Module 2 ; Corporate Finance Strategies;

1. Write the meaning and the uses of corporate financial strategy.

2. Write the various steps for developing successful corporate financial strategies.

3. What is the value based management?

4. Write the various components for financial strategies.

5. What are the roles of the financial manage in the modern corporate sectors?

6. Define the liquidity and working capital decisions.

7. What is real option?

8. Write the various real options under corporate sector.

9. Which are the techniques applied for determining viable real options?

10. Write the various options relating to project size.

11. Describe the different types of real option valuation methods.

12. What are the limitations of real value options?

13. Define the meaning of corporate finance investment decisions.

14. What is capital structuring?

15. Describe the various factors determining capital structure.

16. What is over and under capitalization?

17. Write the effects of over and under capitalization.

18. What is profit and wealth maximization process?

19. Why wealth maximization is better than profit maximization?

20. Write the various methods of taking investment decisions under risk.

21. What are the advantages and disadvantages of sensitivity analysis?

22. What is scenario analysis?

23. What is decision tree analysis?

24. Write the advantages and disadvantages of decision tree analysis.

25. What is break even analysis? Which are the costs forming part of break even analysis?

26. What is certainty equivalent analysis?

27. Define the meaning of discounted cash flow.

28. What is corporate finance project implementation and control?

29. Define the meaning of project cost management.

30. What is risk mitigation process? How are they used?

31. Describe the procedures to overcome the risks.

32. What is inflation and deflation from economy point of view?

33. Write the various effects of inflation on economy.

34. Define the meaning of country risk. Explain how to overcome with these risks?

35. What is working capital management?

36. How many types of working capital are there? How to finance them?

37. Explain the factors affecting for holding working capital.

38. What are the advantages and disadvantages of having excess working capital?

39. Define the meaning of dividend policies.

40. Explain the Modigliani Miller dividend policies and their assumptions.

41. Brief the Walter’s model of dividend theory along with assumptions.

42. Describe the Gordon’s Model of dividend and the assumptions.

43. What is optimal capital structure? How is it derived.

44. Explain the factors affecting the capital structure of the company.

45. Define the meaning of leveraged buyout (LBO).

46. What is financial distress?

47. What are the indications of financial distress?

48. How to overcome the financial distress?

49. What is restructuring?

50. Which are the strategies for restructuring?

51. What are the impacts of inflation on profit calculations?

52. Define Baumol cash management model along with formula.

53. Explain the Miller Orr cash management model along with its chart and formula.

54. State which are the various ratios used for determining the capitalization.

55. What is point of indifference? Explain with an example.

Corporate Financial Strategy. Corporate Financial Strategy --- This course focuses on financing, investment, and risk
management decisions of corporations in creating shareholder value. ... The course also examines the interaction
between financing and investment decisions and operating firms under financial distress. It provides an overview of the
history, strengths, and weaknesses of the corporate financial strategy field. The main components of corporate
financial strategy, including value-based management, strategic planning, mergers and acquisitions, cost analysis, and
capital budgets, are addressed. The relationship between corporate financial strategy and investor relations are
described.

Corporate Financial Strategy; Corporate financial strategy is a business approach in which financial tools and
instruments are used to assess and evaluate the likely success and outcomes of proposed business strategies and
projects. In the twenty-first century, corporate leaders and decision makers use corporate financial strategy to: Actively
enhance shareholder value/Fundraise/Attain venture capital/ Promote corporate growth. Corporations promote
growth through organic or inorganic business activities. Corporate growth refers to economic expansion as measured
by any of a number of indicators such as: Increased revenue, staffing, and market share. Issues that effect corporate
value and growth include human capital, intellectual property, change management, and investment funding. Growth
corporations tend to have an operating business plan that guides the company toward growth choices and activities. An
operating business plan refers to a dynamic document that highlights the strengths and weakness of the company and
guides the company toward learning and increased efficiency. A corporation's operating business plan is informed and
driven by its corporate financial strategy.

The Combination Of Finance; The field of corporate financial strategy brings together the forces of corporate finance
and corporate strategy to compliment and balance one another. In successful corporate finance strategy, corporate
finance and strategy functions work together to create shareholder value. Corporate financial strategy is a multi-
faceted and multi-field approach to business operations and management. The history of finance and strategy in
corporate settings has been one of divisiveness and territoriality. Finance and strategy, and financial and strategic
decision making in general, have long been considered separate intellectual and decision-making forces. Chief financial
officers have been known to favor either finance or strategy as their main decision making influence. For example, chief
financial officers and managers that favor economic or finance-based decision-making may rely on managerial
economics or applied economics to make business decisions. Ultimately, there is no substantial conflict between
corporate finance and corporate strategy tools and instruments. Finance and strategy, which have a history of being
separate endeavors in the corporate sector, are complimentary functions that have the potential to reinforce and
balance one another. Corporations that integrate finance and strategy functions have the greatest opportunities for
growth and value added endeavors (Thackray, 1995).

Corporations, in the twenty-first century, share many of the same characteristics. For example, the modern corporation
is usually organized into business units. Each business unit within the modern corporation is accountable for its' own
profits or losses. Business planning is generally decentralized. Business unit product line managers focus on profits for
single products over the shorter term. Rapid development and innovation in information technology continues to
change production functions and the nature of the products and services sold and delivered to customers (Egan, 1995).
Despite the similarities that characterize modern corporations, corporations do differ in their ability to combine finance
and strategy factors. In the increasingly competitive global market, successful integration between finance and strategy
dimensions may mean the difference between corporate success and corporate failure. Chief financial officers,
managers, and planning teams that use financial strategy as their decision-making compass may create more wealth
and growth for their companies and shareholders than those corporations that base their business decisions on either
finance or strategy.

Steps For Developing Successful Corporate Financial Strategy; Corporate financial strategy is most successful when the
strategy is maintained internally and aligned with the operations of the corporation. Fully integrated corporate financial
strategies can be developed using the following steps (Mallette, 2005):
Build a sufficient capital structure: Capital structure refers to the means through which a company finances itself.
Financing may come from long term-debt, common stock, and retained earnings. Corporations can determine the best
capital structure for its purposes through the use of three forms of analyses: Downside cash flow scenario modeling,
peer group analysis, and bond rating analysis. Downside cash flow scenario modeling is a process in which a capital
structure is taken from a set of downside cash flow scenarios. Peer group analysis is a process in which common capital
structures and fads of peer businesses, are evaluated for insight into operating features. Bond rating analysis is a
process in a review of the debt capacity within certain debt ratings.

Determine the correct market valuation: Correct market valuation evaluates whether the corporation is undervalued or
overvalued in the marketplace. Market valuation refers to a measure of how much the business is worth in the
marketplace. Review financial measures such as investor expectations for growth, margins, and investments. Compare
investors' expectations and managements' expectations to check for disparity.

Establish the optimum corporate financial strategy: Develop an optimum strategy for value creation that provides
sufficient funding, financial balance, and a growing cash reserve.

Ultimately, corporate financial strategy is a firm-specific enterprise. Corporations design their individual corporate
financial strategies based on their available tools, resources, insights, goals, and objectives. Common components of
corporate financial strategies include: Value-based management, strategic planning, mergers and acquisitions, cost
analysis, and capital budgets. The following section describes and analyzes the main components of corporate financial
strategies used today in the private sector. This section serves as the foundation for later discussion of the relationship
between corporate financial strategy and investor relations.

Applications; Chief financial officers, managers, and planning teams develop their corporate financial strategies to
maximize and optimize growth and shareholder value. Corporate financial strategies are characterized as return driven
strategies. A return driven corporate strategy refers to a set of corporation specific guidelines for creating, maintaining,
and analyzing corporate strategy focused on utmost, long-range wealth development. In the twenty-first century,
managers have an increased responsibility to create shareholder value, watch the performance of a business, and
safeguard long-term business success. Return driven corporate financial strategy prioritizes value added outcomes and
directs the business with a critical eye toward return, value, and growth (Frigo, 2003). The following components of
corporate financial strategies, including value-based management, strategic planning, mergers and acquisitions, cost
analysis, and capital budgets, are used by chief financial officers, managers, and planning teams to create shareholder
value.

Value-Based Management; Chief financial officers, managers, and planning teams may choose to base their corporate
financial strategy on the principles of value-based management. Value-based management refers to a management
approach focused on maximizing shareholder value. Value-based management includes strategies for creating,
measuring, and managing value. Value-based management is an integrated and holistic approach to business that
encompasses and informs the corporate culture, corporate communications, corporate mission, corporate strategy,
corporate organization, corporate decision making, and corporate awards and compensation packages. The economic
value added (EVA) strategy is one of the most common tools used in value-based management. Economic value added
refers to the net operating profit minus a charge for the opportunity cost of all the capital invested in the project.
Economic value added analysis is considered a beneficial lens for looking at varying company unit performances on a
cost-of-capital basis where risks are adjusted. Value added managers may receive compensation based on the outcome
of economic value added analysis. Ultimately, the economic value added approach is a measure of economic
performance and a strategy for creating shareholder wealth (Bhalla, 2004).

Strategic financial management[1] is the study of finance with a long term view considering the strategic goals of the
enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to
give it an increased frame of reference. To understand what strategic financial management is about, we must first
understand what is meant by the term "Strategic". Which is something that is done as part of a plan that is meant to
achieve a particular purpose. Therefore, Strategic Financial Management are those aspect of the overall plan of the
organisation that concerns financial managers. This includes different parts of the business plan, for example marketing
and sales plan, production plan, personnel plan, capital expenditure, etc. These all have financial implications for the
financial managers of an organisation.

The objective of the Financial Management is the maximisation of shareholders wealth. To satisfy this objective a
company requires a "long term course of action" and this is where strategy fits in. Strategic planning is an
organisation’s process to outlining and defining its strategy, direction it is going. This led to decision making and
allocation of resources inline with this strategy. Some techniques used in strategic planning includes: SWOT analysis,
PEST analysis, STEER analysis. Often it is a plan for one year but more typically 3 to 5 years if a longer term view is
taken.

Component of a financial strategy; When making a financial strategy, financial managers need to include the following
basic elements. More elements could be added, depending on the size and industry of the project.

Startup cost: For new business ventures and those started by existing companies. Could include new fabricating
equipment costs, new packaging costs, marketing plan.

Competitive analysis: analysis on how the competition will affect your revenues.

Ongoing costs: Includes labour, materials, equipment maintenance, shipping and facilities costs. Needs to be broken
down into monthly numbers and subtracted from the revenue forecast (see below).

Revenue forecast: over the length of the project, to determine how much will be available to pay the ongoing cost and
if the project will be profitable. ALWAYS SURE

Role of a financial manager; Broadly speaking, financial managers have to have decisions regarding 4 main topics within
a company. Those are as follow: Investment decisions - Regarding the long and short term investment decisions. For
example: the most appropriate level and mix of assets a company should hold. Financing decisions - concerns the
optimal levels of each financing source - E.g. Debt - Equity ratio. Liquidity decisions - Involves the current assets and
liabilities of the company - one function is to maintain cash reserves. Dividend decisions - Disbursement of dividend to
shareholders and retained earnings.

Decision making; Each decisions made by financial managers must be strategic sound and not only have benefits
financially (e.g. Increasing value on the Discounted Cash Flow Analysis) but must also consider uncertain, unquantifiable
factors which could be strategically beneficial. To explain this further, a proposal could have a negative impact from the
Discounted Cash Flow analysis, but if it is strategically beneficial to the company this decision will be accepted by the
financial managers over a decision which has a positive impact on the Discounted Cash Flow analysis but is not
strategically beneficial.

Investment decisions; For a financial manager in an organisation this will be mainly regarding the selection of assets
which funds from the firm will be invested in. These assets will be acquired if they are proven to be strategically sound
and assets are classified into 2 classifications: Long term assets - also known as Capital Budgeting for financial
managers. Short term assets/current assets.

Profitability Management. Long term assets: capital budgeting investment decisions. Financial managers in this field
must select assets or an investment proposals which provides a beneficial course of action, that will most likely come in
the future and over the lifetime of the project. This is one of the most crucial financial decisions for a firm. Short term
assets investment decisions. Important for short term survival of the organisation; thus prerequisite for long term
success; mainly concerning the management of current assets that’s held on the company’s balance sheet.

Profitability management; As a more minor role under this section; it comes under investment decisions because
revenue generated will be from investments and divestments.

Evaluation; Under each of the above headings: financial managers have to use the following financial figures as part of
the evaluation process to determine if a proposal should be accepted. Payback period with NPV (Net Present Value),
IRR (internal rate of return) and DCF (Discounted Cash Flow).

Financing decisions; For a financial managers, they have to decide the financing mix, capital structure or leverage of a
firm. Which is the use of a combination of equity, debt or hybrid securities to fund a firm's activities, or new venture.

Decision making; Financial manager often uses the Theory of capital structure to determine the ratio between equity
and debt which should be used in a financing round for a company. The basis of the theory is that debt capital used
beyond the point of minimum weighted average cost of capital will cause devaluation and unnecessary leverage for the
company. The equation of working out the average cost of capital can be found on the right. Where: Re = cost of equity
Weighted Average Cost Of Capital.[2] Rd = cost of debt E = market value of the firm's equity D = market value of the
firm's debt V = E + D. E/V = percentage of financing that is equity. D/V = percentage of financing that is debt. Tc =
corporate tax rate

Liquidity and working capital decisions; The role of a financial manager often includes making sure the firm is liquid –
the firm is able to finance itself in the short run, without running out of cash. They also have to make the firm’s decision
in investing into current assets: which can generally be defined as the assets which can be converted into cash within
one accounting year, which includes cash, short term securities debtors, etc. The main indicator to be used here is the
net working capital: which is the difference between current assets and current liabilities. Being able to be positive and
negative, indicating the companies current financial position and the health of the balance sheet. This can be further
split into: Receivables management; Which includes investment in receivables that is the volume of credit sales, and
collection period. Credit policy which includes credit standards, credit terms and collection efforts.

Inventory management; Which are stocks of manufactured products and the material that make up the product, which
includes raw materials, work-in-progress, finished goods, stores and spares (supplies). For a retail business, for
example, this will be a major component of their current assets.

Cash management; Concerned with the management of cash flow in and out of the firm, within the firm, and cash
balances held by the firm at a point of time by financing deficit or investing surplus cash.

Dividend decisions; Financial managers often have to influence the dividend to 2 outcomes: The ratio as which this is
distributed is called the dividend-pay out ratio. Distribute to the shareholder in the form of dividends

Retain in the business itself; This is largely dependent on the preference of the shareholders and the investment
opportunities available within the firm. But also on the theory that there must be a balance between the pay out to
satisfy shareholders for them to continue to invest in the company. But the company will also need to retain profits to
be reinvested so more profits can be made for the future. This is also beneficial to the shareholders for growth in the
value of shares and for increased dividends paid out in the future. This infers that it is important for management and
shareholders to agree to a balanced ratio which both sides can benefit from, in the long term. Although this is often an
exception for shareholders who only wish to hold for the short term dividend gain.

Corporate Finance Real options; A real option is a choice made available to the managers of a company with respect to
business investment opportunities. It is referred to as “real” because it typically references projects involving a tangible
asset instead of a financial instrument. Real options are a right but not an obligation to make a business decision. The
concept of a real option is crucial to the success of a business as the ability to choose the right business opportunity
bears a significant effect on the company’s profitability and growth. A real option allows the management team to
analyze and evaluate business opportunities and choose the right one. The concept of real options is based on the
concept of financial options; thus, fundamental knowledge of financial options is crucial to understanding real options.

Types of Real Options; Real options may be classified into different groups. The most common types are: option to
expand, option to abandon, option to wait, option to switch, and option to contract. Option to expand is the option to
make an investment or undertake a project in the future to expand the business operations (a fast food chain considers
opening new restaurants). Option to abandon is the option to cease a project or an asset to realize its salvage value (a
manufacturer can opt to sell old equipment). Option to wait is the option of deferring the business decision to the
future (a fast food chain considers opening new restaurants this year or in the next year). Option to contract is the
option to shut down a project at some point in the future if conditions are unfavorable (a multinational corporation can
stop the operations of its branches in a country with an unstable political situation). Option to switch is the option to
shut down a project at some point in the future if the conditions are unfavorable and resume it when the conditions
are favorable (an oil company can shut down the operation of one of its plants when oil prices are low and resume
operation when prices are high).

Pricing of Real Options; The NPV method is the most straightforward approach to real options pricing. For example, for
an option to expand the business operation, we can forecast the future cash flows of this project and discount them to
the present value at the opportunity cost. We will use the option if the NPV is positive and dismiss it if the NPV is
negative. However, in a real-life setting, the NPV approach can be hard to perform correctly. Fortunately, the pricing of
financial options approaches can be applied to price the real options. Some real options behave similarly to calls; some
behave similarly to puts. As for example, the option to expand can be viewed as a call option, while the option to
abandon can be viewed as a put option. In order to use the techniques for pricing financial options for real options, we
should define the relevant variables.

What is a 'Real Option'; A real option is a choice made available to the managers of a company with respect to business
investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset
instead of a financial instrument. Real options are choices a company’s management makes to expand, change or
curtail projects based on changing economic, technological or market conditions. Factoring in real options affects the
valuation of potential investments, although commonly used valuations, such as net present value (NPV), fail to
account for potential benefits provided by real options. Using real options value analysis (ROV), managers can estimate
the opportunity cost of continuing or abandoning a project and make decisions accordingly. Real options do not refer to
a derivative financial instrument, but to actual choices or opportunities of which a business may take advantage or may
realize. For example, investing in a new manufacturing facility may provide a company with real options of introducing
new products, consolidating operations or making other adjustments to changing market conditions. In the course of
making the decision to invest in the new facility, the company should consider the real option value the facility
provides. Other examples of real options include possibilities for mergers and acquisitions (M&A) or joint ventures. The
precise value of real options can be difficult to establish or estimate. Real option value may be realized from a company
undertaking socially responsible projects, such as building a community center. By doing so, the company may realize a
goodwill benefit that makes it easier to obtain necessary permits or approval for other projects. However, it’s difficult
to pin an exact financial value on such benefits. In dealing with such real options, a company’s management team
factors potential real option value into the decision-making process, even though the value is necessarily somewhat
vague and uncertain. Still, valuation techniques for real options do often appear similar to the pricing of financial
options contracts, where the spot price refers to the current net-present value of a project, while the strike price
corresponds to non-recoverable costs involved with the project. The most common method of valuing real options
currently is a form of binomial tree following a latticed (flexible) model. Monte Carlo simulations are also often used in
the evaluation of real options.
Understanding the Basis of Real Options Reasoning; Real options analysis is still often a heuristic – a rule of thumb
allowing for flexibility and quick decisions in a complex, ever-changing environment – based on logical financial choices.
The real options heuristic is simply the recognition of the value of flexibility and alternatives despite the fact that their
value cannot be mathematically quantified with any certainty. Even if a quantitative model is employed to value a real
option, the choice of the model itself is a heuristic because this choice will vary across firms and across project
managers. Thus, real options reasoning is based on logical financial options in the sense that those financial options
create a certain amount of valuable flexibility. Having financial options affords the freedom to make optimal choices in
decisions, such as when and where to make a specific capital expenditure. Various management choices to make
investments can give companies real options to take additional actions in the future, based on existing market
conditions. In short, real options are about companies making decisions and choices that grant them the greatest
amount of flexibility and potential benefit in regard to possible future decisions or choices.

Choices Falling Under Real Options; The choices that corporate managers face that typically fall under real options
analysis are under three categories of project management. The first group are options relating to the size of a project.
Depending on the ROV analysis, options may exist to expand, contract or, in some cases, expand AND contract the
project over time, given various contingencies. A second group relates to the lifetime of a project - to initiate one, delay
starting one, abandon an existing one, or plan the sequencing of the project's steps. A third group of real options deals
with the project's operations: the process flexibility, product mix and operating scale, among others.

Real options are most appropriate when the environment and market conditions relating to a particular project are
highly volatile and flexible. Stable or rigid environments will not benefit much from ROV and should use more
traditional corporate finance techniques instead. Similarly, ROV is applicable only when a firm's corporate strategy
lends itself to flexibility, has sufficient information flow and has sufficient funds to cover potential downside risks
associated with real options. Real options valuation, also often termed real options analysis,[1] (ROV or ROA) applies
option valuation techniques to capital budgeting decisions.[2] A real option itself, is the right—but not the obligation—
to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital
investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell
the factory, is a real call or put option, respectively. Real options are generally distinguished from conventional financial
options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset
that is traded as a financial security.[3] A further distinction is that option holders here, i.e. management, can directly
influence the value of the option's underlying project; whereas this is not a consideration as regards the underlying
security of a financial option. Moreover, management can not lookup for a volatility as uncertainty, instead their
perceived uncertainty matters in real options reasonings. Unlike financial options, management also have to create or
discover real options, and such creation and discovery process comprises an entrepreneurial or business task. Real
options are most valuable when uncertainty is high; management has significant flexibility to change the course of the
project in a favourable direction and is willing to exercise the options.[4] Real options analysis, as a discipline, extends
from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques
developed for financial options to "real-life" decisions. For example, R&D managers can use Real Options Valuation to
help them allocate their R&D budget among diverse projects; a non business example might be the decision to join the
work force, or rather, to forgo several years of income to attend graduate school.[5] It, thus, forces decision makers to
be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a
tool in business strategy formulation.[6][7] This extension of real options to real-world projects often requires
customized decision support systems, because otherwise the complex compound real options will become too
intractable to handle. Investment

This simple example shows the relevance of the real option to delay investment and wait for further information, and is
adapted from "Investment Example"..Consider a firm that has the option to invest in a new factory. It can invest this
year or next year. The question is: when should the firm invest? If the firm invests this year, it has an income stream
earlier. But, if it invests next year, the firm obtains further information about the state of the economy, which can
prevent it from investing with losses. The firm knows its discounted cash flows if it invests this year: 5M. If it invests
next year, the discounted cash flows are 6M with a 66.7% probability, and 3M€ with a 33.3% probability. Assuming a
risk neutral rate of 10%, future discounted cash flows are, in present terms, 5.45M and 2.73M, respectively. The
investment cost is 4M. If the firm invests next year, the present value of the investment cost is 3.63M. Following the
net present value rule for investment, the firm should invest this year because the discounted cash flows (5M) are
greater than the investment costs (4M) by 1M. Yet, if the firm waits for next year, it only invests if discounted cash
flows do not decrease. If discounted cash flows decrease to 3M€, then investment is no longer profitable. If, they grow
to 6M, then the firm invests. This implies that the firm invests next year with a 66.7% probability and earns 5.45M -
3.63M if it does invest. Thus the value to invest next year is 1.21M. Given that the value to invest next year exceeds the
value to invest this year, the firm should wait for further information to prevent losses. This simple example shows how
the net present value may lead the firm to take unnecessary risk, which could be prevented by real options valuation.

Staged Investment ; Staged investments are quite often in the pharmaceutical, mineral, and oil industries. In this
example, it is studied a staged investment abroad in which a firm decides whether to open one or two stores in a
foreign country. This is adapted from "Staged Investment Example"..The firm does not know how well its stores are
accepted in a foreign country. If their stores have high demand, the discounted cash flows per store is 10M. If their
stores have low demand, the discounted cash flows per store is 5M. Assuming that the probability of both events is
50%, the expected discounted cash flows per store is 7.5M. It is also known that if the store's demand is independent of
the store: if one store has high demand, the other also has high demand. The risk neutral rate is 10%. The investment
cost per store is 8M. Should the firm invest in one store, two stores, or not invest? The net present value suggests the
firm should not invest: the net present value is -0.5M per store. But is it the best alternative? Following real options
valuation, it is not: the firm has the real option to open one store this year, wait a year to know its demand, and invest
in the new store next year if demand is high. By opening one store, the firm knows that the probability of high demand
is 50%. The potential value gain to expand next year is thus 50%*(10M-8M)/1.1 = 0.91M. The value to open one store
this year is 7.5M - 8M = -0.5. Thus the value of the real option to invest in one store, wait a year, and invest next year is
0.41M. Given this, the firm should opt by opening one store. This simple example shows that a negative net present
value does not imply that the firm should not invest. The flexibility available to management – i.e. the actual "real
options" – generically, will relate to project size, project timing, and the operation of the project once established.[9] In
all cases, any (non-recoverable) upfront expenditure related to this flexibility is the option premium. Real options are
also commonly applied to stock valuation - see Business valuation #Option pricing approaches - as well as to various
other "Applications" referenced below.

Options relating to project size; Where the project's scope is uncertain, flexibility as to the size of the relevant facilities
is valuable, and constitutes optionality.[10]

Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce
at higher rate if needed. Management then has the option (but not the obligation) to expand – i.e. exercise the option
– should conditions turn out to be favourable. A project with the option to expand will cost more to establish, the
excess being the option premium, but is worth more than the same without the possibility of expansion. This is
equivalent to a call option.

Option to contract : The project is engineered such that output can be contracted in future should conditions turn out
to be unfavourable. Forgoing these future expenditures constitutes option exercise. This is the equivalent to a put
option, and again, the excess upfront expenditure is the option premium.
Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and
off. Management may shut down part or all of the operation when conditions are unfavourable (a put option), and may
restart operations when conditions improve (a call option). A flexible manufacturing system (FMS) is a good example of
this type of option. This option is also known as a Switching option.

Options relating to project life and timing;Where there is uncertainty as to when, and how, business or other conditions
will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality. Growth
options are perhaps the most generic in this category – these entail the option to exercise only those projects that
appear to be profitable at the time of initiation.

Initiation or deferment options: Here management has flexibility as to when to start a project. For example, in natural
resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an
American styled call option.

Option to abandon: Management may have the option to cease a project during its life, and, possibly, to realise its
salvage value. Here, when the present value of the remaining cash flows falls below the liquidation value, the asset may
be sold, and this act is effectively the exercising of a put option. This option is also known as a Termination option.
Abandonment options are American styled.

Sequencing options: This option is related to the initiation option above, although entails flexibility as to the timing of
more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these
sequentially or in parallel. Here, observing the outcomes relating to the first project, the firm can resolve some of the
uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the
development of the other projects. If taken in parallel, management would have already spent the resources and the
value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy.
Related here is also the notion of Intra project vs. Inter project options.

Options relating to project operation; Management may have flexibility relating to the product produced and /or the
process used in manufacture. This flexibility constitutes optionality.

Output mix options: The option to produce different outputs from the same facility is known as an output mix option or
product flexibility. These options are particularly valuable in industries where demand is volatile or where quantities
demanded in total for a particular good are typically low, and management would wish to change to a different product
quickly if required.

Input mix options: An input mix option – process flexibility – allows management to use different inputs to produce the
same output as appropriate. For example, a farmer will value the option to switch between various feed sources,
preferring to use the cheapest acceptable alternative. An electric utility, for example, may have the option to switch
between various fuel sources to produce electricity, and therefore a flexible plant, although more expensive may
actually be more valuable.

Operating scale options: Management may have the option to change the output rate per unit of time or to change the
total length of production run time, for example in response to market conditions. These options are also known as
Intensity options.

Valuation; Given the above, it is clear that there is an analogy between real options and financial options,[11] and we
would therefore expect options-based modelling and analysis to be applied here. At the same time, it is nevertheless
important to understand why the more standard valuation techniques may not be applicable for ROV.[2]

Applicability of standard techniques; ROV is often contrasted with more standard techniques of capital budgeting, such
as discounted cash flow (DCF) analysis / net present value (NPV).[2] Under this "standard" NPV approach, future
expected cash flows are present valued under the empirical probability measure at a discount rate that reflects the
embedded risk in the project; see CAPM, APT, WACC. Here, only the expected cash flows are considered, and the
"flexibility" to alter corporate strategy in view of actual market realizations is "ignored"; see below as well as Valuing
flexibility under Corporate finance. The NPV framework (implicitly) assumes that management is "passive" with regard
to their Capital Investment once committed. Some analysts account for this uncertainty by adjusting the discount rate,
e.g. by increasing the cost of capital, or the cash flows, e.g. using certainty equivalents, or applying (subjective)
"haircuts" to the forecast numbers, or via probability-weighting as in rNPV.[12][13][14] Even when employed, however,
these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to
appropriately adapt the risk adjustment.[15]

By contrast, ROV assumes that management is "active" and can "continuously" respond to market changes. Real
options consider each and every scenario and indicate the best corporate action in any of these contingent events.[16]
Because management adapts to each negative outcome by decreasing its exposure and to positive scenarios by scaling
up, the firm benefits from uncertainty in the underlying market, achieving a lower variability of profits than under the
commitment/NPV stance. The contingent nature of future profits in real option models is captured by employing the
techniques developed for financial options in the literature on contingent claims analysis. Here the approach, known as
risk-neutral valuation, consists in adjusting the probability distribution for risk consideration, while discounting at the
risk-free rate. This technique is also known as the certainty-equivalent or martingale approach, and uses a risk-neutral
measure. For technical considerations here, see below. Given these different treatments, the real options value of a
project is typically higher than the NPV – and the difference will be most marked in projects with major flexibility,
contingency, and volatility.[17] (As for financial options higher volatility of the underlying leads to higher value). An
application of Real Options Valuation in the Philippine banking industry exhibited that increased levels of income
volatility may adversely affect option values on the loan portfolio, when the presence of information asymmetry is
considered. In this case, increased volatility may limit the value of an option.[18]

Options based valuation; Although there is much similarity between the modelling of real options and financial
options,[11][19] ROV is distinguished from the latter, in that it takes into account uncertainty about the future
evolution of the parameters that determine the value of the project, coupled with management's ability to respond to
the evolution of these parameters.[20][21] It is the combined effect of these that makes ROV technically more
challenging than its alternatives.“ First, you must figure out the full range of possible values for the underlying
asset.... This involves estimating what the asset's value would be if it existed today and forecasting to see the full set of
possible future values... [These] calculations provide you with numbers for all the possible future values of the option at
the various points where a decision is needed on whether to continue with the project...[19] ” When valuing the
real option, the analyst must therefore consider the inputs to the valuation, the valuation method employed, and
whether any technical limitations may apply. Conceptually, valuing a real option looks at the premium between inflows
and outlays for a particular project. Inputs to the value of a real option (time, discount rates, volatility, cash inflows and
outflows) are each affected by the terms of business, and external environmental factors that a project exists in. Terms
of business as information regarding ownership, data collection costs, and patents, are formed in relation to political,
environmental, socio-cultural, technological, environmental and legal factors that affect an industry. Just as terms of
business are affected by external environmental factors, these same circumstances affect the volatility of returns, as
well as the discount rate (as firm or project specific risk). Furthermore, the external environmental influences that
affect an industry affect projections on expected inflows and outlays.[22]

Valuation inputs; Given the similarity in valuation approach, the inputs required for modelling the real option
correspond, generically, to those required for a financial option valuation.[11][19][20] The specific application, though,
is as follows: The option's underlying is the project in question – it is modelled in terms of:

Spot price: the starting or current value of the project is required: this is usually based on management's "best guess"
as to the gross value of the project's cash flows and resultant NPV;
Volatility: a measure for uncertainty as to the change in value over time is required: the volatility in project value is
generally used, usually derived via monte carlo simulation;[20][23] sometimes the volatility of the first period's cash
flows are preferred;[21] see further under Corporate finance for a discussion relating to the estimation of NPV and
project volatility. some analysts substitute a listed security as a proxy, using either its price volatility (historical
volatility), or, if options exist on this security, their implied volatility.[1]

Dividends generated by the underlying asset: As part of a project, the dividend equates to any income which could be
derived from real assets and paid to the owner. These reduce the appreciation of the asset.

Option characteristics: Strike price: this corresponds to any (non-recoverable) investment outlays, typically the
prospective costs of the project. In general, management would proceed (i.e. the option would be in the money) given
that the present value of expected cash flows exceeds this amount;

Option term: the time during which management may decide to act, or not act, corresponds to the life of the option. As
above, examples include the time to expiry of a patent, or of the mineral rights for a new mine. See Option time value.
Note though that given the flexibility related to timing as described, caution must be applied here.

Option style and option exercise. Management's ability to respond to changes in value is modeled at each decision
point as a series of options, as above these may comprise, i.a.: the option to contract the project (an American styled
put option); the option to abandon the project (also an American put); the option to expand or extend the project
(both American styled call options); switching options or composite options which may also apply to the project.

Valuation methods; The valuation methods usually employed, likewise, are adapted from techniques developed for
valuing financial options.[24][25] Note though that, in general, while most "real" problems allow for American style
exercise at any point (many points) in the project's life and are impacted by multiple underlying variables, the standard
methods are limited either with regard to dimensionality, to early exercise, or to both. In selecting a model, therefore,
analysts must make a trade off between these considerations; see Option (finance) #Model implementation. The model
must also be flexible enough to allow for the relevant decision rule to be coded appropriately at each decision point.

Closed form, Black–Scholes-like solutions are sometimes employed.[21] These are applicable only for European styled
options or perpetual American options. Note that this application of Black–Scholes assumes constant — i.e.
deterministic — costs: in cases where the project's costs, like its revenue, are also assumed stochastic [random], then
Margrabe's formula can (should) be applied instead,[26][27] here valuing the option to "exchange" expenses for
revenue. (Relatedly, where the project is exposed to two (or more) uncertainties — e.g. for natural resources, price and
quantity — some analysts attempt to use an overall volatility; this, though, is more correctly treated as a rainbow
option,[21] typically valued using simulation as below.) The most commonly employed methods are binomial
lattices.[17][25] These are more widely used given that most real options are American styled. Additionally, and
particularly, lattice-based models allow for flexibility as to exercise, where the relevant, and differing, rules may be
encoded at each node.[19] Note that lattices cannot readily handle high-dimensional problems; treating the project's
costs as stochastic would add (at least) one dimension to the lattice, increasing the number of ending-nodes by the
square (the exponent here, corresponding to the number of sources of uncertainty).

Specialised Monte Carlo Methods have also been developed and are increasingly, and especially, applied to high-
dimensional problems.[28] Note that for American styled real options, this application is somewhat more complex;
although recent research[29] combines a least squares approach with simulation, allowing for the valuation of real
options which are both multidimensional and American styled; see Monte Carlo methods for option pricing #Least
Square Monte Carlo. When the Real Option can be modelled using a partial differential equation, then Finite difference
methods for option pricing are sometimes applied. Although many of the early ROV articles discussed this method,[30]
its use is relatively uncommon today—particularly amongst practitioners—due to the required mathematical
sophistication; these too cannot readily be used for high-dimensional problems.
Various other methods, aimed mainly at practitioners, have been developed for real option valuation. These typically
use cash-flow scenarios for the projection of the future pay-off distribution, and are not based on restricting
assumptions similar to those that underlie the closed form (or even numeric) solutions discussed. The most recent
additions include the Datar–Mathews method[31][32] and the fuzzy pay-off method.[33]

Limitations; The relevance of Real options, even as a thought framework, may be limited due to market, organizational
and / or technical considerations.[34] When the framework is employed, therefore, the analyst must first ensure that
ROV is relevant to the project in question. These considerations are as below.

Market characteristics; As discussed above, the market and environment underlying the project must be one where
"change is most evident", and the "source, trends and evolution" in product demand and supply, create the "flexibility,
contingency, and volatility" [17] which result in optionality. Without this, the NPV framework would be more relevant.

Organizational considerations; Real options are "particularly important for businesses with a few key
characteristics",[17] and may be less relevant otherwise.[21] In overview, it is important to consider the following in
determining that the RO framework is applicable:

Corporate strategy has to be adaptive to contingent events. Some corporations face organizational rigidities and are
unable to react to market changes; in this case, the NPV approach is appropriate. Practically, the business must be
positioned such that it has appropriate information flow, and opportunities to act. This will often be a market leader
and / or a firm enjoying economies of scale and scope. Management must understand options, be able to identify and
create them, and appropriately exercise them.[8] This contrasts with business leaders focused on maintaining the
status quo and / or near-term accounting earnings. The financial position of the business must be such that it has the
ability to fund the project as, and when, required (i.e. issue shares, absorb further debt and / or use internally
generated cash flow); see Financial statement analysis. Management must, correspondingly, have appropriate access to
this capital. Management must be in the position to exercise, in so far as some real options are proprietary (owned or
exercisable by a single individual or a company) while others are shared (can (only) be exercised by many parties).
Technical considerations

Limitations as to the use of these models arise due to the contrast between Real Options and financial options, for
which these were originally developed. The main difference is that the underlying is often not tradable – e.g. the
factory owner cannot easily sell the factory upon which he has the option. Additionally, the real option itself may also
not be tradeable – e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make
this decision (some real options, however, can be sold, e.g., ownership of a vacant lot of land is a real option to develop
that land in the future). Even where a market exists – for the underlying or for the option – in most cases there is
limited (or no) market liquidity. Finally, even if the firm can actively adapt to market changes, it remains to determine
the right paradigm to discount future claims

The difficulties, are then: As above, data issues arise as far as estimating key model inputs. Here, since the value or
price of the underlying cannot be (directly) observed, there will always be some (much) uncertainty as to its value (i.e.
spot price) and volatility (further complicated by uncertainty as to management's actions in the future). It is often
difficult to capture the rules relating to exercise, and consequent actions by management. Further, a project may have
a portfolio of embedded real options, some of which may be mutually exclusive.[8] Theoretical difficulties, which are
more serious, may also arise.[35] Option pricing models are built on rational pricing logic. Here, essentially: (a) it is
presupposed that one can create a "hedged portfolio" comprising one option and "delta" shares of the underlying. (b)
Arbitrage arguments then allow for the option's price to be estimated today; see Rational pricing #Delta hedging. (c)
When hedging of this sort is possible, since delta hedging and risk neutral pricing are mathematically identical, then risk
neutral valuation may be applied, as is the case with most option pricing models. (d) Under ROV however, the option
and (usually) its underlying are clearly not traded, and forming a hedging portfolio would be difficult, if not impossible.
Standard option models: (a) Assume that the risk characteristics of the underlying do not change over the life of the
option, usually expressed via a constant volatility assumption. (b) Hence a standard, risk free rate may be applied as the
discount rate at each decision point, allowing for risk neutral valuation. Under ROV, however: (a) managements' actions
actually change the risk characteristics of the project in question, and hence (b) the Required rate of return could differ
depending on what state was realised, and a premium over risk free would be required, invalidating (technically) the
risk neutrality assumption. These issues are addressed via several interrelated assumptions: As discussed above, the
data issues are usually addressed using a simulation of the project, or a listed proxy. Various new methods – see for
example those described above – also address these issues. Also as above, specific exercise rules can often be
accommodated by coding these in a bespoke binomial tree; see:.[19]

The theoretical issues: To use standard option pricing models here, despite the difficulties relating to rational pricing,
practitioners adopt the "fiction" that the real option and the underlying project are both traded: the so called,
Marketed Asset Disclaimer (MAD) approach. Although this is a strong assumption, it is pointed out that a similar fiction
in fact underpins standard NPV / DCF valuation (and using simulation as above). See:[1] and.[19] To address the fact
that changing characteristics invalidate the use of a constant discount rate, some analysts use the "replicating portfolio
approach", as opposed to Risk neutral valuation, and modify their models correspondingly.[19][27] Under this
approach, (a) we "replicate" the cash flows on the option by holding a risk free bond and the underlying in the correct
proportions. Then, (b) since the cash flows of the option and the portfolio will always be identical, by arbitrage
arguments their values may (must) be equated today, and (c) no discounting is required.

