencing Working Capital Needs

Following factors should be considered in order to determine the amount of working capital required

1) Nature of Business

The amount of working capital is related to the nature and volume of the business. Working capital
requirement is more in case of firms dealing in finance and manufacturing industries. On the
contrary, concerns having large investments in fixed assets require less amount of working capital.
It is, therefore, public utility concerns (such as railways, electricity services) as compared to trading
or manufacturing concern require a lesser amount of working capital partly because of cash nature
of their business and partly their selling a service instead of commodity.

2) Size of Business/ scale of operation

The volume of transaction directly influences the working capital requirements of a concern. Greater
the volume of transaction, generally, larger will be working capital requirement. However, in some
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cases, even a smaller concern may need more working capital due to high overhead charges, inefficient
use of available resources and other economic advantages of small size

3) Seasonal variations

In certain industries, (like oil mills, cotton textiles etc) raw material is not available throughout the
year. They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and
process them during the entire year. A huge amount is, thus, blocked in the form of material inventories
during such seasons, which give rise to more working capital requirements. Generally, during the busy
season, a firm requires larger working capital than in the slack season.

4) Length of production process

Time taken in the process of manufacture/ length of production process is also an important factor in
determining the amount of working capital. Longer the process period of manufacture, larger is the
amount of working capital required.

5) Working capital Cycle

Cash

Drs R/M

Sales WIP

F/G

In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends
with the realization of cash form the sale of finished products. The speed with which the working
capital completes one cycle determines the requirement of working capital. Longer the period of the
cycle, larger is the requirement of working capital.

6) Credit Policy

A concern that purchases its requirements on credit and sells its products on cash requires lesser
amount of working capital. On the other hand, a concern buying its requirements for cash and allowing
credit to its customers need larger amount of working capital as huge amount is blocked up in debtors.

7) Rate of stock turnover

Stock turnover refers to the speed with which sales are effected. A firm having a high rate of stock
turnover needs lower amount of working capital as compared to the firm having a low rate of turnover.
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8) Growth and expansion of Business

Growing concerns require more working capital than those that are static. It is logical to expect larger
amount of working capital in a growing concern to meet its growing needs of funds for its expansion
programmes

9) Profit Margin and profit appropriations

Some firms enjoy a dominant position in the market due to quality product or good marketing
management. Such firms are in a position to earn more cash profits and contribute to their working
capital. The way in which profits are apportioned is also a factor which determines working capital. If
huge amount is transferred to reserve and other contingency purposes, available cash profit is reduced
in turn which reduces the fund available for working capital.

10) Dividend policy

There is a well-established relationship between dividend and working capital. If constant dividend
policy is followed, management needs to adjust cash position before declaring dividend. Storage of
cash is one of the reasons for the issue of stock dividend. Retaining profits in this fashion increases
working capital position. If the whole of the profits are distributed among the shareholders, company’s
working capital position would not be better

11) Business cycle

Business cycle referrers to expansion and contraction in general business activity. When the business is
prosperous (period of boom), there is a need for larger amount of working capital due to increase in
sales , optimistic expansion of business etc. On the contrary, in the times depression, the business
contracts, sales decline, difficulties are faced in collections form debtors and firms may have large
amount of working capital lying idle

12) Price level changes

Changes in the price level also affect the working capital requirements. Generally, rising prices will
require the firm to maintain larger amount of working capital. However, if firms may revise their
product prices, will not face severe working capital problem. The effects of rising price levels will be
different for different firms depending upon their price policies, nature of product etc.,

13) Other Factors

Certain other factors like operating efficiency, management ability, irregularities of supply, asset
structure, banking facilities etc., also influence the requirements of working capital

Importance and advantages of adequate working capital

Inadequate working capital is disastrous; whereas redundant working capita is a criminal waste
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Both starvation and indigestion are injurious to health

No business can run without an adequate amount of working capital. The main advantages of
maintaining adequate working capital are as follows:

1) Cash discounts

If proper cash balance is maintained, the business can avail the advantage of cash discount by paying
cash for the purchase of raw materials and merchandise. It reduces the cost of production

2) Solvency of business.

In order to maintain the solvency of the business, it is very essential to maintain sufficient amounts of
funds. Funds should readily be available to make all the payments in time as and when they are due.
Without ample working capital, production will suffer and business can never flourish in the absence of
adequate
working capital

3) Goodwill

It is common experience of all prudent businessmen that promptness of payment in business creates
goodwill and increases the debt capacity of the business. Due to this, at times, supplies can be obtained
on credit also. In addition, firm can raise funds form the market due to the payment of interest and
principal in time.

4) Easy loans form Banks

An adequate working capital, high solvency and good credit standing helps firm to borrow short term
loans from bank. Banks fell free to grant seasonal loans, if business has good credit standing and trade
reputation

5) Distribution of Dividend

If company has shortage of working capital, it cannot distribute good dividend to its shareholders in
spite of sufficient profits. Profits are to be retained in the business to make up the deficiency of
working capital. On the contrary, if working capital is sufficient, ample dividend can be declared and
distributed. It increases the market value of shares

6) Exploitation of Good Opportunities

Only concerns with adequate working capital can exploit favourable market conditions such as
purchasing its requirements in bulk when the prices are lower and by holding inventories for higher
prices
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7) Ability to face crisis

Depression shoots up the demand of working capital because stockpiling of finished goods become
necessary. Certain other contingencies like unexpected losses, business oscillations etc., can easily be
overcome, if company maintains adequate working capital.

8) Increases Fixed Assets Efficiency.

Adequate working capital increases the efficiency of the fixed assets of the business because of its
proper maintenance. Without working capital , fixed assets are like a motorbike which can not run as
there is no petrol. It is, therefore, said “ the fate of large scale investment in fixed capital is often
determined by a relatively small amount of current assets.”

9) High Morale

A company which has ample working capital can make regular payment of wages, salaries, and other
day-to-day commitments which raises the morale of its employees, increases their efficiency, reduces
wastages and costs and enhances production and profits.

10)Production efficiency

A continuous supply of raw materials, research programmes, innovation and technical developments
and expansion programmes can successfully be carried out if adequate working capital is maintained in
the business. It will increase the production efficiency

Disadvantages of Redundant/ Excess Working Capital

Redundant working capital is also not good for the health of the business. Following are the drawbacks
of excess working capital:

1) No proper return on Investment

The business can not earn a proper rate of return on its investment because excess capital does not
earn anything whereas the profits are distributed on the whole of its capital, thus bringing down the
rate of return to the shareholders.

2) Fall in share value

Due to low rate of return on investments, the value of shares may also fail

3) Unnecessary purchasing

In case of surplus money, it becomes difficult to control the purchases of many things which are not
required in the business or it may result in the purchase of excessive inventories and fixed assets
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which are not so frequently used or it increases the chances of theft, waste, and mishandling of
inventories.

4) No expansion activities / inefficient management

Redundant working capital may be taken as an indication that the management is not interested in
expanding the business. Otherwise, the redundant working capital might have been used in
expanding the business

5) Destruction of relationship

When there is excess working capital, relations with bank and other financial institutions may not
be maintained. This may lead to problems when demand for working capital arises

6) Excessive debtors/ Stock

Excessive working capital implies excessive debtors and defective credit policy which may cause
high rate of bad debts. If the same is implied as stock, it means poor stock turnover which may lead
to outdated stock

7) Overall inefficiency

Excess working capital may lead to overall inefficiency in the organization in turn which may lead
to the closure of the business itself

Principles of Working Capital

We need to know when to look for working capital, how to use them, and how to measure, plan and
control them ( is the core of working capital management)

1. Principle of Risk Variation

2. Principle of Cost of Capital
3. Principle of equity position
4. Principle of maturity of payment

1. Principle of Risk Variation

Risk here refers to the inability of the firm to meet its obligations as and when they become due for
payment. Larger amount in current assets with less dependence on sort-term borrowings increases
liquidity, reduces risk and thereby decreases the possibilities of loss. On the other hand, less investment
in current assets with greater dependence on short-term borrowings increases risk, reduces liquidity and
the profitability. A conservative management prefers to minimize risk by maintaining a higher level of
current assets or working capital. However, the goal of the management should be to establish a
suitable trade off between profitability and risk
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2. Principle of Cost of Capital

The various sources of raising working capital finance have different cost of capital and the degree
of risk involved. Generally, higher the risk lower is the cost and lower the risk higher the cost. A
sound working capital management should always try to achieve a proper balance between these
two

3. Principle of equity position

This principle is concerned with planning the total investment in current assets. According to this
principle, the amount of working capital invested in each component should be adequately justified
by firm’s equity position. Every rupee invested in the current assets should contribute to the net
worth of the firm. The level of current asset may be measured with the help of two ratios: 1) Current
assets as a percentage of total assets, 2) current asset as a percentage of total sales. While deciding
about the composition of current assets, the financial manager may consider the relevant industrial
averages

4. Principle of maturity of payment

This principle is concerned with planning the sources of finance for working capital. According to
this principle, a firm should make every effort to relate maturity of payment to its flow of internally
generated funds. Maturity pattern of various current obligations is an important factor in risk
assessments. Generally, shorter the maturity, the greater the inability to meet its obligations in time

Estimation of working capital requirement

Estimation of working capital is not an easy task and a large number of factors have to be considered
while determining corking capital requirement. Following factors are to be considered while estimating
working capital requirement of a manufacturing concern.
1. Total cost incurred on material, wages and overheads
2. Time-lag in the payment of wages and other expenses
3. The length of time for which raw materials are to remain in stores
4. The length of production cycle- time for conversion of raw material into finished goods.
5. The length of sales cycle during which finished goods are to be kept waiting for sale
6. The average period of credit allowed to customer
7. The amount required to pay day-to-day expense of the business
8. The average amount of cash required to make advance payments, if any
9. The average credit period expected to be allowed by suppliers
10. Margin for contingencies
 20

Management of Working Capital

The basic goal of working capital management is to manage the current assets and current liabilities in
such a way that a satisfactory level of working capital is maintained. A sound working capital
management policy is one which ensures higher profitability, proper liquidity and sound health of the
organization. Following are the important functions of working capital management

1) Determination of the size of Working Capital

2) Determination of working capital mix
3) Determination of source/ means of working capital
4) Continuous and adequate supply of working capital
5) Control on the usage of working capital

The management of working capital can be studied under the following three heads :-

(1) Management of Cash Balances

(2) Management of Receivables and
(3) Management of Inventory

MANAGEMENT OF CASH BALANCES

Every undertaking is desirous of utilizing the available cash most efficiently so as to accomplish the
goals of the undertaking i.e. maximization of profit or wealth with minimum efforts. But management
of cash is not as simple as it appears. If, firm does not maintain sufficient cash balances, it may not be
in a position to face unexpected challenges that may bring down its credit in the market. On the other
hand, excessive cash reserves will remain idle in the business, contributing nothing towards the wealth
of the firm. Not only that , if heavy amounts are blocked for unforeseen contingencies, the company
will not be in a position to carry on its day to day working efficiently. It is where the real problem of
cash management comes, i.e. how much cash should be set aside for the unexpected challenges and
how much for the regular day-to-day working.