History; Whereas business managers have been making capital investment decisions for centuries, the term "real
option" is relatively new, and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977.
In 1930, Irving Fisher wrote explicitly of the "options" available to a business owner (The Theory of Interest, II.VIII). The
description of such opportunities as "real options", however, followed on the development of analytical techniques for
financial options, such as Black–Scholes in 1973. As such, the term "real option" is closely tied to these option methods.
Real options are today an active field of academic research. Professor Lenos Trigeorgis has been a leading name for
many years, publishing several influential books and academic articles. Other pioneering academics in the field include
Professors Eduardo Schwartz, Graham Davis, Gonzalo Cortazar, Michael Brennan, Han Smit, Avinash Dixit and Robert
Pindyck (the latter two, authoring the pioneering text in the discipline). An academic conference on real options is
organized yearly (Annual International Conference on Real Options). Amongst others, the concept was "popularized" by
Michael J. Mauboussin, then chief U.S. investment strategist for Credit Suisse First Boston.[17] He uses real options to
explain the gap between how the stock market prices some businesses and the "intrinsic value" for those businesses.
Trigeorgis also has broadened exposure to real options through layman articles in publications such as The Wall Street
Journal.[16] This popularization is such that ROV is now a standard offering in postgraduate finance degrees, and often,
even in MBA curricula at many Business Schools. Recently, real options have been employed in business strategy, both
for valuation purposes and as a conceptual framework.[6][7] The idea of treating strategic investments as options was
popularized by Timothy Luehrman [36] in two HBR articles:[11] "In financial terms, a business strategy is much more
like a series of options, than a series of static cash flows". Investment opportunities are plotted in an "option space"
with dimensions "volatility" & value-to-cost ("NPVq"). Luehrman also co-authored with William Teichner a Harvard
Business School case study, Arundel Partners: The Sequel Project, in 1992, which may have been the first business
school case study to teach ROV.[37] Reflecting the "mainstreaming" of ROV, Professor Robert C. Merton discussed the
essential points of Arundel in his Nobel Prize Lecture in 1997.[38] Arundel involves a group of investors that is
considering acquiring the sequel rights to a portfolio of yet-to-be released feature films. In particular, the investors
must determine the value of the sequel rights before any of the first films are produced. Here, the investors face two
main choices. They can produce an original movie and sequel at the same time or they can wait to decide on a sequel
after the original film is released. The second approach, he states, provides the option not to make a sequel in the
event the original movie is not successful. This real option has economic worth and can be valued monetarily using an
option-pricing model. See Option (filmmaking).
Corporate Finance Investment Decisions; Corporate finance is primarily concerned with maximizing shareholder value
through long-term and short-term financial planning and the implementation of various strategies. Corporate finance
activities range from capital investment decisions to investment banking. Investment Decision One of the most
important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital
budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following
are the two aspects of investment decision

Evaluation of new investment in terms of profitability; Comparison of cut off rate against new investment and
prevailing investment. Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very
significant role in calculating the expected return of the prospective investment. Therefore while considering
investment proposal it is important to take into consideration both expected return and the risk involved. Investment
decision not only involves allocating capital to long term assets but also involves decisions of using funds which are
obtained by selling those assets which become less profitable and less productive. It wise decisions to decompose
depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An
opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by
using this opportunity cost of the required rate of return (RRR)

Financial Decision; Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired
through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix
of equity capital and debt is known as a firm’s capital structure. A firm tends to benefit most when the market value of
a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On
the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the
return on equity funds. A sound financial structure is said to be one which aims at maximizing shareholders return with
minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure
would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital
structure.

Dividend Decision; Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or
retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the
financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm.
Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of
profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision; It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability,
liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between
profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn
anything for business therefore a proper calculation must be done before investing in current assets. Current assets
should properly be valued and disposed of from time to time once they become non profitable. Currents assets must
be used in times of liquidity problems and times of insolvency.

The Finance Function and the Project Office; Contemporary organizations need to practice cost control if they are to
survive the recessionary times. Given the fact that many top tier companies are currently mired in low growth and less
activity situations, it is imperative that they control their costs as much as possible. This can happen only when the
finance function in these companies is diligent and has a hawk eye towards the costs being incurred. Apart from this,
companies also have to introduce efficiencies in the way their processes operate and this is another role for the finance
function in modern day organizations. There must be synergies between the various processes and this is where the
finance function can play a critical role. Lest one thinks that the finance function, which is essentially a support
function, has to do this all by themselves, it is useful to note that, many contemporary organizations have dedicated
project office teams for each division, which perform this function. In other words, whereas the finance function
oversees the organizational processes at a macro level, the project office teams indulge in the same at the micro level.
This is the reason why finance and project budgeting and cost control have assumed significance because after all,
companies exist to make profits and finance is the lifeblood that determines whether organizations are profitable or
failures.

The Pension Fund Management and Tax Activities of the Finance Function; The next role of the finance function is in
payroll, claims processing, and acting as the repository of pension schemes and gratuity. If the US follow the 401(k) rule
and the finance function manages the defined benefit and defined contribution schemes, in India it is the EPF or the
Employee Provident Funds that are managed by the finance function. Of course, only large organizations have
dedicated EPF trusts to take care of these aspects and the norm in most other organizations is to act as facilitators for
the EPF scheme with the local or regional PF (Provident Fund) commissioner.

The third aspect of the role of the finance function is to manage the taxes and their collection at source from the
employees. Whereas in the US, TDS or Tax Deduction at Source works differently from other countries, in India and
much of the Western world, it is mandatory for organizations to deduct tax at source from the employees
commensurate with their pay and benefits.

The finance function also has to coordinate with the tax authorities and hand out the annual tax statements that form
the basis of the employee’s tax returns. Often, this is a sensitive and critical process since the tax rules mandate very
strict principles for generating the tax statements.

Payroll, Claims Processing, and Automation;We have discussed the pension fund management and the tax deduction.
The other role of the finance function is to process payroll and associated benefits in time and in tune with the
regulatory requirements.

Claims made by the employees with respect to medical, and transport allowances have to be processed by the finance
function. Often, many organizations automate this routine activity wherein the use of ERP (Enterprise Resource
Planning) software and financial workflow automation software make the job and the task of claims processing easier.
Having said that, it must be remembered that the finance function has to do its due diligence on the claims being
submitted to ensure that bogus claims and suspicious activities are found out and stopped. This is the reason why many
organizations have experienced chartered accountants and financial professionals in charge of the finance function so
that these aspects can be managed professionally and in a trustworthy manner. The key aspect here is that the finance
function must be headed by persons of high integrity and trust that the management reposes in them must not be
misused. In conclusion, the finance function though a non-core process in many organizations has come to occupy a
place of prominence because of these aspects. Financial activities of a firm is one of the most important and complex
activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite
financial activities. A financial manger is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in
the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

Raising of Funds; In order to meet the obligation of the business it is important to have enough cash and liquidity. A
firm can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio
between debt and equity. It is important to maintain a good balance between equity and debt.
Allocation of Funds; Once the funds are raised through different channels the next important function is to allocate the
funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the
best possible manner the following point must be considered, The size of the firm and its growth capability, Status of
assets whether they are long-term or short-term, Mode by which the funds are raised, These financial decisions directly
and indirectly influence other managerial activities. Hence formation of a good asset mix and proper allocation of funds
is one of the most important activity

Profit Planning; Profit earning is one of the prime functions of any business organization. Profit earning is important for
survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand
and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the
profitability of the firm. Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In
order to maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of production which has gone thrown wear and
tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.

Understanding Capital Markets; Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager.
When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial
manger understands and calculates the risk involved in this trading of shares and debentures. Its on the discretion of a
financial manager as to how to distribute the profits. Many investors do not like the firm to distribute the profits
amongst share holders as dividend instead invest in the business itself to enhance growth. The practices of a financial
manager directly impact the operation in capital market.

Meaning of Capital Structure; Capital Structure is referred to as the ratio of different kinds of securities raised by a firm
as long-term finance. The capital structure involves two decisions- Type of securities to be issued are equity shares,
preference shares and long term borrowings (Debentures). Relative ratio of securities can be determined by process of
capital gearing. On this basis, the companies are divided into two- Highly geared companies - Those companies whose
proportion of equity capitalization is small. Low geared companies - Those companies whose equity capital dominates
total capitalization. For instance - There are two companies A and B. Total capitalization amounts to be USD 200,000 in
each case. The ratio of equity capital to total capitalization in company A is USD 50,000, while in company B, ratio of
equity capital is USD 150,000 to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion
is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

Factors Determining Capital Structure; Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to
additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on
the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than
the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a
judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important
when expectations of shareholders are high.

Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders.
These members have got maximum voting rights in a concern as compared to the preference shareholders and
debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting
rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the
capital structure consists of debenture holders and loans rather than equity shares.
Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well
as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be
refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the
company should go for issue of debentures and other loans.

Choice of investors- The company’s policy generally is to have different categories of investors for securities. Therefore,
a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally
go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.

Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence.
During the depression period, the company’s capital structure generally consists of debentures and loans. While in
period of boons and inflation, the company’s capital should consist of share capital generally equity shares.

Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other
institutions; while for long period it goes for issue of shares and debentures.

Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is
seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to
equity shares where equity shareholders demand an extra share in profits.

Stability of sales- An established business which has a growing market and high sales turnover, the company is in
position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales
are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest
on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in
position to meet fixed obligations. So, equity capital proves to be safe in such cases.

Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained
profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for
issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the
wider is total capitalization.

What is Capitalization; Capitalization comprises of share capital, debentures, loans, free reserves,etc. Capitalization
represents permanent investment in companies excluding long-term loans. Capitalization can be distinguished from
capital structure. Capital structure is a broad term and it deals with qualitative aspect of finance. While capitalization is
a narrow term and it deals with the quantitative aspect.

Capitalization is generally found to be of following types-Normal/Over/Under

Overcapitalization; Overcapitalization is a situation in which actual profits of a company are not sufficient enough to
pay interest on debentures, on loans and pay dividends on shares over a period of time. This situation arises when the
company raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows
a declining trend. The causes can be-

High promotion cost- When a company goes for high promotional expenditure, i.e., making contracts, canvassing,
underwriting commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high
expenses, the company is over-capitalized in such cases. Purchase of assets at higher prices- When a company
purchases assets at an inflated rate, the result is that the book value of assets is more than the actual returns. This
situation gives rise to over-capitalization of company. A company’s floatation n boom period- At times company has to
secure it’s solvency and thereby float in boom periods. That is the time when rate of returns are less as compared to
capital employed. This results in actual earnings lowering down and earnings per share declining.
Inadequate provision for depreciation- If the finance manager is unable to provide an adequate rate of depreciation,
the result is that inadequate funds are available when the assets have to be replaced or when they become obsolete.
New assets have to be purchased at high prices which prove to be expensive.

Liberal dividend policy- When the directors of a company liberally divide the dividends into the shareholders, the result
is inadequate retained profits which are very essential for high earnings of the company. The result is deficiency in
company. To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and leaves the company to
be over- capitalized.

Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate
financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not
profitably invested. This results in consequent decrease in earnings per share.

Effects of Overcapitalization; On Shareholders- The over capitalized companies have following disadvantages to
shareholders: Since the profitability decreases, the rate of earning of shareholders also decreases. The market price of
shares goes down because of low profitability. The profitability going down has an effect on the shareholders. Their
earnings become uncertain. With the decline in goodwill of the company, share prices decline. As a result shares cannot
be marketed in capital market. On Company-Because of low profitability, reputation of company is lowered. The
company’s shares cannot be easily marketed. With the decline of earnings of company, goodwill of the company
declines and the result is fresh borrowings are difficult to be made because of loss of credibility. In order to retain the
company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings. The
company cuts down it’s expenditure on maintainance, replacement of assets, adequate depreciation, etc. On Public- An
overcapitalized company has got many adverse effects on the public: In order to cover up their earning capacity, the
management indulges in tactics like increase in prices or decrease in quality. Return on capital employed is low. This
gives an impression to the public that their financial resources are not utilized properly. Low earnings of the company
affects the credibility of the company as the company is not able to pay it’s creditors on time. It also has an effect on
working conditions and payment of wages and salaries also lessen.

Undercapitalization; An undercapitalized company is one which incurs exceptionally high profits as compared to
industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to
actual profits. This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on
capital shows an increasing trend. The causes can be- Low promotion costs/ Purchase of assets at deflated rates/
Conservative dividend policy/ Floatation of company in depression stage/ High efficiency of directors/ Adequate
provision of depreciation/Large secret reserves are maintained.

Efffects of Under Capitalization; On Shareholders; Company’s profitability increases. As a result, rate of earnings go up.
Market value of share rises. Financial reputation also increases. Shareholders can expect a high dividend.

On company; With greater earnings, reputation becomes strong. Higher rate of earnings attract competition in market.
Demand of workers may rise because of high profits. The high profitability situation affects consumer interest as they
think that the company is overcharging on products.

On Society; With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in
stock market. ‘Restlessness in general public is developed as they link high profits with high prices of product. Secret
reserves are maintained by the company which can result in paying lower taxes to government. The general public
inculcates high expectations of these companies as these companies can import innovations, high technology and
thereby best quality of product.

Financial Goal - Profit vs Wealth; Every firm has a predefined goal or an objective. Therefore the most important goal of
a financial manager is to increase the owner’s economic welfare. Here economics welfare may refer to maximization of
profit or maximization of shareholders wealth. Therefore Shareholders wealth maximization (SWM) plays a very crucial
role as far as financial goals of a firm are concerned.

Profit is the remuneration paid to the entrepreneur after deduction of all expenses. Maximization of profit can be
defined as maximizing the income of the firm and minimizing the expenditure. The main responsibility of a firm is to
carry out business by manufacturing goods and services and selling them in the open market. The mechanism of
demand and supply in an open market determine the price of a commodity or a service. A firm can only make profit if it
produces a good or delivers a service at a lower cost than what is prevailing in the market. The margin between these
two prices would only increase if the firm strives to produce these goods more efficiently and at a lower price without
compromising on the quality. The demand and supply mechanism plays a very important role in determining the price
of a commodity. A commodity which has a greater demand commands a higher price and hence may result in greater
profits. Competition among other suppliers also effect profits. Manufacturers tends to move towards production of
those goods which guarantee higher profits. Hence there comes a time when equilibrium is reached and profits are
saturated.

According to Adam Smith - business man in order to fulfill their profit motive in turn benefits the society as well. It is
seen that when a firm tends to increase profit it eventually makes use of its resources in a more effective manner.
Profit is regarded as a parameter to measure firm’s productivity and efficiency. Firms which tend to earn continuous
profit eventually improvise their products according to the demand of the consumers. Bulk production due to massive
demand leads to economies of scale which eventually reduces the cost of production. Lower cost of production directly
impacts the profit margins. There are two ways to increase the profit margin due to lower cost. Firstly a firm can
produce at lower sot but continue to sell at the original price, thereby increasing the revenue. Secondly a firm can
reduce the final price offered to the consumer and increase its market thereby superseding its competitors.

Both ways the firm will benefit. The second way would increase its sale and market share while the first way only tend
to increase its revenue. Profit is an important component of any business. Without profit earning capability it is very
difficult to survive in the market. If a firm continues to earn large amount of profits then only it can manage to serve
the society in the long run. Therefore profit earning capacity by a firm and public motive in some way goes hand in
hand. This eventually also leads to the growth of an economy and increase in National Income due to increasing
purchasing power of the consumer.

Profit Maximization Criticisms; Many economists have argued that profit maximization has brought about many
disparities among consumers and manufacturers. In case of perfect competition it may appear as a legitimate and a
reward for efforts but in case of imperfect competition a firm’s prime objective should not be profit maximization. In
olden times when there was not too much of competition selling and manufacturing goods were primarily for mutual
benefit. Manufacturers didn’t produce to earn profits rather produced for mutual benefit and social welfare. The aim of
the single producer was to retain his position in the market and sustain growth, thereby earning some profit which
would help him in maintaining his position. On the other hand in today’s time the production system is dominant by
two tier system of ownership and management. Ownership aims at maximizing profit and management aims at
managing the system of production thereby indirectly increasing the income of the business. These services are used by
customers who in turn are forced to pay a higher price due to formation of cartels and monopoly. Not only have the
customers suffered but also the employees. Employees are forced to work more than their capacity. they is made to
pay in extra hours so that production can increase. Many times manufacturers tend to produce goods which are of no
use to the society and create an artificial demand for the product by rigorous marketing and advertising. They tend to
make the product so tempting by packaging and labeling that its difficult for the consumer to resist. These happen
mainly with products which aim to target kids and teenagers. Ad commercials and print ads tend to provide with wrong
information to artificially hike the expectation of the product. In case of oligopoly where the nature of the product is
more or less same exploit the customer to the max. Since they form cartels and manipulate prices by giving very less
flexibility to the consumer to negotiate or choose from the products available. In such a scenario it is the consumer
who becomes prey of these activities. Profit maximization motive is continuously aiming at increasing the firm’s
revenue and is concentrating less on the social welfare. Government plays a very important role in curbing this practice
of charging extraordinary high prices at the cost of service or product. In fact a market which experiences a high degree
of competition is likely to exploit the customer in the name of profit maximization, and on the other hand where the
production of a particular product or service is limited there is a possibility to charge higher prices is greater. There are
few things which need a greater clarification as far as maximization of profit is concerned

Profit maximization objective is a little vague in terms of returns achieved by a firm in different time period. The time
value of money is often ignored when measuring profit. It leads to uncertainty of returns. Two firms which use same
technology and same factors of production may eventually earn different returns. It is due to the profit margin. It may
not be legitimate if seen from a different stand point.

Modern Financial Management Techniques that Will Change Your Business; Whether you’re a business or an
individual, you have to find a way to manage your finances now and in the future. The cost of everything continues to
increase and there’s no sign that this trend of price increases will stop anytime soon. As a result, all entities have to
develop a financial management system to ensure their stability for many years to come. This system has to provide
the businesses in question with enough flexibility for them to continue to grow and pay for their necessary expenses. It
also has to be stringent enough to allow for money to be put away in the event of future catastrophes. In the case of a
business, all expenses have to be prioritized in the interest of spending money on the right things. When it comes time
for cost cutting measures to be implemented, they have to be come with consequences in mind. Everything that’s done
to cut costs has an end result once it becomes a common procedure. You have to ponder whether you’re cutting
enough or you’re cutting too much. Work has to be done to ensure that cutting individuals from the workforce is the
last possible resort. Odds are there are expenses that can be sliced without having to touch the workforce. Individuals
in the private sector have to manage their finances in the interest of being able to acquire credit. A person’s credit
score can affect every possible aspect of their life. The biggest issue currently impacting the financial future of most
people is the regular use of high interest credit cards. Most retail establishments try to push their credit card on their
customers on a regular basis. These cards should only be used for small purchases that can be paid shortly after they
have been completed. Financial management is a challenge in a world where spending is seen as the key to getting
ahead. You have to exercise the utmost level of restraint if you want solvency to be in your future. Once you have
established an effective budget, your worries about finances will become a thing of the past.

Financial Intermediaries - Meaning, Role and Its Importance- Introduction; A financial intermediary is a firm or an
institution that acts an intermediary between a provider of service and the consumer. It is the institution or individual
that is in between two or more parties in a financial context. In theoretical terms, a financial intermediary channels
savings into investments. Financial intermediaries exist for profit in the financial system and sometimes there is a need
to regulate the activities of the same. Also, recent trends suggest that financial intermediaries role in savings and
investment functions can be used for an efficient market system or like the sub-prime crisis shows, they can be a cause
for concern as well.

Financial Intermediation; Financial intermediaries work in the savings/investment cycle of an economy by serving as
conduits to finance between the borrowers and the lenders. In the financial system, intermediaries like banks and
insurance companies have a huge role to play given that it has been estimated that a major proportion of every dollar
financed externally has been done by the banks. Financial intermediaries are an important source of external funding
for corporates. Unlike the capital markets where investors contract directly with the corporates creating marketable
securities, financial intermediaries borrow from lenders or consumers and lend to the companies that need investment.
Role of the Financial Intermediaries; The reason for the all-pervasive nature of the financial intermediaries like banks
and insurance companies lies in their uniqueness. As outlined above, Banks often serve as the “intermediaries”
between those who have the resources and those who want resources. Financial intermediaries like banks are asset
based or fee based on the kind of service they provide along with the nature of the clientele they handle. Asset based
financial intermediaries are institutions like banks and insurance companies whereas fee based financial intermediaries
provide portfolio management and syndication services.

Need for regulation;The very nature of the complex financial system that we have at this point in time makes the need
for regulation that much more necessary and urgent. As the sub-prime crisis has shown, any financial institution cannot
be made to hold the financial system hostage to its questionable business practices. As the manifestations of the crisis
are being felt and it is now apparent that the asset backed derivatives and other “exotic” instruments are amounting to
trillions, the role of the central bank or the monetary authorities in reining in the rogue financial institutions is
necessary to prevent systemic collapse. As capital becomes mobile and unfettered, it is the monetary authorities that
have to step in and ensure that there are proper checks and balances in the system so as to prevent losses to investors
and the economy in general.

Recent trends; Recent trends in the evolution of financial intermediaries, particularly in the developing world have
shown that these institutions have a pivotal role to play in the elimination of poverty and other debt reduction
programs. Some of the initiatives like micro-credit reaching out to the masses have increased the economic well being
of hitherto neglected sectors of the population. Further, the financial intermediaries like banks are now evolving into
umbrella institutions that cater to the complete needs of investors and borrowers alike and are maturing into “financial
hyper marts”.

Conclusion; As we have seen, financial intermediaries have a key role to play in the world economy today. They are the
“lubricants” that keep the economy going. Due to the increased complexity of financial transactions, it becomes
imperative for the financial intermediaries to keep re-inventing themselves and cater to the diverse portfolios and
needs of the investors. The financial intermediaries have a significant responsibility towards the borrowers as well as
the lenders. The very term intermediary would suggest that these institutions are pivotal to the working of the
economy and they along with the monetary authorities have to ensure that credit reaches to the needy without
jeopardizing the interests of the investors. This is one of the main challenges before them. Financial intermediaries
have a central role to play in a market economy where efficient allocation of resources is the responsibility of the
market mechanism. In these days of increased complexity of the financial system, banks and other financial
intermediaries have to come up with new and innovative products and services to cater to the diverse needs of the
borrowers and lenders. It is the right mix of financial products along with the need for reducing systemic risk that
determines the efficacy of a financial intermediary.

Role of the Finance Function in the Financial Management for Corporates; The Finance Function in Corporates; We
often read about how corporates are doing financially with reference to their profits, asset values, debt, equity, and
other measures. These measures are indicative of how well the corporate is doing financially. The next time you read
about these measures, do think about the people who enable these performance indicators and these are the finance
and treasury functions of the corporates. Before we proceed further, we would like to remind you that the Treasury or
the Finance function does not actualize the broader financial performance which is determined by the various strategic,
operational, and financial management. Rather, the role of the finance function is to record, and keeps track of the
various matters related to financial management in corporates. The finance and the treasury functions are also
responsible for tax calculations, social security payments, payroll, managing the receivables and the payable, and in
recent years, the emergence of the treasury function has meant that they also deal with foreign exchange management
and hedging that has been necessitated due to globalization which means that many corporates are now actively
dealing in multiple currencies and hedging.
The External Functions of the Finance Department; The functions of the finance department can be broadly broken
down into external and internal financial management. The external function encompasses the entire range of activities
to do with paying the suppliers, vendors, and the other stakeholders who do business with the corporates. In addition,
the finance function also keeps track of the receivables meaning that they follow up with the clients and the customers
who owe the corporate money for the services rendered. Apart from this, the finance function also handles the social
security payments of the employees wherein each month or quarter (depending on the prevailing laws of the country),
the finance department makes payments into the 401(k) accounts in the United States and the Provident Fund
Accounts in India. Further, the finance function is also responsible for remitting the TDS or the Tax Deducted at Source
from the employees into the relevant accounts of the governmental agencies. Above all, the finance department also
liaises with the banks in which the corporate holds account. Indeed, in recent years, it has become the norm to have a
single banking relationship in an “Umbrella” format where the corporate engages and partners with a single bank for
the entire financial needs of the corporate.

The Internal Functions of the Finance Department; The internal functions of the finance department are similarly
important wherein it stars the payroll processing and ensures that employees are paid on time. Indeed, payroll is
perhaps the most visible interface that the finance department has with the employees. The next time when your
salary is credited, do think of the people sitting in the secluded (usually the finance department in many multinationals
is seated separately in glassed enclosures for diligence and compliance reasons) areas working to get your salary paid
on time. Further, the internal functions of the finance department also encompass the processing of reimbursements
on account of travel, dining and hospitality, same city transportation, perks, and any other benefits that are due to the
employees. Indeed, perhaps the biggest reason why many employees either praise or curse the finance department is
when their vouchers and bills have to be cashed.In many corporates, this takes some time as not only are the finance
personnel overworked but also they have to perform due diligence before processing the payments. Therefore, the
next time you have a bill to be cashed, you can think of the various steps and the approvals needed before you shoot
off a mail or message on the Bulletin Boards of the organization.

The Treasury Function; We have considered the external and internal functions of the finance department. In recent
years, many multinationals as well as domestic companies that operate globally have added another key and vital
function to the tasks of the finance department and this is the Treasury Function. Simply put, Treasury is all about
managing the foreign exchange payments and ensuring that the corporate does not lose money due to fluctuations in
the exchange rates. Indeed, as those who have received payments in Dollars or Euros would cash them when the
exchange rate is favorable. Similarly the Treasury�s job is to ensure that the corporate does not lose out and towards
this end, it ensures that hedging and escrow accounts are managed. For instance, there are active treasury desks in the
headquarters of most corporates worldwide due to their global payments. Most of the time, the employees are
unaware of this function since the Treasury staff do not sit in the operational offices but instead, are based in the
financial capitals such as New York, London, and Mumbai. Further, details of hedging and treasury management are
usually revealed in the annual reports that many employees do not usually read and hence, little is known to them
about this vital function.

Conclusion: The Finance Departments are Like Ants; Finally, the finance department is like a pump which keeps the
fluids of money and commerce flowing through the system. Indeed, it can be said that though the finance function is a
support function and is away from the limelight unlike the marketing, or the project staff, they are vital cogs in the
machine which keep the wheels greased and the organization moving. Some people like to call the finance function in
corporates as ants who go about their work quietly and diligently. To conclude, just as one needs the financial advisor
from time to time, all employees need the finance function and especially when one sees the money in one�s account
for salaries or bills. Why Financial Innovation can be both a Force for Good and Bad ? Exotic Innovations or Weapons of
Mass Destruction ? Anybody who has followed the severe and protracted financial crises of the last Eight years would
be aware of the damaging role played by Exotic Financial Products such as Derivates, Swaps, Credit Default Swaps, and
Options. These instruments that are supposedly in place to hedge against risk instead have become so toxic to the
health of the global financial system and the global economy that it was no wonder the legendary American investor,
Warren Buffett called them “Financial Weapons of Mass Destruction”. This is because the financial innovative
instruments which were hailed as bringing a measure of stability and hedge against risk when they were first invented
instead turned into liabilities because as it turned out, they were not that good at pricing risk and hedging against
defaults after all.

What is Financial Innovation and Why it was Welcomed ? Before proceeding further, it would be in the fitness of things
to understand what is meant by Financial Innovation. As management students learn during their MBAs and other
courses, financial instruments are usually invented to price, factor in risk, hedge against risks such as counterparty
default. In addition, innovations in finance are also due to the very real possibility that financial and physical assets
might lose value suddenly due to economic cycles and at the same time, they can also inflate beyond measure leading
to wild gyrations in the financial markets. Thus, derivatives which are so named because they “derive” their value from
underlying assets are created in a manner that protects both the buyers and sellers of the assets against excessive
volatility and wild price movements.

When is Financial Innovation Bad ?So, one might very well ask, what is the problem if risk is priced in and credit events
such as defaults are hedged against? The partial answer to this is that innovation is good as long as it is directed and
controlled in a stable manner. Once innovation takes on a life of its own, the net result or the end result is that it often
leads to a situation where neither its creators nor its users understand what exactly they are all about. Of course, this
does not mean that innovation is per se bad and more so, financial innovation is something that is inherently wrong.
Indeed, it is only because of the financial innovations of the last few decades that consumers and especially the retail
ones like you and we have been able to have greater control over our savings, portfolios, and assets.

How can we use Financial Innovation for Good ? Thus, while we are not suggesting that financial innovation should
cease, we are certainly advocating financial innovation that benefits society and which does not become overly
complicated and complex that very few of the financial experts understand what it is all about. Indeed, there are
numerous examples of how financial innovation is undertaken with a view to genuinely improving the condition of the
poor rather than solely as a way of making profits alone. These include the Microcredit Initiative that was pioneered by
the Nobel Prize Winning Bangladeshi Banker and Social Entrepreneur, Mohammed Yunus, who with his Grameen Bank
succeeded in bringing banking to poor women who were hitherto denied access to structured credit and were at the
mercy of unscrupulous money lenders. Or, banks such as Bandhan in the Eastern Indian State of Bengal which similarly,
is spearheading a revolution in banking for the masses. Of course, even in the West, there are numerous instances such
as the Commodity Bourses which as a result of Bankers merging the financial profit imperative with that of social
responsibility has helped the farmers in hedging against bad harvests, weather changes, and even pure speculation that
can result in the volatility of the prices.

Profits are not the Only Criteria; Thus, it can be said that like everything else in the world of business and finance, as
long as financial innovation has the underlying them of genuinely merging the profitability with that of social change,
then it must be welcomed and even supported and encouraged at all costs. However, when financial innovation
becomes yet another instance of speculation wherein the sole objective is to make as much money as possible, then it
is certainly something that we must be worried about.

The Emerging Threats of High Speed Trading with Uber Complex Financial Instruments; Moreover, with the advent of
high speed trading and electronic trading, it is certainly the case that the marriage of advanced technology with that of
overly complex financial products is leading us to a dangerous situation where the speed of technological change and
the increase in complexity results in a high stakes game of cards where the decisions are not made by humans but
machines which though supposedly objective can also veer out of control. Indeed, the fact that at the moment,
computers have taken over the roles that traders used to perform in the markets means that there is every chance that
one day, there would not be too many of the experts who understand what is going on.

Conclusion; To conclude, financial innovation has certainly lead to efficiencies in the markets. However, at times, such
innovation has to be tempered with human and humane considerations. Just like the inventions such as Dynamite and
the scientific achievements such as splitting the atom led to devastating outcomes, even financial innovation that is not
grounded in the realization that greed can sometimes lead to disaster would definitely lead to that as the world learned
the hard way over the last decade or so.

Methods for Taking Investment Decisions under Risk; Some of the most important methods that are used for taking
investment decisions under risk are as follows: 1. Sensitivity Analysis 2. Scenario Analysis 3. Decision Tree Analysis 4.
Break-Even Analysis 5. Risk-Adjusted Discount Rate Method 6. Certainty-Equivalent Analysis. Risk refers to the deviation
of the financial performance of a project from the forecasted performance. One needs to forecast the cash flows and
other financial aspects while selecting a project. However, the actual financial performance of a project may not in
accordance to the forecasted performance. These risks can be decline in demand, uneven cash flow, and high inflation.
For example, an organization is planning to install a machine that would increase the production level of the
organization. However, the demand of the product may vary with the economic environment, for example, the demand
may be very high in economic boom and low if there is recession. Therefore, the organization may earn high income or
incur huge loss, depending on the business environment. However, different kinds of risks can be assessed up to a
certain limit.

The risks can be assessed by using various methods that are shown in Figure-7:

1. Sensitivity Analysis: Forecasting plays an important role in project selection. For example, a project manager needs
to forecast the total cash flow of a project. The cash flow depends on the revenue earned and cost incurred in a
project. The revenue earned from the project depends on various factors, such as sales and market share. Similarly, if
we want to find out the NPV or IRR of the project, we need to make the accurate predictions of independent variables.
Any change in the independent variables can change the NPV or IRR of the project. In sensitivity analysis, we analyze
the degree of responsiveness of the dependent variable (here cash flow) for a given change in any of the dependent
variables (here sales and market share). In other words, sensitivity analysis is a method in which the results of a
decision are forecasted, if the actual performance deviates from the expected or assumed performance.

Sensitivity analysis basically consists of three steps, which are as follows: 1. Identifying all variables that affect the
NPV or IRR of the project 2. Establishing a mathematical relationship between the independent and dependent
variables 3. Studying and analyzing the impact of the change in the variables

Sensitivity analysis helps in providing different cash flow estimations in three circumstances, which are as follows: a.
Worst or Pessimistic Conditions: Refers to the most unfavorable economic situation for the project b. Normal
Conditions: Refers to the most probable economic environment for the project c. Optimistic Conditions: Indicates the
most favorable economic environment for the project

Let us consider the example given in Table-5:

Now, the NPV of each of the projects can be calculated by using the formula of NPV.

The calculation of the NPV of project A is shown in Table-6:

Similarly, the calculation of NPV of project B is shown in Table-7:

Therefore, we can see that the extent of loss in project B is less than that of project A but the extent of profit in project
B is more than that of project A. Therefore, the project manager should select project B.

2. Scenario Analysis: Scenario analysis is another important method of estimating risks involved in a project. It involves
assessing future uncertainness associated with a project and their outcomes. In this method, different probable
scenarios are analyzed and the associated outcomes are also determined. For example, you are going to undertake an
important project and have forecasted your cash flows accordingly. If your forecast goes wrong substantially, the future
of the whole project can be jeopardized. As discussed earlier, in sensitivity analysis, different factors of a project are
interdependent. Therefore, if any of the factors are disrupted, the whole forecast can be wrong. Scenario analysis helps
a project manager in preparing a framework where he/she can explore different kinds of risks associated with a project.
It is more complex as compared to sensitivity analysis. Scenario analysis needs sophisticated computer techniques to
effectively calculate a large number of probable scenarios and their respective outcomes. Scenario analysis is more
useful to a project manager than the sensitivity analysis as the former is more comprehensive and gives more insight
about a project.

However, there are few disadvantages of this method, which are as follows: (a) Complex Process: Involves difficult
calculations as calculating the NPV of a project is not easy by following this method. The complexity of the method
makes it both costly and time consuming. (b) Difficulty in Assessing the Probability: Implies that it is very difficult to
estimate the possibility of different outcomes. Sometimes, in practical life, assessing future uncertainties is not
accurate.

3. Decision Tree Analysis: Decision tree analysis is one of the most effective methods of assessing risks associated in a
project. In this method, a decision tree is drawn for analyzing the risks associated in a project. A decision tree is the
representation of different probable decisions and their probable outcomes in a tree-like diagram. This method takes
into account all probable outcomes and makes the decision making process easier. Let us understand decision tree
analysis with the help of an example, X&Y Manufacturers has two projects, project A and project B. The two projects
need the initial investment of Rs. 25000 and Rs. 32000, respectively. According to an estimation, 35% probability of
project A to give a return is Rs. 46000 in next five years and 65% probability is that it may give a return of Rs. 42000 in
the same period. Similarly, 20% probability of project B to give a return of Rs. 55000 in next five years and 80%
probability is that it may give a return of Rs. 50000 in the same period.

Now, if we express the problem in a decision tree, we will get a tree-like diagram, which is shown in Figure-8:

Now, the net value of each of the projects can be easily calculated. The net value of the project A would be
(46000×0.35) + (42000×0.65) -25000 = (16100+27300-25000) =18400. Similarly, the net value of the project B would be
(55000×.20) + (50000×.80)-32000 = 19000 Now, it is obvious that the project B is more profitable for the organization.
Therefore, the organization should continue with project B.

The advantages of decision tree analysis are as follows: (a) Detail Insight: Provide a detailed view of all the probable
outcomes associated with a project (b) Objective in Nature: Provides a clear evaluation of different alternative
decisions

Following are the disadvantages of decision tree analysis: (a) Difficulty in Large Number of Decisions: Signifies that if
the expected life of the project is long and the number of outcomes are large in numbers, it is quite difficult to draw a
decision tree (b) Difficulty in Interdependent Decisions: Indicates that the calculation becomes very time consuming
and complicated in case the alternative decisions are interdependent

4. Break-Even Analysis: Break-even analysis is a widely used technique in project management. Break-even is a no
profit and no loss situation for a project. In break-even analysis, all costs associated with a project are divided into two
heads, fixed costs and variable costs. The total fixed cost and the total variable cost are then compared with the total
return or revenue of the project. In a breakeven scenario, the total of all fixed costs or variable costs in a project is
equal to the total revenue or return from the project. Therefore, a project can be said to have reached its break-even
when it does not have any profit or loss.

The concept of breakeven point is explained in Figure-9:

The different costs used in break-even analysis are explained as follows: (a) Fixed Costs: Refer to the costs incurred at
the initial stage of the project and does not depend on the production level or operation level of the project. For
example, cost of a machinery and rent. (b) Variable Costs: Refer to the costs that depend on the volume of production.
Wages and raw materials are the examples of variable costs. (c) Total Cost: Refers to the sum total of fixed costs and
variables costs. As shown in Figure-9, at point P, the total cost is equal to the total revenue. Therefore, the project can
be said to have achieved break even at point P.

5. Risk-Adjusted Discount Rate Method: Risk-adjusted discount rate method refers to the adjustment of risk in
valuation model that is NPV. Risk-adjusted discount rate can be expressed as follows: d = 1/ 1+r+µ Where, r = risk free
discount rate. µ = risk probability. The preceding formula can be used for calculating risk-adjusted present value. For
example, if the expected rate of return after five years is equal to R5, then the risk-adjusted present value can be
determined with the help of the following formula. Present Value (PV) = 1/ (1+r+µ) 5 R5 The calculation of risk-adjusted
NPV for nth year can be done with the help of following formula:

Where, Rn = return in nth year, Co = original cost of capital

By substituting the value of d, we get the following equation:

Let us understand the calculation of risk-adjusted discount rate with the help of an example. For example, a project,
ABC cost Rs. 100 million to an organization. The project is expected to give a return of Rs. 132 million in one year. The
discount rate for project 18% and probability of risk is 0.12. Find out whether the organization should accept the
project ABC or not?

Solution: The risk-adjusted NPV for project ABC can be calculated as follows:

Where, R = Rs. 132 million. Co = Rs. 100 million. r = 0.08.H = 0.12

After substituting the given values of different variables, we get the risk-adjusted NPV that is equal to: NPV =
132/1+0.08+0.12 = 100. NPV = 10 million. Therefore, the organization is getting risk-free return of Rs. 10 million. If we
calculate NPV for the same project, it would be equal to:
 NPV = 132/1+0.08 = 100,NPV = 22.22 million,NPV and risk-adjusted NPV both are greater than
zero. Therefore, project is profitable and should be accepted.

The advantages of risk-adjusted discount rate method are as follows: (a) Changing discount rate by changing risk
factor (µ) for different time periods and amount of risk (b) Adjust the high risk of future by increasing the time duration
for risk adjusted rate. For example, the risk-adjusted discounted rate for 50th year is equal to: (c) Regarding as the
easiest method for evaluating projects in risk conditions However, the disadvantage of risk-adjusted discount rate
method is that it fails to provide tool for measuring risk factor. Therefore, it is required to be supplemented with the
method to calculate risk factor.

6. Certainty-Equivalent Analysis: Certainty-equivalent analysis is also used for the adjustment of NPV, thus, selecting or
rejecting a project. It is similar to risk- adjusted discount rate analysis. However, there is one difference between them.
In risk-adjusted discount rate analysis, the discount rate is adjusted while in certainty-equivalent analysis, expected
return is adjusted. Certainty-equivalent NPV can be, calculated with the help of the following formula: NPV= aRn/ (1+
r) n-C0 Where, a= certainty- equivalent coefficient The value of a can be determined with the help of following formula:
α = Rn/Rn* Where, Rn = Expected certain return Rn* = Expected risky return. For example, between two projects P and Q,
P is risky but gives Rs. 100 million of return after one year. However, Q is risk-free but gives Rs. 90 million of return after
one year. The investment for project P is Rs. 70 million and for Q it is Rs. 73 million. The risk-free discount rate is 10%.
In such a case, two projects are equal for the investor. This implies that risk-free project Q is equivalent to risky project
P. Therefore, certainty-equivalent coefficient would be:α = 90/100, α = 0.9 The certainty-equivalent NPV for project P
would be: NPV= α Rn/ (1 + r) n –C0 .NPV = 0.9 * 100/ (1+0.1) -70. NPV = 12 million. The certainty-equivalent NPV for
project Q would be: NPV = Rn/ (1+r) n – C0 .NPV = 90/ (1+0.1) – 73 .NPV = 9 million .The project P yields more with less
investment as compared to project Q. Therefore, project P would be selected. Investment Decision-making .Investment
refers to the purchasing of productive capacity or capital expenditure (spending by a business to buy fixed assets e.g.
property, vehicles etc)

Why Invest? Businesses need to invest to grow; They might want to increase capacity so they can produce more; If they
produce more then they can sell more and increase sales revenue; They could also look to invest to increase the
efficiency of their operations. Because of the major capital outlay involved, managers try to calculate expected
profitability and expected cash flows for the proposed investment. They use three methods of investment appraisal.
Payback period method; This method of investment appraisal calculates how long it takes a project to repay its original
investment. The method therefore concentrates on cash flow, highlighting projects that recover quickly their initial
investment. Here is an example of how it works. A company is considering two different capital investment projects.
Both are expected to operate for four years. Only one of the projects can be financed.
The payback periods are calculated by adding annual depreciation back to the cash flows: depreciation is a non-cash
expense that reduces profit, and so the profit figures given understate the cash inflows by the amount of the
depreciation. Cash flow in year 4 is also increased by the scrap values for each project.

The payback period for project A is two and a half years. At the start of year 3, outflows exceed inflows by £6000. Net
inflows for year 3 are £12 000 (£1000 per month): it therefore recoups its original investment after six months of year
3. Project B’s payback period is three years. The manager would therefore select project A on the basis of this method,
even though project B generates a greater total cash inflow by the end of its life. These calculations also help decisions
to be made between alternative capital projects. Although the payback method is widely used in practice, it is often as a
supplement to the other, more sophisticated, appraisal methods. This method is easy to calculate and understand. Its
use emphasises liquidity, because calculations are based solely on cash flow. It also helps managers to reduce risk by
selecting the project that recovers its outlay most quickly. Early cash flows can be predicted more accurately than later
ones, and are less affected by inflation. The main drawback of this method is that it completely ignores profit and
profitability. It also takes no account of interest rates.

Accounting rate of return (ARR) method; This method of investment appraisal calculates the expected profits from the
investment, expressing them as a percentage of the capital invested. The higher the rate of return, the ‘better’ (i.e. the
more profitable) is the project. The ARR is therefore based on anticipated profits rather than on cash flow.

ARR = (expected average profits / original investment) x 100

Using the above figures, project A generates total profits of £10 000 and project B total profits of £12 000.

Project A (£) Project B (£)

2500 3000

22000 22000

APR = 11.4% APR = 13.6%

Project B would therefore be selected using ARR. The accounting rate of return method is easy to use and simple to
understand. It measures and highlights the profitability of each project. Its disadvantages are that it ignores the timing
of a project’s contributions. High profits in the early years – which can be estimated more accurately, and which help
minimise the project’s risk – are treated in the same way as profits occurring later. It also concentrates on profits rather
than cash flows, ignoring the time value of money (profits in the later years being eroded by the effects of inflation).

Discounted cash flow (DCF) method; The principle of DCF is based on using discounted arithmetic to get a present
value for future cash inflows and outflows. This method is sometimes divided into two elements, which complement
each other: the net present value (NPV) method, which takes account of all relevant cash flows from the project
throughout its life, discounting them to their ‘present value’, the internal rate of return (IRR) method, which compares
the rate of return expected from the project with that identified by the company as being the cost of its capital –
projects having an IRR that exceeds the cost of capital are worth considering. As an example, a company receiving £100
at the start of a year might be able to invest it at 10% per annum: by the end of the year this investment will be worth
£110. Given the choice of £100 now or a higher sum in a year’s time, the managers will choose the higher sum only if it
exceeds £110. This principle works in reverse: the managers know that a project generating £110 in a year’s time is
worth the same as one generating £100 immediately, the project with the future value being discounted to its present
value (by using a set of discounting tables). The NPV method calculates the present value of the project’s future cash
flows. Each year’s cash flow is discounted to a present value, which shows how much the managers would have to
invest now at a given rate of interest to earn these future cash benefits. The present value of the total cash outflows is
compared to that of the total cash inflows to calculate the net present value of the project. The project with the highest
positive NPV will be chosen. If the NPV is positive – cash benefits exceed cash costs – this means that the project will
earn a return in excess of its cost of capital (the rate of interest/discounting used in the calculations). If the NPV is
negative, this means the cost of investing in the project exceeds the present value of future receipts, and so it is not
worth investing in it. If the company planning to invest in either project A or B has a cost of capital equal to 12%, the
future cash flows can be discounted to their present values using discounting tables. The present value of £1 when
discounted at 12% is:

Present value (PV)

Year
factor 12%

0 1.000

1 0.893

2 0.797

3 0.712

4 0.63

Project B has the higher expected NPV and would therefore be selected. The IRR method involves comparing the actual
rates of return – in this illustration, both rates exceed 12% since both show positive NPVs when discounted at 12% –
with the company’s cost of capital. The use of DCF takes account of all cash flows, and it acknowledges the time value
of money. The main problem is in establishing a suitable discount rate to use, because this rate (and the firm’s cost of
capital) is likely to vary over the life of the project.

Corporate Finance Project Implementation & Control; Project Implementation; Implementation simply means carrying
out the activities described in your work plan. Executing a project in the water and sanitation sector is a very complex
mission, as it requires the coordination of a wide range of activities, the overseeing of a team, the management of
budget, the communication to the public, among other issues. Independent of whether it is a social project to raise the
awareness and promote hygiene or it is a construction project for service delivery, there is a certain process that has to
be followed. The following lines will give you an introduction into the implementation of projects in sustainable
sanitation and water management, and highlights key aspects that have to be taken into account for a successful
implementation.

Advantages; Implementation gives the opportunity to see the plans become a reality.Execution of projects allows end-
users to have access to better services and living environment. Success stories and experiences can be shared with
specialists from other cities and towns, encouraging others to adopt similar approaches, which in turn may improve
water resources management in the local area

Disadvantages; Evidence of corrupt practices in procurement will undermine the entire process and waste precious
resources (PHILIP et al. 2008). Poor financial planning can lead to budget constraints in the midst of implementation.
The decision on when a project is complete often causes friction between implementers and the community.
Completion for the implementer is quite straightforward. It is defined by contracts, drawings, and statutes.
Communities have a more practical approach to completion. Once the project produces the benefits for which they
agreed to undertake it they see no reason to spend further time and money on it (DFID 1998).Project implementation
(or project execution) is the phase where visions and plans become reality. This is the logical conclusion, after
evaluating, deciding, visioning, planning, applying for funds and finding the financial resources of a project.

Technical implementation is one part of executing a project. Source: WSP (2000); The implementation of projects in
sustainable sanitation and water management is complex. It requires the coordination of a wide range of activities,
diverse institutional arrangements, and different time frames (DFID 1998). There is not one typical project in water and
sanitation, as the actions may vary from the construction of a new infrastructure, to the introduction of new ways of
working. Projects in this area cover issues such as: social development, health, environmental sustainability,
institutional strengthening, technical implementation, pilot plants, service delivery, social marketing, hygiene
promotion, sanitation promotion and capacity building. It is important to take into account that independently of the
nature of the project, implementation takes time, usually more than it is planned, and that many external constraints
can appear, which should be considered when initiating the implementation step (i.e. seasonality in availability of
community engagement/resources) (NETSSAF 2008).

The objectives of the implementation phase can be summarised as follow: Putting the action plan into operation
(PHILIP et al. 2008). Achieving tangible change and improvements (PHILIP et al. 2008). Ensuring that new infrastructure,
new institutions and new resources are sustainable in every aspect (MORIARTY et al. 2007). Ensuring that any
unforeseen conflicts that might arise during this stage are resolved (MORIARTY et al. 2007). Ensuring transparency with
regard to finances (MORIARTY et al. 2007). Ensuring that potential benefits are not captured by elites at the expenses
of poorer social groups (MORIARTY et al. 2007).

Learn how to write a project proposal!Before you can implement a project, it is imperative that you create a coherent
and high-quality project proposal. We have collected the best tipps in our factsheet here. Read on if you already have
an established project and wish to implement it successfully. Before implementing the action plan, it is important to
ensure that all the roles and responsibilities are distributed and understood. Source: WSP (2009) “The basic requirement
for starting the implementation process is to have the work plan ready and understood by all the actors involved.
Technical and non-technical requirements have to be clearly defined and the financial, technical and institutional
frameworks of the specific project have to be prepared considering the local conditions. The working team should
identify their strengths and weaknesses (internal forces), opportunities and threats (external forces). The strengths and
opportunities are positive forces that should be exploited to efficiently implement a project. The weaknesses and
threats are hindrances that can hamper project implementation. The implementers should ensure that they devise
means of overcoming them. Another basic requirement is that the financial, material and human resources are fully
available for the implementation” (NETSSAF 2008). Other actions need to be taken before work can begin to implement
the detailed action plan, including: Scheduling activities and identifying potential bottlenecks. Communicating with the
members of the team and ensuring all the roles and responsibilities are distributed and understood. Providing
for project management tools to coordinate the process. Ensuring that the financial resources are available and
distributed accordingly. Field management staff must make time to establish an atmosphere of candour and trust with
partners during implementation so that concerns may be raised (and often resolved) informally. Realistic long-term
planning of finances is key to the implementation of an action plan (see also financing and sources of funding). A
communication strategy can be used to raise awareness of the positive benefits for the community, as well as
explaining that there are necessary trade-offs, such as the introduction of water pricing, which will not please
everybody. This will help to further strengthen local ownership of the plan and encourage public participation in the
implementation of projects. At the end of a planning and implementation cycle, a press release is useful to highlight
successful stories and announce the publication of a final document such as a water report (see also media
campaigns).Expectations among stakeholders and the general public are likely to be high following the participatory
approach to the development of the preceding stages of the planning process. It is therefore important that actions are
visible and demonstrate tangible results early to build confidence in the process.

The detailed design, tendering, and construction of the infrastructure will take place during this step. Depending on
the situation and the complexity, the project might be implemented through a formal construction contract or a
voluntary community approach. Formal written contracts are required where external contractors undertake specialist
construction or installation work. This work should be awarded through a competitive tender process to ensure value
for money (DFID 1998). “Other procurement strategies could be a design and build scheme, and a build, own, operate
and transfer conception (BOOT). When formal contracts are used, there is the risk of leaving out the social framework
and the needs of the users. Therefore, it is necessary to integrate the community during the implementation step, in
order to create ownership of the new infrastructure” (NETSSAF 2008). In community-managed projects, the members
of the community are involved in the construction and installation of the new infrastructure through voluntary labour
agreements, in-kind contribution, food for work schemes, and self-help programmes where the communities are
provided training and resources to carry out the work themselves (NETSSAF 2008). It is generally more cost-effective to
use labour from within the community as much as possible. However, there has to be some guarantee of quality and an
understanding of the scope of the work. It is useful to have a written agreement between the primary and secondary
stakeholders (community and government) defining roles and responsibilities and also agreeing the scope of the works.
This will avoid confusion or disagreement later on in the project (DFID 1998). “It is important to take into account that
in urban or peri-urban areas many people already earn a living and would not be prepared to contribute labour to a
water supply or sanitation scheme but would rather contribute cash. This situation needs to be assessed at the early
stages of a project” (DFID 1998). A strategy for capacity development should be prepared in order to ensure an
effective construction, operation and maintenance work. Training activities will target technicians, masons, users, and
other service providers. These activities aim at building the required capacities for the implementation and can be
carried out through workshops, specialised training courses, “learning by doing” approach, amongst others. Whatever
method is selected, the construction and installation activities must be carried out under the supervision of experts and
engineers. "The level of supervision required will naturally depend on the complexity of the construction work.
However, if the design includes any engineering specification, then qualified staff should be available on a full-time
basis to oversee construction of the works. The quality of work will suffer if supervision is inadequate because corners
may be cut, inferior materials used, and safety compromised" (DFID 1998). The involvement of the designers is also
needed during the construction stage, particularly to answer questions and make changes in the design when
improvements and adaptations are required.

A practical implementation plan should be prepared by the implementation team to define real time schedule of
delivery of services, such as (NETSSAF 2008): When the purchase of materials is completed. When the excavation is
finished. When the structures of the buildings are constructed. When the commissioning is expected. Other aspects
that have to be taken into account during the construction phase are: sourcing, availability of funds, payment
procedures, preparation of contracts, supervision of community labour, division of labour between women and men
(see also gender issues, regular meetings with actors, etc.) “Local practices and skills should be exploited in the design
and construction of the infrastructure, for instance, in some countries the quality of concrete work is very poor, while
masonry skills are excellent. Similarly, local materials and construction methods should be employed wherever
possible. This may not always be possible, for example if rotary drilling in rock is required, but the community should be
consulted because they may have their own ideas. In some cases the use of local materials is unacceptable to the
partners if it is of a very low quality; it would probably not be cost-effective to purchase local asbestos cement pipes
with a design life of five years, if imported ones have a design life of 30 years” (DFID 1998). As mentioned before, social
projects are also very common in the water and sanitation field, as they usually target the human factor that is crucial
for achieving sustainability of the SSWM measures. These projects are usually related to the change of behaviours and
strengthening of capacities by awareness raisingcampaigns, training activities, institutional set-ups, etc. As these
projects cover a wide range of activities that are case-specific, how the implementation will take place will vary from
case to case. However, the implementation of a project will always be successful if management strategies and
coordination guidelines are clearly defined. Independent of the type of project to be carried out, a work plan is needed
indicating the pursued objectives, the expected results, the activities to be developed, as well as the budget available
and timeframe given. Each of the activities has to be assigned to a particular individual, department or organisation
that should have proven experience and the capacity to achieve the goals. Local community workers, who can speak
the local languages, are the first to integrate in the project, as these types of actions require that the implementers
know the culture of the community to gain their trust and achieve a real impact.

It is of primordial importance that the financial resources are readily available at the beginning of the action, so the
members of the team have the budget to initiate the activities and cover their own expenses. The management team
should look for strategic partnerships with local leaders and spokespersons, giving institutional backup to the actions.
Directors and CEOs of the leading organisation should participate in the opening ceremonies or kick-off meeting
supporting the local workers, thus facilitating future activities that will be done in the field. An activity and financial
reporting procedure has to be prepared and communicated to the members of the team. It should be clear from the
beginning of the action, how all the costs incurred will be reported and reimbursed. It is important to keep procedures
as simple as possible, using simple tables and template for reporting costs, field visits, interviews, workshops, meeting
minutes, etc. A controlling strategy has to be developed, in order to monitor the work done on the field. A clearly
defined decision making process will set the roles and responsibilities of the members of the team: field worker ->task
leaders -> work package leader -> project manager -> coordinator of the project -> steering committee. This ladder will
allow for immediate correction of actions and efficient use of (human) resources. Communication channels should be
kept open between the field workers and the management team, making use of mobile phones, SMS, E-mails, etc. It is
important to avoid overloading the team with bureaucratic procedures that nobody will follow (like newsletters, long
reports, weekly E-mails, etc). Instead, monthly meetings should be planned, bringing the field workers together to
report, exchange experiences and learn from each other’s successful and failing stories. In project implementation or
project execution, we put it all together. Project planning is complete, as detailed as possible, yet providing enough
flexibility for necessary changes. In a customer-contractor relationship, the contract is signed, based on the right
decisions about the contract structures, and including clauses for change and claim management.

Now we apply all the tools we prepared in order to keep ourselves in control of the project. As project managers and
sub-project managers we have to make sure that we, together with all our team members, take action, in-line with the
plan and / or contract, record and document all the work, work results, special events, decisions about changes,
implementation of changes, etc., analyze, communicate, report, and document status and results of action, in-line with
the plan and / or contract, take decision if and what kind of change we need, in case any result (or action) is not as
required, implement agreed changes, in-line with the plan and / or contract. In project implementation, we manage
implementation of all our project plans, following the triple constraint: Project Scope Management, Project Time
Management, Project Cost Management. In case we are applying the classical planning approach or the critical chain
method, our focus will be on the comparison of actual results with required results.

The most powerful platform for this comparison in order to analyze, communicate, and decide work progress,
problems, and necessary changes are project meetings in which we apply the planned project controlling tools., kick-off
meetings, regular status meetings, special status meetings, risk analysis workshops (as part of our risk management
strategy), problem solving workshops, project management review meetings, continue or terminate decisions.

Kick-off meetings; In project planning, we assigned all necessary resources to the project. We continuously reassured
that those resources are still available and ready to take off. Now is the right time to have the project kick-off meeting.
Its main purpose is to present the project planning status to the stakeholders, especially to all our team members, and
to officially start project implementation phase. This kick-off meeting at the beginning of implementation phase
triggers other meetings and workshops: workshop for the handover from the proposal team to the implementation
team (in projects with a customer-contractor relationship); contract analysis workshop (in projects with a customer-
contractor relationship); engineering or design review meetings (for the product that has to be created). A typical
agenda of a project kick-off meeting could look like this: Introduction of participants and agenda, Presentation of
project goal(s), PBS, and WBS, Presentation of planning milestones and over-all project schedule, Presentation of
project cost structure, Assignment of responsibilities, Commitment of team members, Agreement on minutes of
meeting and conclusion, Regular project status meetings. To keep track of the results achieved, we hold regular status
meetings throughout project implementation and closure phases. The frequency of these regular status meetings
depends on the project duration, e.g. every week for a project of 20 to 40 weeks duration, or every 2 weeks for a
project of 50 to 80 weeks duration. A typical agenda could look like this: Introduction of the agenda, Status of sub-
projects and milestones (MTA), Earned value analysis (EVA), Status of changes, Discussion and decisions,Agreement on
minutes of meeting and conclusion.

Special project meetings; Any event or arising problem in project implementation that disturbs the planned and regular
work progress triggers a special project meeting. These special meetings focus only on the event that happened or the
problem that came up. Most of these events or problems should be on our risk list. However, there will still be some
which we do not have on our radar screen but could jeopardize the project or major parts of it, and hence, need to be
discussed. A typical agenda of such a special project meeting could look as follows. Introduction of the agenda, Report
about the event that triggered the meeting, Comparison with risk list (is the event on our risk list?), Consequences if
nothing would be done: what is the impact?, Planned action(s) according to earlier risk analysis, What other action(s)
are required or can be done?, Update risk list, Discussion and decisions, Agreement on minutes of meeting and
conclusion.

Risk management workshops; Following our risk management process, we repeat risk management workshops
regularly, throughout the whole project management process. The typical agenda of such a risk management workshop
could look as follows. Introduction of the agenda. Status of risk events: which events occurred, which did not occur?
Revision of the risk list: what new risks can be anticipated, which risks cannot occur anymore? Evaluation of new risks:
probability, impact. Identify preventive or corrective actions, etc.? Update risk list.

Discussion and decisions. Agreement on minutes of workshop and conclusion. Problem solving workshops. In case of
any serious problem occurring in project implementation that affects the whole project or major parts of it we hold a
problem solving workshop. These workshops follow the general problem solving process: Introduction of the agenda,
Define the problem, Analyze the problem: causes and impact, Brainstorming on possible solutions, Plan actions,
Discussion and decision, Agreement on minutes of workshop and conclusion.

Project management review meetings. On a regular or non-regular basis, we hold project review meetings. There are
three types of review meetings: The project management team calls for a review meeting in order to have somebody
from outside the team carry out a health check of project implementation (non-regular). The control board calls for a
review meeting in order to obtain an overview of the project status (regular). The customer calls for a review meeting
in order to obtain an overview of the project status (regular). Usually, those who call for the review meeting setup the
agenda as well. In case (A), where the team asks for a project health check, we typically follow an agreed project
assessment procedure. For control board and customer driven review meetings, we generally apply this agenda:
Introduction of the agenda, Project status: Milestone Trend Analysis, Earned Value Analysis, major achievements, major
problems, Suggested solutions of problems, Further steps and actions, Discussion and decisions, Agreement on minutes
of workshop and conclusion.

Project management reports; Further backbones of successful project controlling during project implementation are
well structured and regular project management reports. In most cases, these reports will serve as an excellent basis
for the project meetings and workshops. Good reports also help to keep those meetings and workshops short and
efficient. For projects with virtual team work, they are vital. The project management reports follow the
communications plan. In the sub-section Free Downloads, we offer some useful templates for project status reports,
risk analysis reports, problem reports, and others. We feed their essential data into our project management
dashboard.

Project Records; In project implementation, we need to monitor everything that could jeopardize our project or parts
of it. As emphasized in the section about Contract Management, it is essential to take records of anything that is not in-
line with the contract. Only then we are able to follow the change management process or the claim management
process. In case everything runs smoothly, according to plan, we also keep records of the achieved work progress since
only this ensures timely update of our milestone trend analysis and earned value analysis (if we apply earned value
project management, sometimes simply referred to earned value management). If something is not in line with our
project plans, i.e. an event happens that has serious consequences on our project or parts of it, we need to take all
available records of that event, of its impact, of all possible solutions found in co-operation with the customer, sub-
suppliers, or other stakeholders, and of the decisions made in order to solve the problem. Here, you find what counts
as project records. Should we encounter a situation where we have to pursue a claim we enter the contractual claim
process and settlement procedure as early as possible in order to decrease pressure in project closure phase. For
further details, please refer to sub-section Project Claim Management and to a case study in sub-section Project Claim
Analysis.

Application of controlling tools; All data and information we obtain from records and project meetings go into those
controlling tools we prepared in planning phase. The set of controlling tools we chose earlier, now forms our system of
project management metrics. Application of two of those tools we explain more detailed: Milestone Trend Analysis
(MTA), in sub-section Milestone Trend Analysis; Earned Value Analysis (EVA), in sub-section Earned Value Project
Management. We present MTA and EVA within our project management reports, and feed their essential data into our
project management dashboard.

Project Termination; Amongst the most serious decisions a project management team and its control board have to
take is project termination. Such a decision usually implicates frustration for those stakeholders who sincerely believed
- and in most cases still believe – that the project could produce the results they expected – or still expect. What can we
do to avoid those negative consequences? Please, refer to sub-section Project Termination to pick-up our suggestions.

Conclusion of project implementation phase; Towards the end of project implementation phase, the desired result of
the project takes more and more shape: we integrate, test, and commission last sub-parts. The end product or service
is essentially put together. Then, we declare the project result "ready for preliminary acceptance". In a contractual
based relationship between customer and supplier, the declaration of preliminary acceptance by the customer is
usually accompanied by a List of Open Points (LoP). This LoP covers minor issues that are not yet fully compliant with
the requirements or specifications, and have to be resolved in closure phase. Preliminary acceptance concludes project
implementation phase. Project control is a series of processes and steps that a project manager in cooperation with
other management staff carries out to control the project in terms of progress, quality, changes, products,
commitments and other critical concerns. The ultimate purpose of project control is to manage work during each stage
of the implementation lifecycle and to prepare the project for the next stage. In this article you will find out how to
control a project in 5 steps. Project control is a project management function intended for achieving defined objectives
and expectations within a predetermined timetable. Traditionally it involves these three high-level processes that the
management team needs to carry out throughout their project: Setting standards, Measuring performance, Taking
corrections

Each of the processes can be divided into smaller steps and tasks. In this article I’m going to break down the processes
into these 5 steps: Hold meetings, Perform quality control, Track work progress, Respond to changes, Manage issues

Hold Meetings; The objective of conducting meetings during the course of a project is to assemble and manage an
effective project team that is able to accomplish defined goals and objectives. At a meeting the project manager should
provide an overview of work at the moment, describe current goals and issues, and establish effective communications
with the team. Every meeting starts with an agenda. The project manager needs to write a meeting agenda and then
share this document with all participants of the meeting. As an example, here’s the template of project kick-off agenda
(doc file, 52Kb). Conducting a meeting enables a project manager to accomplish these tasks important to the control
process: Review and (re)assign roles and responsibilities of the team, Provide executive direction of the project to the
team, Notify of current status of project work, including open issues, Provide guidance to the team, Make executable
decisions regarding further actions throughout the project, Establish and review success criteria

Perform Quality Control; By controlling project quality it is possible to confirm that the product is complete and
developed in line with expectations. Quality control involves business and technical staff in a range of activities such as
defining technical standards, setting business expectations, establishing product requirements, others. Quality control
starts when a project is initiated and lasts throughout the entire project lifecycle until the product is developed and
handed over to the customer. It aims to ensure that activities and tasks at any given stage of the lifecycle can be signed
off so that the project can continue developing. Here’s a list of the key tasks a project manager needs to perform to
control quality: Create a quality review schedule that defines timing for controlling a given stage, Develop an agenda
that determines key tasks of people involved in the control process, Assign reviewers who will perform stage quality
control, including stage objectives, products, commitments, roles, responsibilities etc. Allocate other roles such as
Facilitator (who ensures adherence to the agenda and appropriate follow-up) and Author (who provides all necessary
information and takes approved corrective actions after the control process finishes), Document and record all actions
and decisions taken throughout the control process, Ensure that appropriate follow-up actions are taken,Notify
stakeholders of project status after the control process is done.

Track Work Progress; This step in controlling a project refers to monitoring, measuring and controlling progress on the
project. The purpose is to ensure that project work is being done as scheduled. The project manager needs to track
work progress at any given stage to make sure the project goes towards right direction. Please read this article about
reviewing project state to learn more. Here’re the key steps a project manager should take to track progress and
ensure effective project control: Capture task performance data including actual start/finish date for tasks,
planned/actual work effort (in hours), latest estimated duration (in hours) to complete the tasks, others, Update the
schedule with the actual task performance data, Estimate remaining costs and update the cost estimates with actual
costs incurred during a selected period, Capture any non-staff costs incurred, Consider re-planning work for a given
stage in terms of the updates made to the schedule and cost estimates, Adjust staff availability and consider making re-
assignments, Involve additional resources if needed, Measure team performance and determine issues that cause
lower performance, Provide motivation to personnel during team status meetings, Take corrective actions to eliminate
performance issues.
Respond to Changes; The goal of controlling changes is to define and implement the addition of work into a given stage.
By effectively responding to changes the project manager is able to ensure that the scope, schedule and cost remain
relevant to current situation. Here’s a general to-do list a project manager needs to complete when requesting and
responding to changes: Receive and review change requests which provide a description of the proposed change with
priority, Assign change requests to competent team members who must investigate alternative solutions, Review and
approve/cancel alternative solutions and then update change requests accordingly, Approve updated change requests,
Create an action plan for implementing the changes, Define implementation time for each change, Monitor progress
and quality on the changes, Enables the changes to completed products.

Manage Issues; As a process, issue management aims to resolve any issues affecting the success of a project. This
process takes a range of steps which are to identify issues, asses their impact, develop resolution actions, take those
actions and track progress on issues. A project manager needs to manage issues in order to ensure that the project is
carried out as planned. Here’re broad tasks the manager can do to manage issues: Identify and record issues affecting
the project, Create an issue log that specifies the issues including their description, type, priority, assigned personnel,
status, etc., Assess impact of the issues on the scope, schedule and cost, Determine how the issues might be resolved,
Review, correct and accept recommendations regarding managing the issues, Execute the resolution.

Monitor progress on issues; Along with the five listed steps in project control, there are other activities such as risk
management, exception management, communications management. Project control is a complex and comprehensive
process, and thus project managers should realize all the steps of this process. In my future articles I will describe the
rest steps and activities of project control. Thank you for your time and good luck with your project initiatives!

Corporate Finance Mitigating risk & uncertainty;Once risks have been identified and assessed, all techniques to
manage the risk fall into one or more of these four major categories: Avoidance (eliminate, withdraw from or not
become involved) Reduction (optimize – mitigate) Sharing (transfer – outsource or insure) Retention (accept and
budget)

Risk mitigation is defined as taking steps to reduce adverse effects. There are four types of risk mitigation strategies
that hold unique to Business Continuity and Disaster Recovery. ... This strategy limits a company's exposure by taking
some action.

Risk management is the identification, evaluation, and prioritization of risks (defined in ISO 31000 as the effect of
uncertainty on objectives) followed by coordinated and economical application of resources to minimize, monitor, and
control the probability or impact of unfortunate events[1] or to maximize the realization of opportunities. Risks can
come from various sources including uncertainty in financial markets, threats from project failures (at any phase in
design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and
disasters, deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types
of events i.e. negative events can be classified as risks while positive events are classified as opportunities. Several risk
management standards have been developed including the Project Management Institute, the National Institute of
Standards and Technology, actuarial societies, and ISO standards.[2][3] Methods, definitions and goals vary widely
according to whether the risk management method is in the context of project management, security, engineering,
industrial processes, financial portfolios, actuarial assessments, or public health and safety.

Strategies to manage threats (uncertainties with negative consequences) typically include avoiding the threat, reducing
the negative effect or probability of the threat, transferring all or part of the threat to another party, and even retaining
some or all of the potential or actual consequences of a particular threat, and the opposites for opportunities
(uncertain future states with benefits). Certain aspects of many of the risk management standards have come under
criticism for having no measurable improvement on risk; whereas the confidence in estimates and decisions seem to
increase.[1] For example, one study found that one in six IT projects were "black swans" with gigantic overruns (cost
overruns averaged 200%, and schedule overruns 70%).[4] A widely used vocabulary for risk management is defined by
ISO Guide 73:2009, "Risk management. Vocabulary."[2] In ideal risk management, a prioritization process is followed
whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first, and risks
with lower probability of occurrence and lower loss are handled in descending order. In practice the process of
assessing overall risk can be difficult, and balancing resources used to mitigate between risks with a high probability of
occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the
organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a
knowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk
may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of
knowledge workers, decrease cost-effectiveness, profitability, service, quality, reputation, brand value, and earnings
quality. Intangible risk management allows risk management to create immediate value from the identification and
reduction of risks that reduce productivity. Risk management also faces difficulties in allocating resources. This is the
idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities.
Again, ideal risk management minimizes spending (or manpower or other resources) and also minimizes the negative
effects of risks. According to the definition to the risk, the risk is the possibility that an event will occur and adversely
affect the achievement of an objective. Therefore, risk itself has the uncertainty. Risk management such as COSO ERM,
can help managers have a good control for their risk. Each company may have different internal control components,
which leads to different outcomes. For example, the framework for ERM components includes Internal Environment,
Objective Setting, Event Identification, Risk Assessment, Risk Response, Control Activities, Information and
Communication, and Monitoring.

Method; For the most part, these methods consist of the following elements, performed, more or less, in the following
order., identify, characterize threats, assess the vulnerability of critical assets to specific threats, determine the risk (i.e.
the expected likelihood and consequences of specific types of attacks on specific assets), identify ways to reduce those
risks, prioritize risk reduction measures.

Principles; The International Organization for Standardization (ISO) identifies the following principles of risk
management:[5]

Risk management should: create value – resources expended to mitigate risk should be less than the consequence of
inaction, be an integral part of organizational processes, be part of decision making process, explicitly address
uncertainty and assumptions, be a systematic and structured process, be based on the best available information, be
tailorable, take human factors into account, be transparent and inclusive, be dynamic, iterative and responsive to
change, be capable of continual improvement and enhancement, be continually or periodically re-assessed.

Process; According to the standard ISO 31000 "Risk management – Principles and guidelines on implementation,"[3]
the process of risk management consists of several steps as follows:

Establishing the context; This involves: the social scope of risk management, the identity and objectives of stakeholders,
the basis upon which risks will be evaluated, constraints., defining a framework for the activity and an agenda for
identification, developing an analysis of risks involved in the process, mitigation or solution of risks using available
technological, human and organizational resources.

Identification; After establishing the context, the next step in the process of managing risk is to identify potential risks.
Risks are about events that, when triggered, cause problems or benefits. Hence, risk identification can start with the
source of our problems and those of our competitors (benefit), or with the problem itself.
Source analysis[6] – Risk sources may be internal or external to the system that is the target of risk management (use
mitigation instead of management since by its own definition risk deals with factors of decision-making that cannot be
managed). Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an
airport.

Problem analysis[citation needed] – Risks are related to identified threats. For example: the threat of losing money, the
threat of abuse of confidential information or the threat of human errors, accidents and casualties. The threats may
exist with various entities, most important with shareholders, customers and legislative bodies such as the government.
When either source or problem is known, the events that a source may trigger or the events that can lead to a problem
can be investigated. For example: stakeholders withdrawing during a project may endanger funding of the project;
confidential information may be stolen by employees even within a closed network; lightning striking an aircraft during
takeoff may make all people on board immediate casualties. The chosen method of identifying risks may depend on
culture, industry practice and compliance. The identification methods are formed by templates or the development of
templates for identifying source, problem or event. Common risk identification methods are: Objectives-based risk
identification[citation needed] – Organizations and project teams have objectives. Any event that may endanger
achieving an objective partly or completely is identified as risk.

Scenario-based risk identification – In scenario analysis different scenarios are created. The scenarios may be the
alternative ways to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle.
Any event that triggers an undesired scenario alternative is identified as risk – see Futures Studies for methodology
used by Futurists.

Taxonomy-based risk identification – The taxonomy in taxonomy-based risk identification is a breakdown of possible
risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The answers to the
questions reveal risks.[7]

Common-risk checking [8] – In several industries, lists with known risks are available. Each risk in the list can be checked
for application to a particular situation.[9]

Risk charting[10] – This method combines the above approaches by listing resources at risk, threats to those resources,
modifying factors which may increase or decrease the risk and consequences it is wished to avoid. Creating a matrix
under these headings enables a variety of approaches. One can begin with resources and consider the threats they are
exposed to and the consequences of each. Alternatively one can start with the threats and examine which resources
they would affect, or one can begin with the consequences and determine which combination of threats and resources
would be involved to bring them about.

Risk assessment; Once risks have been identified, they must then be assessed as to their potential severity of impact
(generally a negative impact, such as damage or loss) and to the probability of occurrence. These quantities can be
either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of an
unlikely event, the probability of occurrence of which is unknown. Therefore, in the assessment process it is critical to
make the best educated decisions in order to properly prioritize the implementation of the risk management plan. Even
a short-term positive improvement can have long-term negative impacts. Take the "turnpike" example. A highway is
widened to allow more traffic. More traffic capacity leads to greater development in the areas surrounding the
improved traffic capacity. Over time, traffic thereby increases to fill available capacity. Turnpikes thereby need to be
expanded in a seemingly endless cycles. There are many other engineering examples where expanded capacity (to do
any function) is soon filled by increased demand. Since expansion comes at a cost, the resulting growth could become
unsustainable without forecasting and management. The fundamental difficulty in risk assessment is determining the
rate of occurrence since statistical information is not available on all kinds of past incidents and is particularly scanty in
the case of catastrophic events, simply because of their infrequency. Furthermore, evaluating the severity of the
consequences (impact) is often quite difficult for intangible assets. Asset valuation is another question that needs to be
addressed. Thus, best educated opinions and available statistics are the primary sources of information. Nevertheless,
risk assessment should produce such information for senior executives of the organization that the primary risks are
easy to understand and that the risk management decisions may be prioritized within overall company goals. Thus,
there have been several theories and attempts to quantify risks. Numerous different risk formulae exist, but perhaps
the most widely accepted formula for risk quantification is: "Rate (or probability) of occurrence multiplied by the
impact of the event equals risk magnitude."[vague]

Risk options; Risk mitigation measures are usually formulated according to one or more of the following major risk
options, which are: Design a new business process with adequate built-in risk control and containment measures from
the start. Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business operations
and modify mitigation measures. Transfer risks to an external agency (e.g. an insurance company). Avoid risks
altogether (e.g. by closing down a particular high-risk business area). Later research[11] has shown that the financial
benefits of risk management are less dependent on the formula used but are more dependent on the frequency and
how risk assessment is performed. In business it is imperative to be able to present the findings of risk assessments in
financial, market, or schedule terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in
financial terms. The Courtney formula was accepted as the official risk analysis method for the US governmental
agencies. The formula proposes calculation of ALE (annualized loss expectancy) and compares the expected loss value
to the security control implementation costs (cost-benefit analysis).

Potential risk treatments; Once risks have been identified and assessed, all techniques to manage the risk fall into one
or more of these four major categories:[12] Avoidance (eliminate, withdraw from or not become involved), Reduction
(optimize – mitigate), Sharing (transfer – outsource or insure), Retention (accept and budget) Ideal use of these risk
control strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the
organization or person making the risk management decisions. Another source, from the US Department of Defense
(see link), Defense Acquisition University, calls these categories ACAT, for Avoid, Control, Accept, or Transfer. This use
of the ACAT acronym is reminiscent of another ACAT (for Acquisition Category) used in US Defense industry
procurements, in which Risk Management figures prominently in decision making and planning.

Risk avoidance; This includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the legal liability that comes with it. Another would be not flying in order
not to take the risk that the airplane were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks
also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a
business to avoid the risk of loss also avoids the possibility of earning profits. Increasing risk regulation in hospitals has
led to avoidance of treating higher risk conditions, in favor of patients presenting with lower risk.[13]

Risk reduction; Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of the loss
from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This method may
cause a greater loss by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate
that risk, but the cost may be prohibitive as a strategy. Acknowledging that risks can be positive or negative, optimizing
risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk
reduction and effort applied. By an offshore drilling contractor effectively applying Health, Safety and Environment
(HSE) management in its organization, it can optimize risk to achieve levels of residual risk that are tolerable.[14]
Modern software development methodologies reduce risk by developing and delivering software incrementally. Early
methodologies suffered from the fact that they only delivered software in the final phase of development; any
problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing in
iterations, software projects can limit effort wasted to a single iteration. Outsourcing could be an example of risk
sharing strategy if the outsourcer can demonstrate higher capability at managing or reducing risks.[15] For example, a
company may outsource only its software development, the manufacturing of hard goods, or customer support needs
to another company, while handling the business management itself. This way, the company can concentrate more on
business development without having to worry as much about the manufacturing process, managing the development
team, or finding a physical location for a center.

Risk sharing; Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the
measures to reduce a risk." The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that
you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or
contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the
terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer
of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses
"transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism.
For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company.
The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply
provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to
the policy holder that is commensurate with the suffering/damage. Some ways of managing risk fall into multiple
categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group
involves transfer among individual members of the group. This is different from traditional insurance, in that no
premium is exchanged between members of the group up front, but instead losses are assessed to all members of the
group.

Risk retention; Risk retention involves accepting the loss, or benefit of gain, from a risk when the incident occurs. True
self-insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against
the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are
retained by default. This includes risks that are so large or catastrophic that either they cannot be insured against or the
premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss
attributed to war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is
retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater
coverage amounts is so great that it would hinder the goals of the organization too much.

Risk management plan; Select appropriate controls or countermeasures to mitigate each risk. Risk mitigation needs to
be approved by the appropriate level of management. For instance, a risk concerning the image of the organization
should have top management decision behind it whereas IT management would have the authority to decide on
computer virus risks. The risk management plan should propose applicable and effective security controls for managing
the risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and implementing
antivirus software. A good risk management plan should contain a schedule for control implementation and
responsible persons for those actions. According to ISO/IEC 27001, the stage immediately after completion of the risk
assessment phase consists of preparing a Risk Treatment Plan, which should document the decisions about how each of
the identified risks should be handled. Mitigation of risks often means selection of security controls, which should be
documented in a Statement of Applicability, which identifies which particular control objectives and controls from the
standard have been selected, and why.

Implementation; Implementation follows all of the planned methods for mitigating the effect of the risks. Purchase
insurance policies for the risks that it has been decided to transferred to an insurer, avoid all risks that can be avoided
without sacrificing the entity's goals, reduce others, and retain the rest.

Review and evaluation of the plan; Initial risk management plans will never be perfect. Practice, experience, and actual
loss results will necessitate changes in the plan and contribute information to allow possible different decisions to be
made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are two primary reasons for this: to
evaluate whether the previously selected security controls are still applicable and effective, to evaluate the possible risk
level changes in the business environment. For example, information risks are a good example of rapidly changing
business environment.

Limitations; Prioritizing the risk management processes too highly could keep an organization from ever completing a
project or even getting started. This is especially true if other work is suspended until the risk management process is
considered complete. It is also important to keep in mind the distinction between risk and uncertainty. Risk can be
measured by impacts × probability. If risks are improperly assessed and prioritized, time can be wasted in dealing with
risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert
resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may
be better to simply retain the risk and deal with the result if the loss does in fact occur. Qualitative risk assessment is
subjective and lacks consistency. The primary justification for a formal risk assessment process is legal and
bureaucratic.

Areas; As applied to corporate finance, risk management is the technique for measuring, monitoring and controlling the
financial or operational risk on a firm's balance sheet, a traditional measure is the value at risk (VaR), but there also
other measures like profit at risk (PaR) or margin at risk. The Basel II framework breaks risks into market risk (price risk),
credit risk and operational risk and also specifies methods for calculating capital requirements for each of these
components. In Information Technology, Risk management includes "Incident Handling", an action plan for dealing with
intrusions, cyber-theft, denial of service, fire, floods, and other security-related events. According to the SANS
Institute,[16] it is a six step process: Preparation, Identification, Containment, Eradication, Recovery, and Lessons
Learned.