Cash management involves the following

1) Controlling level of cash

2) Controlling inflow of cash
3) Controlling outflow of cash
4) Optimal investment of surplus cash

1) Controlling level of cash

Every concern desires to keep minimum balance of cash for its unforeseen obligations. What
should be that minimum balance of cash is really a problem for the financial management to solve.
In deciding the level of cash the following considerations should be taken into account: -
 21
a) knowledge of inflow and outflow of cash
b) knowledge of unforeseen problems
c) Sources of funds within the business and other sources
d) Relations with banks

a) knowledge of inflow and outflow of cash

The basic toll for the management to forecast the requirement of cash balances is the
knowledge of cash inflow and cash outflow. Cash budget reveals the timing and the size
of net cash flow as well as the period during which surplus cash may be available for
temporary investment.
b) knowledge of unforeseen problems

In addition to the known inflows and outflows, there are certain unexpected
discrepancies like strike, lock out, rise in the cost of material, problem of transportation
etc. It is desirable to reserve an adequate balance to meet such contingencies. Such
reserves must be created carefully as unnecessary blockage of funds may destroy the
smooth operation of the business
c) Sources of funds

Cash level depends very much on the sources of funds form which the company can
obtain funds at short notice. The company can maintain less cash, it has internal sources
of funds to meet the expenses

d) Relation with Banks

The level of cash balance is determined largely by relationship of the firm with banks.
Relationship with banks mainly depends upon the credibility of the concern. If
company has cordial relations with banks, banks will come forward to assist the
undertaking as and when it needs cash. In this connection, points of major importance
are financial condition of the bank, its location, the services it offers, and the
managerial ability of its chief officers.

2) Controlling inflow of cash

Adequate control should be exercised on the inflow of cash. Follow up and collection mechanism
should be improved to collect the receivables as and as and when they need to be collected.
Fraudulent diversion of cash can be checked easily by installing an internal check system.
 22
3) Controlling outflow of cash

Company can maintain credibility in the market and in the minds of suppliers only if the company
makes payment in time. While dealing with outflow of cash, care should be taken to see that the
early payments are not made before due date unless cash discounts are offered by the suppliers and
payment is not delayed so as not to create incredibility in the minds of the suppliers.

4) Optimal investment of surplus cash

After controlling inflow and outflow of cash, the next problem is to invest surplus cash available
with the company for a short period. In investing the surplus fund, the following consideration are
usually given due weight – a) security b) liquidity c) yield and d) maturity. From this point of
view short-term government securities or treasury bills are better investments.

MANAGEMENT OF RECEIVABLES

Selling goods on credit increases the volume of sale. It involves an element of risk. While managing
receivables following points are to be noted

1) Whom to grant credit

Sales can be made to customers after considering (Character, Capacity, Collateral (Security) and nature
of product

2) Period of credit

Period of credit must not lead to a disastrous condition to the company. Effect of credit on liquidity of
funds must be carefully analyzed.

3) Credit Collection Policy

Company should take all necessary steps to collect receivables as early as possible to avoid bad debts.
The company should follow up collection procedure in a clear-cut sequence i.e. polite letter,
progressively strong –worded reminders, personal visits and then legal action. Though the collection
procedure should be firmly adhered to but individual cases should be considered in its merit.

4) Analyzing receivable mechanism

From time to time receivable mechanism should be appraised through various ratios like debtor
turnover ratio, ratio of receivable to current asset etc.,
 23
MANAGEMENT OF INVENTORY

An efficient system of inventory management will determine (a) what to purchase (b) how much to
purchase (c) from where to purchase (d) where to store etc

There are conflicting interests of different departmental heads over the issue of inventory. The finance
manager will try to invest less in inventory because for him it is an idle investment; whereas production
manager will emphasize to acquire more and more inventory as he does not want any interruption in
production due to shortage of inventory.

Inventories mean the stock of raw materials semi-finished products and finished products. Nearly 60%
of the current assets are represented by inventories. Shortage of stock reduces profitability and holding
excess inventories involves storage costs. Inventory management will minimize these costs. It is,
therefore, the prime responsibility of the financial executives to have proper management and control
over the investment in inventories so that it should not be unprofitable for the business. The inventory
management includes the following aspects 1) size of inventory, 2) establishing time schedules,
procedures and lot of sizes for the new orders, 3) asserting minimum safety levels 4) coordinating
sales, production and inventory policies, 5) providing proper storage facilities, 6) arranging the
receipts, disbursement of materials and developing the form of recording these transactions, 7)
assigning responsibilities for carrying out inventory functions, 8) providing the report necessary for
supervising over all activity.

Objectives of inventory management

1) Availability of Materials:

The first and foremost objective of inventory management is to make all types of materials
available at all times whenever they are needed by the production departments so that the
production many not be held up for want of materials. It is therefore advisable to maintain a
minimum quantity of all types of materials to move on the production on schedule

2) Minimizing wastage

Inventory control is essential to minimize the wastage at all levels i.e. during its storage in the
godown or at work in the factory. Normal wastage, in other words uncontrollable wastage, should
only be permitted. Any abnormal but controllable wastage should strictly be controlled. Wastage of
materials by leakage, theft, embezzlement and spoilage due to rust dust or dirt should be avoided.

3) Promotion of manufacturing efficiency

The manufacturing efficiency of the enterprise increases if right types of raw materials is made
available to the production at the right time. It reduces wastage and cost of production and improves
the profitability and morale of workers
 24
4) Better service to customer

In order to meet the demand of the customers, it is the responsibility of the concern to produce
sufficient stock of finished goods to execute the orders received. It means, a flow of production
should be maintained

5) Control of production level

The concern may decide to increase or decrease the production level in favourable time and the
inventory may be controlled accordingly. Proper control of inventory helps in creating and
maintaining buffer stock to meet any eventuality. Production variations can also be avoided through
proper control of inventories.

6) Optimal level of inventories

Proper control of inventories help management to procure materials in time in order to run the
operation smoothly. It also avoids the out of stock situations

7) Economy in purchasing

Proper inventory control brings certain advantages and economies in purchasing the raw materials.
Management makes every attempt to purchase the raw material in bulk quantities and to take
advantage of favourable market conditions.

8) Optimum investment and efficient use of capital

The prime objective of inventory control is to ensure optimum level of investment in inventories.
There should neither be any deficiency of stock of raw materials so as to hold up the production
process nor should there be any excessive investment in inventories so as to block the capital that
could be used in an efficient manner otherwise. It is, therefore, the responsibility of financial
management to set up the maximum levels of stocks to avoid deficiency or surplus stock positions.

9) Reasonable price

Management should ensure the supply of raw materials at a reasonably low price but without
sacrificing quality of it. It helps in controlling the cost of production and the quality of finished
goods in order to maximize the profits of the concern.

10) Minimizing cost

Minimizing inventory costs such as handling, ordaining and carrying costs etc., is one of the main
objectives of inventory management. Financial management should help controlling the inventory
costs in a way that reduces the cost per unit of inventory. Inventory costs are the part of total cost of
production hence cost of production can also be minimized by controlling the inventory costs.
 25
11) Designing proper organization

To design proper organization for inventory management. A clear-cut accountability should be fixed
at various levels of the organization

Inventory control System

A proper inventory control not only provides liquidity but also increases profit and cause substantial
reduction in the working capital of the concern. Inventory control involves the following:

1) Stock Levels

a) Minimum Level
b) Re-ordering Level
c) Maximum Level
d) Danger Level

2) Determination of safety stock

Safety stock is a buffer to meet some unanticipated increase in usage.

3) Ordering system of inventory (e.g. EOQ, Periodic re-ordering system, single order and scheduled
part delivery system)

4) Inventory reports

The management should be kept informed with the latest stock position of different items. This is
usually done by preparing periodical inventory reports. These reports should contain all information
necessary for managerial action. The more frequently these reports are prepared the less will be the
chances of lapse in the administration of inventories.

Tools and techniques of inventory management

A-B-C Analysis

It is generally seen that in manufacturing concerns, a small percentage of items contribute a large
percentage of value of consumption and a large percentage of items of material contribute a small
percentage of value. In between these two items there are some items which have almost equal
percentage of value of materials. Under A-B-C Analysis , the materials are dividend into 3 categories
viz. A, B and C. Past experience has shown that almost 10% of the items contribute to 70% of value of
consumption and this category is called ‘A’ Category. About 20% of items contribute about 20% of
value of consumption and is known as ‘B’ Category. Category ‘C’ covers about 70% of items of
materials which contribute only 10% of value of consumption.
 26
Class No of items Value of Items
(%) (%)
A 10 70
B 20 20
C 70 10

A-B-C analysis helps to concentrate more on category A since greatest monetary advantage will come
by controlling these items. An attention should be paid in estimating requirements, purchasing,
maintaining safety stocks and properly storing of ‘A’ category materials. These items are kept under a
constant review so that a substantial material cost may be controlled. The control of ‘C’ items may be
relaxed and these stocks may be purchased for the year. A little more attention should be given towards
‘B’ category items and their purchase should be undertaken at quarterly or half-yearly intervals

VED Analysis

The VED Analysis is generally used for spare parts. The requirements and urgency of spare parts is
different form that of materials. A-B-C analysis may not properly used for spare parts. The demand for
spare depends upon the performance of the plant and machinery. Spare parts are classified as Vital(V) ,
Essential( E) and Desirable (D) . The vital spares are a must for running the concern smoothly and
these must be stored adequately. The non-availability of vital spares will cause havoc in the concern.
The E type of spares are also necessary but their stocks may be kept at low figures. The stocking of D
type of spares may be avoided at times. If the lead-time of these spares is less than stocking of these
spares can be avoided.