Enterprise; In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative
influences on the enterprise in question. Its impact can be on the very existence, the resources (human and capital), the
products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the
environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit
risk, interest rate risk or asset liability management, liquidity risk, market risk, and operational risk. In the more general
case, every probable risk can have a pre-formulated plan to deal with its possible consequences (to ensure contingency
if the risk becomes a liability). From the information above and the average cost per employee over time, or cost
accrual ratio, a project manager can estimate: the cost associated with the risk if it arises, estimated by multiplying
employee costs per unit time by the estimated time lost (cost impact, C where C = cost accrual ratio * S) This article
uses abbreviations that may be confusing or ambiguous. There might be a discussion about this on the talk page. Please
improve this article if you can. (September 2016) (Learn how and when to remove this template message), the
probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = P * S): Sorting on this
value puts the highest risks to the schedule first. This is intended to cause the greatest risks to the project to be
attempted first so that risk is minimized as quickly as possible. This is slightly misleading as schedule variances with a
large P and small S and vice versa are not equivalent. (The risk of the RMS Titanic sinking vs. the passengers' meals
being served at slightly the wrong time). the probable increase in cost associated with a risk (cost variance due to risk,
Rc where Rc = P*C = P*CAR*S = P*S*CAR), sorting on this value puts the highest risks to the budget first. see concerns
about schedule variance as this is a function of it, as illustrated in the equation above. Risk in a project or process can
be due either to Special Cause Variation or Common Cause Variation and requires appropriate treatment. That is to re-
iterate the concern about extremal cases not being equivalent in the list immediately above.

Enterprise Security; ESRM is a security program management approach that links security activities to an enterprise's
mission and business goals through risk management methods. The security leader's role in ESRM is to manage risks of
harm to enterprise assets in partnership with the business leaders whose assets are exposed to those risks. ESRM
involves educating business leaders on the realistic impacts of identified risks, presenting potential strategies to
mitigate those impacts, then enacting the option chosen by the business in line with accepted levels of business risk
tolerance[17]

Medical device; For medical devices, risk management is a process for identifying, evaluating and mitigating risks
associated with harm to people and damage to property or the environment. Risk management is an integral part of
medical device design and development, production processes and evaluation of field experience, and is applicable to
all types of medical devices. The evidence of its application is required by most regulatory bodies such as the US FDA.
The management of risks for medical devices is described by the International Organization for Standardization (ISO) in
ISO 14971:2007, Medical Devices—The application of risk management to medical devices, a product safety standard.
The standard provides a process framework and associated requirements for management responsibilities, risk analysis
and evaluation, risk controls and lifecycle risk management. The European version of the risk management standard
was updated in 2009 and again in 2012 to refer to the Medical Devices Directive (MDD) and Active Implantable Medical
Device Directive (AIMDD) revision in 2007, as well as the In Vitro Medical Device Directive (IVDD). The requirements of
EN 14971:2012 are nearly identical to ISO 14971:2007. The differences include three "(informative)" Z Annexes that
refer to the new MDD, AIMDD, and IVDD. These annexes indicate content deviations that include the requirement for
risks to be reduced as far as possible, and the requirement that risks be mitigated by design and not by labeling on the
medical device (i.e., labeling can no longer be used to mitigate risk). Typical risk analysis and evaluation techniques
adopted by the medical device industry include hazard analysis, fault tree analysis (FTA), failure mode and effects
analysis (FMEA), hazard and operability study (HAZOP), and risk traceability analysis for ensuring risk controls are
implemented and effective (i.e. tracking risks identified to product requirements, design specifications, verification and
validation results etc.). FTA analysis requires diagramming software. FMEA analysis can be done using a spreadsheet
program. There are also integrated medical device risk management solutions. Through a draft guidance, the FDA has
introduced another method named "Safety Assurance Case" for medical device safety assurance analysis. The safety
assurance case is structured argument reasoning about systems appropriate for scientists and engineers, supported by
a body of evidence, that provides a compelling, comprehensible and valid case that a system is safe for a given
application in a given environment. With the guidance, a safety assurance case is expected for safety critical devices
(e.g. infusion devices) as part of the pre-market clearance submission, e.g. 510(k). In 2013, the FDA introduced another
draft guidance expecting medical device manufacturers to submit cybersecurity risk analysis information.

Project management; Project risk management must be considered at the different phases of acquisition. In the
beginning of a project, the advancement of technical developments, or threats presented by a competitor's projects,
may cause a risk or threat assessment and subsequent evaluation of alternatives (see Analysis of Alternatives). Once a
decision is made, and the project begun, more familiar project management applications can be used:[18][19][20] An
example of the Risk Register for a project that includes 4 steps: Identify, Analyze, Plan Response, Monitor and
Control.[21] Planning how risk will be managed in the particular project. Plans should include risk management tasks,
responsibilities, activities and budget. Assigning a risk officer – a team member other than a project manager who is
responsible for foreseeing potential project problems. Typical characteristic of risk officer is a healthy skepticism.
Maintaining live project risk database. Each risk should have the following attributes: opening date, title, short
description, probability and importance. Optionally a risk may have an assigned person responsible for its resolution
and a date by which the risk must be resolved. Creating anonymous risk reporting channel. Each team member should
have the possibility to report risks that he/she foresees in the project. Preparing mitigation plans for risks that are
chosen to be mitigated. The purpose of the mitigation plan is to describe how this particular risk will be handled –
what, when, by whom and how will it be done to avoid it or minimize consequences if it becomes a liability.
Summarizing planned and faced risks, effectiveness of mitigation activities, and effort spent for the risk management.

Megaprojects (infrastructure); Megaprojects (sometimes also called "major programs") are large-scale investment
projects, typically costing more than $1 billion per project. Megaprojects include major bridges, tunnels, highways,
railways, airports, seaports, power plants, dams, wastewater projects, coastal flood protection schemes, oil and natural
gas extraction projects, public buildings, information technology systems, aerospace projects, and defense systems.
Megaprojects have been shown to be particularly risky in terms of finance, safety, and social and environmental
impacts.[22] Risk management is therefore particularly pertinent for megaprojects and special methods and special
education have been developed for such risk management.[23]

Natural disasters; It is important to assess risk in regard to natural disasters like floods, earthquakes, and so on.
Outcomes of natural disaster risk assessment are valuable when considering future repair costs, business interruption
losses and other downtime, effects on the environment, insurance costs, and the proposed costs of reducing the
risk.[24][25] The Sendai Framework for Disaster Risk Reduction is a 2015 international accord that has set goals and
targets for disaster risk reduction in response to natural disasters.[26] There are regular International Disaster and Risk
Conferences in Davos to deal with integral risk management.

Wilderness; The management of risks to persons and property in wilderness and remote natural areas has developed
with increases in outdoor recreation participation and decreased social tolerance for loss. Organizations providing
commercial wilderness experiences can now align with national and international consensus standards for training and
equipment such as ANSI/NASBLA 101-2017 (boating)[27], UIAA 152 (ice climbing tools)[28], and European Norm
13089:2015 + A1:2015 (mountaineering equipment)[29][30]. The Association for Experiential Education offers
accreditation for wilderness adventure programs[31]. The Wilderness Risk Management Conference provides access to
best practices, and specialist organizations provide wilderness risk management consulting and
training[32][33][34][35].

Information technology; IT risk is a risk related to information technology. This is a relatively new term due to an
increasing awareness that information security is simply one facet of a multitude of risks that are relevant to IT and the
real world processes it supports. ISACA's Risk IT framework ties IT risk to enterprise risk management. Duty of Care Risk
Analysis (DoCRA)[36] evaluates risks and their safeguards and considers the interests of all parties potentially affected
by those risks. CIS RAM provides a method to design and evaluate the implementation of the CIS Controls™.

Petroleum and natural gas; For the offshore oil and gas industry, operational risk management is regulated by the
safety case regime in many countries. Hazard identification and risk assessment tools and techniques are described in
the international standard ISO 17776:2000, and organisations such as the IADC (International Association of Drilling
Contractors) publish guidelines for Health, Safety and Environment (HSE) Case development which are based on the ISO
standard. Further, diagrammatic representations of hazardous events are often expected by governmental regulators
as part of risk management in safety case submissions; these are known as bow-tie diagrams (see Network theory in
risk assessment). The technique is also used by organisations and regulators in mining, aviation, health, defence,
industrial and finance.

Pharmaceutical sector; The principles and tools for quality risk management are increasingly being applied to different
aspects of pharmaceutical quality systems. These aspects include development, manufacturing, distribution, inspection,
and submission/review processes throughout the lifecycle of drug substances, drug products, biological and
biotechnological products (including the use of raw materials, solvents, excipients, packaging and labeling materials in
drug products, biological and biotechnological products). Risk management is also applied to the assessment of
microbiological contamination in relation to pharmaceutical products and cleanroom manufacturing environments.[37]

Risk communication; Risk communication is a complex cross-disciplinary academic field related to core values of the
targeted audiences.[38][39] Problems for risk communicators involve how to reach the intended audience, how to
make the risk comprehensible and relatable to other risks, how to pay appropriate respect to the audience's values
related to the risk, how to predict the audience's response to the communication, etc. A main goal of risk
communication is to improve collective and individual decision making. Risk communication is somewhat related to
crisis communication. Some experts coincide that risk is not only enrooted in the communication process but also it
cannot be dissociated from the use of language. Though each culture develops its own fears and risks, these construes
apply only by the hosting culture.

Inflation, Rising prices, known as inflation, impact the cost of living, the cost of doing business, borrowing money,
mortgages, corporate and government bond yields, and every other facet of the economy. Inflation can be both
beneficial to economic recovery and, in some cases, negative. 9 Common Effects of Inflation; If you believe the
headlines, inflation is back after a long post-crisis stint of disinflation and, in some instances, outright deflation. Since
investors haven't seen significant price rises in years, it's worth brushing up on the most common effects of inflation.

1. Erodes Purchasing Power; This first effect of inflation is really just a different way of stating what it is. Inflation is a
decrease in the purchasing power of currency due to a rise in prices across the economy. Within living memory, the
average price of a cup of coffee was a dime. Today the price is closer to two dollars.

Such a price change could conceivably have resulted from a surge in the popularity of coffee, or price pooling by a
cartel of coffee producers, or years of devastating drought/flooding/conflict in a key coffee-growing region. In those
scenarios, the price of coffee would rise, but the rest of the economy would carry on largely unaffected. That example
would not qualify as inflation, since the only the most caffeine-addled consumers would experience significant
depreciation in their overall purchasing power. Inflation requires prices to rise across a "basket" of goods and services,
such as the one that comprises the most common measure of price changes, the consumer price index (CPI). When the
prices of goods that are non-discretionary and impossible to substitute – food and fuel – rise, they can affect inflation
all by themselves. For this reason, economists often strip out food and fuel to look at "core" inflation, a
less volatile measure of price changes.

2. Encourages Spending and Investing; A predictable response to declining purchasing power is to buy now, rather than
later. Cash will only lose value, so it is better to get your shopping out of the way and stock up on things that probably
won't lose value. For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in the next size up
for the kids, and so on. For businesses, it means making capital investments that, under different circumstances, might
be put off until later. Many investors buy gold and other precious metals when inflation takes hold, but these assets'
volatility can cancel out the benefits of their insulation from price rises, especially in the short term. Over the long
term, equities have been among the best hedges against inflation. At close on Dec. 12, 1980, a share of Apple Inc.
(AAPL) cost $29 in current (not inflation-adjusted) dollars. According to Yahoo Finance, that share would be
worth $7,035.01 at close on Feb. 13, 2018, after adjusting for dividends and stock splits. The Bureau of Labor Statistics'
(BLS) CPI calculator gives that figure as $2,449.38 in 1980 dollars, implying a real (inflation-adjusted) gain of 8,346%. Say
you had buried that $29 in the backyard instead. The nominal value wouldn't have changed when you dug it up, but the
purchasing power would have fallen to $10.10 in 1980 terms; that's about a 65% depreciation. Of course not every
stock would have performed as well as Apple: you would have been better off burying your cash in 1980 than buying
and holding a share of Houston Natural Gas, which would merge to become Enron.

3. Causes More Inflation; Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in
turn, creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an effort to
reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly
wants. In other words, the supply of money outstrips the demand, and the price of money – the purchasing power of
currency – falls at an ever-faster rate. When things get really bad, a sensible tendency to keep business and household
supplies stocked rather than sitting on cash devolves into hoarding, leading to empty grocery store shelves. People
become desperate to offload currency, so that every payday turns into a frenzy of spending on just about anything so
long as it's not ever-more-worthless money. From 1913 to December 1923, an index of the cost of living in Germany
rose by 153.5 trillion percent. The result is hyperinflation, which has seen Germans papering their walls with
the Weimar Republic's worthless marks (1920s), Peruvian cafes raising their prices multiple times a day (1980s),
Zimbabwean consumers hauling around wheelbarrow-loads of million- and billion-Zim dollar notes (2000s) and
Venezuelan thieves refusing even to steal bolívares (2010s).

4. Raises the Cost of Borrowing; As these examples of hyperinflation show, states have a powerful incentive to keep
price rises in check. For the past century in the U.S. the approach has been to manage inflation using monetary policy.
To do so, the Federal Reserve (the U.S. central bank) relies on the relationship between inflation and interest rates. If
interest rates are low, companies and individuals can borrow cheaply to start a business, earn a degree, hire new
workers, or buy a shiny new boat. In other words, low rates encourage spending and investing, which generally stoke
inflation in turn. (See also, What is the relationship between inflation and interest rates?) By raising interest rates,
central banks can put a damper on these rampaging animal spirits. Suddenly the monthly payments on that boat, or
that corporate bond issue, seem a bit high. Better to put some money in the bank, where it can earn interest. When
there is not so much cash sloshing around, money becomes more scarce. That scarcity increases its value, although as a
rule, central banks don't want money literally to become more valuable: they fear outright deflation nearly as much as
they do hyperinflation (see section 7). Rather, they tug on interest rates in either direction in order to maintain inflation
close to a target rate (generally 2% in developed economies and 3% to 4% in emerging ones). Another way of looking at
central banks' role in controlling inflation is through the money supply. If the amount of money is growing faster than
the economy, money will be worth less and inflation will ensue. That's what happened when Weimar Germany fired up
the printing presses to pay its World War I reparations, and when Aztec and Inca bullion flooded Habsburg Spain in the
16th century. When central banks want to raise rates, they generally cannot do so by simple fiat; rather they sell
government securities and remove the proceeds from the money supply. As the money supply decreases, so does the
rate of inflation. (See also, How Central Banks Control the Supply of Money.)

5. Lowers the Cost of Borrowing; When there is no central bank, or when central bankers are beholden to elected
politicians, inflation will generally lower borrowing costs. Say you borrow $1,000 at a 5% annual rate of interest. If
inflation is 10%, the real value of your debt is decreasing faster than the combined interest and principle you're paying
off. When levels of household debt are high, politicians find it electorally profitable to print money, stoking inflation
and whisking away voters' obligations. If the government itself is heavily indebted, politicians have an even more
obvious incentive to print money and use it to pay down debt. If inflation is the result, so be it (once again, Weimar
Germany is the most infamous example of this phenomenon). Politicians' occasionally detrimental fondness for
inflation has convinced several countries that fiscal and monetary policymaking should be carried out by independent
central banks. While the Fed has a statutory mandate to seek maximum employment and steady prices, it does not
need a congressional or presidential go-ahead to make its rate-setting decisions. That does not mean the Fed has
always had a totally free hand in policy-making, however. Former Minneapolis Fed president Narayana
Kocherlakota wrote in 2016 that the Fed's independence is "a post-1979 development that rests largely on the restraint
of the president." (See also, Breaking Down the Federal Reserve's Dual Mandate.)

6. Reduces Unemployment; There is some evidence that inflation can push down unemployment. Wages tend to
be sticky, meaning that they change slowly in response to economic shifts. John Maynard Keynes theorized that
the Great Depression resulted in part from wages' downward stickiness: unemployment surged because workers
resisted pay cuts and were fired instead (the ultimate pay cut). The same phenomenon may also work in reverse:
wages' upward stickiness means that once inflation hits a certain rate, employers' real payroll costs fall, and they're
able to hire more workers. (See also, Giants of Finance: John Maynard Keynes.) That hypothesis appears to explain the
inverse correlation between unemployment and inflation — a relationship known as the Phillips curve – but a more
common explanation puts the onus on unemployment. As unemployment falls, the theory goes, employers are forced
to pay more for workers with the skills they need. As wages rise, so does consumers' spending power, leading the
economy to heat up and spur inflation; this model is known as cost-push inflation. (See also, How Inflation and
Unemployment Are Related.)
7. Increases Growth; Unless there is an attentive central bank on hand to push up interest rates, inflation discourages
saving, since the purchasing power of deposits erodes over time. That prospect gives consumers and businesses an
incentive to spend or invest. At least in the short term, the boost to spending and investment leads to economic
growth. By the same token, inflation's negative correlation with unemployment implies a tendency to put more people
to work, spurring growth. This effect is most conspicuous in its absence. In 2016, central banks across the developed
world found themselves vexingly unable to coax inflation or growth up to healthy levels. Cutting interest rates to zero
and below did not seem to be working; neither did buying trillions of dollars' worth of bonds in a money-creation
exercise known as quantitative easing. This conundrum recalled Keynes's liquidity trap, in which central banks' ability to
spur growth by increasing the money supply (liquidity) is rendered ineffective by cash hoarding, itself the result
of economic actors' risk aversion in the wake of a financial crisis. Liquidity traps cause disinflation, if not deflation. (See
also, Why Didn't Quantitative Easing Lead to Hyperinflation?)

In this environment, moderate inflation was seen as a desirable growth-driver, and markets welcomed the increase in
inflation expectations due to Donald Trump's election. In February 2018, however, markets sold off steeply due to
worries that inflation would lead to a rapid increase in interest rates. (See also, The Recovery Eats Its Children.)

8. Reduces Employment and Growth; Wistful talk about inflation's benefits is likely to sound strange to those who
remember the economic woes of the 1970s. In today's context of low growth, high unemployment (in Europe) and
menacing deflation, there are reasons think a healthy rise in prices – 2% or even 3% per year – would do more good
than harm. On the other hand, when growth is slow, unemployment is high and inflation is in the double digits, you
have what a British Tory MP in 1965 dubbed "stagflation." Economists have struggled to explain stagflation. Early
on, Keynesians did not accept that it could happen, since it appeared to defy the inverse correlation between
unemployment and inflation described by the Phillips curve. After reconciling themselves to the reality of the situation,
they attributed the most acute phase to the supply shock caused by the 1973 oil embargo: as transportation costs
spiked, the theory went, the economy ground to a halt. In other words, it was a case of cost-push inflation. Evidence for
this idea can be found in five consecutive quarters of productivity decline, ending with a healthy expansion in the
fourth quarter of 1974. But the 3.8% drop in productivity in the third quarter of 1973 occurred before Arab members of
OPEC shut off the taps in October of that year. The kink in the timeline points to another, earlier contributor to the
1970s' malaise, the so-called Nixon shock. Following other countries' departures, the U.S. pulled out of the Bretton
Woods Agreement in August 1971, ending the dollar's convertibility to gold. The greenback plunged against other
currencies: for example, a dollar bought 3.48 Deutsche marks in July 1971, but just 1.75 in July 1980. Inflation is a
typical result of depreciating currencies. And yet even dollar devaluation does not fully explain stagflation, since
inflation began to take off in the mid-to-late 1960s (unemployment lagged by a few years). As monetarists see it, the
Fed was ultimately to blame. M2 money stock rose by 97.7% in the decade to 1970, nearly twice as fast as gross
domestic product (GDP), leading to what economists commonly describe as "too much money chasing too few goods,"
or demand-pull inflation. Supply-side economists, who emerged in the 1970s as a foil to Keynesian hegemony, won the
argument at the polls when Reagan swept the popular vote and electoral college. They blamed high taxes, burdensome
regulation and a generous welfare state for the malaise; their policies, combined with aggressive, monetarist-inspired
tightening by the Fed, put an end to stagflation. (See also, Understanding Supply-side Economics.)

9. Weakens (or Strengthens) the Currency; High inflation is usually associated with a slumping exchange rate, though
this is generally a case of the weaker currency leading to inflation, not the other way around. Economies that import
significant amounts of goods and services – which, for now, is just about every economy – must pay more for these
imports in local-currency terms when their currencies fall against those of their trading partners. Say that Country X's
currency falls 10% against Country Y's. The latter doesn't have to raise the price of the products it exports to Country X
for them to cost Country X 10% more; the weaker exchange rate alone has that effect. Multiply cost increases across
enough trading partners selling enough products, and the result is economy-wide inflation in Country X. But once
again, inflation can do one thing, or its polar opposite, depending on the context. When you strip away most of the
global economy's moving parts it seems perfectly reasonable that rising prices lead to a weaker currency. In the wake
of Trump's election victory, however, rising inflation expectations drove the dollar higher for several months. The
reason is that interest rates around the globe were dismally low – almost certainly the lowest they've been in human
history – making markets likely to jump on any opportunity to earn a bit of money for lending, rather than paying for
the privilege (as the holders of $11.7 trillion in sovereign bonds were doing in June 2016, according to Fitch). (See
also, How Negative Interest Rates Work.) Because the U.S. has a central bank (see section 4), rising inflation generally
translates into higher interest rates. The Fed has raised the federal funds rate five times following the election,
from 0.5%-0.75% to 1.5%-1.75%.

Corporate Finance country risk, The direct effects of violence risk are the impairment of the firms assets including fixed
and human capital. The indirect effects are possibly more common and affect the value of the operating firm as a
consequence of collateral effects, such as an economic recession during periods of war.

What is 'Country Risk'; Country risk is a term for the risks involved when someone invests in a particular country.
Country risk varies from one country to the next, and can include political risk, exchange-rate risk, economic risk, and
transfer risk. In particular, country risk denotes the risk that a foreign government will default on its bonds or other
financial commitments. In a broader sense, country risk is the degree to which political and economic unrest affect the
securities of issuers doing business in a particular country. Country risk is critical to consider when investing outside of
the United States. Because factors such as political instability can cause great turmoil in financial markets, country risk
can reduce the expected return on investment (ROI) of securities. Investors may protect against some country risks, like
exchange-rate risk, by hedging; but other risks, like political instability, do not have an effective hedge. Thus, when
analysts look at sovereign debt, they will examine the business fundamentals—what is happening in politics,
economics, general health of the society, and so forth—of the country that is issuing the debt. Foreign direct
investment—those not made through a regulated market or exchange—and longer-term investments face the greatest
potential for country risk.

Weighing Country Risk; Most people think of the United States as the benchmark for low country risk, as do most other
most nations themselves. So if an investor is attracted to investments in countries with high levels of civil conflict, like
Argentina or Venezuela for instance, he would be wise to compare their country risk to that of the U.S. or Canada.

Getting Help in Assessing Country Risk; Some international organizations evaluate the country risk on behalf of their
member nations. For example, the Organisation for Economic Co-Operation and Development (OECD), as part of its
arrangement regarding officially supported export credits, publishes an updated list of countries and their associated
risks for the purpose of setting interest rates and payment terms. In addition, the major credit rating agencies—
Standard & Poor's (S&P), Moody's, and Fitch—all have their own lists of sovereign ratings, which also analyze
fundamentals such as effectiveness of institutions and government, economic structure, growth prospects, external
finances, and fiscal and monetary flexibility. Large investment-management firms also rate country risk in their specific
business lines. BlackRock Inc., for example, publishes the BlackRock Sovereign Risk Index (BSRI), a quarterly sovereign
risk index that tracks current risk levels and trends for various countries and regions.

How important is an understanding of country risk for investors? Given the increasingly global nature of investment
portfolios, we believe it is very important. Our paper measures the economic content of five different measures of
country risk: The International Country Risk Guide's political risk, the financial risk, economic risk and composite risk
indices and Institutional Investor's country credit ratings. First, we explore whether any of these measures contain
information about future expected stock returns by conducting trading simulations. Next, we conduct time-series-
cross-sectional analysis linking these risk measures to future expected returns. Second, we investigate the relation
between these measures and other, more standard, approaches to risk exposures. Finally, we analyze the linkages
between fundamental attributes within each economy, such as book-to-price ratios, and the risk measures. Our results
suggest that the country risk measures are correlated future equity returns. We find that the country risk measures are
correlated with each other, however, financial risk measures contain the most information about future equity returns.
Finally, we find that country risk measures are highly correlated with country equity valuation measures. This provides
some insight into the reason for higher returns for value-oriented strategies.

Corporate Finance taxation (withholding taxes) ; Corporate Tax for Financial Year 2018-19 & Assessment Year 2019-20;
The process of taxation dates back to an ancient time. Various kinds of taxes are levied by governments of various
countries. In India, taxes on income, wealth, Capital Gains are some of the most significant taxes paid by customers.
Corporate houses too, be it domestic or foreign, are required to pay taxes in order to run their business. One of the
may taxes that corporates are required to pay to the Indian government is corporate tax or company tax.

What is Corporate Tax? Corporate tax is a form of tax levied on profits earned by businessmen in a particular period of
time. Various rates of corporate taxes are levied for different levels of profits earned by business houses. Corporate tax
is generally levied on the revenues of a company after deductions such as depreciation, COGS (Cost of goods sold) and
SG&A (Selling general and administrative expenses) have been taken into account. Corporate tax or company tax can
be assumed as an Income Tax for income earned by businesses. Many countries levy corporate tax in order to smooth
out the tax process for enterprises. Different countries have different rules that apply to taxing of income.

Corporate Tax in India: Corporate tax in India is levied on both domestic as well as foreign companies. Like all
individuals earning income are supposed to pay a tax on their income, business houses too are supposed to pay as tax a
certain portion of their income earned. This tax is known as corporate tax, corporation tax or company tax.

Definition of a Corporate: Any juristic person having a separate and independent legal entity from its shareholders is
termed as a corporate. The income earned by a company is computed and assessed separately from the dividends that
it offers to its shareholders. These dividends do not figure out in the tax calculation of the company but are assessed as
part of the income of shareholder. For the purpose of tax calculation, companies in India have been broadly divided
into the following two categories.

Domestic Corporate: Any company that is Indian is called as domestic company or if the company is foreign but the
control and management is wholly situated in India then also it is termed as a domestic company. An Indian company
means a company registered under the Companies Act 1956

Foreign Corporate: Any foreign company is one that is not of Indian origin and has some part of control and
management of affairs located outside India

Dividend Distribution Tax: Corporate tax is tax paid by companies on revenues earned minus certain expenses.
Similarly, dividend distribution tax is tax paid by corporates on the dividend that they pay to their shareholders.
Corporate dividend tax is a percentage of the dividend paid. Currently, the dividend distribution tax in India is 15%.

Corporate Tax Rate: Depending upon the type of company, domestic or foreign and depending upon the income earned
in one financial year, corporate or company tax rates vary for different companies. Currently for the financial year
2015-16, corporate tax in India has been reduced by a certain percentage. In the subsequent sections, corporate tax
rates for the current fiscal have been detailed out more clearly.

What is meant by Income of a Company? In order to compute corporate tax on the income of a company it is necessary
to first learn what all factors make up the total income of any company. Profits from business, Income from property,
Capital gains, Income from other sources such as foreign dividends, interests etc.

Corporate Tax Rate for Domestic Companies in India: A domestic company in India refers to any enterprise that has its
base location in India and is of Indian origin. Given below is the tax rate applicable to domestic businesses in the
country. A flat rate of 25% corporate tax is levied on the income earned by a domestic corporate. A surcharge of 12% is
levied in case the turnover of a company is more than Rs.1 Crore for a specific financial year. 3% educational cess is
levied. Corporate tax is also levied on the global earnings of the domestic company. This takes into account income
earned by the company abroad.

Corporate Tax Rate for Foreign Companies in India: A foreign company means an enterprise that has operations and
origin in any other country except India. The taxation rules are not as simple for foreign enterprises as for domestic
businesses. Corporate tax on foreign companies depends a lot on the taxation agreements made between India and
other foreign countries. For example, corporate tax on an Australian company in India will depend upon the taxation
agreement between the governments of India and Australia.

Tax Rebates Applicable on Corporate Tax: Apart from various types of taxes levied on company income, there are
several provisions of tax rebates available to companies. A list of all these rebates is detailed below. In certain cases,
domestic companies can deduct dividend received from other domestic companies Special provisions are applicable to
venture fund and venture capital enterprises Deductions, in some cases are allowed for exports and new undertakings
New infrastructure and power sources set-up is subject to certain deductions Business losses have the provision of
being carried over for a maximum of 8 years Interest, capital gains and dividends can also be deducted in some cases

Corporate Tax Planning: Corporate tax planning can be understood as strategizing one’s financial business affairs in
such a way so as to maximize profit and minimize payable tax by taking into account the allowed benefits of
deductions, rebates and exemptions. Tax management is a risky as well as tricky business and most corporates that
have a huge money at stake involve financial experts to take care of their taxation process. In India also there are
various financial players that provide consultation and implementation of corporate tax. Due diligence and absolute
awareness about all tax laws and corresponding rules and regulations, is a must to ensure healthy tax planning.
Corporate tax planning is different from tax evasion or non-payment. Tax planning refers to the act of planning one’s
finances in such a way that the payable tax amount is reduced while the gains are maximized. One of the most essential
features of tax planning in that it is absolutely in-line with the legal and financial rules set by the government of India.

Highlights of Union Budget 2018 for Corporate Tax; The government had declared to decrease corporate tax rate to
25% in the Union Budget of 2017. This was applicable only to organisations who had turnovers less than Rs.50 crore
during FY 2015-16. Under the Union Budget 2018, Finance Minister Mr. Arun Jaitley announced that this particular
decreased rate of 25% will be applicable even to companies that have had turnovers of up to Rs.250 crore during FY
2016-17. The government made this change to help all companies that fall under the micro, small, and medium
enterprises. This is particularly because approximately 99% of these organisations’ employees file tax returns.
According to the Budget 2018, 7,000 organisations out of 7 lakh organisations that file returns will be retained in the
30% tax rate slab. These 7,000 companies will be companies who have turnovers higher than Rs.250 crore. It is
anticipated that the revenue that has been sacrificed due to this particular move of extending the 25% decrease rate is
Rs.7,000 crore for the financial year 2018-19. This significant move by the Finance Minister is a great economic reform
that will enhance the overall tax system of the country. This will also help in enhancing the competitive edge of the
nation. This reduced corporate income tax rate for the majority of companies will enable them to offer more and more
employment opportunities.

Corporate Finance Forex issues in Capital Budgeting, In January 2003, the CFO of a Michigan-based auto parts
manufacturer reviewed his capital budget with his firm's Budget Committee. One conspicuous line item identified the
cost of retooling the company's parts plant in Asia. But from February 2002 to September 2003, the value of the U.S.
dollar decreased by 17 percent, according the Federal Reserve's Nominal Major Currencies Dollar Index. As a result, the
actual cost to retool the Asian parts facility was millions of dollars more than anticipated. This oversimplified scenario
illustrates the need for exporters, importers or companies with overseas subsidiaries to factor foreign exchange risk
into their budgets.
The Impact of Currency Volatility; Although exchange rates usually move gradually over time, they have been known to
fluctuate with extreme volatility. This not only can reduce corporate profits, but can put companies out of business and
economies into recession. For example, on December 20, 1994, an attempted currency adjustment by the Mexican
government accelerated out of control. Within two days pressures mounted; currency reserves used to prop up the
peso quickly dwindled. As a result, the peso was allowed to float freely. Shortly thereafter, it nose-dived. Like falling
dominoes, the ensuing panic spread to Brazil and Argentina, whose currencies also dropped precipitously. The impact
of the 1997 Asian financial crisis was felt worldwide. With front page news of plunging currencies — beginning with the
Thai baht and quickly affecting the Malaysian ringgit, the Indonesian rupiah, and the Korean won — the tremendous
damage caused by currency fluctuations became evident. Not only did the domino effect put pressure on traditionally
strong currencies, but it also resulted in economic recession in several countries. When budgeting for expenses and
revenues from overseas transactions, clearly CFOs must manage and account for minimal, as well as potentially severe,
currency fluctuations

Minimize Foreign Exchange Exposure; A purchase contract that is signed on January 1 with a foreign currency payment
due on February 1 represents 30 days of foreign exchange exposure. Consequently, a U.S. exporter who sells goods to
Germany (priced in euros) runs the risk of collecting euros in 30 days at a depreciated rate when they are converted
into dollars. Should this occur, the exporter will receive lower than expected revenue — which must be accounted for
in the budget. On the other hand, a U.S. importer who buys French wine (also priced in euros) will benefit if the euro
rises compared to the dollar, making the same case of burgundy less expensive. Due to fluctuating exchange rates,
CFOs should seek to stabilize cash flows and reduce uncertainty in their financial forecasts. In doing so, they must
consider the three most important factors that impact currency exchange: foreign exchange exposure, the expected
and actual rate of exchange, and the date the exchange actually occurs. In doing so, a variety of interest rate hedges
may be used.

Employ Foreign Exchange Contracts; Contracts are one way to hedge against foreign exchange risk and bring certainty
into the budget process. Spot contracts deal with the exchange of currency that deal with a contract term of two
business days. (This two-day period applies to all currency with the exception of the Canadian dollar.) For the purposes
of establishing an annual budget, a forward contract may be an ideal tool. This locks in the future foreign currency
purchase price at the time of agreement. To determine the rate of exchange, two items must be factored in: the
current spot rate and the forward rate adjustment, which involves the interest rates of the currencies in question and
the time frame between contract date and settlement date. Overall, currency volatility requires CFOs to account for all
risks when deciding which projects to finance and how to fund them. If they use the Net Present Value (NPV) method of
evaluating budgets for a foreign project, the parent company could hedge against currency risk, especially if the NPV of
the project is greater then the NPV to the company. Foreign exchange risk can be shown on the projected balance
sheet when the firm discounts foreign currency cash flow at the foreign discount rate, and converts it at the current
spot rate. Or, the foreign exchange risk can be converted at a future spot rate and discount domestic cash flows at the
domestic discount rate. Often, either a higher discount rate can be applied for what is conceived to be a riskier
investment or project — or expectations of cash flows from the project can be reduced.

Borrowing in the Global Market? Borrowing for a project in foreign currency can provide a sound solution, and the cost
of borrowing from the global capital market is generally less than the cost of borrowing domestically. However, host-
government regulations or demands may drive up the discount rate used in capital budgeting. Nevertheless, the
discount rate should be appropriate for the risk of the cash flow.

Consider Hedging; In addition to adjusting capital budgeting, there are many ways to hedge against exposure to foreign
exchange risk. These include: Buying forward, Using currency swaps, Leading and lagging payables and receivables,
Manipulating transfer prices, Using local debt financing, Accelerating dividend payments, Control Risk by Recognizing
and Controlling Exposure. In today's dynamic global economy where currency values constantly fluctuate, it is
necessary to monitor your exposure and risk-control activities measures. And when deciding which hedges to employ, a
reasonable idea of future exchange rate movements is helpful. But perhaps most importantly, your company should
consider monitoring exposure to make adjustments to the annual budget as needed.

Five steps to managing your foreign exchange risk; It’s an unfortunate fact that not many Canadian exporters are really
good at managing their foreign exchange (FX) risk. This seems surprising, since every exporting company knows that
changes in the FX rate of the Canadian dollar can pose risks to its profit margins and cash flow. Fluctuating rates also
mean more guesswork in your budget forecasts, and they can make it harder to know exactly how much you’ll get paid
when you complete a contract. But that’s not all, according to Jean-François Lamoureux, a Senior Underwriter at EDC.
Remember that your bank wants to see good margins, accurate business forecasts and healthy cash flows before it
issues credit. “If you can’t offer these things because of poor FX risk management, it may curtail your ability to obtain
the term financing you need. This can cause your growth and competitiveness to suffer,” he says. Conversely, good FX
risk management can bring your company the following benefits: Better protection for your cash flow and profit
margins Improved financial forecasting More realistic budgeting Deeper understanding of how FX fluctuations affect
your balance sheet Increased borrowing capacity, leading to faster growth and a stronger competitive edge Create your
own FX risk management program These are all excellent reasons to take a hands-on approach to FX risk management.
And while setting up a solid FX risk management program isn’t trivial, it’s well within the reach of any company willing
to make the effort. To create your own program, you’ll need to take the following steps: 1. Analyze your business’
operating cycle to identify where FX risk exists. This helps you determine the sensitivity of your profit margins to FX
fluctuations and the stages of your operating cycle where you need protection. 2. Calculate your exposure to FX risk.
This covers both unconfirmed risk (the risk that exists before a sales agreement is finalized) and confirmed risk (the risk
that exists after a firm sale is completed but you haven’t yet been paid). Once you know your level of exposure, you can
decide how much risk coverage (“hedging”) you need. 3. Hedge your FX risk. Hedging simply means that you use
specially designed financial instruments to lock in the FX rate so that it remains the same over a specified period of
time. There are numerous ways to hedge, but as an exporter you’re most likely to use an “FX facility,” which you’ll
obtain from your bank. An FX facility resembles an operating line and can support various types of financial instruments
(or “hedges”), all of which are designed to secure a specific exchange rate for an export contract so you won’t get any
surprises at payment time. 4. Create an FX policy and follow it. In this step you establish the FX risk criteria, procedures
and mechanisms that will support your FX risk management program, and implement this policy across the company. 5.
Don’t let hedges squeeze your working capital. The essential advantage of a hedge is that it protects your profits from
unfavourable movements in the FX rate. The drawback is that your bank will want security for any FX facility it issues to
you, which it will usually carve out of your operating line. This will leave you with less working capital, which is never a
good thing. There’s an EDC solution designed for just this situation: the Foreign Exchange Facility Guarantee (FXG). An
FXG provides a 100 percent guarantee of the security your bank requires for providing you with an FX facility. Once the
guarantee is in place, the bank won’t need to take the security from your operating line, which means you’ll have full
access to your working capital. The view from the front line Normand Faubert is President of Optionsdevises, a
Montreal consulting firm that for 20 years has helped exporters deal with their FX issues. In his view, a business that
wants to take control of its bottom line and profit margins will follow carefully designed strategies for managing its FX
risk. “EDC’s FXG is a great tool for this since companies can sometimes be very tight for cash,” he says. “By providing
guarantees, EDC can help them obtain the financial tools they need to hedge their FX risk, while avoiding any
restrictions on their credit and thus on their working capital.” Want to learn more about managing your FX risk? Watch
a video with me and my EDC colleague Dominique Bergevin, then download EDC’s (whitepaper download) Managing
Foreign Exchange Risk with EDC Guarantees and EDC’s guide to Building a Foreign Exchange Policy. Have you ever had
your bottom line diminished because of fluctuating exchange rates? What steps did you take to diminish your future
risk?

Corporate Finance WC Management ;Working capital financing helps you meet the daily expenses of running your
business—short-term cash needs such as making payroll or purchasing a new shipment of inventory. ... Trade credit:
Sometimes called vendor credit, trade credit is a common form of working capital financing that you are probably using
already. Net working capital is a liquidity calculation that measures a company’s ability to pay off its current liabilities
with current assets. This measurement is important to management, vendors, and general creditors because it shows
the firm’s short-term liquidity as well as management’s ability to use its assets efficiently. Much like the working capital
ratio, the net working capital formula focuses on current liabilities like trade debts, accounts payable, and vendor notes
that must be repaid in the current year. It only makes sense the vendors and creditors would like to see how much
current assets, assets that are expected to be converted into cash in the current year, are available to pay for the
liabilities that will become due in the coming 12 months. If a company can’t meet its current obligations with current
assets, it will be forced to use it’s long-term assets, or income producing assets, to pay off its current obligations. This
can lead decreased operations, sales, and may even be an indicator of more severe organizational and financial
problems.

Formula; The net working capital formula is calculated by subtracting the current liabilities from the current assets.
Here is what the basic equation looks like.