Tandon Committee Report

RBI set up a committee under the chairmanship of Shri. P.L Tandon in July 1974. The terms of
reference of the Committee were:
1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of
view of encoring proper end-use of funds and keeping watch on the safety of advances
2. To suggest the type of operational data and other information that may be obtained by banks
periodically form the borrower and by the RBI form the leading banks
3. To make recommendations for obtaining periodical forecasts form borrowers in regarding 1)
business/production plans and 2) credit needs
4. To make suggestions for prescribing inventory norms for the different industries, both in the private
and public sectors.
5. To make recommendations regarding satisfactory capital structure and sound financial basis in
relation to borrowings
6. To make recommendation regarding resources for financing the minimum working capital
7. To make recommendations as to whether the existing pattern of financing working capital
requirements by cash credit/overdraft system etc., requires to be modified. If so, to suggest suitable
modifications.
8. To make recommendations on any other related matter as the Group may consider necessary.
 27
The Study Group reviewed the system of working capital financing and identified its major
shortcomings as follows:
1. The cash credit system of lending wherein the borrower can draw freely within limits sanctioned by
the banker hinders sound credit planning on the part of the banker and induces financial in-
discipline in the borrower.
2. The committee was of the opinion that bank credit is extended on the amount of security available
and not according to the level of operations of the customer
3. Bank credit instead of being taken as a supplementary to other sources of finance is treated as the
first source of finance.
4. Working capital finance provided by banks theoretically supposed to be short-term in nature, but in
practice, has become long-term source of finance.

The committee of the opinion that the banks should get the information regarding the operational plans
of the customer in advance so as to carry a realistic appraisal of such plans and the banks should also
know the end-use of bank credit so that the finance is used only for the purpose for which it was lent

Regarding bank credit, the Study group made comprehensive recommendations which have been by
and large accepted the RBI. The recommendations relate to :

1) Norms for inventory and receivables

2) Quantum of permissible bank finance
a) 0.75(CA-CL)
b) 0.75(CA)-CL
c) 0.75(CA-CL)-CL
3) Style of lending
Loan, cash credit( by charging a slightly higher rate of interest than the loan) . Excess borrowings than
estimated over a period of time should also carry a slightly higher rate. Apart from loan and cash credit
bank may go for bills lending also. Each bank may take its own decision in this regard.
4) Information and reporting
The Study Group suggested a comprehensive information and reporting system which seeks to 1)
induce the borrower to plan his credit needs carefully and maintain greater discipline in its use 2)
promote a freer flow of information between the borrower and the banker so that the latter can monitor
the credit situation better and 3) ensure that credit is used for the purpose for which it was taken

Quarterly P/L Statement, Quarterly CA and CL statement. Apart from these (1) half-yearly P/L and B/s
within 60 days 2) Annual audited B/s within 3 months and monthly stock statement should also to be
submitted

Chore Committee Recommendations

The RBI in March 1979 appointed another committee under the chairmanship of Shri. K.B Chore to
review the working or cash credit system in recent yeas with particular reference to the gap between
sanctioned limits and the extent of their utilization and also to suggest alternative type of credit
facilities which should ensure greater credit discipline.

The important recommendations of the Committee are as follows:

 28

1. The existing three types of lending, viz. CC, Loan and Bill should be retained. At the same time it is
necessary to give some directional changes to ensure that wherever possible the use of CC would be
supplanted by loans and bills. It would also be necessary corrective measures to remove the
drawbacks observed in the CC system
2. The banks should obtain quarterly statements in the prescribed format from all the borrowers
having working capital credit limits of Rs. 50 lacks and above.
3. The banks should undertake a periodical review of limits of Rs. 10 lacks and above
4. The banks should not bifurcate cash credit accounts into demand loan and fluctuating cash credit
component. Such bifurcation may not serve any purpose of better planning by narrowing the gap
between sanctioned limits and the extent of utilization thereof.
5. If a borrower does not submit the quarterly returns in time, the banks may charge penal interest o
one percent on the total amount outstanding for the period of default
6. The banks should discourage sanction of temporary limits by charging additional one percent
interest over the normal rate on the term loan
7. The bank should fix separate credit limits for peak level and non-peak level wherever possible
8. The need for reducing the over-dependence of the medium and large borrowers on bank finance for
their production/trading purpose is recognized. The net surplus cash generation of an established
industrial unit should be utilized partly at least for reducing borrowing for working capital purpose
9. Requests for relaxation of inventory norms and for ad hoc increases in limits should be subjected
by banks to close scrutiny and agreed to only in exceptional circumstances
10. Delays on the part of banks in sanctioning credit limits could be reduced in cases where the
borrowers co-operate in giving necessary information about their past performance and future
projects in time
11. Banks should give particular attention to monitor the key branches and critical accounts
12. The communication channels and systems and procedures within the banking system should be
toned up so as to ensure that minimum time is taken for collection of instruments
13. Although banks usually object to their borrowers’ dealing with other banks without their consent,
some of the borrowers still maintain current accounts and arrange bills facilities with other banks,
which vitiate the credit discipline. The RBI may issue suitable instructions in this behalf.
 29
Statement of working capital requirements

Rs.
Current Assets:

(1) Cash Required *****

(2) Stock of Raw materials *****
(3) Work-in-progress:
a) Raw Materials *****
b) Labour *****
c) Overheads ***** *****
(4) Stock of Finished goods ****
(5) Debtors/Receivables *****
(6) Advance Payments *****
(7) Others *****
*****

Current Liabilities:

(1) Creditors *****

(2) Lag in payment of expenses *****
(3) Others ***** *****

Working Capital (CA-CL) *****

Add: Provision for Contingencies *****

Net Working Capital Required *****

Notes: 1) Profits should be ignored while calculating working capital requirement as it may or may not
be used as working capital.
2) Even profits have to be used for working capital, they should be reduced by the amount of
income tax, dividend, drawings etc.
3) Element of depreciation included in overheads should be ignored as it is a notional
expenditure.
4) If problem is silent regarding W-I-P, it is assumed that WIP is complete to the extent of 100%
regarding raw materials 50% complete regarding labour and overheads.
5) Calculation for stocks of finished goods and debtors should made at cost unless otherwise
asked in the question.
 30
Features of Capital Budgeting

1) Large investments
2) Long-term commitment of funds – hence involves financial risk
3) Irreversible nature – difficult to reverse the decision as it is very difficult to dispose the asset
without heavy loss
4) Long term effect on profitability
5) Difficulties of investment decisions – future uncertain
6) National importance- employment, economic growth

Methods of capital budgeting / Evaluation of investment proposals

1) Pay-Back method
2) NPV
3) IRR
4) Profitability

1) Pay-Back method
Payback period refers to the minimum number of years required to recover the original cash outlay
invested in a project. It means where the total earnings (cash-inflow) from investment equals the
total outlay, that period is the payback period.

In case of the project generating constant cash inflows, the PBP is calculated as below
Outflow/initial investment
Annual inflows
Net cash inflow is calculated as below:

Cash inflow from sales revenue *****

Less: Operating Exp. including depn. *****
Net Income before Tax *****
Less: IT *****
Net Income after Tax *****
Add: Depn *****
Net Cash inflow *****

As because depreciation does not affect the cash inflow, it shall not be taken into consideration in
calculating net cash inflow. But it is an admissible deduction under income tax act, it has been deducted
from the gross sale revenue and added in the net income

1) Determine the payback period for a project which require a cash outlay of Rs. 10,000 and generates
cash inflows of Rs. 2000, Rs. 4000, Rs. 3000 and Rs. 2000 in the first, second, third and fourth year
respectively
 31
Inflow Rs. 10,000 Cash Outflows
I 2000
II 4000 9000
III 3000
IV 2000

PBP is 3 years and a fraction of 4th year. The fraction year is calculated as below

Balance earnings required 1000 x 12 = 6 months

Total earnings in the 4th year 2000
PBP= 3 ½ years
2)

Capital Budgeting:

Capital budgeting is the process of making investment decisions in capital expenditures.

The significance of capital budgeting:
(1) Large investments: Capital budgeting decisions, generally, involve large investment of
funds. But the funds available with a firm are always limited and the demand for fund far
exceeds the resources. Hence, it is very important for a firm to plan and control its capital
expenditure.
(2) Long-term commitment of funds : capital expenditure involves not only large amount of
funds but also funds for long-term or more or less on permanent basis. The long-term
commitment of funds increases the financial risk involved in the investment decision.
Greater the risk involved, greater is the need for careful planning of capital expenditure, i.e.,
Capital Budgeting.
(3) Irreversible Nature: The capital expenditure decisions are of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very difficult to reverse that
decisions for the reason that it is very difficult to dispose of these assets without incurring
heavy losses.
(4) Long-term Effect on Profitability: Capital budgeting decisions have a long-term and
significant effect on the profitability of a concern. Not only the present earnings of the firm
are affected by the investments in capital assets but also the future growth and profitability
of the firm depends upon the investment decision taken today. An unwise decision may
prove disastrous and fatal to the very existence of the concern. Capital budgeting is of
utmost importance to avoid over-investment or under-investment in fixed assets.
(5) National Importance: Investment decision through taken by individual concerns is of
national importance because it determines employment, economic activities and economic
growth.

Methods of evaluation
(1) Pay back Period Method
The payback sometimes called as pay out or pay off period method represents the period in
which the total investment in permanent assets pays back itself. This method is based on the principle
that every capital expenditure pays itself back within a certain period out of the additional earnings
generated from the capital assets. Thus, it measures the period of time for the original cost of a project
 32
to be recovered from the additional earnings of the project itself. Under this method, various
investments are ranked according to the length of their pay back periods in such a manner that the
investment with a shorter pay-back period is preferred to the one which has a longer pay-back period.

Advantages of pay-back period method

(1) The main advantage of this method is that it is simple to understand and easy to calculate.
(2) It saves in cost, it requires lesser time and labour as compared to other methods of capital
budgeting.
(3) In this method, as a project with a shorter pay-back period is preferred to the one having a
longer pay-back period, it reduces the loss through obsolescence and is more suited to the
developing countries like India which are in the process of development and have quick
obsolescence.
(4) Due to its short-term approach, this method is particularly suited to a firm which has
shortage of cash or whose liquidity position is not particularly good.