Net Working Capital Formula; Typical current assets that are included in the net working capital calculation are cash,
accounts receivable, inventory, and short-term investments. The current liabilities section typically includes accounts
payable, accrued expenses and taxes, customer deposits, and other trade debt. Some people also choice to include the
current portion of long-term debt in the liabilities section. This makes sense because although it stems from a long-
term obligation, the current portion will have to be repaid in the current year. Thus, it’s appropriate to include it in with
the other obligations that must be met in the next 12 months.

Example; Let’s look at Paula’s Retail store as an example. Paula owns and operates a women’s clothing and apparel
store that has the following current assets and liabilities: Cash: $10,000, Accounts Receivable: $5,000, Inventory:
$15,000, Accounts Payable: $7,500, Accrued Expenses: $2,500, Other Trade Debt: $5,000. Paula would can use a net
working capital calculator to compute the measurement like this: Net Working Capital Calculator. Since Paula’s current
assets exceed her current liabilities her WC is positive. This means that Paula can pay all of her current liabilities using
only current assets. In other words, her store is very liquid and financially sound in the short-term. She can use this
extra liquidity to grow the business or branch out into additional apparel niches. If Paula’s liabilities exceeded her
assets, her WC would be negative indicating that her short-term liquidity isn’t as high as it could be.

What is Net Working Capital Used For? Obviously, a positive net WC is better than a negative one. A positive calculation
shows creditors and investors that the company is able to generate enough from operations to pay for its current
obligations with current assets. A large positive measurement could also mean that the business has available capital to
expand rapidly without taking on new, additional debt or investors. It can fund its own expansion through its current
growing operations.

What is Negative Net Working Capital? A negative net working capital, on the other hand, shows creditors and
investors that the operations of the business aren’t producing enough to support the business’ current debts. If this
negative number continues over time, the business might be required to sell some of its long-term, income producing
assets to pay for current obligations like AP and payroll. Expanding without taking on new debt or investors would be
out of the question and if the negative trend continues, net WC could lead to a company declaring bankruptcy. Keep in
mind that a negative number is worse than a positive one, but it doesn’t necessarily mean that the company is going to
go under. It’s just a sign that the short-term liquidity of the business isn’t that good. There are many factors in what
creates a healthy, sustainable business. For example, a positive WC might not really mean much if the company can’t
convert its inventory or receivables to cash in a short period of time. Technically, it might have more current assets
than current liabilities, but it can’t pay its creditors off in inventory, so it doesn’t matter. Conversely, a negative WC
might not mean the company is in poor shape if it has access to large amounts of financing to meet short-term
obligations such as a line of credit. What is a more telling indicator of a company’s short-term liquidity is an increasing
or decreasing trend in their net WC. A company with a negative net WC that has continual improvement year over year
could be viewed as a more stable business than one with a positive net WC and a downward trend year over year.

Change in Net Working Capital; You might ask, “how does a company change its net working capital over time?” There
are three main ways the liquidity of the company can be improved year over year. First, the company can decrease its
accounts receivable collection time. Second, it can reduce the amount of carrying inventory by sending back
unmarketable goods to suppliers. Third, the company can negotiate with vendors and suppliers for longer accounts
payable payment terms. Each one of these steps will help improve the short-term liquidity of the company and
positively impact the analysis of net working capital.

Methods for Estimating Working Capital Requirement; There are broadly three methods of estimating or analyzing the
requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating
cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible
because the planning of working capital would be based on these estimates and bank and other financial institutes
finance the working capital needs to be based on such estimates only.

METHODS OF ESTIMATING / ANALYZING WORKING CAPITAL ARE AS FOLLOWS;

PERCENTAGE OF SALES METHOD: It is the easiest of the methods for calculating the working capital requirement of a
company. This method is based on the principle of ‘history repeats itself’. For estimating, a relationship of sales and
working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40%
of sales, the next year estimation is done based on this estimate. If the expected sales are 500 million dollars, 200
million dollars would be required as working capital. The advantage of this method is that it is very simple to
understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many
organizations. So, where there is no linear relationship between the revenue and working capital, this method is not
useful. In new startup projects also, this method is not applicable because there is no past.

ANALYSIS METHOD: This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish
trend relationship. We will use it for working capital estimation. This method expresses the relationship between
revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). The slope is the
rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and
working capital axis meets (Will not go deeper into statistical details). At the end of the statistical exercise with past
revenue and working capital data, we will get an equation like below: Working Capital = -6.34 + 0.46 * Revenue. To
calculate working capital, just put the targeted revenue figure in the above equation, say 200 million dollars. Working
Capital = -6.34 + 0.46 * 200 = -6.34 + 92 = 85.66 ~ 86 Million Dollar. Therefore, we need 86 million dollars of working
capital to achieve revenue of 200 million dollars.

OPERATING CYCLE METHOD: This is probably the best of the methods because it takes into account the actual business
or industry situation into consideration while giving an estimate of working capital. A general rule can be stated in this
method. Longer the working capital operating cycle, higher would be the requirement of working capital and vice versa.
We would agree to the point also. The following formula can be used to estimate or calculate the working capital.
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating Cycle / 365 Days) + Bank and Cash
Balance. If the cost of goods sold (estimated) is $35 million and operating cycle is 75 days and bank balance required is
1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 = $8.44 Million. In this method, each component can also
be calculated. It means bifurcation of $8.44 million can be done in inventory, cash, accounts receivable, accounts
payable etc.

Working capital finance; Working capital finance is business finance designed to boost the working capital available to a
business. It's often used for specific growth projects, such as taking on a bigger contract or investing in a new market.
Different businesses use working capital finance for a variety of purposes, but the general idea is that using working
capital finance frees up cash for growing the business which will be recouped in the short- to medium-term. There are
many different types of lending that could be considered working capital finance. Some are explicitly designed to help
working capital (whatever industry you’re in), while others are useful for specific sectors or requirements.

Working capital is the amount of cash a business can safely spend. It’s commonly defined as current assets minus
current liabilities. Usually working capital is calculated based on cash, assets that can quickly be converted to cash (such
as invoices from debtors), and expenses that will be due within a year. For example, if a business has £5,000 in the
bank, a customer that owes them £4,000, an invoice from a supplier payable for £2,000, and a VAT bill worth £4,000, its
working capital would be £3,000 (5,000 + 4,000) - (2,000 + 4,000).

Liquid cash; Working capital is seen as ‘working’ because the business can use it — in other words, it’s not tied up in
anything long-term. Whether you want to buy stock, invest in the business, or take on a big contract, all of these
activities require working capital — cash that’s quickly accessible. On the other hand, if your business is profitable but
has big bills to pay soon, your working capital situation could be worse than it might seem — or could even be negative.

Working capital loans; Working capital loans are normally over a short or medium term, designed to boost cash in the
business to go after new opportunities. The size of the working capital loan you can get depends on many facets of your
business profile. Secured working capital loans will require assets to use as security, so the amount you can borrow is
restricted by the assets available. Meanwhile, it’s possible to get unsecured business loans up to £250,000 to help with
working capital — but for these loans your credit rating will be more important, and you’ll often have to give a personal
guarantee.

Overdrafts; Overdrafts have traditionally been a useful source of working capital finance for many businesses across all
sectors, but they're hard to get with a business bank these days. On the alternative finance market there are lots of
flexible business overdrafts, which are a great way to finance working capital at short notice when you need it. The
downside of using overdrafts for working capital is that they often have low credit limits, which might limit your plans.
They’re effectively a form of unsecured lending, so even if you’re lucky enough to get one, the limit is likely to be fairly
low unless your business has a strong history.

Revolving credit facilities; Similar to overdrafts, revolving credit facilities give you a pre-approved source of funding that
you can use when you need. But the key difference is that with a revolving credit facility you don't need a specific bank
account with that provider — you can direct the money wherever you need it. The best part is that with many
providers, once they're set up you only pay interest on outstanding funds, which means they can sit idle for a few
weeks but are ready to go at a moment's notice. That makes revolving credit facilities a useful safety net to have in
place.

Invoice finance; For businesses that offer credit terms to their customers, invoice finance is a common type of working
capital finance. Along with other types of receivables finance, invoice finance is based on money owed to your
business, and you normally get a percentage of the value owed via one invoice or the entire debtor book. Factoring
includes credit control, and is often favoured by smaller companies with lower value invoices, whereas discounting and
selective invoice finance are other potential options for larger companies with creditworthy customers. Although
invoice finance is a good way of unlocking working capital in the short-term, the amount you borrow is (by definition)
limited by the value already owed to you via customer invoices — so it’s not necessarily the right option if you need a
more significant amount of money for longer-term growth plans.

Trade finance and supply chain finance; Trade finance and supply chain finance work in a similar way to invoice finance.
They’re both types of working capital financing designed for businesses that focus on physical stock rather than services
rendered. Supply chain finance is a mutually beneficial arrangement based on the creditworthiness of buyers, where
the buyer can delay payment for longer while the supplier gets payment from the lender immediately (the payment
delay is shouldered by the lender, rather than the supplier). Trade finance is a more complex finance partnership that
facilitates international trade, and often involves arrangements like prepayment for the shipment of goods from
overseas manufacturers.

Asset refinancing; If you can’t get enough funding via an unsecured business loan, you can often use assets in your
business to raise finance via an asset refinance. Asset refinancing is based on valuable assets in the business, so you
won’t usually be required to offer a personal guarantee or involve your personal home. Like invoice finance, the
amount you can borrow depends on the value of the items used to secure funding against.

Merchant cash advances; If your business accepts payment from customers using card terminals, a merchant cash
advance is another useful way to increase working capital. The product gets its name simply because it’s a cash advance
for merchants — meaning businesses like retailers, pubs, cafés and restaurants are all suitable. The amount you get
advanced is normally expressed as a percentage of your average monthly card revenue (e.g. 120% of an average
month), and critically, repayments are taken as a percentage of future card revenue too. That means repayments can
feel relatively painless because they’re taken at the source.

Tax bill and VAT funding; If you've got a tax bill and it's putting a strain on your working capital, there is funding
available specifically designed for paying VAT or corporation tax. Getting a loan for your tax bill allows you to spread
the costs over 3-12 months, so you'll have a bit more cash available for other things in your business.

Conclusion; There are many types of working capital financing available, and choosing the right product depends on
your sector and circumstances, as well as what you're trying to achieve. To find out more about working capital
financing, browse the related articles below or get in touch.

WC Management Control, Meaning of Working Capital; Capital required for a business can be classified under two
main categories viz.(i) Fixed capital(ii) Working capital.

Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long-
term funds are required to create production facilities through purchase of fixed assets such as plant and machinery,
land, Building etc. Investments in these assets represent that part of firm’s capital which is blocked on permanent basis
and is called fixed capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of
wages and other day-to-day expenses etc. These funds are known as working capital which is also known as Revolving
or circulating capital or short term capital. According to Shubin, “Working capital is amount of funds necessary to cover
the cost of operating the enterprise”.

Concept of Working Capital; There are two concepts of working capital:(i) Gross working capital(ii Net working capital.

Gross working capital is the capital invested in total current assets of the enterprise. Examples of current assets are :
cash in hand and bank balances, Bills Receivable, Short term loans and advances, prepaid expenses, Accrued Incomes
etc. The gross working capital is financial or going concern concept. Net working capital is excess of Current Assets over
Current liabilities. Net Working Capital = Current Assets – Current Liabilities. When current assets exceed the current
liabilities the working capital is positive and negative working capital results when current liabilities are more than
current assets. Examples of current liabilities are Bills Payable, Sunday debtors, accrued expenses, Bank Overdraft,
Provision for taxation etc. Net working capital is an accounting concept of working capital.

Classification or Kinds of Working Capital; Working capital may be classified in two ways: (a) On the basis of concept
(b) On the basis of time. On the basis of concept working capital is classified as gross working capital and net working
capital. On the basis of time working capital may be classifies as Permanent or fixed working capital and Temporary or
variable working capital.
 Permanent or Fixed working capital; It is the minimum amount which is required to ensure effective utilisation of
fixed facilities and for maintaining the circulation of current assets. There is always a minimum level of current assets
which its continuously required by enterprise to carry out its normal business operations. As the business grows, the
requirements of permanent working capital also increase due to increase in current assets. The permanent working
capital can further be classified as regular working capital and reserve working capital required to ensure circulation of
current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on.
Reserve working capital is the excess mount over the requirement for regular working capital which may be provided
for contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.

Temporary or Variable working capital; It is the amount of working capital which is required to meet the seasonal
demands and some special exigencies. Variable working capital is further classified as seasonal working capital and
special working capital. The capital required to meet seasonal needs of the enterprise is called seasonal working
capital. Special working capital is that part of working capital which is required to meet special exigencies such as
launching of extensive marketing campaigns for conducting research etc.

Importance or Advantages of Adequate Working Capital : Working capital is the life blood and nerve centre of a
business. Hence, it is very essential to maintain smooth running of a business. No business can run successfully without
an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are
as follows:1. Solvency of the Business: Adequate working capital helps in maintaining solvency of business by
providing uninterrupted flow of production.2. Goodwill: Sufficient working capital enables a business concern to
make prompt payments and hence helps in creating and maintaining goodwill. 3. Easy Loans: A concern having
adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and
favourable terms. 4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on
purchases and hence it reduces cost. 5. Regular Supply of Raw Material: Sufficient working capital ensure
regular supply of raw materials and continuous production. 6. Regular payment of salaries, wages and other day
to day commitments: A company which has ample working capital can make regular payment of salaries, wages and
other day to day commitments which raises morale of its employees, increases their efficiency, reduces costs and
wastages. 7. Ability to face crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression. 8. Quick and regular return on investments: Every investor wants a quick and
regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends
to is investor as there may not be much pressure to plough back profits which gains the confidence of investors and
creates a favourable market to raise additional funds in future. 9. Exploitation of Favourable market
conditions: 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 its inventories for higher prices. 10. High
Morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall
efficiency in a business.

Excess or Inadequate Working Capital; Every business concern should have adequate working capital to run its
business operations. It should have neither excess working capital nor inadequate working capital. Both excess as well
as short working capital positions are bad for any business.

Disadvantages of Excessive Working Capital.1. Excessive working capital means idle funds which earn no profits for
business and hence business cannot earn a proper rate of return..2.When there is a redundant working capital it may
lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses..3.It
may result into overall inefficiency in organization..4.Due to low rate of return on investments, the value of shares may
also fall..5.The redundant working capital gives rise to speculative transaction..6.When there is excessive working
capital, relations with banks and other financial institutions may not be maintained.
Disadvantages of Inadequate working capital;.1. A concern which has inadequate working capital cannot pay its short-
term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities..2. It cannot buy
its requirements in bulk and cannot avail of discounts..3. It becomes difficult for firm to exploit favourable market
conditions and undertake profitable projects due to lack of working capital..4. The rate of return on investments also
falls with shortage of working capital..5. The firm cannot pay day-to-day expenses of its operations and it created
inefficiencies, increases costs and reduces the profits of business.

The Need or Objects or Working Capital; The need for working capital arises due to time gap between production and
realisation of cash from sales. There is an operating cycle involved in sales and realisation of cash. There are time gaps
in purchase of raw materials and production, production and sales, and sales and realisation of cash. Thus, working
capital is needed for following purposes. For purchase of raw materials, components and spares. To pay wages and
salaries. To incur day-to-day expenses and overhead costs such as fuel, power etc. To meet selling costs as packing,
advertisement .To provide credit facilities to customers. To maintain inventories of raw materials, work in progress,
stores and spares and finished stock. Greater size of business unit large will be requirements of working capital. The
amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity. At
maturity the amount of working capital needed is called normal working capital.

Factors Determing the Working Capital Requirements; The following are important factors which influence working
capital requirements:1. Nature or Character of Business: The working capital requirements of firm depend
upon nature of its business. Public utility undertakings like electricity, water supply need very limited working capital
because they offer cash sales only and supply services, not products, and such no funds are tied up in inventories and
receivables whereas trading and financial firms require less investment in fixed assets but have to invest large amounts
in current assets and as such they need large amount of working capital. Manufacturing undertaking require sizeable
working capital between these two.2. Size of Business/Scale of Operations: Greater the size of a business unit,
larger will be requirement of working capital and vice-versa.3. Production Policy: The requirements of working
capital depend upon production policy. If the policy is to keep production steady by accumulating inventories it will
require higher working capital. The production could be kept either steady by accumulating inventories during slack
periods with view to meet high demand during peak season or production could be curtailed during slack season and
increased during peak season.4. Manufacturing process / Length of Production cycle: Longer the process
period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw
materials and other supplies have to be carried for longer period in the process with progressive increment of labour
and service costs before finished product is finally obtained. Therefore, if there are alternative processes of production,
the process with the shortest production period should be chosen.5. Credit Policy: A concern that purchases its
requirements on credit and sell its products/services on cash requires lesser amount of working capital. On other hand
a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working
capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.6. Business
Cycles: In period of boom i.e. when business is prosperous, there is need for larger amount of working capital due to
increase in sales, rise in prices etc. On contrary in times of depression the business contracts, sales decline, difficulties
are faced in collections from debtors and firms may have large amount of working capital lying idle.7. Rate of
Growth of Business: The working capital requirements of a concern increase with growth and expansion of its business
activities. In fast growing concerns large amount of working capital is required whereas in normal rate of expansion in
the volume of business the firm may have retained profits to provide for more working capital.8. Earning
Capacity and Dividend Policy. The firms with high earning capacity generate cash profits from operations and
contribute to working capital. The dividend policy of concern also influences the requirements of its working capital. A
firm that maintains a steady high rate of cash dividend irrespective of its generation of profits need more working
capital than firm that retains larger part of its profits and does not pay so high rate of cash dividend.9. Price
Level Changes: Changes in price level affect the working capital requirements. Generally, the rising prices will require
the firm to maintain large amount of working capital as more funds will be required to maintain the same current
assets. The effect of rising prices may be different for different firms.10. Working Capital Cycle: In a
manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with realisation of
cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into
stocks of finished goods through work in progress with progressive increment of labour and service costs, conversion of
finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle again from cash to
purchase of raw material and so on. The speed with which the working capital completes one cycle determines the
requirements of working capital longer the period of cycle larger is requirement of working capital.

Managemant of Working Capital; Working capital refers to excess of current assets over current liabilities.
Management of working capital therefore is concerned with the problems that arise in attempting to manage current
assets, current liabilities and inter relationship that exists between them. The basic goal of working capital
management is to manage the current assets and current of a firm in such a way that satisfactory level of working
capital is maintained i.e. it is neither inadequate nor excessive. This is so because both inadequate as well as excessive
working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and
excessive working capital implies idle funds which earns no profits for the business. Working capital Management
policies of a firm have a great effect on its profitability, liquidity and structural health of organization. In this context,
evolving capital management is three dimensional in nature..1. Dimension I is concerned with formulation of policies
with regard to profitability, risk and liquidity..2.Dimension II is concerned with decisions about composition and level of
current assets..3. Dimension III is concerned with decisions about composition and level of current liabilities.

Principles of Working Capital Management; 1. Principle of Risk Variation: Risk refers to inability of firm to meet its
obligation as and when they become due for payment. Larger investment in current assets with less dependence on
short-term borrowings increases liquidity, reduces risk and thereby decreases opportunity for gain or loss. On other
hand less investment in current assets with greater dependence on short-term borrowings increases risk, reduces
liquidity and increases profitability. There is definite direct relationship between degree of risk and profitability. A
conservative management prefers to minimize risk by maintaining higher level of current assets while liberal
management assumes greater risk by reducing working capital. However, the goal of management should be to
establish suitable trade off between profitability and risk. The various working capital policies indicating relationship
between current assets and sales are depicted below:-

2. Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and
degree of risk involved. Generally, higher the risk lower is cost and lower the risk higher is the cost. A sound working
capital management should always try to achieve 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 current assets should contribute to the net worth of firm. The level of
current assets may be measured with help of two ratios. (i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.

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 maturities of payment to its flow of
internally generated funds. Generally, shorter the maturity schedule of current liabilities in relation to expected cash
inflows, the greater inability to meet its obligations in time.

(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two off-selling transactions of a simultaneous
but opposite nature which counterbalance effect of each other. With reference to financing mix, the term hedging
refers to ‘process of matching of maturities of debt with maturities of financial needs’. According to this approach the
maturity of sources of funds should match the nature of assets to be financed. This approach is also known as
‘matching approach’ which classifies the requirements of total working capital into permanent and temporary working
capital. The hedging approach suggests that permanent working capital requirements should be financed with funds
from long-term sources while temporary working capital requirements should be financed with short-term funds.

(2) The Conservative Approach: This approach suggests that the entire estimated investments in current assets should
be financed from long-term sources and short-term sources should be used only for emergency requirements. The
distinct features of this approach are:(ii) Liquidity is greater(iii) Risk is minimized(iv) The cost of
financing is relatively more as interest has to be paid even on seasonal requirements for entire period.

Trade off Between the Hedging and Conservative Approaches; The hedging approach implies low cost, high profit and
high risk while the conservative approach leads to high cost, low profits and low risk. Both the approaches are the two
extremes and neither of them serves the purpose of efficient working capital management. A trade off between the
two will then be an acceptable approach. The level of trade off may differ from case to case depending upon the
perception of risk by the persons involved in financial decision making. However, one way of determining the trade off
is by finding the average of maximum and the minimum requirements of current assets. The average requirements so
calculated may be financed out of long-term funds and excess over the average from short-term funds.

(3). Aggressive Approach: The aggressive approach suggests that entire estimated requirements of current asset
should be financed from short-term sources even a part of fixed assets investments be financed from short-term
sources. This approach makes the finance – mix more risky, less costly and more profitable.

Hedging Vs Conservative Approach

Hedging Approach Conservative Approach

1. The cost of financing is reduced. 1. The cost of financing is higher

2. The investment in net working capital 2. Large Investment is blocked in

is nil. temporary working capital.

3. Frequent efforts are required to 3. The firm does not face frequent
arrange funds. financing problems.

4. The risk is increased as firm is 4. It is less risky and firm is able to

vulnerable to sudden shocks. absorb shocks.

Lets Sum Up; The term working capital may be used to denote either the gross working capital which refers to total
current assets or net working capital which refers to excess of current asset over current liabilities. The working capital
requirement for a firm depends upon several factors such as Nature or Character of Business, Credit Policy, Price level
changes, business cycles, manufacturing process, production policy. The working capital need of the firm may be
bifurcated into permanent and temporary working capital. The Hedging Approach says that permanent requirement
should be financed by long term sources while the temporary requirement should be financed by short-term sources of
finance. The Conservative approach on the other hand says that the working capital requirement be financed from
long-term sources. The Aggressive approach says that even a part of permanent requirement may be financed out of
short-term funds. Every firm must monitor the working capital position and for this purpose certain accounting ratios
may be calculated.
Dividend theories & policies, Dividend decision is an important decision, which a financial manager has to take. It
refers to that profits of a company which is distributed by company among its shareholders. There has been a
difference of opinion on the effect of dividend policy on value of firm.

Top 3 Theories of Dividend Policy; This article throws light upon the top three theories of dividend policy. The theories
are: 1. Modigliani-Miller (M-M) Hypothesis 2. Walter’s Model 3. Gordon’s Model.

Theory # 1. Modigliani-Miller (M-M) Hypothesis: Modigliani-Miller hypothesis provides the irrelevance concept of
dividend in a comprehensive manner. According to them, the dividend policy of a firm is irrelevant since, it does not
have any effect on the price of shares of a firm, i.e., it does not affect the shareholders’ wealth. They expressed that the
value of the firm is deter­mined by the earnings power of the firms’ assets or its investment policy and not the dividend
decisions by splitting the earnings of retentions and dividends.

M-M Hypothesis — Assumptions: (i) Taxes do not exist: That is, there is no difference in tax rates between dividends
and capital gains. (ii) Investors behave rationally: It means that investors should prefer to maximize their wealth and as
such, they are indifferent between dividends and the appreciation in the value of shares. (iv) Investment policy of the
Jinn does not change, i.e., fixed. (v) Risk and Uncertainty do not exist .In other words, investors may predict future
prices and dividends with certainty and one discount rate is used for all types of securities at all times — this was
subsequently dropped by M-M.

Proof of M-M Hypothesis: According to M-M, the market price of a share at the beginning of a period is equal to the
present value of dividend paid at the end of the period plus the market price of the share at the end of the period. The
same can be illustrated with the help of the following formula: If no new/external financing exists, the value of the firm
(V) will simply be the number of outstanding shares (n) times the prices of each share (P) by multiplying both sides of
equation (1) we get: If, however, the firm sells (m) number of new shares at time 1 at a price of P1, the value of the firm
(V) at time 0 will be: It has been explained some-where in this volume that the investment programme, at a given
period of time, can be financed either from the proceeds of new issues or from the retained earnings or from both. So,
the amount of new issues will be: That is, total financing by the new issues is determined by the amount of investment
in first period and not by retained earnings. By substituting equation (4) into equation (3), M-M reveal that the value of
the firm is unaffected by the dividend policy, i.e., nD1, term cancels out as under: Thus, M-M’s valuation model in
equation (5) is consistent with the valuation equation (2) and (3) stated above in terms of external financing. As the
value of the firm (V) can be restated as equation (5) without dividends, D1. it proves that dividends have no effect on
the value of the firm (when the external financing is being applied).

Illustration: Qmega Company has a cost of equity capital of 10%, the current market value of the firm (V) is Rs
20,00,000 (@ Rs. 20 per share). Assume values for I (new investment), Y (earnings) and D = (Dividends) at the end of the
year as I = Rs. 6,80,000, Y = Rs. 1,50,000 and D = Re. 1 per share. Show that under the M-M (Modigliani-Miller)
assumptions, the payment of D does not affect the value of the firm. Since the value of the firm in both the cases (i.e.,
when dividends are not paid and when paid) is Rs. 20, 00, 000. It can be concluded that the payment of dividend (D)
does not affect the value of the firm.

Criticism of M-M Hypothesis: It has already been stated in earlier paragraphs that M-M hypothesis is actually based on
some assumptions. Under these assumptions, no doubt, the conclusion which is derived is logically sound and
consistent although they are not well-based. For instance, the assumption of perfect capital market does not usually
hold good in many countries. Since the assumptions are unrealistic in nature in real world situation, it lacks practical
relevance which indicates that internal and external financing are not equivalent. The shareholders/investors cannot be
indifferent between dividends and capital gains as dividend policy itself affects their perceptions, which, in other words,
proves that dividend policy is relevant. As a result, M-M hypothesis, is criticised on the following grounds:
(i) Tax Differential: M-M hypothesis assumes that taxes do not exist, in reality, it is impossible. On the contrary, the
shareholders have to pay taxes on the dividend so received or on capital gains. We know that different tax rates are
applicable to dividend and capital gains and tax rate on capital gains is comparatively low than the tax rate on dividend.

That is why, an investor should prefer the capital gains as against the dividend due to the fact that capital gains tax is
comparatively less and such capital gains tax is payable only when the shares are actually sold in the market at a profit.
In short, the cost of internal financing is cheaper as compared to cost of external financing. Thus, on account of tax
advantages/differential, an investor will prefer a dividend policy with retention of earnings as compared to cash
dividend.

(ii) Existence of Floatation Costs: M-M also assumes that both internal and external financing are equivalent. It
indicates that if dividend is paid in cash, a firm is to raise external funds for its own investment opportunities. There will
not be any difference in shareholders’ wealth whether the firm retains its earnings or issues fresh shares provided
there will not be any floatation cost. But, in reality, floatation cost exists for issuing fresh shares, and there is no such
cost if earnings are retained. As a result of the floatation cost, the external financing becomes costlier than internal
financing. Therefore, if floatation costs are considered external and internal financing, i.e., fresh issue and retained
earnings will never be equivalent.

(iii) Existence of Transaction Costs: M-M also assumes that whether the dividends are paid or not, the shareholders”
wealth will be the same. When the dividends are not paid in cash to the shareholder, he may desire current income and
are as such, he can sell his shares. When a shareholder sells his shares for the desire of his current income, there
remain the transaction costs which are not considered by M-M. Because, at the time of sale, a shareholder must have
to incur some expenses by way of brokerage, commission, etc., which is again more for small sales. A shareholder will
prefer dividends to capital gains in order to avoid the said difficulties and inconvenience.

(iv) Diversification: M-M considers that the discount rate should be the same whether a firm uses internal or external
financing. But, practically, it does not so happen. If the share-holders desire to diversify their portfolios they would like
to distribute earnings which they may be able to invest in such dividends in other firms. In such a case,
shareholders/investors will be inclined to have a higher value of discount rate if internal financing is being used and
vice-versa.

(v) Uncertainty: According to M-M hypothesis, dividend policy of a firm will be irrelevant even if uncertainty is
considered. M-M reveal that if the two firms have identical invest-ment policies, business risks and expected future
earnings, the market price of the two firms will be the same. This view is actually not accepted by some other
authorities. According to them, under conditions of uncertainty, dividends are rel-evant because, investors are risk-
averters and as such, they prefer near dividends than future dividends since future dividends are discounted at a higher
rate as dividends involve uncertainty. Thus, the value of the firm will be higher if dividend is paid earlier than when the
firm follows a retention policy. We critically examine the two notable theories viz.: (a) Walter’s Model, and (b) Gordon’s
Model, below.

Theory # 2. Walter’s Model: Professor, James, E. Walter’s model suggests that dividend policy and investment policy of
a firm cannot be isolated rather they are interlinked as such, choice of the former affects the value of a firm. His
proposition clearly states the relationship between the firms’ (i) internal rate of return (i.e., r) and its cost of capital or
the required rate of return (i.e., k). That is, in other words, an optimum dividend policy will have to be determined by
the relationship of r and k. In short, a firm should retain its earnings it the return on investment exceeds the cost of
capital and in the opposite case, it should distribute its earnings to the shareholders. His proposition may be summed
up as under:
(a) When r > k (Growth Firms): When r > k, it implies that a firm has adequate profitable investment oppor-tunities, i.e.,
it can earn more what the investors expect. They are called growth firms. The optimum dividend policy, in case of those
firms, may be given by a D/P ratio (Dividend pay-out ratio) of 0. It means a firm should retain its entire earnings within
itself and as such, the market value of the share will be maximised.

(b) When r<k (Declining Firms): On the contrary, when r<k, it indicates that a firm does not have profitable investment
opportunities to invest their earnings. They are known as declining firms. In this case, rate of return from new
investment (r) is less than the required rate of return or cost of capital (k), and as such, retention is not at all profitable.
The investors will be better-off if earnings are paid to them by way of dividend and they will earn a higher rate of return
by investing such amounts elsewhere. In that case, the market price of a share will be maximised by the payment of the
entire earnings by way of dividends amongst the investors. There will be an optimum dividend policy when D/P ratio is
100%.

(c) When r = k (Normal Firms); If r = k, it means there is no one optimum dividend policy and it is not a matter whether
earnings are distributed or retained due to the fact that all D/P ratios, ranging from 0 to 100, the market price of shares
will remain constant. In other words, when the profitable investment opportunities are not available, the return from
investment (r) is equal to the cost of capital (k), i.e., when r = k, the dividend policy does not affect the market price of a
share.

Assumptions: Walter’s model is based on the following assumptions: (i) All financing through retained earnings is done
by the firm, i.e., external sources of funds, like, debt or new equity capital is not being used; (ii) It assumes that the
internal rate of return (r) and cost of capital (k) are constant; (iii) It assumes that key variables do not change, viz.,
beginning earnings per share, E, and dividend per share, D, may be changed in the model in order to determine results,
but any given value of E and D are assumed to remain constant in determining a given value; (iv) All earnings are either
re-invested internally immediately or distributed by way of dividends; (v) The firm has perpetual or very long life.
Professor Walter has evolved a mathematical formula in order to arrive at the appropriate dividend decision to
determine the market price of a share which is reproduced as under: where, P = Market price per share; D = Dividend
per share; E = Earning per share; r = Internal rate of return; k = Cost of capital or capitalization rate. In this proposition it
is evident that the optimal D/P ratio is determined by varying ‘D’ until and unless one receives the maximum market
price per share.

Illustration: Cost of Capital (k) = 10% Earnings per share (E) = Rs. 10. Assume Internal Rate of Return (r): (i) 15%; (ii) 10%;
and (iii) 8% respectively Assuming that the D/P ratios are: 0; 40%; 76% and 100% i.e., dividend share is (a) Rs. 0, (b) Rs.
4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different dividend policies for three alternatives of r may be shown as under:
Thus, according to the Walter’s model, the optimum dividend policy depends on the relationship between the internal
rate of return r and the cost of capital, k. The conclusion, which can be drawn up is that the firm should retain all
earnings if r > k and it should distribute entire earnings if r < k and it will remain indifferent when r = k.

Criticisms: Walter’s model has been criticized on the following grounds since some of its assumptions are unrealistic in
real world situation: They are: (i) Walter assumes that all investments are financed only be retained earnings and not by
external financing which is seldom true in real world situation and which ignores the benefits of optimum capital
structure. Not only that, even when a firm reaches the optimum capital structure level, the same should also be
maintained in future. In this context, it can be concluded that Walter’s model is applicable only in limited cases. (ii)
Walter also assumes that the internal rate of return (r) of a firm will remain constant which also stands against real
world situation. Because, when more invest-ment proposals are taken, r also generally declines. (iii) Finally, this model
also assumes that the cost of capital, k, remains constant which also does not hold good in real world situation.
Because if the risk pattern of a firm changes there is a corresponding change in cost of capital, k, also. Thus, Walter’s
model ignores the effect of risk on the value of the firm by assuming that the cost of capital is constant.
Theory # 3. Gordon’s Model: Another theory on relevance of dividend has been developed by Myron Gordon. Gordon’s
model is based on the following assumptions: (i) The firm is an all-equity firm; (ii) No external financing is available or
used. Only retained earnings are used to finance the investment programmes; (iii) The internal rate of return, r, and the
capitalization rate or cost of capital, k, is constant; (iv) The firm has perpetual or long life; (v) Corporate taxes do not
exist; (vi) The retention ratio, b, once decided upon is constant. Thus the growth rate, g = br, is also constant; (vii) k > br
= g.

According to Gordon’s model, the market value of a share is equal to the present value of an infinite future stream of
dividends. Thus, Gordon clearly states the relationship between internal rate of return, r, and the cost of capital, k. He
also contends that dividend policy depends on the profitable investment opportunities. However, his proposition may
be summed up as under: (a) When r > k (Growth Firms): When r > A, the value per share P increases since the retention
ratio, b, increases, i.e., P increases with decrease in dividend pay-out ratio. In short, under this condition, the firm
should distribute smaller dividends and should retain higher earnings. (b) When r < k (Declining Firms): When r<k, the
value per share P decreases since the retention ratio b, increases, i.e., P increases with increase in dividend pay-out
ratio. It can be proved that the value of b increases, the value of the share continuously falls. If the internal rate of
return is smaller than k, which is equal to the rate available in the market, profit retention clearly becomes undesirable
from the shareholders’ viewpoint. Each additional rupee retained reduces the amount of funds that shareholders could
invest at a higher rate elsewhere and thus it further reduces the value of the company’s share. (c) When r = k (Normal
Firms): When r = k, the value of the firm is not affected by dividend policy and is equal to the book value of assets, i.e.,
when r = k, dividend policy is irrelevant. It implies that under competitive conditions, k must be equal to the rate of
return, r, available to investors in comparable shares in such a manner that any funds distrib-uted as dividends may be
invested in the market at the rate which is equal to the internal rate of return of the firm. Consequently, shareholders
can neither lose nor gain by any change in the company’s dividend policy and the market value of the shares must
remain unchanged.

Dividend and Uncertainty: It has already been explained while defining Gordon’s model that when all the assumptions
are present and when r = k, the dividend policy is irrelevant. If assump-tions are modified in order to conform with
practical utility, Gordon assumes that even when r = k, dividend policy affects the value of shares which is based on the
assumption that under conditions of uncertainty, investors tend to discount distant dividends at a higher rate than they
discount near dividends. That is, there is a twofold assumption, viz: (a) investors are risk-averse, and (b) they put a
premium on certain return while discount uncertain returns. Because, the investors are rational and are risk averse, as
such, they prefer near dividends than future dividends. This argument is described as a bird-in-the-hand argument
which was put forward by Krishnan in the following words. “Of two stocks with identical earnings, record, prospectus,
but the one paying a larger dividend than the other, the former will undoubtedly command a higher price merely
because stockholders prefer present to future values. Myopic vision plays a part in the price-making process.
Stockholders often act upon the principle that a bird in the hand is worth than .two in the bushes and for this reason
are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower
rate.” In short, a bird in the hand is better than two in the bushes oh the ground that what is available in hand (at
present) is preferable to what will be available in future. On the basis of this argument, Gordon reveals that the future
is no doubt uncertain and as such, the more distant the future the more uncertain it will be. Thus, if dividend policy is
considered in the context of uncertainty, the cost of capital (discount rate) cannot be assumed to be constant, i.e., it
will increase with uncertainty. Since investors prefer to avoid uncertainty and they are willing to pay higher price for
the share which pays higher current dividend (all other things being constant), the appropriate discount rate will be
increased with the retention rate which is shown in Fig. 11.4 below.

Retention Rate and Discount Rate; Therefore, distant dividends will be discounted at a higher rate than the near
dividends. The above argument (i.e., the investors prefer for current dividends to future dividends) is not even free
from certain criticisms.That is, this may not be proved to be true in all cases due to low capital gains tax, particularly
applicable to the investors who are in high-tax brackets, i.e., they may have a preference for capital gains (which is
caused by high retention) than the current dividends so available.

capital structure issues, The capital structure is how a firm finances its overall operations and growth by using different
sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. What is capital structure? Capital Structure refers to the amount
of debt and/or equity employed by a firm to fund its operations and finance its assets. The structure is typically
expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund a business’ operations,
capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide
whether to raise debt or equity and managers will balance the two try and find the optimal capital structure.

Optimal capital structure; The optimal capital structure of a firm is often defined as the proportion of debt and equity
that result in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always
used in practice, and firms often have a strategic or philosophical view of what the structure should be.

In order to optimize the structure, a firm will decide if it needs

more debt or equity and can issue whichever it requires. The new capital that’s issued may be used to invest in new
assets or may be used to repurchase debt/equity that’s currently outstanding as a form or recapitalization.

Dynamics of debt and equity; Below is an illustration of the dynamics between debt and equity from the view of
investors and the firm.

Debt investors take less risk because they have the first claim on the assets of the business in the event
of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a lower cost of capital when it
issues debt compared to equity. Equity investors take more risk as they only receive the residual value after debt
investors have been repaid. In exchange for this risk equity investors expect a higher rate of return and therefore the
implied cost of equity is greater than that of debt.

Cost of capitalA firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known as
the weighted average cost of capital (WACC).

The formula is equal to:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where: E = market value of the firm’s equity (market cap), D = market value of the firm’s debt, V = total value of capital
(equity plus debt), E/V = percentage of capital that is equity, D/V = percentage of capital that is debt, Re = cost of equity
(required rate of return), Rd = cost of debt (yield to maturity on existing debt), T = tax rate

Capital structure by industry; Capital structures can vary significantly by industry. Cyclical industries like mining are
often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about
their ability to repay the debt. Other industries like banking and insurance use huge amounts of leverage and are their
business models require large amounts of debt. Private companies may have a harder time using debt over equity,
particularly small business which are required to have personal guarantees from their owners.

How to recapitalize a business; A firm that decides they should optimize their capital structure by changing the mix of
debt and equity has a few options to effect this change. Methods of recapitalization include:.1.Issue debt and
repurchase equity.2. Issue debt and pay a large dividend to equity investors.3. Issue equity and repay debt. Each of
these three methods can be an effective way of recapitalizing the business.

In the first approach, the firm borrows money by issuing debt and then uses all that capital to repurchase shares from
its equity investors. This has the effect of increasing the amount of debt and decreasing the amount of equity on the
balance sheet.

In the second approach, the firm will borrow money (i.e. issue debt) and use that money to pay a one-time special
dividend, which has the effect of reducing the value of equity by the value of the divided. This is another method of
increasing debt and reducing equity.

In the third approach, the firm moves in the opposite direction and issues equity by selling new shares, then takes the
money and uses it to repay debt. Since equity is costlier than debt, this approach is not desirable and often only done
when a firm is overleveraged and desperately needs to reduce its debt.