Disadvantages

` Though pay-back period method is the simplest, oldest and most frequently used method, it
suffers from the following limitations:
(1) It does not take into account the cash inflows earned after the pay-back period and hence the
true profitability of the projects cannot be correctly assessed. For example, there are two
projects x and y. Each project requires an investment of Rs.25,000. The profit before
depreciation and after taxes from the two projects are as follows:

Year Project x Project y

Rs. Rs.
st
1 5,000 4,000
2nd 8,000 6,000
3rd 12,000 8,000
4th 3,000 7,000
5th ___ 6,000
6th ___ 4,000

According to the pay-back method, project X is better because of earlier pay-back period of 3
years as compared to 4 years pay-back period in case of project Y. But it ignores the earnings after the
pay-back period. Project X gives only Rs.3,000 of earnings after the pay-back period while project Y
gives more earnings, i.e., Rs.10,000 after the pay-back period. It may not be appropriate to ignore
earnings after the pay-back period especially when these are substantial.

(2) This method ignores the time value of money and does not consider the magnitude and timing of
cash inflows. It treats all cash flows as equal though they occur in different periods. It ignores the fact
that cash received today is more important than the same amount of cash received after say, 3 years.
For Example:
 33
Years Annual cash inflows

Project No.1 Project No.2

Rs. Rs.
1 10,000 4,000
2 8,000 6,000
3 7,000 7,000
4 6,000 8,000
5 4,000 10,000
_______ _________
35,000 35,000
_______ _________
According to the pay-back method, both the projects may be treated equal as both have the same
cash inflow in 5 years. But in reality Project No.1 gives more rapid returns in the initial years and is
better than project No. 2.
(3) It does not takes into consideration the cost of capital which is a very important factor in
making sound investment decisions.
(4) It may be difficult to determine the minimum acceptable pay-back period, it is usually, a
subjective decision.
(5) It treats each asset individually in isolation with other assets which is not feasible in real
practice.
(6) Pay-back period method does not measure the true profitability of the project as the period
considered under this method is limited to a short period only and not the full life of the
asset.

In spite of the above mentioned limitations, this method can be used in evaluating the profitability of
short-term and medium-term capital investment proposals. It this technique can also be made powerful
if we consider post payback results.

2) NPV: The Net Present Value( NPV) takes into consideration the time value of money. It recognizes
the fact that a rupee earned today is worth more than the same rupee earned tomorrow. The
net present value of all inflows and outflows of cash occurring during the entire life of the
project is determined separately for each year by discounting these flows by the firm’s cost of
capital or a pre-determined rate.

NPV= Discounted inflows- Discounted outflow

Evaluation : to chose between mutually exclusive projects, the projects should be ranked in order of net
present values i.e. the project having maximum positive NPV is given first preference. The project with
negative NPV is rejected.
 34
Formula used to determine discounting factors at a given cutoff rate is given under:

PV= 1
(1+r)n

Advantages of NPV technique

1. It recognizes time value of money
2. It considers earnings over the entire life of the project and hence true profitability of the
proposal can be ascertained
3. It takes into consideration the objective of maximum profitability

Disadvantages:

1. compared to traditional methods of evaluation, the net present value method is more difficult to
understand and operate.
2. this technique cannot be applied effectively to the projects with unequal lives
3. in the same way the proposal cannot applied effectively to the projects with unequal investment
4. it is not easy to determine an appropriate discount rate.

IRR (Internal Rate of Return)

The internal rate of return can be defined as that rate of discount at which the present value of cash
inflows is equal to the present value of cash outflows. IRR is sometimes called trial and error method.
Under this technique two discounted factors are used Viz. lower discounting factor and the higher
discounted factor

Advantages of IRR
1. It takes into account the time value of money
2. this technique can be usefully applied in the situations with even as well as uneven cash flow at
different periods of time
3. the determination of cost of capital is not a prerequisite for the use of this method and hence it is
better than net present value method where the cost of capital cannot be determined easily
4. this method is also compatible with the objective of maximum profitability and is considered to
be amore reliable technique of capital budgeting

IRR= L+PVLF - I. I X (H-L)

PVLF – PVHF

PVLF= Present Value of Cash inflows at Lower dis. Factor

PVHF= Present Value of Cash inflows at Higher dis. Factor
I.I = Initial Investment
H= Higher Discounting factor
L= Lower Discounting factor
 35
Disadvantages

1. It is difficult to understand and is the most difficult method of evaluation of investment

proposals
2. this method is based on the assumption that the earnings are reinvested at the internal rate of
return for the remaining life of the project which is not a justified assumption
3. it takes more time to evaluate a proposal as it is a technique of trial and error

Accounting Rate of Returns (ARR)

ARR consider the earnings of the project of the economic life of the project. ARR can be calculated
either on the basis of earnings or cash inflows.

ARR= Annual Average Net Earnings x 100

Average Investment

Or

Annual Average Cash inflows x 100

Average Investment

Annual Average Net Earnings = Inflows after tax but before depreciation
Number of years under consideration
Annual Average Cash inflows = PVS of cash inflows
Number of years under consideration
Average Investment = Initial Investment / Cost of the proposal
2

Advantages:
1. it is very simple to understand
2. it considers earnings throughout the economic life of the proposal
 36
DIVIDEND DECISION
Dividend policy determines the division of earnings between payments to shareholders and retained
earnings.

Dividend is that part of profit which is distributed among the shareholders according to the decision
taken and resolution passed in the Board Meeting.

Factors Affecting Dividend Policy

1. Magnitude and Stability of earnings

The amount and stability of earnings is an important aspect of dividend policy. As dividend can be
paid only out of present or past year’s profits, earnings of the company fix the upper limit on dividends.
The dividends should, generally, be paid out of current year’s earnings only as the retained earnings of
the previous years become more or less part of permanent investment in the business to earn current
profits. The past trend of the company’s earnings should also be kept in consideration while making the
dividend decision

2. Legal restrictions

Legal provisions provided by the Companies Act, 1956 relating to dividend are relevant because they
lay down a framework within which dividend policy is formulated. These provisions require that
dividend can be paid only out of current profits or past profits after providing for depreciation or out of
money provided by the Government for the payment of dividends in pursuance of a guarantee given by
the Government. The Act require that a company providing more than 10% of dividend to transfer
certain % of the current profit’s to reserves. The Act, further, provides that dividends cannot be paid out
of capital, as it will amount to reduction of capital adversely affecting the security of its creditors.

3. Nature of Industry

Nature of industry considerably affects the dividend policy. Certain industries have comparatively a
steady and stable demand irrespective of prevailing economic conditions. For instance, people used to
drink liquor both in boom as well as in recession. The same is the case regarding smoking. Such firms
expect regular earnings and hence can follow a consistent dividend policy. On the other hand, if the
earnings are uncertain, as in the case of luxury goods, conservative policy should be followed. Such
firms should retain a substantial part of their current earnings during boom period in order to provide
funds to pay adequate dividends in recession periods. Thus, industries with steady demand for their
products can follow a higher dividend payout ratio while cyclical industries should follow a lower
payout ratio.

4. Age of the Company

Age of the company also influences the dividend decisions of a company. A newly established concern
has to limit payment of dividend and retain a substantial part of earnings for financing its future growth
and development, while older companies which have established sufficient resources can afford to pay
liberal dividends.
 37
Past dividend rates

While formulating dividend policy, the directors must keep in mind the dividend paid in the past year.
The current rate should be around the average past rate. If it has been abnormally increased, the shares
will be subject to speculation. In a new concern, the company should consider the dividend policy of
the rival organizations

5. Ability to borrow

Well established and large firms have better access to the capital market than the new companies and
may borrow funds from other external sources if there arises any need. Such companies may have a
better dividend payout ratio. Where as smaller firms have to depend on their internal sources and
therefore they will have to build up good reserves by reducing the dividend payout ratio for meeting
any obligation requiring heavy funds.

6. Policy of control

Policy of control is another determining factor in so far as dividends are concerned. If the directors
want to have control on company, they would not like to add new shareholders and therefore, declare a
dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of
policies and programmes of the existing management. So, they prefer to meet the needs through
retained earnings. If the directors do not bother about the control of the affairs they will follow a liberal
dividend policy. Thus, control is an influencing factor in framing the dividend policy.

7. Future financial requirements

It is not only the desires of the shareholders but also future financial requirements of the company that
have to be taken into consideration while making a dividend decision. The management of a concern
has to reconcile the conflicting interests of shareholders and those of the company’s financial needs. If
a company has highly profitable investment opportunities it can convince the shareholders of the need
for limitation of dividend to increase the future earnings and stabilize its financial position. But when
profitable investment opportunities do not exist then the company may not be justified in retaining
substantial part of its current earnings. Thus, a concern having few investment opportunities should
follow high payout ratio as compared to one having more profitable investment opportunities

8. Taxation policy

The taxation policy of the Government also affects the dividend decision of a firm. A high or low rate
of business taxation affects the net earnings of a company and thereby its dividend policy. Similarly, a
firm’s dividend policy may be dictated by the income-tax status of its shareholders. If the dividend
income of shareholders is heavily taxed being in high income bracket, the shareholders may forgo cash
dividend and prefer bonus shares and capital gains.
 38
9. Liquid resources

The divided policy of a firm is also influenced by the availability of liquid resources. Although, a firm
may have sufficient available profits to be declare dividends, yet it may not be desirable to pay
dividends if it does not have sufficient liquid resources. Hence the liquidity position of a company is an
important consideration in paying dividends.

If company does not have liquid resources, it is better to declare stock-dividend i.e. issue of bonus
shares also amounts to distribution of a firm’s earnings among the existing shareholders without
affecting its cash position

10. Time of payment of dividend

When should the dividend be paid is another consideration. Payment of dividend means out flow of
cash. It is , therefore, desirable to distribute dividend at a time when it is least needed by the company
because there are peak times as well as lean periods of expenditure. Wise management should plan the
payment of dividend in such a manner that there is no cash outflow at the time when the undertaking is
already in need of urgent finances.

11. Regularity and stability in dividend payment

Dividends should be paid regularly because each investor is interested in the regular payment of
dividend. The management should, in spite of regular payment of dividend, consider that the rate of
dividend should be all the most constant. For this purpose sometimes companies maintain Dividend
equalization Fund

12. Repayment of loan

A company having loan indebtedness generally transfers considerable amount of profits to reserves,
unless some other arrangements are made for the redemption of debt on maturity. It will naturally lower
down the rate of dividend. Sometimes the lenders put restrictions on the dividend distribution till such
time their loan is outstanding. Management is bound to honour such restriction and to limit rate of
dividend payout.