Tradeoffs between debt and equity; There are many tradeoffs that owners and managers of firms have to consider
when determining their capital structure. Below are some of the tradeoffs that should be considered. Pros and cons of
equity:* No interest payments* No mandatory fixed payments (dividends are discretionary)* No maturity dates (no
capital repayment)* Has ownership and control over the business* Has voting rights (typically)* Has a high implied cost
of capital*Expects a high rate of return (dividends and capital appreciation)*Has last claim on the firm’s assets in the
event of liquidation*Provides maximum operational flexibility

Pros and cons of debt: Has interest payments (typically), Has a fixed repayment schedule, Has first claim on the firm’s
assets in the event of liquidation, Requires covenants and financial performance metrics that must be met, Contains
restrictions on operational flexibility, Has a lower cost than equity, Expects a lower rate of return than equity

Capital structure in mergers and acquisitions (M&A); When firms execute mergers and acquisitions the capital
structure of the combined entities can often undergo a major change. There resulting structure will depend on many
factors, including the form of consideration provided to the target (cash vs shares) and whether existing debt for both
companies is left in place or not. For example, if Elephant Inc decides to acquire Squirrel Co using its own shares as the
form of consideration it will increase the value of equity capital on its balance sheet. If, however, Elephant Inc uses
cash (which it financed with debt) to acquire Squirrel Co, it will have increased the amount of debt on its balance sheet.
Determining the pro forma capital structure of the combined entity is a major part of M&A financial modeling. The
screenshot below shows how two companies are combined and recapitalized to produce an entirely new balance
sheet.

Leveraged buyouts; In a leveraged buyout (LBO) transaction a firm will take on significant leverage to finance the
acquisition. This practice is commonly performed by private equity firms seeking to invest the smallest possible
amount of equity and finance the balance with borrowed funds. The image below demonstrates how the use of
leverage can significantly increase equity returns as the debt is paid off over time.
 Financial distress ; Financial distress is a term in corporate finance used to indicate a condition when promises to
creditors of a company are broken or honored with difficulty. If financial distress cannot be relieved, it can lead to
bankruptcy. Financial distress is a term in corporate finance used to indicate a condition when promises to creditors of
a company are broken or honored with difficulty. If financial distress cannot be relieved, it can lead to bankruptcy.
Financial distress is usually associated with some costs to the company; these are known as costs of financial distress.

Cost; A common example of a cost of financial distress are bankruptcy costs. These direct costs include auditors' fees,
legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided
(indirect costs). Financial distress in companies requires management attention and might lead to reduced attention on
the operations of the company. Another source of indirect costs of financial distress are higher costs of capital as
usually banks increase the interest rates if a state of financial distress occurs.

Options for relieving financial distress; If high debt burden is the cause of financial distress, the company can undergo a
debt restructuring. If operational issues are the reason for the distress, the company can negotiate a payment holiday
with its creditors and improve operations to be able to service its debt. Financial distress refers to a condition in which
a company cannot meet, or has difficulty paying off, its financial obligations to its creditors, typically due to high fixed
costs, illiquid assets, or revenues sensitive to economic downturns. A company under financial distress can incur costs
related to the situation, such as more expensive financing, opportunity costs of projects, and less productive
employees. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance
of bankruptcy, which could force them out of their jobs. There are multiple warning signs that may indicate a company
is experiencing financial distress.

Signs of Financial Distress; Poor profits indicate a company is not experiencing good financial health. Struggling to break
even indicates a business cannot sustain itself from internal funds and needs to raise capital externally. This raises the
company’s business risk and lowers its creditworthiness with lenders, suppliers, investors and banks. Limiting access to
funds typically results in a company failing.

Poor sales growth or decline indicates the market is not positively receiving a company’s products or services based on
its business model. When extreme marketing activities result in no growth, the market may not be satisfied with the
offerings, and the company may close down. Likewise, if a company offers poor quality in its products or services,
consumers start buying from competitors, eventually forcing a business to close its doors.

When debtors take too much time paying their debts to the company, cash flow may be severely stretched. The
business may be unable to pay its own liabilities. The risk is especially enhanced when a company has one or two major
customers.

Financial Distress in Large Financial Institutions; One factor contributing to the financial crisis of 2007-2008 was the
government’s history of emergency loans to distressed financial institutions and markets believed “too big to fail.” This
history created an expectation for parts of the financial sector being protected against losses. The federal financial
safety net is supposed to protect large financial institutions and their creditors from failure and reduce systemic risk to
the financial system. However, federal guarantees may encourage imprudent risk-taking that can lead to instability in
the system the safety net is supposed to protect. Because the government safety net subsidizes risk-taking, investors
that feel protected by the government may be less likely to demand higher yields as compensation for assuming
greater risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected. Excessive risk-taking
means firms are more likely to experience distress and may require bailouts to stay solvent. Additional bailouts may
erode market discipline further. Resolution plans, or living wills, may be an important method of establishing credibility
against bailouts. The government safety net may be a less-attractive option in times of financial distress. There are a
variety of warning signs that indicate that a company is experiencing financial distress. Being aware of these signals can
help prevent failure. Here are some of the top 10 signs which could help you avoid financial distress.

1. Poor profits; However obvious, poor profits are usually the first indicator that a business is not doing well. When a
business struggles to break even, that is an indicator it will not sustain itself from internal funds and will be forced to
raise capital externally. This will raise its business risk and lower its creditworthiness with creditors, suppliers, investors
and banks eventually limiting access to funds and eventual failure.

2. Poor sales growth or decline; Growth in sales is an indicator that the market is positively receiving your chosen
products or services based on your business model. Where there is no growth despite extreme marketing activities, this
could mean that the market is not satisfied with the product or service and the business may inevitably close down.

3. Poor quality of products and services; When the quality of your product starts to decline it is more than likely your
customers will start buying from your competitors.

4. Negative cash flow; Cash flow statements are a critical indicator of financial distress. A negative cash flow statement
implies that the company is paying more cash than it is generating from its operations. If cash flow stays negative over
a sustained period, it is a signal that cash in the bank could be running low.

5. Slow paying customers; Debtors may take too long to settle their debts with the company. This can severely stretch
the cash flow and as a result, the company will not have enough cash on time to pay its own creditors and liabilities. In
instances where the company has significant dependency in one or two major customers, this risk is greatly enhanced.

6. Low current ratio; Current ratio is the ratio between current assets and current liabilities. Best practice dictates that
this ratio should always remain greater than one. To the uninitiated, this means that the company’s current assets are
enough to pay off its current liabilities. Where the ratio is below one, trouble is already brewing

7. Declining relationship with the bank; When this relationship becomes significantly strained; asking for extra security,
personal guarantees, debentures, withdrawing overdrafts and of course declined loans, it more often than not implies
that the business’ creditworthiness has been adversely eroded.

8. Lack of financial reports; Many business owners do not know the financial position of their businesses. Similar to
flying blind, this is always a recipe for catastrophe. By not being able to track rising costs and accounts payables, these
businesses may become insolvent due to lack of good financial information. A company may be growing rapidly making
profit but also suffering negative cash flows.

9. Borrowing to cover shortfalls; When a company is constantly borrowing and asking its investors to inject more
capital, this is an underlying sign that it is increasingly finding it difficult to self-sustain. At this point, a critical re-
evaluation is needed to assess whether the venture is viable in the long-term.

10. Managerial signals; Management systems that rely heavily on one individual for decision making could result in a
decision-making gridlock. An inexperienced management team with weak financial and organizational skills as well as a
poor understanding of finance and business may also foreshadow problems. In addition internal problems such as
changes in senior management and the resignation of members of the Board of Directors are a bellwether of trouble in
an organization.

Financial restructuring. CHANGES IN OWNERSHIPSTRUCTURE; Going private: It refers to transformation of a public

corporation in to private held firm. Exchange offer: An exchange offer provides one or more classes of securities,
theright or option to exchange part or all of their holdings for a different class of securities of the firm. LBO: LBO are
structured transactions where a company or sponsor , that is proposing the investment creates or uses another
company or vehicle to borrow substantially to fund the project. Buyback of Shares: It is the repurchase of the equity
once offered by the company..

RESTRCUTURING & VALUE CREATION; THE HURDLES : Design, Execution, Marketing , Value of Business: Asset, Culture,
Integration of Various Resources, Area of Operation, Equity , Debt, Value of Organization: Changes in Leadership,
Financial Differences, Effect of Taxation Value of the Firm, It is the present value of all the above -Present value of
Financial Risks Restructuring is the corporate management term for the act of reorganizing the legal, ownership,
operational, or other structures of a company for the purpose of making it more profitable, or better organized for its
present needs.

Corporate Restructuring Strategies Business; Corporate restructuring is the process of redesigning one or more aspects
of a company. The process of reorganizing a company may be implemented due to a number of different factors, such
as positioning the company to be more competitive, survive a currently adverse economic climate, or poise the
corporation to move in an entirely new direction. Here are some examples of why corporate restructuring may take
place and what it can mean for the company. In general, the idea of corporate restructuring is to allow the company to
continue functioning in some manner. Even when corporate raiders break up the company and leave behind a shell of
the original structure, there is still usually a hope, what remains can function well enough for a new buyer to purchase
the diminished corporation and return it to profitability.

Purpose of Corporate Restructuring –To enhance the share holder value, The company should continuously evaluate
its: Portfolio of businesses, Capital mix, Ownership & Asset arrangements to find opportunities to increase the share
holder’s value. To focus on asset utilization and profitable investment opportunities. To reorganize or divest less
profitable or loss making businesses/products. The company can also enhance value through capital Restructuring, it
can innovate securities that help to reduce cost of capital. Corporate Restructuring entails a range of activities including
financial restructuring and organization restructuring.

1. Financial Restructuring; Financial restructuring is the reorganization of the financial assets and liabilities of a
corporation in order to create the most beneficial financial environment for the company. The process of financial
restructuring is often associated with corporate restructuring, in that restructuring the general function and
composition of the company is likely to impact the financial health of the corporation. When completed, this reordering
of corporate assets and liabilities can help the company to remain competitive, even in a depressed economy. Just
about every business goes through a phase of financial restructuring at one time or another. In some cases, the process
of restructuring takes place as a means of allocating resources for a new marketing campaign or the launch of a new
product line. When this happens, the restructure is often viewed as a sign that the company is financially stable and has
set goals for future growth and expansion.

Need For Financial Restructuring; The process of financial restructuring may be undertaken as a means of eliminating
waste from the operations of the company. For example, the restructuring effort may find that two divisions or
departments of the company perform related functions and in some cases duplicate efforts. Rather than continue to
use financial resources to fund the operation of both departments, their efforts are combined. This helps to reduce
costs without impairing the ability of the company to still achieve the same ends in a timely manner In some cases,
financial restructuring is a strategy that must take place in order for the company to continue operations. This is
especially true when sales decline and the corporation no longer generates a consistent net profit. A financial
restructuring may include a review of the costs associated with each sector of the business and identify ways to cut
costs and increase the net profit. The restructuring may also call for the reduction or suspension of production facilities
that are obsolete or currently produce goods that are not selling well and are scheduled to be phased out. Financial
restructuring also take place in response to a drop in sales, due to a sluggish economy or temporary concerns about the
economy in general. When this happens, the corporation may need to reorder finances as a means of keeping the
company operational through this rough time. Costs may be cut by combining divisions or departments, reassigning
responsibilities and eliminating personnel, or scaling back production at various facilities owned by the company. With
this type of corporate restructuring, the focus is on survival in a difficult market rather than on expanding the company
to meet growing consumer demand. All businesses must pay attention to matters of finance in order to remain
operational and to also hopefully grow over time. From this perspective, financial restructuring can be seen as a tool
that can ensure the corporation is making the most efficient use of available resources and thus generating the highest
amount of net profit possible within the current set economic environment.

2. Organizational Restructuring; In organizational restructuring, the focus is on management and internal corporate
governance structures. Organizational restructuring has become a very common practice amongst the firms in order to
match the growing competition of the market. This makes the firms to change the organizational structure of the
company for the betterment of the business. Need For Organization Restructuring; New skills and capabilities are
needed to meet current or expected operational requirements. Accountability for results are not clearly communicated
and measurable resulting in subjective and biased performance appraisals. Parts of the organization are significantly
over or under staffed. Organizational communications are inconsistent, fragmented, and inefficient. Technology and/or
innovation are creating changes in workflow and production processes. Significant staffing increases or decreases are
contemplated. Personnel retention and turnover is a significant problem. Workforce productivity is stagnant or
deteriorating. Morale is deteriorating. Some of the most common features of organizational restructures are:

Regrouping of business: This involves the firms regrouping their existing business into fewer business units. The
management then handles theses lesser number of compact and strategic business units in an easier and better way
that ensures the business to earn profit.

Downsizing: Often companies may need to retrench the surplus manpower of the business. For that purpose offering
voluntary retirement schemes (VRS) is the most useful tool taken by the firms for downsizing the business’s workforce.

Decentralization: In order to enhance the organizational response to the developments in dynamic environment, the
firms go for decentralization. This involves reducing the layers of management in the business so that the people at
lower hierarchy are benefited.

Outsourcing: Outsourcing is another measure of organizational restructuring that reduces the manpower and transfers
the fixed costs of the company to variable costs.

Enterprise Resource Planning: Enterprise resource planning is an integrated management information system that is
enterprise-wide and computer-base. This management system enables the business management to understand any
situation in faster and better way. The advancement of the information technology enhances the planning of a
business.

Business Process Engineering: It involves redesigning the business process so that the business maximizes the operation
and value added content of the business while minimizing everything else.

Total Quality Management: The businesses now have started to realize that an outside certification for the quality of
the product helps to get a good will in the market. Quality improvement is also necessary to improve the customer
service and reduce the cost of the business.
VARIOUS STRATEGIES FOR BUSINESS RESTRUCTURING; Smart sizing: It is the process of reducing the size of a company
by laying off employees on the basis of incompetence and inefficiency. Some Examples. Acquisitions: HLL took over
TOMCO. Diversification: Videocon group is diversified into power projects, oil exploration and basic telecom services.
Merger: Asea and Brown Boveri came together to form ABB. Strategic alliances: Siemens India has got a Strategic
alliance with Bharati Telecom for marketing of its EPABX. Expansion: Siemens is expanding its medical electronics
division- a new factory for medical electronics is already come up in Goa.

Networking: It refers to the process of breaking companies into smaller independant business units for significant
improvement in productivity and flexibility. The phenomenon is predominant in South Korea, where big companies like
Samsung, Hyundai and Daewoo are breaking themselves up into smaller units. These firms convert their managers into
entrepreneurs.

Virtual Corporation: It is a company that has taken steps to turn itself inside out. Rather than having managers and staff
sitting INSIDE in their offices moving papers from in basket to out basket, a virtual corporation kicks the employees
outside, sending them to work in customer’s offices and plants, determining what the customer needs and wants, then
reshaping the corporate products and services to the customer’s exact needs. This is a futuristic concept wherein
companies will be edgeless, adaptable and perpetually changing. The centrepiece of the business revolution is a new
kind of product called a “Virtual Product” Some of the these products already exist, camcorders create instant movies,
personal computers and laser printers have made instant desktop publishing a reality. And for all these we can obtain
cash instantly at ATMs.

Verticalization: It refers to regrouping of management functions for particular functions for a particular product range
to achieve higher accountability and transparency. Siemens in 1990 moved from a “function-oriented” structure to a
vertical “entrepreneur-oriented” structure embracing size business and three support divisions.

Delayering- Flat organization: In the post-world war period the demand for goods was ever increasing. Main objective
of the corporations was production and capacity build up to meet the demand. The classical, pyramidal structure was
well suited to this high growth environment. This structure was scalable and the corporations could immediately
translate their growth plans into action by adding workers at the bottom layer and filling in the management layers. But
the price paid in the whole process was much higher. The overall process became complicated; number of middle
managers and functional managers grew making the coordination of various functions complex. Senior/top
management was alienated from the front-line people as well as the end users of the product or sen/ice. Decision-
making became slower. Hence, a need is felt to attack the unproductive, bulky and sluggish network of white-collar
staff. A powerful strategy would be to remove the layers of senior and middle management i.e. making the
organization structure flat. The perspective of organizational restructuring may be different for the employees. When a
company goes for the organizational restructuring, it often leads to reducing the manpower and hence meaning that
people are losing their jobs. This may decrease the morale of employee in a large manner. Hence many firms provide
strategies on career transitioning and outplacement support to their existing employees for an easy transition to their
next job.

The important methods of Corporate Restructuring are: Joint ventures, Sell off and spin off, Divestitures, Equity carve
out, Leveraged buy outs (LBO), Management buy outs.

1. Joint Ventures; Joint ventures are new enterprises owned by two or more participants. They are typically formed for
special purposes for a limited duration. It is a combination of subsets of assets contributed by two (or more) business
entities for a specific business purpose and a limited duration. Each of the venture partners continues to exist as a
separate firm, and the joint venture represents a new business enterprise. It is a contract to work together for a period
of time each participant expects to gain from the activity but also must make a contribution. For Example: GM-Toyota
JV: GM hoped to gain new experience in the management techniques of the Japanese in building high-quality, low-cost
compact & subcompact cars. Whereas, Toyota was seeking to learn from the management traditions that had made GE
the no. 1 auto producer in the world and In addition to learn how to operate an auto company in the environment
under the conditions in the US, dealing with contractors, suppliers, and workers. DCM group and Daewoo motors
entered in to JV to form DCM DAEWOO Ltd. to manufacture automobiles in India.

2. Spin-off; Spinoffs are a way to get rid of underperforming or non-core business divisions that can drag down profits.
Process of spin-off. The company decides to spin off a business division. The parent company files the necessary
paperwork with the Securities and Exchange Board of India (SEBI). The spinoff becomes a company of its own and must
also file paperwork with the SEBI. Shares in the new company are distributed to parent company shareholders. The
spinoff company goes public. Notice that the spinoff shares are distributed to the parent company shareholders. There
are two reasons why this creates value: Parent company shareholders rarely want anything to do with the new spinoff.
After all, it’s an underperforming division that was cut off to improve the bottom line. As a result, many new
shareholders sell immediately after the new company goes public. Large institutions are often forbidden to hold shares
in spinoffs due to the smaller market capitalization, increased risk, or poor financials of the new company. Therefore,
many large institutions automatically sell their shares immediately after the new company goes public. There is no
money transaction in spin-off. The transaction is treated as stock dividend & tax free exchange.

Split-off: Is a transaction in which some, but not all, parent company shareholders receive shares in a subsidiary, in
return for relinquishing their parent company’s share. In other words some parent company shareholders receive the
subsidiary’s shares in return for which they must give up their parent company shares Feature of split-offs is that a
portion of existing shareholders receives stock in a subsidiary in exchange for parent company stock.

Split-up: Is a transaction in which a company spins off all of its subsidiaries to its shareholders & ceases to exist. The
entire firm is broken up in a series of spin-offs. The parent no longer exists and Only the new offspring survive. In a
split-up, a company is split up into two or more independent companies. As a sequel, the parent company disappears
as a corporate entity and in its place two or more separate companies emerge.

3. Divestures; Divesture is a transaction through which a firm sells a portion of its assets or a division to another
company. It involves selling some of the assets or division for cash or securities to a third party which is an outsider.
Divestiture is a form of contraction for the selling company. means of expansion for the purchasing company. It
represents the sale of a segment of a company (assets, a product line, a subsidiary) to a third party for cash and or
securities. Mergers, assets purchase and takeovers lead to expansion in some way or the other. They are based on the
principle of synergy which says 2 + 2 = 5! , divestiture on the other hand is based on the principle of “anergy” which
says 5 – 3 = 3!. Among the various methods of divestiture, the most important ones are partial sell-off, demerger (spin-
off & split off) and equity carve out. Some scholars define divestiture rather narrowly as partial sell off and some
scholars define divestiture more broadly to include partial sell offs, demergers and so on.

Motives: Change of focus or corporate strategy, Unit unprofitable can mistake, Sale to pay off leveraged finance,
Antitrust, Need cash, Defend against takeover, Good price.

4. Equity Carve-Out; A transaction in which a parent firm offers some of a subsidiaries common stock to the general
public, to bring in a cash infusion to the parent without loss of control. In other words equity carve outs are those in
which some of a subsidiaries shares are offered for a sale to the general public, bringing an infusion of cash to the
parent firm without loss of control. Equity carve out is also a means of reducing their exposure to a riskier line of
business and to boost shareholders value.

5. Leveraged Buyout; A buyout is a transaction in which a person, group of people, or organization buys a company or a
controlling share in the stock of a company. Buyouts great and small occur all over the world on a daily basis. Buyouts
can also be negotiated with people or companies on the outside. For example, a large candy company might buy out
smaller candy companies with the goal of cornering the market more effectively and purchasing new brands which it
can use to increase its customer base. Likewise, a company which makes widgets might decide to buy a company which
makes thingamabobs in order to expand its operations, using an establishing company as a base rather than trying to
start from scratch.

6. Management buyout; In this case, management of the company buys the company, and they may be joined by
employees in the venture. This practice is sometimes questioned because management can have unfair advantages in
negotiations, and could potentially manipulate the value of the company in order to bring down the purchase price for
themselves. On the other hand, for employees and management, the possibility of being able to buy out their
employers in the future may serve as an incentive to make the company strong. It occurs when a company’s managers
buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers’ interest in the
success of the company. Purpose of Management buyouts From management point of view may be: To save their jobs,
either if the business has been scheduled for closure or if an outside purchaser would bring in its own management
team. To maximize the financial benefits they receive from the success they bring to the company by taking the profits
for themselves. To ward off aggressive buyers. The goal of an MBO may be to strengthen the manager’s interest in the
success of the company. Key considerations in MBO are fairness to shareholders price, the future business plan, and
legal and tax issues.

Benefits of Management buyouts; It provides an excellent opportunity for management of undervalued co’s to realize
the intrinsic value of the company. Lower agency cost: cost associated with conflict of interest between owners and
managers.

Source of tax savings: since interest payments are tax deductible, pushing up gearing rations to fund a management
buyout can provide large tax covers.

Conclusion: Restructuring strategies encompasses enhancing economy and improving efficiency. When a company
wants to grow or survive in a competitive environment, it needs to restructure itself and focus on its competitive
advantage. Thus, the merger and acquisition strategies have been conceived to improve general economic well-being
of all those who are, directly or indirectly, connected with the corporate sector. The intension of buy back is visualized
as to support share value during periods of temporary weakness, survival and to prevent takeover bids.

MODULE II; INVESTMENT DECISIONS;

Business Investment Decision Evaluations: When you make an investment in your business, it's important to evaluate
the results. This will help you determine if it's an investment that you should repeat or if you should invest in a different
direction in the future. One of the most generally accepted and basic methods of evaluating a business investment
decision is to calculate the ROI (return on investment) of the action or expenditure. 1. Add up all costs associated with
the business investment decision you've made. For example, if you've made a decision to place an advertisement,
include the cost of designing and submitting the ad via the service you've chosen in the total cost of the investment. 2.
Identify the total income you've taken in as a direct result of making this investment based on sales reports. This can be
difficult to determine, which is why it's helpful to direct potential customers to a specific website or phone number, or
query customers at the point of purchase to track the source of those sales. 3. Subtract your cost from the total sales,
and then divide that figure by the total cost. This will give you your ROI. Multiply that number by 100 to get the ROI
percentage. 4. Examine the ROI percentage to evaluate whether you've made a productive and smart business
investment decision. A positive ROI indicates that the investment was worthwhile. 5. Continue to evaluate the business
investment over the next several months by calculating the ROI periodically. This calculation is valuable because it
allows you to evaluate your decisions based on how well you recuperate your costs; you can then continue to set clear
goals to either meet or exceed previous results.
• You should also evaluate the business investment by seeking feedback from key parties who were involved.
These include customers and sales personnel. This will allow you to get a fuller view of what specifically did or did not
work in your formula. If you plan to re-invest, you can make any adjustments before going forward. The following
points highlight the top seven methods used for the evaluation of investment proposals. 1. Urgency Method: In many
situations in the life of a business concern an ad hoc decision is needed in respect of an investment expenditure. For
instance, if a part of machine stops working leading to complete break¬down and disruption in the production process,
it will be justified to replace it immediately by new one even without comparing the cost and future profit. Any decision
on investment expenditure on the basis of urgency should be taken only if it is fully warranted and justified.

2. Pay-Back Period Method: This is also known as ‘payoff and pay out’ method. This method is employed to determine
the number of years in which the capital expenditure incurred is expected to pay for itself. This method describes in
terms of period of time, the relationship between cash inflow and total amount of invest¬ment. The pay-back period is
the number of years during which the income is expected. The criterion here is that the average income from a
proposed investment be sufficient to cover investment within a period of time. It is calculated by dividing investment
by the amount of return per annum after charging taxation but before charging depreciation. This period may be
calculated by the following formula: Pay-back Period = Net Investment/Cash Inflow

3. Unadjusted Return on Investment Method: This method is also called Accounting Rate of Return Method or Financial
Statement Method or Return on Investment or Average Rate of Return Method. Here the main feature is that the rate
of return is based on the figures for income and investment which are determined according to conventional
accounting concepts. The rate of return is expressed as a percentage of the earnings to the investment in a particular
project. There is no general agreement as to what constitutes investment and income. Income may be taken as the
average annual earnings, normal earnings or the earnings of the first year of the project. Investments may be taken as
the initial investment or the average outlay over the life of the investment. The rate of return on investment refers to
the rate of interest that will make the present value of future earnings just equal to the cost of investment.

It may be calculated according to any one of the following methods: (i) Annual Average Net Earning/Original
Investment x 100. (ii) Annual Average over Earning/Average Investment x 100. The term average annual net earnings is
the average of the earning over the whole of the economic life of the project. (iii) Increase in Expected Future Annual
Net Earnings/Initial Increase in required Investment x 100

The amount of average investment can be calculated according to any one of the following methods: (i) Original
Investment/2. (ii) Original Investment – Scrap Value of the Asset/2. (iii) Original Investment + Scrap Value of the Asset/2

4. Net Present Value Method: The net present value method is one of the discounted cash flow or time adjusted
method. This is generally considered to be the best method for evaluating capital investment proposals. In case of this
method, cash inflows and cash outflows associated with each project are first worked out. The net present value is the
difference between the total present value of future cash inflows and the total present value of future cash outflows.
The equation for calculating net profit value in case of conventional cash flows can be as follows: where NPV = Net
present value. R = Cash inflows at different time periods. K = Cost of capital, I = Cash outflows at different time periods.

5. Internal Rate of Return Method: This method is also called Time Adjusted Return on Investment or Discounted Rate
of Return. This method measures the rate of return which earnings are expected to yield on investments. Internal rate
of return is defined as the maximum rate of interest that could be paid for the capital employed over the life of an
investment without loss on the projects. The rate is similar to the effective rate of interest calculated on debentures
purchased or sold. This is calculated on the basis of the funds utilised from time to time as opposed to the investment
made at the beginning. This method incorporates the time value of money in the investment calculation.The formula
for the discounted rate of return is: C = the supply price of the asset. F = the future cash flows. S = the salvage value of
the asset in years, r = the discounted rate of return.

6. Terminal Value Method: This method is based on the assumption that operating saving of each year is invested in
another outlet at a certain rate of return from the moment of its receipt till the end of the economic life of the projects.
This method incorporates the assumption about how the cash inflows are reinvested once they are received and thus
avoids any influence of the cost of capital on cash inflows. However, cash inflows of the last year of the project will not
be reinvested. As such, the compounded values of cash inflows should be determined as the basis of compounding
factor which may be obtained from com¬pound interest table or by the following formula: A =P (1+i)n where P=1

7. Benefit-Cost Ratio Method: This method is based on time adjusted techniques and is also called Profitability Index or
Desir¬ability Factor. The procedure of deriving the benefit cost ratio criterion is the same as that of NPV. What is done
is to divide the present value of benefit by the present value of cost. The ratio between the two would give us the
benefit-cost ratio which indicates benefit per rupee of cost. The calculation of benefit-cost ratio is shown as follows:
Benefit Cost Ratio (BCR) = Present Value of Benefits/Present Value of Cost

Payback Period . The payback period is the most basic and simple decision tool. With this method, you are basically
determining how long it will take to pay back the initial investment that is required to undergo a project. In order to
calculate this, you would take the total cost of the project and divide it by how much cash inflow you expect to receive
each year; this will give you the total number of years or the payback period. For example, if you are considering buying
a gas station that is selling for $100,000 and that gas station produces cash flows of $20,000 a year, the payback period
is five years. As you might surmise, the payback period is probably best served when dealing with small and simple
investment projects. This simplicity should not be interpreted as ineffective, however. If the business is generating
healthy levels of cash flow that allow a project to recoup its investment in a few short years, the payback period can be
a highly effective and efficient way to evaluate a project. When dealing with mutually exclusive projects, the project
with the shorter payback period should be selected.
Net Present Value (NPV) . The net present value decision tool is a more common and more effective process of
evaluating a project. Perform a net present value calculation essentially requires calculating the difference between the
project cost (cash outflows) and cash flows generated by that project (cash inflows). The NPV tool is effective because it
uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the
uncertainty of those future cash flows. The term "present value" in NPV refers to the fact that cash flows earned in the
future are not worth as much as cash flows today. Discounting those future cash flows back to the present creates an
apples to apples comparison between the cash flows. The difference provides you with the net present value. The
general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV
is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.

Internal Rate of Return (IRR) .The internal rate of return is a discount rate that is commonly used to determine how
much of a return an investor can expect to realize from a particular project. Strictly defined, the internal rate of return
is the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the decision rule is
simple: choose the project where the IRR is higher than the cost of financing. In other words, if your cost of capital is
5%, you don't accept projects unless the IRR is greater than 5%. The greater the difference between the financing cost
and the IRR, the more attractive the project becomes.The IRR decision rule is straightforward when it comes to
independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually
exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than
another project. These issues can arise when initial investments between two projects are not equal. Despite the issues
with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value percentages more than
numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much more meaningful and effective), as
percentages are more impactful in measuring investment success. Capital budgeting decision tools, like any other
business formula, are certainly not perfect barometers, but IRR is a highly-effective concept that serves its purpose in
the investment decision making process. All businesses require capital equipment (fixed assets) such as machinery,
premises and vehicles. The purchase of such assets is known as capital investment and is undertaken for the following
reasons: i.To replace existing equipment which is out-of-date or obsolete ii.To expand the productive capacity of the
business iii. To reduce the production costs per unit (i.e. to achieve economies of scale) iv. To produce new products
and, therefore, break into new markets. Capital investment, like all other business activities, involves an element of
uncertainty, because expenditure is incurred today in order to produce some benefit in the future. Investment
appraisal techniques are designed to aid decision-making regarding such investment projects. There are 3 methods
which can be used to appraise any investment project:

Payback Method. This is the simplest method of investment appraisal and is usually preferred by small businesses
because of its simplicity. Larger businesses may use it as a screening process before embarking on one of the more
complicated techniques. The payback period is the time taken for the equipment, (machinery etc.), to generate
sufficient net cash flow to pay for itself. For example: A manufacturing firm is considering investing £ 500,000 in new
machinery. The equipment is expected increase the firm's cashflow by £ 150,000 per year. How long is the payback
period ? After 1 year, the cashflow will be £ 150,000. After 2 years, the cashflow will be £ 300,000. After 3 years, the
cashflow will be £ 450,000. The firm will need £ 50,000 (or one third) of the cashflow from year 4 in order to reach the
payback point. Therefore, the payback period is 3 1/3 years (or 3 years, 4 months). Firms can use this technique in one
of two ways: Firstly, a firm could set an upper limit on the time allowed for payback, and any project which is not
expected to payback within this period is rejected. Secondly, when faced with a choice of projects, the payback method
can be used to rank projects according to the speed at which they payback.

However, the payback method ignores the following two important factors: The total return on the investment project
(i.e. the earnings after payback).1.The timing of the return prior to payback. The payback method clearly discriminates
against projects which produce a slow but substantial return, resulting in the danger that highly profitable projects will
be rejected because of the delay in producing a return (yield).Example: Each of the three alternative projects below
involve an initial cost of £ 1 million, and produce net cash flow as shown:

PROJECT YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

A £ 0m £ 0.5m £ 0.5m £ 0.5m £ 0.5m

B £ 0.5m £ 0.5m £ 0.5m £ 0m £ 0m

C £ 0m £ 0m £ 0.5m £ 1m £ 1m

Project A pays back in 3 years (£ 0 in year 1 + £ 0.5m in year 2 + £ 0.5m in year 3). Project B pays back in 2 years (£ 0.5m
in year 1 + £ 0.5m in year 2). Project C pays back in 3 1/2 years (£ 0 in year 1 + £ 0 in year 2 + £ 0.5m in year 3 + half of
the £ 1m in year 4). Using 'The Pay-back Method' to decide between these projects, project B would be selected. But if
you looked at the total revenue over the full life of each project, project C actually brings more cash into the business
and would be the better project to select.

Average Rate of Return (A.R.R.) Method This method takes the total return (yield) over the whole life of the asset into
account and therefore overcomes one of the defects of the payback method. In order to understand the arithmetic,
consider an item of capital (e.g. a machine) which will cost £ 1 million to purchase, is expected to last 5 years, and will
produce an annual net cash flow of £ 0.5 million. The total return (yield) is: 5 x £ 0.5 million = £ 2.5 million If we now
deduct the initial cost of investment (£ 1 million) we are left with a total return (yield), net of the initial capital outlay,
of £ 1.5 million. Annually, this works out at: When we express this annual figure as a percentage of the original capital
outlay we get the Average Rate of Return for the project: To recap, the 4 steps for calculating the A.R.R. are: Add up the
total forecasted net cash flow, Deduct the capital outlay from this, Divide the resulting figure by the expected life (in
years) of the capital, Express this annual figure as a percentage of the capital outlay. As with the Payback method, we
can use the A.R.R. in two ways. Firstly, the firm might set a predetermined level and reject any project which has an
expected A.R.R. less than this percentage. Secondly, when faced with a choice of alternative projects, then the projects
can be ranked by their A.R.R. Further examples. A firm is considering three alternative investment projects. The
maximum life of each asset is three years and the capital outlay is £ 100,000 in each case. The table below depicts net
cash flow in each of the three years:

PROJECT YEAR 1 YEAR 2 YEAR 3

A £ 50,000 £ 50,000 £ 50,000

B £ 100,000 £ 20,000 £0

C £0 £ 50,000 £ 140,000

Project A:Total forecasted net cash flow = £ 150,000. Total forecasted net cash flow - capital outlay = £ 50,000, £
16,666.67 (this is the amount of profit per year)= 16.67%.
Project B: Total forecasted net cash flow = £ 120,000 Total forecasted net cash flow - capital outlay = £ 20,000, £
6,666.67 (this is the amount of profit per year)= 6.67%

Project C: Total forecasted net cash flow = £ 190,000 Total forecasted net cash flow - capital outlay = £ 90,000, £
30,000 (this is the amount of profit per year)= 30%

The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to the timing of the
inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received. Hence, a project may be
favoured even though it only produces a return over a long period of time. The more sophisticated methods of
investment appraisal take the timing of the cash inflows into account, as well as the size of the inflows. A sum of money
in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of
money over the year). This is where the notion of present value is used.

Net Present Value (N.P.V.) Method. The return on an investment comes in the form of a stream of earnings in the
future. The N.P.V. method of investment appraisal takes into account the size of the cash inflows over the life of the
equipment, but also makes adjustment for the timing of the money. A greater weighting (or importance) is given to the
inflows of cash in the earlier years. The weighting can be calculated from the following formula: A = the actual sum of
money concerned. r = the rate of discount (called the 'Discount factor'). n = the number of years. This enables us to
calculate the present value of money, net of operating costs, to be received in a certain number of years. Hence, £ 1000
in two years time, at a 3% rate of discount, has a present value of: In examinations you will usually be given the
discount factor, so that you do not have to work it out! The present value of each year's cash inflow are then
aggregated (this is called the discounted cash flow, or D.C.F) and this figure is compared with the initial capital outlay. If
the sum of present values (minus the capital cost) is positive, then it is worthwhile proceeding with the project. If the
resulting figure is negative, then the project should not be undertaken.

Example: In appraising a £ 300,000 investment project, a firm uses a discount rate of 5%. The equipment will produce a
cash inflow (net of operating costs) of £ 75,000 per year, over a five year period. At the end of the five years, the firm
expects to sell the equipment for £ 10,000. What is the Net Present Value of the project?

Year cashflow Present Value

0 -£ 300,000 -£ 300,000

1 +£ 75,000 +£ 71,428.57

2 +£ 75,000 +£ 68,027.21

3 +£ 75,000 +£ 64,787.82

4 +£ 75,000 +£ 61,702.69

5 +£ 85,000 +£ 66,599.72

Year 0 is the present day (i.e. when the initial capital outlay is spent). The cashflow of £ 75,000 in year 1 has a present
value of: £ 71,428.57. The cashflow of £ 75,000 in year 2 has a present value of: £ 68,027.21

The process continues for the remaining years. The discounted cashflow is the sum of the present values for the 5 cash
inflows (i.e. from year 1 to year 5). This figure is £ 332,546.01 The net present value is found by deducting the initial
capital outlay from the discounted cashflow. In other words: £ 332,546.01 - £ 300,000 = £ 32,546.01 Since this result is
positive, then it is advisable for the firm to go ahead with the investment project. If the result had been negative, then
the investment project should not be undertaken.

Other Influencing Factors. There are many other factors that a business will need to take into consideration when
appraising an investment project, other than the financial (quantitative) factors. Qualitative factors such as the
objectives of the business must be considered at all times, as well as the effect upon the employees of new machinery,
new working practices and changes to their working conditions. The external environment needs to be considered
before any decision can be taken regarding a proposed investment project. These factors include the state of the
economy (e.g. it may be dangerous to attempt to expand during a recession, because demand for products may be
falling), pressure group activity, the level of technological progress in the industry (e.g. competitors may already be
using the new machinery), and any legislation (e.g. restricting the use of certain materials, components). The effects of
the actions of the business on the environment must also be taken into consideration, since any external costs (e.g.
pollution) will have a detrimental effect on the image and reputation of the business. Finally, as with any investment
decision, the business will also need to consider the amount of finance that is available for expansion, and the effect
that any borrowing to raise extra finance will have on the gearing ratio

Certainty, Risk and Uncertainty in Investment Decision. If a finance manager feels he knows exactly what the outcomes
of a project would be and is willing to act as if no alternative were in existence, he will be presumably acting under
conditions of certainty. Thus, certainty is a state of nature which arises when outcomes are known and determinate.
Riskiness of an investment project is defined as the variability of its cash flows from those that are expected. The
greater the variability, the riskier the project is said to be. In risky situations the probabilities of an event occurring are
known and these probabilities are objectively determinable. The main attribute of risk situation is that the event is
repetitive in nature and possesses a frequency distribution. This frequency distribution is used to draw inferences on
the basis of objective statistical technique. Thus, risk refers to a set of unique outcomes for a given event which can be
assigned probabilities. In contrast, when an event is not repetitive and unique in character and the finance manager is
not sure about probabilities themselves, uncertainty is said to prevail. Uncertainty is a subjective phenomenon. In such
situation no observations can be drawn from frequency distributions. Capital expenditure projects are often unique.
The finance manager may not have store of historical data to draw upon to see as to how the same project had fared in
the past. The outcomes in the state of uncertainty are too unsure to be assigned probabilities. It is worth noting that
distinction between risk and uncertainty is of academic interest only. Practically, no generally accepted methods exist.
With the introduction of risk factor, no company can afford to remain indifferent between two investment projects
with varying probability distributions, as exhibited in figure 20.1, although each investment proposal is expected to
yield inflows of Rs. 10,000 in its three-year life. A look at figure 20.1 will make it crystal clear that dispersion of the
probability distribution of expected cash flows for proposal B is greater than that for proposal A. Since the task is
associated with the deviation of actual outcome from that which was expected, proposal B is the riskier investment.
This is why risk factor should be given due importance in investment decision.

Decision-making under Certainty: A condition of certainty exists when the decision-maker knows with reasonable
certainty what the alternatives are, what conditions are associated with each alternative, and the outcome of each
alternative. Under conditions of certainty, accurate, measurable, and reliable information on which to base decisions is
available. The cause and effect relationships are known and the future is highly predictable under conditions of
certainty. Such conditions exist in case of routine and repetitive decisions concerning the day-to-day operations of the
business.