13. State of capital market

If the capital market position is comfortable in the country and the funds may be raised from different
sources without much difficulty, the management may tempt to declare a high rate of dividend to attract
the investors and maintain the existing shareholders. Contrarily, if there is a slump in the stock market
and the stockholders are not interested in making the investment in securities, the management should
follow a conservative dividend policy by maintaining a low rate of dividend and ploughing back a
sizable portion of profits to face any contingency. Likewise, if the term lending financial institutions
advance loans of stiffer terms, it may be desirable to rely on internal sources of financing, and
accordingly conservative dividend policy should be pursued
 39
Dividend decision and valuation of firm

The value of firm can be maximized. There are conflicting views regarding the impact of dividend
decision on the valuation of the firm. According to one school of thought, dividend decision does not
affect the shareholders’ wealth and hence the valuation of the firm. On the other hand, according to the
other school of thought, dividend decision materially affects the shareholders’ wealth and also the
valuation of the firm. Below are the views of the two schools of thought under two groups:

1. The Irrelevance Concept of Dividend or the Theory of Irrelevance and

2. The Relevance Concept of Dividend or the Theory of Relevance

Theory Of Irrelevance
a) Residual Approach
b) MM Model

a) Residual Approach

According to this theory, dividend decision has no effect on the wealth of the shareholders or the prices
of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned. This theory
regards dividend decision merely as a part of financing decision because the earnings available may be
retained in the business for re-investment. But, if the funds are not required for the business they may
be distributed as dividends. Thus, the decision to pay dividends or retain the earnings may be taken as a
residual decision. This theory assumes that investors do not differentiate between dividends and
retentions by the firm. Their basic desire is to earn higher returns on their investment. In case the firm
has profitable investment opportunities giving a higher rate of return than the cost of retained earnings,
the investors would be content with firm retaining the earnings to finance the same. However, if the
firm is not in a position to find profitable investment opportunities, the investors would prefer to
receive the earnings in the form of dividends. Thus, a firm should retain the earnings if it has profitable
investment opportunities otherwise it should pay them as dividends.

b) MM Approach
Modigliani and Miller have expressed in the most comprehensive manner in support of the theory of
irrelevance. They maintain that dividend policy has no effect on the market price of the shares and the
value of the firm is determined by the earning capacity of the firm or its investment policy. The
splitting of earnings between retentions and dividends may be in any manner the firm likes, does not
affect the value of the firm. Following are the assumptions MM Hypothesis

1) There are perfect markets

2) Investors behave rationally
3) Information about the company is available to all with out any cost
4) There are no floatation and transaction costs
5) No investor is large enough to affect the market price of shares
6) There are either no taxes or there are no differences in the rates of taxes applicable to dividends and
capital gains
7) The firm has a rigid investment policy
8) There is no risk or uncertainty in regard to the future of the firm
 40
Argument of MM Hypothesis
The argument given by MM in support of their hypothesis is that whatever increase in the value of the
firm resulted form the payment of dividend, will be exactly offset by the decline in the market price of
shares because of external financing and there will be no change in the total wealth of the
shareholders. For example, if a company having investment opportunities distributes all its earnings
among the shareholders, it will have to raise additional funds from external sources. This will result in
the increase in number of shares or payment of interest charges, resulting in fall in the earnings per
share in the future. Thus, whatever a shareholder gains on account of dividend payments is neutralized
completely by the fall in the market price of shares due to decline in expected future earnings per share.
To be more specific, the market price of a share in the beginning of a period is equal to the present
value of dividends paid at the end of the period plus the market price of the shares at the end of the
period. This can be put in the form of the following formula:

P0=D1+P1
1+ ke
P0 = Market price per share at the beginning of the period or prevailing market price of a share
D1= Dividend to be received at the end of the period
P1 = Market price per share at the end of the period
Ke = Cost of equity capital or rate of capitalization
The above formula can also be written as
P1=P0 (1+ke)-D1

The MM hypothesis can be explained in another form also presuming that investment required by the
firm on account of payment of dividends is financed out of the new issue of equity shares
In such case, the number of shares to be issued can be computed with the help of the following
equation:
m =I-(E-nD1)
P1
Further, the value of the firm can be ascertained with the help of the following formula:
nP0= (n +m) P1-(I-E)
1+Ke
Where
m= number of shares to be issued
I= Investment required
E= Total earnings of the firm during the period
P1= Market price per share at the end of the period
Ke= Cost to equity capital
n= number of shares outstanding at the beginning of the period
D1= Dividend to be paid at the end of the period
Problem: 1
ABC Ltd., belongs to a risk class for which the appropriate capitalization rate is 10%. It currently has
outstanding 5000 shares selling at Rs. 100 each. The firm is contemplating the declaration of dividend
of Rs. 6 per share at the end of the current financial year. The company expects to have a net income of
Rs. 50,000 and has a proposal of making new investments of Rs. 100,000. Show that under the MM
hypothesis, the payment of dividend does not affect the value of the firm
 41
A) Valuation of the firm when dividends are paid

Step –1 Price of the share at the end of the current financial year

P1= P0 (1+Ke)-D1
=100(1+. 10)-6
=100 x 1.10-6
=110-6
Rs. 104
Step-2 Number of shares to be issued

m= I-(E-nD1)
P1

= 100,000-(50,000-5000x6)
104
= 80,000
104

Step-3 Value of the firm

nP0= (n + m) P1-(I-E)
1+Ke

= (5,000 + 80,000) x 104 – (1,00,000 – 50,000)

104
1+. 10

= (5,000 + 80,000) x 104 – (50,000)

104 1
1. 10

= 5,20,000 + 80,000 x 104 – (50,000)

104
1.10

= 6,00,000 – 50,000

1+. 10
5,50,000
1.10
Rs. 5,00,000
 42
B) Valuation of the firm when dividends are not paid

Step –1 Price of the share at the end of the current financial year

P1= P0 (1+Ke)-D1
=100(1+. 10)-0
=100 x 1.10
=110

Step-2 Number of shares to be issued

m= I-(E-nD1)
P1

= 100,000-(50,000-0)
110
= 50,000
110

Step-3 Value of the firm

nP0= (n + m) P1-(I-E)
1+Ke

= (5,000 + 50,000) x 110 – (1,00,000 – 50,000)

110
1+. 10

= (50,000 + 50,000) x 110 – (50,000)

110 1
1. 10

= 5,50,000 + 50,000 x 110– (50,000)

110 1
1.10

= 6,00,000 – 50,000

1. 10
5,50,000
1.10
Rs. 5,00,000

Hence, whether dividends are paid or not, the value of the firm remains the same i.e. Rs. 5,00,000
 43
Criticism of MM Approach

MM hypothesis has been criticized on account of various unrealistic assumptions as given below:
1. Perfect capital market does not exist in reality
2. Information about the company is not available to all the persons
3. The firms have to incur floatation costs while issuing securities
4. Taxes do exist and there is normally different tax treatment for dividends and capital gains
5. The firms do not follow a rigid investment policy
6. The investors have to pay brokerage, fees etc, while doing any transaction
7. Shareholders may prefer current income as compared to further gains.

2. Theory of Relevance
The other school of thought on dividend decision holds that the dividend decisions considerably affect
the value of the firm. The advocates of this school of thought include mainly Walter’s Approach and
Garden’s Approach

Walter’s Approach

Pro. Walter’s Approach supports the doctrine that dividend decisions are relevant and affect the value
of the firm. The relationship between the internal rate of return earned by the firm and its cost of capital
or required rate or return is very significant in determining the dividend policy to sub-serve the
ultimate goal of maximizing the wealth of the shareholders.

According to Prof. Walter, if r > k i.e. if the firm earns a higher rate of return on its investment than the
required rate of return, the firm should retain the earnings and plough back the entire earnings within
the firm . Such firms are termed as growth firms and the optimum payout would be zero in their case.
This would maximize the value of shares

In case of declining firms which do not have profitable investment i.e. where r < k , the shareholders
would stand to gain if the firm distributes the earnings. The implication of r < k is that the shareholders
can earn a higher return by investing elsewhere. For such firms, the optimum payout would be 100%
and the firms should distribute the entire earnings as dividends

In case of normal firms where r = k, the dividend policy will not affect the market value of shares as
the shareholders will get the same return from as expected by them. For such firms, there is no
optimum dividend payout and the value of the firm would not change with the change in dividend rate.

Assumptions of the Model

1) The investments of the firm are financed through retained earnings only and the firm does not use
external sources of funds
2) The internal rate of return (r) and cost of capital (k) of the firm are constant, with additional
investments undertaken
3) Earnings and dividends do not change while determining the value
4) The firm has a very long life
 44
Formula

P = D + r(E-D)/Ke
r
Ke Ke D + Ke E-D
P= Market price per share P=
Ke
D= Dividend per share
r = Internal rate of return
E = Earnings per share
Ke = Cost of equity

Following illustration explains the concept

Capitalization rate(Ke) = 10%

Earnings per share(E) = Rs. 10
Assumed rate of Return on Investments (R)
1) 15% (2) 8% and (3) 10%

Show the effect of the dividend policy on market price of shares using Walter’s Model when Payout
ratio (P/O) is a) 0% b) 25% c) 50% d) 75% and e) 100%

Dividend Policy and Value of Shares (Walter’s Model) – When r= 15%

(a) D/P Ratio = 0 % (Dividend per share = Zero)

0 + 0.15 (10-0)
0.10
P= = Rs.150
0.10

(b) D/P Ratio = 25 % (Dividend per share = Rs. 2.5)

2.5 + 0.15 (10-2.5)
0.10
P= = Rs.137.50
0.10
(c) D/P Ratio = 50 % (Dividend per share = Rs.5)

5.0 + 0.15 (10-5.0)

0.10
P= = Rs.125.00
0.10
(d) D/P Ratio = 75 % (Dividend per share = Rs.7.5)

7.5 + 0.15 (10-7.5)

0.10
 45
P= = Rs.112.50
0.10
(e) D/P Ratio = 100 % (Dividend per share = Rs.10)

10 + 0.15 (10-10)
0.10
P= = Rs.100
0.10

Dividend Policy and Value of Shares (Walter’s Model) – When r= 8%

(a) D/P Ratio = 0 % (Dividend per share = Zero)

0 + 0.08 (10-0)
0.10
P= = Rs.80
0.10
(b) D/P Ratio = 25 % (Dividend per share = Rs. 2.5)
2.5 + 0.08 (10-2.5)
0.10
P= = Rs.90
0.10

(c) D/P Ratio = 50 % (Dividend per share = Rs.5)

5.0 + 0.08 (10-5.0)

0.10
P= = Rs.95.00
0.10

(d) D/P Ratio = 75 % (Dividend per share = Rs.7.5)

7.5 + 0.08 (10-7.5)

0.10
P= = Rs.112.50
0.10

(e) D/P Ratio = 100 % (Dividend per share = Rs.10)

10 + 0.15 (10-10)
0.10
P= = Rs.100
0.10
 46
Dividend Policy and Value of Shares (Walter’s Model) – When r= 10%

(a) D/P Ratio = 0 % (Dividend per share = Zero)

0 + 0.10 (10-0)
0.10
P= = Rs.100
0.10
(b) D/P Ratio = 25 % (Dividend per share = Rs. 2.5)
2.5 + 0.10 (10-2.5)
0.10
P= = Rs.100
0.10
(c) D/P Ratio = 50 % (Dividend per share = Rs.5)

5.0 + 0.10 (10-5.0)

0.10
P= = Rs.100
0.10

(d) D/P Ratio = 75 % (Dividend per share = Rs.7.5)

7.5 + 0.10 (10-7.5)

0.10
P= = Rs.100
0.10
(e) D/P Ratio = 100 % (Dividend per share = Rs.10)

10 + 0.10 (10-10)
0.10
P= = Rs.100
0.10
Criticism of the Model

The model has been criticized on the following grounds

1) The basic assumption that investments are financed out of retained earnings is seldom true in the
real world. Firms do raise funds by external financing
2) The internal rate of return (r) also does not remain constant, with increased investment the rate of
return also changes
3) The assumption that cost of capital (k) will remain constant also does not hold good. As firm’s risk
pattern does not remain constant, it is not proper to assume that k will always remain constant,
 47
Gorden’s Approach

According to this model value of a rupee of dividend income is more than the value of a rupee of
capital gain. This is an account of uncertainty of future and shareholders discount future dividends at a
higher rate. According to Gorden, the market value of future stream of dividends.

As the investors are rational, they want to avoid risk. The term risk here refers to the possibility of not
getting a return on investment. The argument underlying Gorden’s model of dividend relevance is also
described as a bird-in-the –hand argument. That a bird in hand is better than two in the bush is based
on the logic that what is available at present is preferable to what may be available in the future. It is
certain that the future is uncertain and more distant the future is, the more uncertain is the receipt of
return. Therefore, omission of dividends or payment of low dividends would lower the value of the
shares. Shareholders discount the value of shares of a firm which postpones dividends. The discount
rate would vary with the retention rate or level of retained earnings

Gorden’s Model is symbolically expressed as

P = E (1-b)
Ke-br

P= Price of shares
E= Earnings per share
b= Retention ratio or % of earnings retained
1-b= D/P ratio i.e. % of earnings distributed as dividends
Ke = Cost of capital
br = growth rate =rate or return on investment

Gorden’s Model is explained below

Given r = 12%
E = Rs.20
Determine the value of shares, assuming the following:

D/P ratio (1-b) retention ratio (b) Ke(%)

1) 10 90 20
2) 20 80 19
3) 30 70 18
4) 40 60 17
5) 50 50 16
6) 60 40 15
7) 70 30 14
 48
Dividend policy and value of shares using Gordon’s Model

a) D/P ratio 10 %
Retention ratio 90 %

br = 0.9 x 0.12 = 0.108

P = Rs. 20 (1-0.9) = Rs.2 = 21.74
0.20-0.108 0.092
b) D/P ratio 20 %
Retention ratio 80 %

br = 0.8 x 0.12 = 0.096

P = Rs. 20 (1-0.8) = Rs.4 = 42.55
0.19-0.096 0.094
c) D/P ratio 30 %
Retention ratio 70 %

br = 0.7 x 0.12 = 0.084

P = Rs. 20 (1-0.7) = Rs.6 = 62.50
0.18-0.084 0.096

d) D/P ratio 40 %
Retention ratio 60 %

br = 0.6 x 0.12 = 0.072

P = Rs. 20 (1-0.6) = Rs.8 = 81.63
0.17-0.072 0.098
e) D/P ratio 50 %
Retention ratio 50 %
br = 0.5 x 0.12 = 0.060
P = Rs. 20 (1-0.5) = Rs.10 = 100
0.16-0.060 0.10
f) D/P ratio 60 %
Retention ratio 40 %

br = 0.4 x 0.12 = 0.048

P = Rs. 20 (1-0.4) = Rs.12 = 117
0.15-0.048 0.102
g) D/P ratio 70%
Retention ratio 30 %
br = 0.3 x 0.12 = 0.036
P = Rs. 20 (1-0.3) = Rs.14 = 134.62
0.14-0.036 0.104
 49
From the above it is observed that dividend decision has a bearing on the market price of the share. The
market price of the share is favorably affected with more dividends
COST OF CAPITAL

Compare And Contrast Various Long Term Sources

Normally, financial requirements of a concern are financed either through Owned Capital or through
Borrowed Capital. Following sources are available for long term financing

1) Share capital
a) Preference
b) Equity
2) Debentures
3) Ploughing-back of profits

Advantages of Preference shares

1. Almost a permanent source of finance

2. As preference shareholders have no voting rights, control of the company remains with the
company only
3. By issuing redeemable preference shares company can have flexible capital structure
4. No need to mortgage any property
5. Trading on equity is ensured because of the fixed financial obligation

Disadvantages

1. Cost of raising the preference share capital is relatively higher

2. Permanent burden on the company (especially in case of cumulative preference shares)

Equity shares

1. No obligation to pay a fixed rate of dividend

2. No charge on the assets of the company
3. Permanent source of finance
4. Voting right
5. Value of the firm is mainly dependent on equity

Disadvantages

1. Trading on equity is not possible of company issue only equity

2. It does not provide flexibility in the capital structure. It may cause over capitalization
3. They can put obstacles in management by manipulation and organizing themselves
4. Due to higher rates of dividends during prosperous periods may lead to speculation
5. It is not suited for those who needs security and fixed returns on their investments
 50
Debentures

Difference between shares and debentures

Shares
1) Part of owned capital
2) Dividend is the reward
3) No Fixed obligation
4) Charge against P/L Appn. A/c
5) Have voting rights
6) Not redeemable( except R.P.S)
7) At the time of liquidation, share Debentures are payable in priority over share capital
capital is payable after meeting all
outside liabilities
Debentures
Part of debt
Interest is the reward
Involves fixed obligation
Charge against P/L A/c
No voting rights
Normally redeemable after a certain period

Advantages

1) Control of the company is not surrendered to the debenture holders

2) Trading on equity is possible
3) Interest on debenture is an allowable expenditure under IT Act
4) It provides flexibility as they can be redeemed after a certain period

Disadvantages

1) Cost of raising debentures is relatively high due to high stamp duty

2) As they bear high denomination, common people cannot by them
3) It is not suited for newly started companies

Ploughing Back of Capital

Advantages

1) Economical source of finance

2) Cushion for expansion programmes and dividends
3) Aids in capital formation
4) Makes the company self-dependent
5) Smooth and undisrupted running of the business is ensured

Disadvantages

1) Manipulation in the value of shares.

2) Over-capitalization
3) Misuse of savings by the authorities
4) Opportunity cost
 51

Cost of Retained earnings

Some people regard retained earnings as a source of capital without any cost : while others think
that retained earnings do have cost

Retained earnings are profits which have not been distributed by the company to its shareholders in the
form of dividend and have been retained in the company to be used for future expansion. They are
represented by the uncommitted or free reserves and surplus. The company is not required to pay any
dividend on retained earnings. It is, therefore , observed that this source of finance is cost free. This
view seems to be based on the assumption that the company is a separate entity from that of the
shareholders and it pays nothing to the shareholders to withhold these earnings. But this view is not
correct. Retained earnings is the dividend foregone by the shareholders by not putting funds elsewhere.

From shareholder’s point of view, the opportunity cost of retained earnings is the rate of return that
they can obtain by putting after tax dividend in the other securities of equal qualities, if earnings are
paid to them as dividend in cash. An individual pays income tax on dividend hence he would only be
able to invest the amount remained after paying individual income tax on such earnings. This can be
expressed as below

Kr = Ke(1-tp)(1-B)

Where Kr = Cost of retained earnings

Ke = Required rate of return to shareholders
tp = Personal Tax rate
B = Brokerage on purchase of securities

For example, a company retains Rs. 50,000 out of its current earnings. The expected rate of return to
the shareholders, if they had invested the funds elsewhere, is 10%. The brokerage is 2% and the
shareholders came in 30% tax bracket. The cost of retained earnings may be calculated as:-

Kr = Ke (1-tp)(1-B)

= 0.10 (1-0.30) (1-0.02)

= 0.10 (0.70) (0.98)
= 0.0686 or 6.85%
It is always less than the shareholders required rate of return.