Decision-making under Risk: When a manager lacks perfect information or whenever an information asymmetry exists,
risk arises. Under a state of risk, the decision maker has incomplete information about available alternatives but has a
good idea of the probability of outcomes for each alternative. While making decisions under a state of risk, managers
must determine the probability associated with each alternative on the basis of the available information and his
experience.

Decision-making under Uncertainty: Most significant decisions made in today’s complex environment are formulated
under a state of uncertainty. Conditions of uncertainty exist when the future environment is unpredictable and
everything is in a state of flux. The decision-maker is not aware of all available alternatives, the risks associated with
each, and the consequences of each alternative or their probabilities. The manager does not possess complete
information about the alternatives and whatever information is available, may not be completely reliable. In the face of
such uncertainty, managers need to make certain assumptions about the situation in order to provide a reasonable
framework for decision-making. They have to depend upon their judgment and experience for making decisions.
Modern Approaches to Decision-making under Uncertainty: There are several modern techniques to improve the
quality of decision-making under conditions of uncertainty. The most important among these are:(1) Risk analysis,(2)
Decision trees and(3) preference theory.

Risk Analysis: Managers who follow this approach analyze the size and nature of the risk involved in choosing a
particular course of action. For instance, while launching a new product, a manager has to carefully analyze each of the
following variables the cost of launching the product, its production cost, the capital investment required, the price that
can be set for the product, the potential market size and what percent of the total market it will represent. Risk analysis
involves quantitative and qualitative risk assessment, risk management and risk communication and provides managers
with a better understanding of the risk and the benefits associated with a proposed course of action. The decision
represents a trade-off between the risks and the benefits associated with a particular course of action under conditions
of uncertainty.

Decision Trees: These are considered to be one of the best ways to analyze a decision. A decision-tree approach
involves a graphic representation of alternative courses of action and the possible outcomes and risks associated with
each action. By means of a “tree” diagram depicting the decision points, chance events and probabilities involved in
various courses of action, this technique of decision-making allows the decision-maker to trace the optimum path or
course of action.

Preference or Utility Theory: This is another approach to decision-making under conditions of uncertainty. This
approach is based on the notion that individual attitudes towards risk vary. Some individuals are willing to take only
smaller risks (“risk averters”), while others are willing to take greater risks (“gamblers”). Statistical probabilities
associated with the various courses of action are based on the assumption that decision-makers will follow them. For
instance, if there were a 60 percent chance of a decision being right, it might seem reasonable that a person would take
the risk. This may not be necessarily true as the individual might not wish to take the risk, since the chances of the
decision being wrong are 40 percent. The attitudes towards risk vary with events, with people and positions.

Top-level managers usually take the largest amount of risk. However, the same managers who make a decision that
risks millions of rupees of the company in a given program with a 75 percent chance of success are not likely to do the
same with their own money. Moreover, a manager willing to take a 75 percent risk in one situation may not be willing
to do so in another. Similarly, a top executive might launch an advertising campaign having a 70 percent chance of
success but might decide against investing in plant and machinery unless it involves a higher probability of success.
Though personal attitudes towards risk vary, two things are certain. Firstly, attitudes towards risk vary with situations,
i.e. some people are risk averters in some situations and gamblers in others. Secondly, some people have a high
aversion to risk, while others have a low aversion. Most managers prefer to be risk averters to a certain extent, and
may thus also forego opportunities. When the stakes are high, most managers tend to be risk averters; when the stakes
are small, they tend to be gamblers.

Methods for Taking Investment Decisions under Risk. Some of the most important methods that are used for taking
investment decisions under risk are as follows: 1. Sensitivity Analysis 2. Scenario Analysis 3. Decision Tree Analysis 4.
Break-Even Analysis 5. Risk-Adjusted Discount Rate Method 6. Certainty-Equivalent Analysis. Risk refers to the deviation
of the financial performance of a project from the forecasted performance. One needs to forecast the cash flows and
other financial aspects while selecting a project. However, the actual financial performance of a project may not in
accordance to the forecasted performance. These risks can be decline in demand, uneven cash flow, and high inflation.
For example, an organization is planning to install a machine that would increase the production level of the
organization. However, the demand of the product may vary with the economic environment, for example, the demand
may be very high in economic boom and low if there is recession. Therefore, the organization may earn high income or
incur huge loss, depending on the business environment. However, different kinds of risks can be assessed up to a
certain limit.

The risks can be assessed by using various methods that are shown in Figure-7:

1. Sensitivity Analysis: Forecasting plays an important role in project selection. For example, a project manager needs to
forecast the total cash flow of a project. The cash flow depends on the revenue earned and cost incurred in a project.
The revenue earned from the project depends on various factors, such as sales and market share. Similarly, if we want
to find out the NPV or IRR of the project, we need to make the accurate predictions of independent variables. Any
change in the independent variables can change the NPV or IRR of the project. In sensitivity analysis, we analyze the
degree of responsiveness of the dependent variable (here cash flow) for a given change in any of the dependent
variables (here sales and market share). In other words, sensitivity analysis is a method in which the results of a
decision are forecasted, if the actual performance deviates from the expected or assumed performance.

Sensitivity analysis basically consists of three steps, which are as follows: 1. Identifying all variables that affect the NPV
or IRR of the project.2. Establishing a mathematical relationship between the independent and dependent variables. 3.
Studying and analyzing the impact of the change in the variables Sensitivity analysis helps in providing different cash
flow estimations in three circumstances, which are as follows: a. Worst or Pessimistic Conditions: Refers to the most
unfavorable economic situation for the project b. Normal Conditions: Refers to the most probable economic
environment for the project c. Optimistic Conditions: Indicates the most favorable economic environment for the
project. Let us consider the example given in Table-5: Now, the NPV of each of the projects can be calculated by using
the formula of NPV. The calculation of the NPV of project A is shown in Table-6: Similarly, the calculation of NPV of
project B is shown in Table-7: Therefore, we can see that the extent of loss in project B is less than that of project A but
the extent of profit in project B is more than that of project A. Therefore, the project manager should select project B.

2. Scenario Analysis: Scenario analysis is another important method of estimating risks involved in a project. It involves
assessing future uncertainness associated with a project and their outcomes. In this method, different probable
scenarios are analyzed and the associated outcomes are also determined. For example, you are going to undertake an
important project and have forecasted your cash flows accordingly. If your forecast goes wrong substantially, the future
of the whole project can be jeopardized. As discussed earlier, in sensitivity analysis, different factors of a project are
interdependent. Therefore, if any of the factors are disrupted, the whole forecast can be wrong. Scenario analysis helps
a project manager in preparing a framework where he/she can explore different kinds of risks associated with a project.
It is more complex as compared to sensitivity analysis. Scenario analysis needs sophisticated computer techniques to
effectively calculate a large number of probable scenarios and their respective outcomes. Scenario analysis is more
useful to a project manager than the sensitivity analysis as the former is more comprehensive and gives more insight
about a project. However, there are few disadvantages of this method, which are as follows: (a) Complex Process:
Involves difficult calculations as calculating the NPV of a project is not easy by following this method. The complexity of
the method makes it both costly and time consuming. (b) Difficulty in Assessing the Probability: Implies that it is very
difficult to estimate the possibility of different outcomes. Sometimes, in practical life, assessing future uncertainties is
not accurate.

3. Decision Tree Analysis: Decision tree analysis is one of the most effective methods of assessing risks associated in a
project. In this method, a decision tree is drawn for analyzing the risks associated in a project. A decision tree is the
representation of different probable decisions and their probable outcomes in a tree-like diagram. This method takes
into account all probable outcomes and makes the decision making process easier. Let us understand decision tree
analysis with the help of an example, X&Y Manufacturers has two projects, project A and project B. The two projects
need the initial investment of Rs. 25000 and Rs. 32000, respectively. According to an estimation, 35% probability of
project A to give a return is Rs. 46000 in next five years and 65% probability is that it may give a return of Rs. 42000 in
the same period. Similarly, 20% probability of project B to give a return of Rs. 55000 in next five years and 80%
probability is that it may give a return of Rs. 50000 in the same period. Now, if we express the problem in a decision
tree, we will get a tree-like diagram, which is shown in Figure-8: Now, the net value of each of the projects can be easily
calculated. The net value of the project A would be (46000×0.35) + (42000×0.65) -25000 = (16100+27300-25000)
=18400. Similarly, the net value of the project B would be (55000×.20) + (50000×.80)-32000 = 19000 Now, it is obvious
that the project B is more profitable for the organization. Therefore, the organization should continue with project B.

The advantages of decision tree analysis are as follows: (a) Detail Insight: Provide a detailed view of all the probable
outcomes associated with a project (b) Objective in Nature: Provides a clear evaluation of different alternative
decisions

Following are the disadvantages of decision tree analysis: (a) Difficulty in Large Number of Decisions: Signifies that if the
expected life of the project is long and the number of outcomes are large in numbers, it is quite difficult to draw a
decision tree (b) Difficulty in Interdependent Decisions: Indicates that the calculation becomes very time consuming
and complicated in case the alternative decisions are interdependent

4. Break-Even Analysis: Break-even analysis is a widely used technique in project management. Break-even is a no profit
and no loss situation for a project. In break-even analysis, all costs associated with a project are divided into two heads,
fixed costs and variable costs. The total fixed cost and the total variable cost are then compared with the total return or
revenue of the project. In a break¬even scenario, the total of all fixed costs or variable costs in a project is equal to the
total revenue or return from the project. Therefore, a project can be said to have reached its break-even when it does
not have any profit or loss.

The concept of breakeven point is explained in Figure-9: The different costs used in break-even analysis are explained
as follows: (a) Fixed Costs: Refer to the costs incurred at the initial stage of the project and does not depend on the
production level or operation level of the project. For example, cost of a machinery and rent. (b) Variable Costs: Refer
to the costs that depend on the volume of production. Wages and raw materials are the examples of variable costs. (c)
Total Cost: Refers to the sum total of fixed costs and variables costs. As shown in Figure-9, at point P, the total cost is
equal to the total revenue. Therefore, the project can be said to have achieved break even at point P.

5. Risk-Adjusted Discount Rate Method: Risk-adjusted discount rate method refers to the adjustment of risk in
valuation model that is NPV. Risk-adjusted discount rate can be expressed as follows: d = 1/ 1+r+µ. Where, r = risk free
discount rate µ = risk probability. The preceding formula can be used for calculating risk-adjusted present value. For
example, if the expected rate of return after five years is equal to R5, then the risk-adjusted present value can be
determined with the help of the following formula. Present Value (PV) = 1/ (1+r+µ) 5 R5 .The calculation of risk-
adjusted NPV for nth year can be done with the help of following formula: Where, Rn = return in nth year. Co = original
cost of capital. By substituting the value of d, we get the following equation: Let us understand the calculation of risk-
adjusted discount rate with the help of an example. For example, a project, ABC cost Rs. 100 million to an organization.
The project is expected to give a return of Rs. 132 million in one year. The discount rate for project 18% and probability
of risk is 0.12. Find out whether the organization should accept the project ABC or not? Solution:The risk-adjusted NPV
for project ABC can be calculated as follows: Where, R = Rs. 132 million. Co = Rs. 100 million. r = 0.08. H = 0.12. After
substituting the given values of different variables, we get the risk-adjusted NPV that is equal to: NPV =
132/1+0.08+0.12 = 100. NPV = 10 million. Therefore, the organization is getting risk-free return of Rs. 10 million. If we
calculate NPV for the same project, it would be equal to: NPV = 132/1+0.08 = 100. NPV = 22.22 million. NPV and risk-
adjusted NPV both are greater than zero. Therefore, project is profitable and should be accepted. The advantages of
risk-adjusted discount rate method are as follows: (a) Changing discount rate by changing risk factor (µ) for different
time periods and amount of risk (b) Adjust the high risk of future by increasing the time duration for risk adjusted rate.
For example, the risk-adjusted discounted rate for 50th year is equal to: (c) Regarding as the easiest method for
evaluating projects in risk conditions .However, the disadvantage of risk-adjusted discount rate method is that it fails to
provide tool for measuring risk factor. Therefore, it is required to be supplemented with the method to calculate risk
factor.

6. Certainty-Equivalent Analysis:.Certainty-equivalent analysis is also used for the adjustment of NPV, thus, selecting or
rejecting a project. It is similar to risk- adjusted discount rate analysis. However, there is one difference between them.
In risk-adjusted discount rate analysis, the discount rate is adjusted while in certainty-equivalent analysis, expected
return is adjusted. Certainty-equivalent NPV can be, calculated with the help of the following formula: NPV= aRn/ (1+ r)
n-C0. Where, a= certainty- equivalent coefficient .The value of a can be determined with the help of following formula:
α = Rn/Rn* Where, Rn = Expected certain return. Rn* = Expected risky return. For example, between two projects P and
Q, P is risky but gives Rs. 100 million of return after one year. However, Q is risk-free but gives Rs. 90 million of return
after one year. The investment for project P is Rs. 70 million and for Q it is Rs. 73 million. The risk-free discount rate is
10%. In such a case, two projects are equal for the investor. This implies that risk-free project Q is equivalent to risky
project P. Therefore, certainty-equivalent coefficient would be: α = 90/100. α = 0.9 The certainty-equivalent NPV for
project P would be:NPV= α Rn/ (1 + r) n –C0. NPV = 0.9 * 100/ (1+0.1) -70. NPV = 12 million. The certainty-equivalent
NPV for project Q would be:NPV = Rn/ (1+r) n – C0. NPV = 90/ (1+0.1) – 73 . NPV = 9 million. The project P yields more
with less investment as compared to project Q. Therefore, project P would be selected.
The Impact of Inflation on Management Decisions. This article is from a paper delivered before a symposium of the
Academy of Political Science at Columbia University, November 11, 1974, under the overall topic of "Inflation, Fiscal,
Social and Economic Impacts." Data herein on the 1974-75 recession have worsened since this paper was given.
Recession, I submit, is the unwanted offspring of inflation. Inflation is of course the all too familiar problem of too much
money (demand) chasing too few goods (supply), with the upshot of prices and expectations everywhere tending to
rise higher and higher. How should business managers cope with inflation? This paper seeks answers to that question.
To do so we should define our terms. What is management? What is business? And what is at stake in the onslaught of
inflation? A reading of Peter Drucker’s new book, Management: Tasks, Responsibilities, Practices, leads me to the
following in answer to the question, What is management? The answer is manifold. Management is planning.
Management is organization. Management is responsibility. Management is profitability. It is also leadership, discipline,
practice, performance, accounting, marketing, tasks, communication and information. Management is — in the final
analysis — decision-making. But making decisions on whose behalf? Management’s? The employees’? The
shareholders’? The community’s? The business’ as a whole? Not really. For what is business? Business is service. Or, to
put it baldly, business is a hired servant. Hired by whom? The consumer. Yes, business is guided ‘by profitability, by its
own self-interest; yet it is subject to the sovereignty of the consumer. As Ludwig von Mises pointed out, "Production for
profit is necessarily production for use, as profits can only be earned by providing the consumers with those things they
most urgently want to use." So the test of a manager’s decisions is profitability — the extent to which he increases
revenues and cuts costs. Business management is profit management. Consumers reward efficient management with
profits and penalize inefficient management with losses. Now, what is at stake when we weigh the impact of inflation
on management? Remember that business — or, more broadly, the private sector — is the principal source of jobs: Of
our total labor force of about 94 million, government furnishes only 16.5 million jobs. This includes more than two
million members of the armed forces. With 5.5 million presently unemployed, this means that business, including
agriculture and the professions, furnishes the remainder — around 72 million jobs. Business is also the source of most
economic output. Thus it generates the bulk of real income in our society — food, clothing, shelter, transportation,
medicine, information, and the like. So what is at stake in the onslaught of inflation? Nothing less than the survival of
the business system itself. Note that while I tick off the inflationary distortions on management decisions, I reserve the
greatest distortion until last — the possibility of a sharp recession or even a depression. Managers can get a fast
overview of the problem of coping with soaring prices by simply noting how the process of inflation distorts the
traditional functions of money.

Impact on Functions of Money .Money, we were told in Economics 101, is first and foremost a medium of exchange.
Quite obviously, then, under inflation the purchasing and employment managers will find that, economize though they
may, more and more money is required to buy the same amount of goods and services, including labor. The pricing
manager also must be quick on his feet to avoid a cost-price squeeze; hence he must seek to keep his prices ahead of
costs as far as competition and other factors allow. Ironically, money has become such a "hot potato" that some
managers, especially those involved in international transactions, don’t want to hold it and prefer goods instead.
Indeed, some managers trade raw materials for finished goods and vice versa. Thus, through swap arrangements, they
alleviate shortages while retreating from money as a medium of exchange. Too, Eco. 101 reminded us money has a
store of value function —the retention of purchasing power over time. Inflation, however, is a thief of that power. The
financial manager is thereby under pressure to put his liquid assets to work as rapidly as possible. Bluntly, he must
hedge against inflation, balancing his choice of investments between yield and risk. He will also seek to expedite the
collection of accounts receivable, exacerbating the general squeeze on liquidity. Again, money is a standard of value —
a unit of account, a yardstick for relative prices. Inflation similarly distorts this function of money by shrinking this key
accounting measurement. A dollar is no longer a dollar over time; it is no longer predictable; it no longer permits
accurate economic calculation; it is 80¢ or 700 or 60¢ and so on, depending on the length of time and the pace of
inflation; and all historical financial records thus call for careful interpretation. The usual tool to accomplish such
interpretation is the concept of constant dollars which allows some comparability among accounting periods. I say
"some comparability" for changes in the Consumer Price Index, the Wholesale Price Index and the GNP Implicit Price
Deflator can still not be considered scientific measurements of inflation. Inflation is notoriously uneven, with some
prices advancing rapidly, some moderately and some lagging behind. Constant dollars are an especially inadequate tool
for multinational corporations. They use different currencies, each with a different history of inflation. Also, rates of
inflation and rates of exchange in money markets vary, rendering translation of foreign currencies into U.S. dollars for
consolidated financial statements much more difficult. Lastly, Eco. 101 assigned a fourth function to money—a
standard for deferred payments. One of inflation’s most bitter repercussions is that it warps all debtor-creditor
relations. In other words, money as a standard for deferred payments has all too often become a shrinking standard.
The borrower is thereby able to repay his debt with cheaper money than that he initially borrowed. In other words,
inflation fleeces the creditor. This hard fact of our inflationary era means financial managers have to adjust their
lending activities, such as acquiring commercial paper and certificates of deposit. By the same token, financial
managers have to adjust their borrowing activities, such as getting bank lines of credit and issuing corporate bonds.
Lending or borrowing, financial managers should recognize that the largest single element in the height of interest
rates today is the level of inflation, currently at a two-digit level. The foregoing section points up some current
monetary distortions. My purpose in this paper is to give some perspective to the management side of inflation and to
detail some ramifications of the impact of inflation on the decision process. In particular, I wish to briefly examine the
distortions of inflation in the decision areas of profits, inventory, capital investment, wages, international operations,
price controls and the business cycle. The overriding distortion is informational. Good decisions are dependent upon
good information. Much if not most of that information, however, is undermined both quantitatively and qualitatively
by inflation. It therefore behooves managers to seek to correct, as best they can, their information for inflation.

Impact of Inflation on Profit Calculations. In 1974 people in high places have been charging that corporate profits are
"excessive," "unconscionable" and even "obscene." These adjectives sound hollow against the backdrop of a disastrous
stock market. The words sound even more hollow when corrections of profit figures are made for inflation. Dramatic
results are obtained with three major corrections: 1. Under depreciation of plant and equipment, due to depreciation
allowances based on original cost rather than replacement cost. This practice has long led to a general overstatement
of corporate profits, with consequent overpayment of corporate income taxes and even overpayment of dividends.
These result in diminution of potential capital formation. Tax authorities have recognized this problem and have dealt
with it to some extent by setting up investment tax credits and accelerated depreciation methods. Financial managers
have taken advantage of these provisions to varying degrees. Yet these provisions have proven to be inadequate in
view of our two-digit inflation. Both tax authorities and financial managers would be well advised to recognize this
depreciation deficiency and the drag it imposes on economic growth — on the economy as a whole and on each
individual enterprise. The average age of American plant and equipment continues to lag behind that of our major
industrial competitors overseas, and behind what is needed to meet the expectations of our growing population. So
still more realistic and competitive depreciation methods are clearly needed.

2. Allowance for the inflation that has diminished the profit dollar. Inflation has eroded the purchasing power of the
dollar by more than 40 per cent since 1965. So on this count alone, and despite more than a trillion dollars (in today’s
prices) poured into plant and equipment, corporate profits have shown but minor increases since 1965 in real terms.
For as sensible is the conversion of money wages into real wages, so financial managers can sensibly convert money
profits into real profits. To be sure, second quarter results in 1974 were about 25 per cent ahead of those of the second
quarter of 1973. But price controls came off completely April 30, 1974, allowing many firms to catch up with true
supply and demand. Moreover, if the spectacular gains of some basic materials industries are excluded, along with the
atypical profits of the auto industry, the bulk of industrial companies made only a moderate increase of 10 to 11 per
cent in the first half of 1974 — just about equal to the rate of inflation. In any event, corporate financial and public
relations managers may want to deflate their profit figures and remind the public of the corporate return in real terms.
Yet these managers are frequently reluctant to do so, beholden as they are to shareholders and given to pointing with
pride to "record" profits. The economy therefore suffers because of management’s desire to show good earnings
during an inflationary era.

3. Overstatement of profits because of the understatement of inventory values. Some authorities call inventory gains
"phantom profits," which disappear the moment inventory is replaced. The magnitude of inventory profits can be seen
in the Commerce Department calculations of $37.9 billion annual rate in the second quarter of 1974, up from $31
billion in the first quarter and $20 billion a year earlier. For perspective, after-tax corporate profits ran at a seasonally
adjusted annual rate of $85.6 billion in the second quarter of 1974, up only $500 million from the first quarter, despite
$6.9 billion of inventory profits. To put their own corporate profits in a truer light, quite a few financial managers are
switching from first-in, first-out (FIFO) to last-in, first-out (LIFO) for more accurate inventory valuation. It’s about time.
In an editorial on October 1, 1974, the Wall Street Journalcriticized those financial managers who got caught up in the
earnings-per-share mystique and used FIFO to that end. With rising inventory prices, FIFO permitted higher reported
earnings all right, but it also permitted —in fact, required — higher taxes on those earnings. Indeed, FIFO thereby
fostered less capital to invest for long run returns. Capital markets don’t ignore such unrealistic accounting. The Journal
referred to a study by Shyam Sunder, an accounting professor at the University of Chicago graduate business school, in
which 118 LIFO firms listed on the New York Stock Exchange outperformed the market in stock price appreciation by
4.7 per cent. Economist George Terborgh of the Machinery and Allied Products Institute in Washington, D.C. has made
all three of the foregoing adjustments to 1973 corporate profits. He found that such adjusted profits came to less than
60 per cent of what they were in 1965. Retained earnings, he found, were down even more significantly; they were but
around $3 billion, or 16 per cent of what they were in 1965. The portent for real capital investment and real economic
growth in the immediate future is hence not very great, mainly because of the disastrous inflation we have been
incurring for the past two years.

Impact on Inventory Planning. Inflation also muddies inventory planning, as can be gathered from my references to
LIFO-FIFO accounting methods. Ideally, the inventory-sales ratio should be kept as low as feasible so as to minimize the
cost of storage and the cost of money tied up in inventory. But inflation creates all manner of uncertainties because of
rising prices in raw materials, semi-finished and finished goods. As these prices rise, purchasing managers naturally
undergo temptations to "beat the gun" by accelerating their forward buying. The purchasing manager of course realizes
that his cost of storage and tied-up money will thereby go up. But he may hold that these costs are more than offset by
being able to obtain inventory at lower prices than he could later. Too, with a surge of buying he may also begin to
worry about availability and delivery delays. So, he inadvertently adds to speculative activity and puts pressure on
prices, as he accelerates his forward buying. With all this, however, his inventory-sales ratio may not advance if other
purchasing managers adopt the same hedging behavior and also increase their forward buying; the result is that as his
inventory climbs, so do his sales. This would be especially true if the purchasing manager is in a basic materials industry.
But such inventory build-up behavior, stimulated by surging demand, tends to be short-lived. For on this score alone,
inflation may be contributing to a key factor in the business cycle — inventory buildups, which can lead to a boom, and
inventory liquidations, which can lead to a bust. Ironically, the liquidations in effect contribute to deflationary pressures
on the very price-inflated commodities and goods that brought on the inventory build-up in the first place.

Impact on Capital Planning. In like manner, inflation disrupts capital planning. Business may be good and the backlog
long, but the long-run outlook remains unclear. The planning manager is thus put in the same quandary as the
purchasing manager. On the one hand, he doesn’t want to tie up his financial resources in the fixed costs of under-
utilized plant and equipment and incur the burden of unnecessary overhead. On the other hand, he is lured by the
possibility of obtaining capacity at a significantly lower cost than he could in later stages of inflation; and, he hopes,
maybe his order backlog won’t evaporate. This quandary is especially visible in the basic materials industries such as
energy, metals, paper, chemicals, and so on. These industries are extremely capital-intensive. Moreover, because these
industries lend themselves to significant economies of scale and require long lead times for new facility construction,
new capacity demands tend to come in lumps rather than in evenly spaced-out requirements. The process is
exacerbated by inflation and the business cycle which give wider swings and a feast-famine aspect to the capital goods
industry. This aspect is inherent in the capital goods industry anyway, as the accelerator theory of J. M. Clark
demonstrates. This theory says that a change in demand for consumer goods tends to have an accelerated change in
the demand for capital goods, assuming that the economy is operating at full capacity. Inflation accentuates the
problem of the accelerator by giving exaggerated indications of consumer and capital goods demand. Inflation and the
business cycle itself seem to be initiated by credit expansion and artificially low interest rates, both aided and abetted
by the central bank. The low interest rates give businessmen false signals of genuine capital availability made possible
by savings when the fact of the matter is usually a central bank speedup of money supply growth. The speedup
provides the familiar scenario of too much money chasing too few goods, winding up in "stagflation" — a combination
of inflation, extremely high interest rates and economic stagnation. (The cyclical process is spelled out more fully at the
close of this paper.) The scenario comes at a bad time. Capital formation has lagged for a long time in America. The
American economy must modernize and expand its plant and equipment to accommodate its growing labor force, to
reach its energy and ecological goals and to compete in an increasingly competitive one-world economy. International
competitiveness has been rising at the same time that the U.S. has been lagging behind its major overseas competitors
in the pace of investment. Here are comparative rates of capital investment for 1973, using gross private domestic
investment as a percentage of GNP: United States 16 per cent West Germany 26 per cent France 28 per
cent Japan 37 per cent So U.S. capital needs are enormous. The New York Stock Exchange has just completed a
careful technical study on the capital needs and savings potential of the U.S. economy through 1985. The study aimed
at developing realistic projections of U.S. capital supply and demand over the next 12 years. For this period the study
came up with the following quantitative conclusion: Saving potential $4,050,000,000,000. Capital requirements —
4,700,000,000,000 (650,000,000,000)

In other words, the numbers suggest that the present estimated saving potential in the American economy through
1985 — from all domestic sources — is slightly better than $4 trillion. At the same time, capital demand or
requirements will possibly hit a grand total of $4.7 trillion, or more than three times the rate of the previous twelve
years in current dollars. The painful indicated capital gap — fraught with human misery — is hence estimated at $650
billion or $54 billion a year. Continued inflation can only compound this problem, impeding, as it does, the two critical
processes involved in capital formation: saving and investing.

Impact of Inflation on Wages. Wages constitute some three-quarters or more of all industrial costs, or much more than
most businessmen seem aware, inasmuch as a large fraction of this amount is paid indirectly in the form of purchased
goods and services. These goods and services, in other words, themselves embody much labor cost. The point is that
cost-push inflation is largely wage-push inflation. So, to quite an extent under the doctrine of "full employment," as
wages go so goes inflation. In any event, given the state of our relatively one-sided collective bargaining today in what
Sumner Slichter of Harvard called our "laboristic" economy, the industrial relations manager can not do a great deal to
soften the terms of the labor contract, other than to inform his opposite-number union negotiators of the state of the
industry and his company, the competitive realities and the stage of the business cycle. Also, he can advise top
management whether the company should accept a strike as a way of winning more amenable terms. With all this,
however, the traditional collective bargaining areas of wages, hours and working conditions will likely be set in contract
provisions not entirely to the industrial relations manager’s liking. Inflation tends to induce work laxity. Working
conditions, for example, may be characterized by restrictive work practices, which of course hamper labor productivity
improvement — practically the only source of real wage gains. Lessened productivity, in turn, contributes to the
inflationary situation of "too few goods." Some of these restrictive work practices are obvious and direct. For example,
size restrictions on the width of paint brushes and rollers, a 150-mile definition of a "day’s work" for trainmen, a limit
on the size of cargo slings used by longshoremen, a typographers union requirement that "bogus type" be set as an
offset to the use of advertising mats. Some restrictive work practices are indirect and not so obvious. For example,
hiring hall arrangements in some fields of employment and control of the labor market by limiting entrants to a
particular labor force such as construction. Importantly, too, the wages provision of the labor contract is similarly
inflationary when agreed-upon wage increases exceed productivity gains and worsen the unit labor cost picture of the
firm. The firm is thereby under pressure to recoup the added cost burden from its customers. It will unquestionably do
so if the union contract is in the industry pattern and if the banking system has in effect accommodated the higher
wages with greater demand. If the accommodation isn’t made, unemployment will likely expand. Even with such
accommodation, unemployment will still ultimately expand because of the additional demand pressures created by the
new money leading to uneconomic higher unit labor costs. Demand by employers is likely to falter anyway as inflation
brings about excessive minimum wages and labor union settlements over and above market demands. In any event,
the long-run correlation between increases in unit labor costs and the rate of inflation is unmistakable. At the same
time inflation tends to give management a cost-plus mentality with regard to these-settlements. If demand is rampant,
the employer may shrug his shoulders at the otherwise exorbitant wage demands, yield to them and raise his prices
accordingly — a scenario that works in the early stages of inflation. The scenario is accentuated by inflated expectations
on the union’s part. Not so many years ago a 4 or 5 per cent wage increase demand was workable. Now the teamsters
or the plumbers or the coal miners or the phone workers demand 20 to 30 per cent and settle for 10 to 15 per cent.
Thus in the third quarter of 1974, according to the Labor Department, the average wage increase for new major union
contracts came to 11.3 per cent, up from 10 per cent in the second quarter. These increases add fuel to expectations
and the inflationary process, in light of the historical postwar labor productivity improvement factor in the U.S. of
around three per cent a year. The process is exacerbated, I submit, by the use of cost-of-living escalator clauses. Some
five million members of the labor force are covered by such clauses and this number is growing. Escalator clauses tend
to be little engines of inflation since they push up wages and unit labor costs as "the Consumer Price Index rises, and
thereby tend to push prices and the CPI even higher, or create unemployment and pressure for monetary expansion. In
other words, the escalator clauses act as a built-in wage-price spiral as well as a built-in worker dis employing agent.

Impact on International Operations. Decisions in the international area are greatly influenced by inflation. Corporate
money managers, for example, have had to deal in recent years with "hot money" around the world. They have had to
hedge against threatened currencies to protect their accumulated investment funds from erosion because of inflation
or devaluation. Currencies have been not only devalued but upvalued, floated and repegged. The United States dollar
itself has undergone two devaluations since December 1971, causing quite a turmoil in the currency portfolio of
virtually every multinational corporation. Quite a few multinational corporations, including banks, have had to absorb
significant losses from currency fluctuations. A prime example is the Franklin National Bank failure. Corporate money
managers have therefore found it necessary to increase their hedging and swap arrangements to minimize these
losses. Again, the quadrupling of oil prices via the OPEC cartel has led to some second thoughts in corporate board-
rooms on industrial expansion projects here and abroad. Energy the world over has become not only very expensive,
but has become tied up in political problems involving its basic availability. Indeed, there is even a growing possibility of
further nationalization and expropriation, although this possibility is also brought about by general inflation and other
factors. The high cost of oil and almost every other basic commodity, including wheat, rice, sugar, zinc, tin, aluminum,
steel, and the like, has worsened the balance of payments positions of virtually every major industrial country. The
result is that these countries are now tending to discourage non-energy imports while pushing their exports harder to
offset higher oil prices. Accordingly, corporate money managers will probably find export credit financing sweetened by
government agencies in all the countries in which their companies do business, and new barriers to entry for the goods
they wish to import into those countries. The effect of all this is to increase trade restrictions — to narrow world
markets while ironically accelerating world competition. Another result stemming from the OPEC model is the incentive
for other developing nations to exploit the basic commodities with which they are blessed. The bauxite countries,
notably Jamaica and Guyana, have already sharply raised prices to the aluminum companies. Rumblings of like action
have been heard from the copper-producing, coffee-producing and tin-producing countries, among others. So we begin
to see how inflation more and more disrupts normal international economic relations for multinational corporations.
The years since World War II of harmonious trade and international division of labor, so conducive to world peace,
seem to be coming to an end. We are apparently entering an era of economic isolationism wrought by the
internationalization of runaway inflation.

Impact of Price Controls on Management. One impact of inflation is political — a tendency for governments to react to
inflation with wage and price controls. The irony of such government reaction is twofold: First, government itself is
overwhelmingly responsible for the inflation it seeks to correct; and second, wage and price controls treat symptoms,
not causes; they repress inflation, mask it, causing shortages and distortions while allowing inflationary forces to
become even more virulent. The period of the "New Economic Policy" from August 15, 1971 to April 30, 1974 is a case
in point. Corporate managers in this period generally experienced a cost-price squeeze. In other words, they found
their prices lagging behind their costs, chiefly labor and interest costs. In such a squeeze, many of them fled the
regulated domestic market and shipped to unregulated markets abroad. This situation merely worsened the distortions
in relative prices and the shortages endemic to the entire wage-price control era. Besides shortages, corporate
managers had to contend with rampant demand, shipment delays, quality lapses, multiplying bureaucratic
interferences and, ultimately, breakdown of the controls themselves. This breakdown in turn led to a rash of "catch-up"
wage and price increases, which haunt us down to this very hour. The controls led not only to a profit squeeze, but to a
capital investment squeeze. Many basic materials industries, for example, knew that they had exhausted their capacity
limits and that their backlogs could be measured not in months but in years. Yet they still could not set aside expansion
funds by the retained earnings route, with earnings so squeezed; they could not raise equity funds with their stock
prices so depressed; and they could not go to the bond market, with inflated interest rates reaching double-digit levels.
The upshot was that supply became tighter and tighter across the country.

Inflation and Business Cycle. Of critical concern to management is the turn of the business cycle. Should the company
expand operations or retrench? What lies ahead: boom or bust? Management is helpless in doing anything about the
cycle; like death and taxes it is there, stark and inexorable. Or so it seems. About all management can do is to try to
forecast the turn and act accordingly. But forecasting, even by elaborate computerized econometric models, has
proven woefully ineffective over recent years. It has shown itself to be anything but a science. It is an art, and a dubious
art at that, as the record of business forecasts sadly evidences. As Walter W. Heller, chairman of the Council of
Economic Advisers under Presidents Kennedy and Johnson, declared at the December 1973 meeting of the American
Economic Association meeting in New York: "Economists are distinctly in a period of re-examination. The energy crisis
caught us with our parameters down. The food crisis caught us, too. This was a year of infamy in inflation forecasting.
There are many things we really just don’t know." But why is it that practically the entire business community is
suddenly thrust into a huge crop of sharp profit setbacks or outright losses? Why is it that even blue-chip
managements, noted for their track record of achieving profits and shunning losses, suddenly find their order backlog
fading, the more so for capital goods managements? I believe inflation is at the root of the business cycle, as Ludwig
von Mises and 1974 Nobel Prize winner Friedrich von Hayek have long pointed out. Specifically, they have observed
that the appearance of the business cycle roughly coincided with the origins of the fractional reserve banking system
along with central banks. They have criticized credit expansion (not based upon actual savings) and the doctrine of easy
money —ready availability at artificially low interest rates. They have also criticized central banks for aiding and
abetting the process by pumping in additional bank reserves and becoming lenders of last resort. And they have
criticized central banks for becoming giant printing presses through monetizing government deficits. For management
the process looks like this. Credit expansion puts pressure on resource prices but profits boom. Capacity is strained, so
new capital expansion projects are launched. Cost-price squeezes develop. Inflation leaps ahead. Interest rates soar.
The stock market falls. Consumers retreat. Businesses fail, especially as their debt structure becomes unserviceable.
Expansion slows down, and the recession begins. The recession, if allowed to run its course and if inflation slows down,
becomes part of the cure. If these two criteria are not met, the recession can turn into a depression. In sum, the impact
of inflation on management decisions is all-pervasive. There is no handyescape hatch. Losses for management — and
for society! — are almost inevitable due to the deterioration of economic calculation, the increase of uncertainty, the
evaporation of purchasing power, the damages of recession. The best remedy for inflation is to get at its taproot —
deficit spending and excessive money creation. As good citizens, corporate managers might well remember the
observation of Dante: "The hottest places in hell are reserved for those who, in a period of moral crisis, maintain their
neutrality.

Protect Your Foreign Investments From Currency Risk Investing in foreign securities, while a good thing for your long-
term portfolio, continues to pose new threats for investors. As more people broaden their investment universe by
expanding into foreign stocks and bonds, they must also bear the risk associated with fluctuations in exchange rates.
Fluctuations in these currency values, whether the home currency or the foreign currency, can either enhance or
reduce the returns associated with foreign investments. Currency plays a significant role in investing; read on to
uncover potential strategies that might downplay its effects. Pros of Foreign Diversification There is simply no doubting
the benefits of owning foreign securities in your portfolio. After all, modern portfolio theory (MPT) has established that
the world's markets do not move in lockstep and that by mixing asset classes with low correlation to one another in the
appropriate proportions, risk can be reduced at the portfolio level, despite the presence of volatile underlying
securities. As a refresher, correlation coefficients range between -1 and +1. Anything less than perfect positive
correlation (+1) is considered a good diversifier. The correlation matrix depicted below demonstrates the low
correlation of foreign securities against domestic positions. Combining foreign and domestic assets together tends to
have a magical effect on long-term returns and portfolio volatility; however, these benefits also come with some
underlying risks.

Risks of International Investments Several levels of investment risks are inherent in foreign investing: political risk, local
tax implications and exchange rate risk. Exchange rate risk is especially important, because the returns associated with
a particular foreign stock (or mutual fund with foreign stocks) must then be converted into U.S. dollars before an
investor can spend the profits. Let's break each risk down. Portfolio Risk The political climate of foreign countries
creates portfolio risks because governments and political systems are constantly in flux. This typically has a very direct
impact on economic and business sectors. Political risk is considered a type of unsystematic riskassociated with specific
countries, which can be diversified away by investing in a broad range of countries, effectively accomplished with
broad-based foreign mutual funds or exchange-traded funds (ETFs). Taxation

Foreign taxation poses another complication. Just as foreign investors with U.S. securities are subject to U.S.
government taxes, foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are
typically withheld at the source country before an investor can realize any gains. Profits are then taxed again when the
investor repatriates the funds. Currency Risk

Finally, there's currency risk. Fluctuations in the value of currencies can directly impact foreign investments, and these
fluctuations affect the risks of investing in non-U.S. assets. Sometimes these risks work in your favor, other times they
do not. For example, let's say your foreign investment portfolio generated a 12% rate of return last year, but your home
currency lost 10% of its value. In this case, your net return will be enhanced when you convert your profits to U.S.
dollars, since a declining dollar makes international investments more attractive. But the reverse is also true; if a
foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the returns of
the foreign position.Minimizing Currency Risk Despite the perceived dangers of foreign investing, an investor may
reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging
involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case a
currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock
in the current exchange rate by entering into an offsetting currency futures position. In the currency markets,
speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take
long or short positions in their currency of choice, depending on how they believe that currency will perform. For
example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy the
euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that
the same speculator has taken a short position in the U.S. dollar. There are two possible outcomes with this hedging
strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too,
and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract
decreases. When you buy or sell a futures contract, as in our example above, the price of the good (in this case the
currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up
margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are
calculated each day. Currency hedging can also be accomplished in a different way. Rather than locking in a currency
price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up
buying the same currency, but in one scenario you do not pay for the asset up front.