The cost of retained earnings would be equal to the cost of capital on equity shares (i.e. Kr = Ke) if the
shareholders do not pay any income tax on dividends, and incur no brokerage cost when investing the
dividend received.
 52
Cost of Preference Shares

Preference shares are the fixed cost bearing securities. The rate of dividend is fixed well in advance at
the time of their issue. So, cost of capital of preference shares is equal to the ratio called current
dividend yield. The formula for calculating the cost of preference share is: -
When there is Div. Tax
Kp = R Kp = R+ Div. Tax
P P
Kp = Cost of Preference shares
R = Rate of Preference Dividend
P= Net Proceeds ( sale price – floatation cost)

For example, suppose a company issues 9% preference share of Rs. 100 each at a premium of Rs. 5 per
share. The issue expenses per share comes to Rs.3. The cost of preference capital shall be calculated as
under:

Kp = 9
100+5-3

= 9 = 8.82%
102

3) A company issues 14% irredeemable preference shares of the face value of Rs. 100 each.
Floatation costs are estimated at 5% of the expected sale price. What is Kp, if preference shares are
issued at 1) par 2) 10% premium 3) 5% discount. What if there is 10% tax on dividend

When there is no dividend tax When there is dividend tax

1. Issued at Par 1. Issued at Par

Kp = 14 = 14.73% Kp = 14+(14x 10%) = 16.20%

100.5 100-5

2. Issued at Premium 2. Issued at Premium

Kp = 14 = 13.40% Kp = 14+(14x 10%) = 14.70%

110-5.5 110-5.5

3. Issued at Par 3. Issued at Par

Kp = 14= 15.51% Kp = 14+(14x 10%) = 17.10%
95-4.75 95-4.75

The cost of preference share capital is not adjusted for taxes, because dividend on preference capital is
paid after the tax had been paid by the company as the dividend is not a deductible expenditure under
tax laws. Moreover, company is not under an obligation to pay dividend on preference shares. Thus, the
cost of preference capital is substantially greater than cost of debt.
 53
Cost of Redeemable Preference Shares

The explicit cost of preference shares in such a situation is the discount rate that equates the net
proceeds of the sale of preference shares with the present value of the future dividends and principal
payments. The formula is given bellow

(explicit cost of any source of capital is the discount rate that equates the present value of the cash
inflows that are incremental to the financial opportunity with the present value of its incremental cash
outflows)
n dt + Pn
Σ
P0 (1-f)t-1
(1+ kp)t (1+ kp)n
P0 = Expected sale price of preference shares
f= floatation Cost as % of P0
d= Dividends paid on preference shares
Pn= Repayment of preference capital amount

ABC Ltd has issued 14% Preference shares of the face value of Rs. 100 each to be redeemed after 10
years. Floatation cost is expected to be 5%. Determine the cost of preference shares (Kp)

The value of Kp is likely to be between 14% and 15% as the rate of dividend is 14%

Determination of the PV at 14% and 15%

10 Rs.14 + Rs.100
Rs.95 t-1
Σ
(1+ kp)t (1+ kp)10

Year Cash Outflows PV Factor Total PV

14% 15% 14% 15%

1.10 Rs. 14 5.216 5.019 Rs.73 Rs.70.30

10 Rs. 100 0.270 0.247 27 Rs. 24.70
100 95.00

Kp = 15%

Cost of perpetual debt

 54

Cost of debt is the contractual interest rate adjusted further for the tax-liability of the firm.

Formula
Before-Tax Cost of Debt After -Tax Cost of Debt

Kd = I Kd = I (1-t)
SV SV

I= Annual Interest Rate

SV= Sale Value of Debenture
t= tax rate

A company issues 15% Rs.100,000 debentures. Tax rate is 35% . Determine before-tax and after-tax
cost of debt if debt is issued at 1) par 2) 10% discount and 3) 10% premium

Debt issued at par

1) Before tax

Kd = 15000 = 15%
1,00,000

2) After Tax
Kd = 15000 ( 1-0.35) = 9.75%
1,00,000

Debt issued at discount

1) Before tax

Kd = 15000 = 16.7%
90,000

2) After Tax
Kd = 15000 ( 1-0.35) = 10.85%
90,000
Debt issued at premium

1) Before tax

Kd = 15000 = 13.6%
110,000
2) After Tax
Kd = 15000 ( 1-0.35) = 8.84%
110,000
 55
Cost of Redeemable debt

In the case of calculation of cost of redeemable debt, account has to be taken, in addition to interest
payment, repayment of the principal.

The formula is given by

Kd = I(1-t) + (f+d+pr-pi)/Nm
(RV+SV)/2

I= Annual Interest
RV= Redeemable Value of debt
SV= Net sale proceeds (FV-Issue expenses)
Nm = Term of debt
f= Flatation cost
d= discount on issue of debt
pi= Premium on issue of debt
Pr= premium on redemption of debt
I = Tax Rate

A company issues a new 15% debentures of Rs.1000 face value to be redeemed after 10 years. The
debenture is expected to be sold at 5% discount. It will also involve floatation costs of 2.5%. The
company’s tax rate is 35%. What would be the cost of debt?

Cost of debt = Interest cost + (other cost-benefit)/ No of years

(FV) + ( RV )
RV= FV+ Premium on deb-Discount on deb-Floatation cost

The same formula can be reduced and written as

I(t-1)+(FV-RV)/N
FV+RV

Kd= Rs. 150(1-0.35)+(Rs.50+Rs.25)/10 = 10.9 %

(Rs. 925 + Rs. 1,000)/2
 56
Cost of Equity

The cost of equity is difficult to measure . There are two different methods of calculating equity capital.
Viz., Dividend Approach and Capital Asset Pricing Model Approach

Dividend Approach

Under this method cost of capital is based on the expected dividend to be declared to the equity
shareholders. It is assumed here that the dividend will be keep on growing every year.

The formula is given by

Ke= D1 + g
P0

D1 = Expected Dividend
P0= Net proceeds or current market price
g= growth expected in dividend

Market value of share in different year is calculated using the formula

Ex: price at the end of first year

P1= D2
Ke-g
price at the end of 2nd year
P2= D3
Ke-g

1) Suppose the dividend of the company is expected to be at Re.1 per share next year and is expected
to grow at 6% per year perpetually. Assume market price as Rs.25. Determine the cost of equity

Ke = D1 +g Re. 1 + 0.06 = 10%

P0 Rs.25

To predict the price at the end of a future year

Price at the end of the first year (P1) = D2 Rs. 1.06 = Rs.26.50
Ke-g 0.10-0.06

Price at the end of the second year (P2) = D3 Rs. 1.124 = Rs.28.00
Ke-g 0.10-0.06
 57
CAPM Approach

CAPM tries to explain that the investors are risk averse and hence they think rationally while investing
in securities. They will not be considering the individual investment. They would like to calculate the
investment proposal on their entire portfolio management. Risk can be either diversifiable risk non-
diversifiable risk. Diversifiable risk may be in the form of management capabilities and decisions,
strikes, unique government regulations, availability or otherwise of raw materials, competition, level of
financial and operating leverage etc. This types of risks can be minimized/ eliminated through
diversification.

Non-diversifiable risk is attributed to factors that affect all firms. Interest rates, changes in investor
expectations about the overall performance of the company etc.,

Major problem of CAPM approach is the availability of data. It may not be available readily available
or in a country like India may be altogether absent .

The symbolic expression of the method is given by

Ke= Rf + b (Km-Rf)

Ke= Cost of equity

Rf = The rate of return required on a risk free asset
Km= the required rate of return on the market portfolio of assets that can be viewed as the average
rate of return on all assets
b= the beta coefficient

1) A Ltd. Company finds that the risk free rate of return on the investment is 10%: firms beta equals
to 1.50 and the return on the market portfolio equals to 12.5%

Ke= 10% +(1.5 x ( 12.5%-10%))= 13.75%

2) Following information is available to you

Investment in Equity initial Price Dividends Year-end Beta

Mkt. Price risk Factor

a) Cement Co Rs.25 Rs.2 Rs. 50 Rs.0.80

Steel Co Rs.35 Rs.2 Rs. 60 Rs.0.70
Liquor Ltd Rs.45 Rs.2 Rs. 135 Rs.0.50
b) Govt. of India Bonds Rs.1000 Rs.140 Rs. 1005 Rs.0.99

You are requested to calculate 1) expected rate of returns of market portfolio and
3) expected return in each security, using capital asset pricing model
 58
Expected return on market portfolio

Security Returns Investment

Dividends Cap. Appn Total

A Cement Ltd. Rs. 2 Rs.25 Rs. 27 Rs. 25

Steel Ltd. Rs. 2 Rs.25 Rs. 27 Rs. 35
Liquor Ltd. Rs. 2 Rs.90 Rs. 92 Rs. 45
B. Govt. of India Bonds Rs.140 Rs. 5 Rs. 145 Rs. 1000
Rs.146 Rs. 145 Rs.291 Rs. 1105

Rate of return (expected) on market portfolio = Rs. 291/Rs. 1105 = 26.33%

Expected returns on individual security

Ke = Rf +b(Km-Rf)

Cement Ltd. = 14% + 0.8(26.33% -14%) 23.86 %

Steel Ltd. = 14% + 0.7(26.33% -14%) 22.63 %
Liquor Ltd. = 14% + 0.5(26.33% -14%) 20.16 %
Govt. Bonds = 14% + 0.99(26.33% -14%) 26.21%

Guidelines pertaining to the issue of bonus shares

1) There should be a provision in the articles of association for capitalization of reserves. If not, the
company should produce a resolution passed at the general body making provisions in the articles
for capitalization
2) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceeds the
authorized capital, a resolution is passed at the genera body meeting in respect of increase in the
authorized capital is necessary
3) The company should furnish a resolution passed at the general body meeting for bonus issue before
an application is made to the CCI. In the general body resolution the management’s intention
regarding the rate of dividend to be declared in the year immediately after the bonus issue should be
indicated
4) The bonus issue is permitted to be made out of free reserves built out of genuine profits or share
premium collected in cash only
5) Reserves created by revaluation of fixed assets are not permitted to be capitalized
6) Development rebate reserve / investment allowance reserve is considered as free reserve for the
purpose of calculation of residual reserve test
7) All contingent liabilities disclosed in the audited account which have a bearing on the net profits
shall be taken into account in the calculation of the minimum residual reserves
8) The residual reserves after the proposed capitalization should be at least 40% of the increased paid-
up capital
9) 30% of the average profits before tax of the company for the previous 3 years should yield a rate of
dividend on the extended capital base of the company at 10%
 59
10) There must be an interval of 36 months between two successive bonus issues
11) Bonus issues are not permitted unless the partly paid shares, if any, are made fully paid up
12)No bonus issue will be permitted if there is sufficient reason to believe that the company has
defaulted in respect of the payment of statutory dues of the employees such as contribution to PF,
gratuity, bonus etc
13) Application for issue of bonus shares should be made within one month of the bonus
announcement by the board of directors of the company
14) In case where there is any default in the payment of any term loans outstanding to any public
financial institution a no objection letter from that institution in respect of the issue of bonus shares
should be furnished by the companies concerned with the bonus issue application
15)If there is a composite proposal for the issue of bonus shares and right shares , the bonus shares will
be sanctioned first and the right shares only after some time

Stock Splits (Sub –division of shares)

One share of Rs. 50/- may be subdivided into Rs. 5 new shares of Rs. 10/- each

Stock split refers to an act of subdividing shares of higher denomination into shares of lower
denominations. The sub division takes place when the present face value of the shares is considered too
high and when the shares of such high denominations are not popular on the Stock Exchange

1) Board meeting will consider the plan for stock splits and fix the date of extraordinary general
meeting
2) Notices and circulars relating to the extraordinary general meeting will be issued to members
3) An ordinary resolution (if the articles do not require otherwise) is sufficient to sanction subdivision
o shares
4) Notice of subdivision should be given to the Registrar with in 30 days
5) Notice of closure of transfer will be issued and the list of members will be prepared
6) A circular to the member will be issued requesting them to surrender their share certificate for
cancellation
7) The old certificates will be cancelled and new certificates will be sealed and signed, necessary
entries will be made in the registrar of members, shares will be re-numbered and the new
certificates will be issued to the members in due course

The impact of Bonus and stock splits is one and the same- increase in the number of shares.

Capital structure and Dividend policies

Capital structure refers to the composition of its capitalization and it includes all long term capital
resources, viz., loans, reserves, shares and debentures.

The capital structure is made up of debit and equity and refers to permanent financing of a firm. It is
composed of long term debt, preference share and share holders’ fund.
 60
Theories of capital structure
1) Net income approach
2) Net operating income approach
3) The traditional approach
4) Modigliani and Miller Approach

1. Net Income Approach

According to this approach, a firm can minimize the cost of capital and increase the value of the firm as
well as market price of equity shares by using debt financing to the maximum possible extent. This
approach is based upon the following assumptions

a) The cost of debt is less than the cost of equity

b) There is no tax
c) The risk perception of the investors is not changed by the use of debt.

The line of argument in favour of net income approach is that as the proportion of debt financing
increases the proportion of an expensive source of funds decreases. This results in the decrease in
overall cost of capital leading to an increase in the value of the firm. The reasons for assuming cost of
debt to be less than the cost of equity are that interest rates are usually lower than dividend rates due to
element of risk and the benefit of tax as the interest is a deductible expense. This theory is explained in
the following illustration
a) A Company expects a net income of Rs. 80000. It has Rs. 2,00,000, 8% Debentures. The equity
capitalization rate is 10%. Calculate the value of the firm and overall capitalization rate according
to the net income approach( ignore tax)
b) If the debenture debt is increased to Rs. 300,000, what shall be the value of the firm and overall
capitalization rate?

Calculation of the value of the firm

Net income Rs. 80000
Less: interest on 8% Debentures (200,000 x 8/100) Rs. 16000
Earnings available to equity shareholders Rs. 64000

Equity capitalization ratio 10%

Market Value of Equity = 64000 x 100/10 = 6,40,000

Market Value of Debentures = 2,00,000
8,40,000

Overall cost of capital = Earnings x 100 ( EBIT)

Value of the firm V
80000 x 100 = 9.52%
840000
 61
Calculation of the value of firm if debenture debt is increased to 3,00,000

Net income Rs. 80000

Less: interest on 8% Debentures (300,000 x 8/100) Rs. 24000
Earnings available to equity shareholders Rs. 56000

Equity capitalization ratio 10%

Market Value of Equity = 56000 x 100/10 = 5,60,000

Market Value of Debentures = 3,00,000
8,60,000

Overall cost of capital (ke)= Earnings x 100

Value of the firm
80000 x 100 = 9.30%
860000
This is evident that with the increase in debt financing the value of the firm has increased and the
overall cost of capital has decreased.

2. Net operating income approach

According to this approach, change in the capital structure of a company does not affect the market
value of the firm and the overall cost of capital remains constant irrespective of the method of
financing. It implies that the overall cost of capital remains the same whether the debt-equity mix is
50:50, 20:80, or 0:100. Thus, there is nothing as an optimum capital structure. This theory presumes
that:

1) the market capitalizes the value of the firm as a whole;

2) the business risk remains constant at every level of debt- equity mix

The reasons propounded for such assumptions are that the increased use of debt increases the financial
risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of
debt remains constant with the increasing proportion of debt as the financial risk of the lenders is not
affected. Thus, the advantage of using the cheaper sources of funds i.e. debt is exactly offset by the use
of equity. Net income approach is explained bellow with an illustration

(a) Company expects a net operating income of Rs. 100,000. It has Rs. 500,000, 6% debentures. The
overall capitalization rate is 10%. Calculate the value of the firm and equity capitalization rate
(b) If the debenture debts is increased to Rs. 7,50,000, what will be the effect on the value of firm and
the equity capitalization rate

a) Net operating Income Rs.100,000

Overall cost of capital 10%
Market value of the firm (V) = Net operating income (EBIT)
Overall cost of capital ke
 62
1,00,000 x 100
10
Market value of firm Rs. 10,00,000
Less: Market value of Debentures 5,00,000
Total market value of equity 5,00,000

Equity capitalization rate or cost of equity (ke)

= EBIT-I EBIT = Earnings before Interest = 1,00,000-30,000 x100 V-D

and tax 1,00,000-5,00,000
V = Value of the firm
D = Value of debt capital = 70,000 x 100 = 14%
I = Interest on debt 5,00,000

b) If the debenture debt is increased to Rs. 7,50,000, the value of the firm shall remain unchanged at
Rs. 10,00,000. The equity capitalization rate will increase as follows

Net operating Income Rs.100, 000

Overall cost of capital 10%
Market value of the firm (V) = Net operating income (EBIT)
Overall cost of capital ke
1,00,000 x 100
10
Market value of firm Rs. 10,00,000
Less: Market value of Debentures 7,50,000
Total market value of equity 2,50,000

Equity capitalization rate or cost of equity (ke)

= EBIT-I EBIT = Earnings before Interest = 1,00,000-45,000 x100 V-D

and tax 1,00,000-7,50,000
V = Value of the firm
D = Value of debt capital = 55,000 x 100 = 22%
I = Interest on debt 2,50,000

3. The Traditional approach

The traditional approach is a compromise between the two extremes of net income approach and net
operating income approach. According to this theory, the value of the firm can be increased initially or
the cost of capital can be decreased by using more debt as the debt is ore cheaper source of funds than
 63
equity. Thus, optimum capital structure can be reached by a proper debt-equity mix. Beyond a
particular point, the cost of equity increases because increased debt increases the financial risk of the
equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by
increased cost of equity cannot be offset by the advantage of low cost debt. Thus, overall cost of
capital, according to this theory, decreases upto a certain point, remains more or less unchanged for
moderate increase in debt thereafter; and increases beyond a certain point. Even the cost of debt may
increase at this state due to increased financial risk. The theory has been explained as below

Net operating income Rs. 2,00,000

Total Investment Rs. 10,00,000
Equity capitalization
a) If the firm uses no debt 10%
b) If the firm uses Rs. 4,00,000 Debentures 11%
c) If the firm uses Rs. 6,00,000 Debentures 13%
Assume that the Rs. 4,00,000 debentures can be raised at 5% interest and Rs.6,00,000 debenture can be
raised at 6% interest

Calculation of market value of firm, value of shares and the average cost of capital

Particulars (a) No debt (b) Rs. 4,00,000 (c) 6,00,000

@ 5% interest @ 6% interest

Net operating income Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000

Less: Int.(Cost of cap.) -- 20,000 36,000
Earnings av. for equity sh. 2,00,000 1,80,000 1,64,000
Equity capitalization rate 10% 11% 13%
Market value of sh. 200,000x100 180000x100 164000x 100
10 11 13
= 20,00,000 = 16,36,363 = 12,61,538
Market value of deb. - 4,00,000 6,00,000
Market value of the firm 20,00,000 20,36,361 18,61,538

Average cost of capital

Earnings EBIT 2,00,000 x 100 2,00,000 x 100 2,00,000 x 100

Value of firm V 20,00,000 20,36,363 18,61,538
=10% =9.8% = 10.7%
It is clear from the above that if debt of Rs.400,000 is used the value of the firm increases and the
overall cost of capital decreases. But if more debt is used to finance in place of equity Rs.600,000
debentures, the value of the firm decreases and the overall cost of capital increases
 64
4. Modigliani and Miller Approach (MM approach)

M and M hypothesis is identical with the net operating income approach, if taxes are ignored. However,
when corporate taxes are assumed to exist, their hypothesis is similar to the net income approach.

1) In the absence of taxes: The theory proves that the cost of capital is not affected by changes in the
capital structure or say that the debt-equity mix is irrelevant in the determination of the total value
of a firm. The reason argued is that though debt is a cheaper to equity, with increased use of debt as
a source of finance, the cost of equity increases. This 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 emphasizes the fact that a firm’s operating income is
determinant of its total value. The theory further propounds that beyond a certain limit of debt, the
cost of debt increases (due to increased financial risk) but the cost of equity falls thereby again
balancing the two costs. In the opinion of M& M, two identical firms in all respects except their
capital structure cannot have different market values or cost of capital because of arbitrage process.
In case two identical firms, except their capital structure, have different market value or cost of
capital arbitrage will take place and the investors will engage in personal leverage ( i.e. they will
buy equity of the other company in preference to the company having lesser value) as against the
corporate leverage and this will again render the two firms have the same total value

The MM Model is based upon the following assumptions:

(1) There are corporate Taxes
(2) There is a perfect market
(3) Investors act rationally
(4) The expected earning of all the firms have identical risk characteristic
(5) The cut-off point for investment in a firm is capitalization rate.
(6) Risk to investors depends upon the random fluctuations of the expected earning and the
possibility that the actual value of the variables may turn out to be different from their best
estimate.
(7) All earnings are distributed to the shareholders

 A Company has EBIT of Rs. 1,00,000. It expects a return on its investment at a rate of
12.5%. What is the total value of firm according to the M & M theory?

According to the M and M theory, total value of the firm remains constant. It does not change with
the change in capital structure.

The total value of firm = EBIT

Ke
= 1,00,000 = 1,00,000 x 100 = 8,00,000
12.50 12.50
100
 65
There are two firms X and Y which are exactly identical except that X does not use any debt in its
financing, while Y has Rs. 100,000 5% debentures in its financing. Both the firms have EBIT of Rs.
25,000 and the equity capitalization rate is 10%. Assuming the corporate tax of 50% calculate the value
of the firm

The market value of firm X which does not use any debt
Vu = EBIT
Ke
= 25,000 =25000 x 100 = 2,50,000
10 10
100
The market value of firm Y which uses debt financing of Rs.100,000

Vt= Vu + td Tax Rate Quantum of debt

= 2,50,000 + 0.5 x 1,00,000
= 2,50,000 + 50,000 = 3,00,000