Investing in the Currency Market The value of currencies fluctuates with the global supply and demand for a specific
currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price.
Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market
(forex for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is
conducted electronically in what is considered one of the largest liquid markets in the world. There are several ways to
invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up
their own accounts, or they can access currency investments through forex brokers. However, margined currency
trading is an extremely risky form of investment, and is only suitable for individuals and institutions capable of handling
the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served
acquiring them through funds or ETFs - and there are plenty to choose from. Some of these products make bets against
the dollar - some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an
ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that
currencies associated with high interest rates tend to rise in value relative to currencies associated with low interest
rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes
(historically, currency investing has been very tax-inefficient) and finding the appropriate allocation percentage.

The Bottom Line Investing in foreign stocks has a clear benefit in portfolio construction. However, foreign stocks also
have unique risk traits that U.S.-based stocks do not. As investors expand their investments overseas, they may wish to
implement some hedging strategies to protect themselves from ongoing fluctuations in currency values. Today, there is
no shortage of investment products available to help you easily achieve this goal.

What is a 'Real Option' A real option is a choice made available with business investment opportunities, referred to as
“real” because it typically references a tangible asset instead of financial instrument. Real options are choices a
company’s management makes to expand, change or curtail projects based on changing economic, technological or
market conditions. Factoring in real options impacts the valuation of potential investments, although commonly used
valuations, such as net present value (NPV), fail to account for potential benefits provided by real options.

BREAKING DOWN 'Real Option' Real options do not refer to a derivative financial instrument, but to actual choices or
opportunities of which a business may take advantage or may realize. For example, investing in a new manufacturing
facility may provide a company with real options of introducing new products, consolidating operations or making
other adjustments to changing market conditions. In the course of making the decision to invest in the new facility, the
company should consider of the real option value the facility provides. Other examples of real options include
possibilities for mergers and acquisitions (M&A) or joint ventures. The precise value of real options can be difficult to
establish or estimate. Real option value may be realized from a company undertaking socially responsible projects, such
as building a community center. By doing so, the company may realize a goodwill benefit that makes it easier to obtain
necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits.
In dealing with such real options, a company’s management team factors potential real option value into the decision-
making process, even though the value is necessarily somewhat vague and uncertain.

Understanding the Basis of Real Options Reasoning Real options reasoning is a heuristic – a rule of thumb allowing for
flexibility and quick decisions in a complex, ever-changing environment – based on logical financial choices. The real
options heuristic is simply the recognition of the value of flexibility and alternatives despite the fact that their value
cannot be mathematically quantified with any certainty.

Thus, real options reasoning is based on logical financial options in the sense that those financial options create a
certain amount of valuable flexibility. Having financial options affords the freedom to make optimal choices in
decisions, such as when and where to make a specific capital expenditure. Various management choices to make
investments can give companies real options to take additional actions in the future, based on existing market
conditions. In short, real options are about companies making decisions and choices that grant them the greatest
amount of flexibility and potential benefit in regard to possible future decisions or choices.

Expansion Option Expansion option is an embedded option that allows the firm that purchased a real option, which is a
right to undertake certain actions, to expand its operations in the future at little or no cost. An expansion option, unlike
typical options that obtain their value from an underlying security, receives its worth from the flexibility it provides to a
company. Once the initial stage of a capital project has been implemented, an expansion option holder can decide
whether to move forward with the project. In terms of real estate, expansion options provide tenants with the choice
to add more space to their living premises.

BREAKING DOWN 'Expansion Option' For example, if a company is unsure as to whether or not its newly introduced
product will be successful in the market, it can purchase an expansion option. The expansion option will allow the firm
to assess the economic environment in the future and determine whether it is profitable to continue developing the
particular product. If the firm initially expected to produce 1,000 units five years, exercising the expansion option would
let them purchase additional equipment to increase capacity for a price which is below market value. If economic
conditions are good and expansion is desirable, the option will be exercised. Otherwise, the expansion option expires.

Back Fee A payment made to the writer of a compound option in the case that the call option is exercised in order to
obtain a put option. Back fee is a premium charged at the second portion of the option, since a compound option is an
option to purchase an option.

BREAKING DOWN 'Back Fee' Compound options are most commonly used by mortgage originators as a way to mitigate
risk. The back fee is offered at a premium, because it provides an investor with the ability to wait before executing an
option. Call On A Put. One of the four types of compound options, this is a call option on an underlying put option. If
the option owner exercises the call option, he or she receives a put option, which is an option that gives the owner the
right but not the obligation to sell a specific asset at a set price within a defined time period. The value of a call on a put
changes in inverse proportion to the stock price, i.e. it decreases as the stock price increases, and increases as the stock
price decreases. Also known as a split-fee option.

BREAKING DOWN 'Call On A Put'. A call on a put will have therefore two strike prices and two expiration dates, one for
the call option and the other for the underlying put option. As well, there are two option premiums involved; the initial
premium is paid upfront for the call option; the additional premium is only paid if the call option is exercised and the
option owner receives the put option. The premium in this case would generally be higher than if the option owner had
only purchased the underlying put option to begin with. For example, consider a U.S. company that is bidding on a
contract for a European project; if the company's bid is successful, it would receive say 10 million euros upon project
completion in one year's time. The company is concerned about the exchange risk posed to it by the weaker euro if it
wins the project. Buying a put option on 10 million euros expiring in one year would involve significant expense for a
risk that is as yet uncertain (since the company is not sure that it would be awarded the bid). Therefore, one hedging
strategy the company could use would be to buy, for example, a two-month call on a one-year put on the euro
(contract amount of 10 million euros). The premium in this case would be significantly lower than it would be if it had
instead purchased the one-year put option on the 10 million euros outright. On the two-month expiry date of the call
option, the company has two alternatives to consider. If it has won the project contract or is in a winning position, and
still desires to hedge its currency risk, it can exercise the call option and obtain the put option on 10 million euros. Note
that the put option will now have ten months (i.e. 12 - 2 months) left to expiry. On the other hand, if the company does
not win the contract, or no longer wishes to hedge currency risk, it can let the call option expire unexercised and walk
away.

Option Class.The set of all the call options or all the put options for a particular stock, index fund, or futures security on
a listed exchange. The number of options available for purchase or sale within a given option class will depend on the
size and trading volume of the underlying company or index, as well as overall market conditions.

BREAKING DOWN 'Option Class'. An options class can be studied as a gauge of investor sentiment for a given security,
as activity in the all of the calls (options to buy) or all of the puts (options to sell) along with premium values signify
investors' bets on future price activity. With the advent of LEAPs, these evaluations can go out as far as a year, or more.
A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity
or other instrument at a specified price within a specific time period. It may help you to remember that a call option
gives you the right to call in, or buy, an asset. You profit on a call when the underlying asset increases in price.

BREAKING DOWN 'Call Option' Call options are typically used by investors for three primary purposes. These are tax
management, income generation and speculation. In the money means that a call option's strike price is below the
market price of the underlying asset or that the strike price of a put option is above the market price of the underlying
asset. Being in the money does not mean you will profit, it just means the option is worth exercising. This is because the
option costs money to buy.

BREAKING DOWN 'In The Money' In the money means that your stock option is worth money and you can turn around
and sell or exercise it. For example, if John buys a call optionon ABC stock with a strike price of $12, and the price of the
stock is sitting at $15, the option is considered to be in the money. This is because the option gives John the right to buy
the stock for $12 but he could immediately sell the stock for $15, a gain of $3. If John paid $3.50 for the call, then he
wouldn't actually profit from the total trade, but it is still considered in the money. An option is a financial derivative
that represents a contract sold by one party (the option writer) to another party (the option holder). The contract
offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an
agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

BREAKING DOWN 'Option' Options are extremely versatile securities. Traders use options to speculate, which is a
relatively risky practice. Others use options to reduce the risk of holding an asset. In terms of speculation, option buyers
and writers have conflicting views regarding the outlook on the performance of an underlying security.

Mid-Atlantic Option. An option that can be exercised at different times during the life of the option. The various times
set for exercise are written within the option and allow for flexibility for both the writer and holder of the option.

BREAKING DOWN 'Mid-Atlantic Option' The Mid-Atlantic option is named as such because its exercise dates are more
flexible than European options and less flexible than American options. Thus, it is in the middle, just like the Atlantic
Ocean is between Europe and America. Mid-Atlantic options are also referred to as Bermuda, Quasi American, or Semi-
American options.

Step Premium. A type of option where the cost of purchasing the option is paid gradually as the strike approaches
instead of when the trade is initiated. The options contract spells out how much premium must be paid and when. A
step premium option is more expensive than a plain vanilla in-the-money option, but less expensive than a contingent
premium option. With the latter, the investor does not pay a premium if the option expires out of the money.

BREAKING DOWN 'Step Premium' A step premium option is considered a structured option. A wide variety of options
exist to meet different investment needs, and their premiums reflect the unique risks and rewards associated with each
type of option. Investors like options because they offer a cost-efficient way to invest in an underlying asset, they can
reduce investment risk when used correctly, they allow the potential for higher percentage returns by using leverage
and they provide the flexibility to develop numerous trading strategies.
Real options valuation, also often termed real options analysis,[1] (ROV or ROA) applies option valuation techniques to
capital budgeting decisions.[2] A real option itself, is the right—but not the obligation—to undertake certain business
initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example,
the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put
option, respectively. Real options are generally distinguished from conventional financial options in that they are not
typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial
security.[3] A further distinction is that option holders here, i.e. management, can directly influence the value of the
option's underlying project; whereas this is not a consideration as regards the underlying security of a financial option.
Moreover, management can not lookup for a volatility as uncertainty, instead their perceived uncertainty matters in
real options reasonings. Unlike financial options, management also have to create or discover real options, and such
creation and discovery process comprises an entrepreneurial or business task. Real options are most valuable when
uncertainty is high; management has significant flexibility to change the course of the project in a favourable direction
and is willing to exercise the options.[4] Real options analysis, as a discipline, extends from its application in corporate
finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to
"real-life" decisions. For example, R&D managers can use Real Options Valuation to help them allocate their R&D
budget among diverse projects; a non business example might be the decision to join the work force, or rather, to forgo
several years of income to attend graduate school.[5] It, thus, forces decision makers to be explicit about the
assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business
strategy formulation.[6][7] This extension of real options to real-world projects often requires customized decision
support systems, because otherwise the complex compound real options will become too intractable to handle.[8]

Types of real option[edit] Investment; This simple example shows the relevance of the real option to delay investment
and wait for further information, and is adapted from "Investment Example"..

Consider a firm that has the option to invest in a new factory. It can invest this year or next year. The question is: when
should the firm invest? If the firm invests this year, it has an income stream earlier. But, if it invests next year, the firm
obtains further information about the state of the economy, which can prevent it from investing with losses.

The firm knows its discounted cash flows if it invests this year: 5M. If it invests next year, the discounted cash flows are
6M with a 66.7% probability, and 3M€ with a 33.3% probability. Assuming a risk neutral rate of 10%, future discounted
cash flows are, in present terms, 5.45M and 2.73M, respectively. The investment cost is 4M. If the firm invests next
year, the present value of the investment cost is 3.63M.

Following the net present value rule for investment, the firm should invest this year because the discounted cash
flows(5M) are greater than the investment costs (4M) by 1M. Yet, if the firm waits for next year, it only invests if
discounted cash flows do not decrease. If discounted cash flows decrease to 3M€, then investment is no longer
profitable. If, they grow to 6M, then the firm invests. This implies that the firm invests next year with a 66.7%
probability and earns 5.45M - 3.63M if it does invest. Thus the value to invest next year is 1.21M. Given that the value
to invest next year exceeds the value to invest this year, the firm should wait for further information to prevent losses.
This simple example shows how the net present value may lead the firm to take unnecessary risk, which could be
prevented by real options valuation. Staged Investment Staged investments are quite often in the pharmaceutical,
mineral, and oil industries. In this example, it is studied a staged investment abroad in which a firm decides whether to
open one or two stores in a foreign country. This is adapted from "Staged Investment Example".. The firm does not
know how well its stores are accepted in a foreign country. If their stores have high demand, the discounted cash flows
per store is 10M. If their stores have low demand, the discounted cash flows per store is 5M. Assuming that the
probability of both events is 50%, the expected discounted cash flows per store is 7.5M. It is also known that if the
store's demand is independent of the store: if one store has high demand, the other also has high demand. The risk
neutral rate is 10%. The investment cost per store is 8M. Should the firm invest in one store, two stores, or not invest?
The net present value suggests the firm should not invest: the net present value is -0.5M per store. But is it the best
alternative? Following real options valuation, it is not: the firm has the real option to open one store this year, wait a
year to know its demand, and invest in the new store next year if demand is high. By opening one store, the firm knows
that the probability of high demand is 50%. The potential value gain to expand next year is thus 50%*(10M-8M)/1.1 =
0.91M. The value to open one store this year is 7.5M - 8M = -0.5. Thus the value of the real option to invest in one
store, wait a year, and invest next year is 0.41M. Given this, the firm should opt by opening one store. This simple
example shows that a negative net present value does not imply that the firm should not invest. The flexibility available
to management – i.e. the actual "real options" – generically, will relate to project size, project timing, and the operation
of the project once established.[9] In all cases, any (non-recoverable) upfront expenditure related to this flexibility is
the option premium. Real options are also commonly applied to stock valuation - see Business valuation #Option
pricing approaches - as well as to various other "Applications" referenced below.

Options relating to project size[edit] Where the project's scope is uncertain, flexibility as to the size of the relevant
facilities is valuable, and constitutes optionality.[10] Option to expand: Here the project is built with capacity in excess
of the expected level of output so that it can produce at higher rate if needed. Management then has the option (but
not the obligation) to expand – i.e. exercise the option – should conditions turn out to be favourable. A project with the
option to expand will cost more to establish, the excess being the option premium, but is worth more than the same
without the possibility of expansion. This is equivalent to a call option. Option to contract : The project is engineered
such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future
expenditures constitutes option exercise. This is the equivalent to a put option, and again, the excess upfront
expenditure is the option premium. Option to expand or contract: Here the project is designed such that its operation
can be dynamically turned on and off. Management may shut down part or all of the operation when conditions are
unfavourable (a put option), and may restart operations when conditions improve (a call option). A flexible
manufacturing system(FMS) is a good example of this type of option. This option is also known as a Switching option.

Options relating to project life and timing[edit] Where there is uncertainty as to when, and how, business or other
conditions will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality.
Growth options are perhaps the most generic in this category – these entail the option to exercise only those projects
that appear to be profitable at the time of initiation. Initiation or deferment options: Here management has flexibility
as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until
market conditions are favorable. This constitutes an American styled call option. Option to abandon: Management may
have the option to cease a project during its life, and, possibly, to realise its salvage value. Here, when the present
value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the
exercising of a put option. This option is also known as a Termination option. Abandonment options are American
styled. Sequencing options: This option is related to the initiation option above, although entails flexibility as to the
timing of more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these
sequentially or in parallel. Here, observing the outcomes relating to the first project, the firm can resolve some of the
uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the
development of the other projects. If taken in parallel, management would have already spent the resources and the
value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy.
Related here is also the notion of Intraproject vs. Interproject options.

Options relating to project operation[edit] Management may have flexibility relating to the product produced and /or
the process used in manufacture. This flexibility constitutes optionality. Output mix options: The option to produce
different outputs from the same facility is known as an output mix option or product flexibility. These options are
particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good
are typically low, and management would wish to change to a different product quickly if required. Input mix options:
An input mix option – process flexibility – allows management to use different inputs to produce the same output as
appropriate. For example, a farmer will value the option to switch between various feed sources, preferring to use the
cheapest acceptable alternative. An electric utility, for example, may have the option to switch between various fuel
sources to produce electricity, and therefore a flexible plant, although more expensive may actually be more valuable.
Operating scale options: Management may have the option to change the output rate per unit of time or to change the
total length of production run time, for example in response to market conditions. These options are also known as
Intensity options. Given the above, it is clear that there is an analogy between real options and financial options,[11]
and we would therefore expect options-based modelling and analysis to be applied here. At the same time, it is
nevertheless important to understand why the more standard valuation techniques may not be applicable for ROV.[2]

Applicability of standard techniques[edit] ROV is often contrasted with more standard techniques of capital budgeting,
such as discounted cash flow (DCF) analysis / net present value (NPV).[2] Under this "standard" NPV approach, future
expected cash flows are present valued under the empirical probability measure at a discount rate that reflects the
embedded risk in the project; see CAPM, APT, WACC. Here, only the expected cash flows are considered, and the
"flexibility" to alter corporate strategy in view of actual market realizations is "ignored"; see below as well as Valuing
flexibility under Corporate finance. The NPV framework (implicitly) assumes that management is "passive" with regard
to their Capital Investment once committed. Some analysts account for this uncertainty by adjusting the discount rate,
e.g. by increasing the cost of capital, or the cash flows, e.g. using certainty equivalents, or applying (subjective)
"haircuts" to the forecast numbers, or via probability-weighting as in rNPV.[12][13][14] Even when employed, however,
these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to
appropriately adapt the risk adjustment.[15] By contrast, ROV assumes that management is "active" and can
"continuously" respond to market changes. Real options consider each and every scenario and indicate the best
corporate action in any of these contingent events.[16] Because management adapts to each negative outcome by
decreasing its exposure and to positive scenarios by scaling up, the firm benefits from uncertainty in the underlying
market, achieving a lower variability of profits than under the commitment/NPV stance. The contingent nature of
future profits in real option models is captured by employing the techniques developed for financial options in the
literature on contingent claims analysis. Here the approach, known as risk-neutral valuation, consists in adjusting the
probability distribution for risk consideration, while discounting at the risk-free rate. This technique is also known as
the certainty-equivalent or martingale approach, and uses a risk-neutral measure. For technical considerations here,
see below. Given these different treatments, the real options value of a project is typically higher than the NPV – and
the difference will be most marked in projects with major flexibility, contingency, and volatility.[17] (As for financial
options higher volatility of the underlying leads to higher value).

Options based valuation[edit] Although there is much similarity between the modelling of real options and financial
options,[11][18] ROV is distinguished from the latter, in that it takes into account uncertainty about the future
evolution of the parameters that determine the value of the project, coupled with management's ability to respond to
the evolution of these parameters.[19][20] It is the combined effect of these that makes ROV technically more
challenging than its alternatives. First, you must figure out the full range of possible values for the underlying asset....
This involves estimating what the asset's value would be if it existed today and forecasting to see the full set of possible
future values... [These] calculations provide you with numbers for all the possible future values of the option at the
various points where a decision is needed on whether to continue with the project...[18]When valuing the real option,
the analyst must therefore consider the inputs to the valuation, the valuation method employed, and whether any
technical limitations may apply.

Valuation inputs[edit] Given the similarity in valuation approach, the inputs required for modelling the real option
correspond, generically, to those required for a financial option valuation.[11][18][19] The specific application, though,
is as follows: The option's underlying is the project in question – it is modelled in terms of: Spot price: the starting or
current value of the project is required: this is usually based on management's "best guess" as to the gross value of the
project's cash flows and resultant NPV; Volatility: a measure for uncertainty as to the change in value over time is
required: the volatility in project value is generally used, usually derived via monte carlo simulation;[19][21] sometimes
the volatility of the first period's cash flows are preferred;[20]see further under Corporate finance for a discussion
relating to the estimation of NPV and project volatility. some analysts substitute a listed security as a proxy, using either
its price volatility (historical volatility), or, if options exist on this security, their implied volatility.[1] Dividends
generated by the underlying asset: As part of a project, the dividend equates to any income which could be derived
from real assets and paid to the owner. These reduce the appreciation of the asset. Option characteristics: Strike price:
this corresponds to any (non-recoverable) investment outlays, typically the prospective costs of the project. In general,
management would proceed (i.e. the option would be in the money) given that the present value of expected cash
flows exceeds this amount; Option term: the time during which management may decide to act, or not act,
corresponds to the life of the option. As above, examples include the time to expiry of a patent, or of the mineral rights
for a new mine. See Option time value. Note though that given the flexibility related to timing as described, caution
must be applied here. Option style and option exercise. Management's ability to respond to changes in value is
modeled at each decision point as a series of options, as above these may comprise, i.a.: the option to contract the
project (an American styled put option); the option to abandon the project (also an American put); the option to
expand or extend the project (both American styled call options); switching options or composite options which may
also apply to the project.
Valuation methods[edit] The valuation methods usually employed, likewise, are adapted from techniques developed
for valuing financial options.[22][23] Note though that, in general, while most "real" problems allow for American style
exercise at any point (many points) in the project's life and are impacted by multiple underlying variables, the standard
methods are limited either with regard to dimensionality, to early exercise, or to both. In selecting a model, therefore,
analysts must make a trade off between these considerations; see Option (finance) #Model implementation. The model
must also be flexible enough to allow for the relevant decision rule to be coded appropriately at each decision point.
Closed form, Black–Scholes-like solutions are sometimes employed.[20] These are applicable only for European styled
options or perpetual American options. Note that this application of Black–Scholes assumes constant — i.e.
deterministic — costs: in cases where the project's costs, like its revenue, are also assumed stochastic, then Margrabe's
formula can (should) be applied instead,[24][25] here valuing the option to "exchange" expenses for revenue.
(Relatedly, where the project is exposed to two (or more) uncertainties — e.g. for natural resources, price and quantity
— some analysts attempt to use an overall volatility; this, though, is more correctly treated as a rainbow
option,[20]typically valued using simulation as below.).The most commonly employed methods are binomial
lattices.[17][23] These are more widely used given that most real options are American styled. Additionally, and
particularly, lattice-based models allow for flexibility as to exercise, where the relevant, and differing, rules may be
encoded at each node.[18] Note that lattices cannot readily handle high-dimensional problems; treating the project's
costs as stochastic would add (at least) one dimension to the lattice, increasing the number of ending-nodes by the
square (the exponent here, corresponding to the number of sources of uncertainty). Specialised Monte Carlo Methods
have also been developed and are increasingly, and especially, applied to high-dimensional problems.[26] Note that for
American styled real options, this application is somewhat more complex; although recent research[27] combines a
least squares approach with simulation, allowing for the valuation of real options which are both multidimensional and
American styled; see Monte Carlo methods for option pricing #Least Square Monte Carlo. When the Real Option can be
modelled using a partial differential equation, then Finite difference methods for option pricing are sometimes applied.
Although many of the early ROV articles discussed this method,[28] its use is relatively uncommon today—particularly
amongst practitioners—due to the required mathematical sophistication; these too cannot readily be used for high-
dimensional problems. Various other methods, aimed mainly at practitioners, have been developed for real option
valuation. These typically use cash-flow scenarios for the projection of the future pay-off distribution, and are not
based on restricting assumptions similar to those that underlie the closed form (or even numeric) solutions discussed.
The most recent additions include the Datar–Mathews method[29][30] and the fuzzy pay-off
method.[31];Limitations[edit] The relevance of Real options, even as a thought framework, may be limited due to
market, organizational and / or technical considerations.[32] When the framework is employed, therefore, the analyst
must first ensure that ROV is relevant to the project in question. These considerations are as below.

Market characteristics[edit] As discussed above, the market and environment underlying the project must be one
where "change is most evident", and the "source, trends and evolution" in product demand and supply, create the
"flexibility, contingency, and volatility" [17] which result in optionality. Without this, the NPV framework would be
more relevant.

Organizational considerations[edit] Real options are "particularly important for businesses with a few key
characteristics",[17] and may be less relevant otherwise.[20] In overview, it is important to consider the following in
determining that the RO framework is applicable: Corporate strategy has to be adaptive to contingent events. Some
corporations face organizational rigidities and are unable to react to market changes; in this case, the NPV approach is
appropriate. Practically, the business must be positioned such that it has appropriate information flow, and
opportunities to act. This will often be a market leader and / or a firm enjoying economies of scale and scope.
Management must understand options, be able to identify and create them, and appropriately exercise them.[8] This
contrasts with business leaders focused on maintaining the status quo and / or near-term accounting earnings. The
financial position of the business must be such that it has the ability to fund the project as, and when, required (i.e.
issue shares, absorb further debt and / or use internally generated cash flow); see Financial statement analysis.
Management must, correspondingly, have appropriate access to this capital. Management must be in the position to
exercise, in so far as some real options are proprietary (owned or exercisable by a single individual or a company) while
others are shared (can (only) be exercised by many parties).

Technical considerations[edit] Limitations as to the use of these models arise due to the contrast between Real Options
and financial options, for which these were originally developed. The main difference is that the underlying is often not
tradable – e.g. the factory owner cannot easily sell the factory upon which he has the option. Additionally, the real
option itself may also not be tradeable – e.g. the factory owner cannot sell the right to extend his factory to another
party, only he can make this decision (some real options, however, can be sold, e.g., ownership of a vacant lot of land is
a real option to develop that land in the future). Even where a market exists – for the underlying or for the option – in
most cases there is limited (or no) market liquidity. Finally, even if the firm can actively adapt to market changes, it
remains to determine the right paradigm to discount future claims

The difficulties, are then: As above, data issues arise as far as estimating key model inputs. Here, since the value or
price of the underlying cannot be (directly) observed, there will always be some (much) uncertainty as to its value (i.e.
spot price) and volatility (further complicated by uncertainty as to management's actions in the future). It is often
difficult to capture the rules relating to exercise, and consequent actions by management. Further, a project may have
a portfolio of embedded real options, some of which may be mutually exclusive.[8] Theoretical difficulties, which are
more serious, may also arise.[33] Option pricing models are built on rational pricing logic. Here, essentially: (a) it is
presupposed that one can create a "hedged portfolio" comprising one option and "delta" shares of the underlying. (b)
Arbitrage arguments then allow for the option's price to be estimated today; see Rational pricing #Delta hedging. (c)
When hedging of this sort is possible, since delta hedging and risk neutral pricing are mathematically identical, then risk
neutral valuation may be applied, as is the case with most option pricing models. (d) Under ROV however, the option
and (usually) its underlying are clearly not traded, and forming a hedging portfolio would be difficult, if not impossible.
Standard option models: (a) Assume that the risk characteristics of the underlying do not change over the life of the
option, usually expressed via a constant volatility assumption. (b) Hence a standard, risk free rate may be applied as the
discount rate at each decision point, allowing for risk neutral valuation. Under ROV, however: (a) managements' actions
actually change the risk characteristics of the project in question, and hence (b) the Required rate of return could differ
depending on what state was realised, and a premium over risk free would be required, invalidating (technically) the
risk neutrality assumption. These issues are addressed via several interrelated assumptions: As discussed above, the
data issues are usually addressed using a simulation of the project, or a listed proxy. Various new methods – see for
example those described above – also address these issues. Also as above, specific exercise rules can often be
accommodated by coding these in a bespoke binomial tree; see:.[18] The theoretical issues: To use standard option
pricing models here, despite the difficulties relating to rational pricing, practitioners adopt the "fiction" that the real
option and the underlying project are both traded: the so called, Marketed Asset Disclaimer (MAD) approach. Although
this is a strong assumption, it is pointed out that, interestingly, a similar fiction in fact underpins standard NPV / DCF
valuation (and using simulation as above). See:[1] and.[18] To address the fact that changing characteristics invalidate
the use of a constant discount rate, some analysts use the "replicating portfolio approach", as opposed to Risk neutral
valuation, and modify their models correspondingly.[18][25] Under this approach, (a) we "replicate" the cash flows on
the option by holding a risk free bond and the underlying in the correct proportions. Then, (b) since the cash flows of
the option and the portfolio will always be identical, by arbitrage arguments their values may (must) be equated today,
and (c) no discounting is required.

History[edit] Whereas business managers have been making capital investment decisions for centuries, the term "real
option" is relatively new, and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977.
It is interesting to note though, that in 1930, Irving Fisher wrote explicitly of the "options" available to a business owner
(The Theory of Interest, II.VIII). The description of such opportunities as "real options", however, followed on the
development of analytical techniques for financial options, such as Black–Scholes in 1973. As such, the term "real
option" is closely tied to these option methods. Real options are today an active field of academic research. Professor
Lenos Trigeorgis has been a leading name for many years, publishing several influential books and academic articles.
Other pioneering academics in the field include Professors Eduardo Schwartz, Graham Davis, Gonzalo Cortazar, Michael
Brennan, Han Smit, Avinash Dixitand Robert Pindyck (the latter two, authoring the pioneering text in the discipline). An
academic conference on real options is organized yearly (Annual International Conference on Real Options). Amongst
others, the concept was "popularized" by Michael J. Mauboussin, then chief U.S. investment strategist for Credit Suisse
First Boston.[17] He uses real options to explain the gap between how the stock market prices some businesses and the
"intrinsic value" for those businesses. Trigeorgis also has broadened exposure to real options through layman articles in
publications such as The Wall Street Journal.[16] This popularization is such that ROV is now a standard offering in
postgraduate finance degrees, and often, even in MBA curricula at many Business Schools. Recently, real options have
been employed in business strategy, both for valuation purposes and as a conceptual framework.[6][7] The idea of
treating strategic investments as options was popularized by Timothy Luehrman [34] in two HBR articles:[11] "In
financial terms, a business strategy is much more like a series of options, than a series of static cash flows". Investment
opportunities are plotted in an "option space" with dimensions "volatility" & value-to-cost ("NPVq"). Luehrman also co-
authored with William Teichner a Harvard Business School case study, Arundel Partners: The Sequel Project, in 1992,
which may have been the first business school case study to teach ROV.[35] Interestingly, and reflecting the
"mainstreaming" of ROV, Professor Robert C. Merton discussed the essential points of Arundel in his Nobel Prize
Lecture in 1997.[36] Arundel involves a group of investors that is considering acquiring the sequel rights to a portfolio
of yet-to-be released feature films. In particular, the investors must determine the value of the sequel rights before any
of the first films are produced. Here, the investors face two main choices. They can produce an original movie and
sequel at the same time or they can wait to decide on a sequel after the original film is released. The second approach,
he states, provides the option not to make a sequel in the event the original movie is not successful. This real option
has economic worth and can be valued monetarily using an option-pricing model. See Option (filmmaking).

What is 'Working Capital Management' Working capital management refers to a company's managerial accounting
strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities,
to ensure the most financially efficient operation of the company. The primary purpose of working capital management
is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-
term debt obligations.

BREAKING DOWN 'Working Capital Management' Working capital management commonly involves monitoring cash
flow, assets and liabilities through ratio analysis of key elements of operating expenses, including the working capital
ratio, collection ratio and the inventory turnover ratio. Efficient working capital management helps with a company's
smooth financial operation, and can also help to improve the company's earnings and profitability. Management of
working capital includes inventory management and management of accounts receivables and accounts payables.

Elements of Working Capital Management The working capital ratio, calculated as current assets divided by current
liabilities, is considered a key indicator of a company's fundamental financial health since it indicates the company's
ability to successfully meet all of its short-term financial obligations. Although numbers vary by industry, a working
capital ratio below 1.0 is generally indicative of a company having trouble meeting short-term obligations, usually due
to insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may
indicate a company is not making the most effective use of its assets to increase revenues. The collection ratio, also
known as the average collection period ratio, is a principal measure of how efficiently a company manages its accounts
receivables. The collection ratio is calculated as the number of days in an accounting period, such as one month,
multiplied by the average amount of outstanding accounts receivables, with that total then divided by the total amount
of net credit sales during the accounting period. The collection ratio calculation provides the average number of days it
takes a company to receive payment, in other words, to convert sales into cash. The lower a company's collection ratio,
the more efficient its cash flow. The final element of working capital management is inventory management. To
operate with maximum efficiency and maintain a comfortably high level of working capital, a company has to carefully
balance sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up
working capital for a long period of time before it is converted into cash. Companies typically measure how efficiently
that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as
revenues divided by inventory cost, reveals how rapidly a company's inventory is being sold and replenished. A
relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high
ratio indicates the efficiency of inventory ordering can be improved. Efficiency Ratio; The efficiency ratio is typically
used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the
turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory
and machinery. This ratio can also be used to track and analyze the performance of commercial and investment banks.
BREAKING DOWN 'Efficiency Ratio'Analysts use efficiency ratios, also known as activity ratios, to measure the
performance of a company's short-term or current performance. All of these ratios use numbers in a company's current
assets or current liabilities, quantifying the operations of the business.

An efficiency ratio measures a company's ability to use its assets to generate income. For example, an efficiency ratio
often looks at aspects of the company, such as the time it takes to collect cash from customers or the amount of time it
takes to convert inventory to cash. This makes efficiency ratios important, because an improvement in the efficiency
ratios usually translates to improved profitability.These ratios can be compared to peers in the same industry and can
identify businesses that are better managed relative to the others. Some common efficiency ratios are accounts
receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and
stock turnover ratio. Efficiency Ratios for Banks The efficiency ratio also applies to banks. For example, a bank efficiency
ratio measures a bank's overhead as a percentage of its revenue. Like the efficiency ratios above, this allows analysts to
assess the performance of commercial and investment banks. For a bank, an efficiency ratio is an easy way to measure
the ability to turn assets into revenue. Since a bank's operating expenses are in the numerator and its revenue is in the
denominator, a lower efficiency ratio means that a bank is operating better. I's believed that a ratio of 50% is the
maximum optimal efficiency ratio. If the efficiency ratio increases, it means a bank's expenses are increasing or its
revenues are decreasing. An Example of Efficiency Ratio For example, Bankwell Financial Group Inc. reported second
quarter 2016 earnings on July 27, 2016. The report stated that the financial group had an efficiency ratio of 57.1%,
which was lower than the 63.2% ratio it reported for the same quarter in 2015. This means the company's operations
became more efficient; it increased its assets by $80 million for the quarter.

Activity Ratios; Activity ratios measure a firm's ability to convert different accounts within its balance sheets into cash
or sales. Activity ratios measure the relative efficiency of a firm based on its use of its assets, leverage or other such
balance sheet items and are important in determining whether a company's management is doing a good enough job
of generating revenues and cash from its resources.

BREAKING DOWN 'Activity Ratios' Companies typically try to turn their production into cash or sales as fast as possible
because this will generally lead to higher revenues, so analysts perform fundamental analysis by using common ratios
such as the total assets turnover ratio and inventory turnover.

Activity ratios measure the amount of resources invested in a company's collection and inventory management.
Because businesses typically operate using materials, inventory and debtors, activity ratios determine how well an
organization manages these areas. Activity ratios are one major category in which a ratio may be classified; other ratios
may be classified as measurements of liquidity, profitability or leverage. Activity ratios gauge an organization's
operational efficiency and profitability. Activity ratios are most useful when compared to competitor or industry to
establish whether an entity's processes are favorable or unfavorable. Activity ratios can form a basis of comparison
across multiple reporting periods to determine changes over time. The following activity ratios may be analyzed as
some of an organization's key performance indicators. Accounts Receivable Turnover Ratio The accounts receivable
turnover ratio determines an entity's ability to collect money from its customers. Total credit sales are divided by the
average accounts receivable balance for a specific period. This activity ratio calculates management's ability to receive
cash. A low ratio suggests a deficiency in the collection process. Merchandise Inventory Turnover Ratio The
merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting period.
The cost of goods sold is divided by the average inventory for a specific period. Higher calculations indicate inventory is
quickly converted into sales and cash. A useful way to use this activity ratio is to compare it to previous periods. Total
Assets Turnover Ratio The total assets turnover ratio take a look at how efficiently an entity uses its assets to make a
sale. Total sales are divided by total assets to see how proficient a business is at using its assets. Smaller ratios may
indicate that the company is holding higher levels of inventory instead of selling. Efficiency Ratio Activity Ratios Days
Working Capital Current Ratio Ratio Analysis Days Sales Of Inventory – DSI Cash Asset Ratio Gross Working Capital
Receivables Turnover Ratio Days Working Capital. Days working capital is an accounting and finance term used to
describe how many days it takes for a company to convert its working capital into revenue. It can be used in ratio and
fundamental analysis. When utilizing any ratio, it is important to consider how the company compares to similar
companies in the same industry. BREAKING DOWN 'Days Working Capital'

Working capital is a measure of liquidity, and days working capital is a measure that helps to quantify this liquidity. The
more days a company has of working capital, the more time it takes to convert that working capital into sales. In other
words, a high number is indicative of an inefficient company and vice versa.

Working Capital Working capital is calculated by subtracting current liabilities from current assets. Current assets
include cash, marketable securities, inventory, accounts receivable and other short-term assets to be used within the
year. Current liabilities include accounts payable and the current portion of long-term debt. These are debts that are
due within the year. The difference between the two represents the company's short-term need for, or surplus of, cash.
A positive working capital balance means current assets cover current liabilities. A negative working capital balance
means current liabilities are more than current assets.

Current Ratio. The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term
obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and
illiquid) relative to that company’s current total liabilities. The formula for calculating a company’s current ratio is:
Current Ratio = Current Assets / Current Liabilities. The current ratio is called “current” because, unlike some other
liquidity ratios, it incorporates all current assets and liabilities. The current ratio is also known as the working capital
ratio. BREAKING DOWN 'Current Ratio'

The current ratio is mainly used to give an idea of a company's ability to pay back its liabilities (debt and accounts
payable) with its assets (cash, marketable securities, inventory, accounts receivable). As such, current ratio can be used
to make a rough estimate of a company’s financial health. The current ratio can give a sense of the efficiency of a
company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their
receivables or that have high inventory turnover can run into liquidity problems if they are unable to alleviate their
obligations. A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its
efficiency, liquidity, profitability and solvency. Ratio analysis is a cornerstone of fundamental analysis.BREAKING DOWN
'Ratio Analysis' When investors and analysts talk about fundamental or quantitative analysis, they are usually referring
to ratio analysis. Ratio analysis involves evaluating the performance and financial health of a company by using data
from the current and historical financial statements. The data retrieved from the statements is used to - compare a
company's performance over time to assess whether the company is improving or deteriorating; compare a company's
financial standing with the industry average; or compare a company to one or more other companies operating in its
sector to see how the company stacks up. The days sales of inventory value (DSI) is a financial measure of a company's
performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are
a work in progress, if applicable) into sales. Generally, a lower (or shorter) DSI is preferred, but it is important to note
that the average DSI varies from one industry to another. The DSI is calculated as:

Days sales of inventory is also referred to as days inventory outstanding (DIO), days in inventory (DII) or, simply, days
inventory. BREAKING DOWN 'Days Sales Of Inventory - DSI' Days sales of inventory, or days inventory, is one part of the
cash conversion cycle, which represents the process of turning raw materials into cash. The days sales of inventory is
the first stage in that process. The other two stages are days sales outstanding (DSO) and days payable outstanding
(DPO). DSO measures how long it takes a company to receive payment on accounts receivable, while the DPO measures
how long it takes a company to pay off its accounts payable.

Cash Asset Ratio. The cash asset ratio is the current value of marketable securities and cash, divided by the company's
current liabilities. Also known as the cash ratio, the cash asset ratio compares the dollar amount of highly liquid assets
(such as cash and marketable securities) for every one dollar of short-term liabilities. This figure is used to measure a
firm's liquidity or its ability to pay its short-term obligations. Ideal ratios will be different for different industries and for
different sizes of corporations, and for many other reasons. BREAKING DOWN 'Cash Asset Ratio'. The cash asset ratio is
similar to the current ratio, except that the current ratio includes current assets such as inventories in the numerator.
Some analysts believe that including current assets makes it difficult to convert them into usable funds for debt
obligations. The cash asset ratio is a much more accurate measure of a firm's liquidity.

For example, if a firm had $130,000 in marketable securities, $110,000 in cash and $200,000 in current liabilities, the
cash asset ratio would be (130,000+110,000)/200,000 = 1.20. Ratios greater than 1 demonstrate a firm's ability to cover
its current debt, but ratios that are too high might indicate that a company is not allocating enough resources to grow
its business.

Gross Working Capital. Gross working capital is the sum of all of a company's current assets (assets that are convertible
to cash within a year or less). Gross working capital includes assets such as cash, accounts receivable, inventory, short-
term investments and marketable securities. Gross working capital less current liabilities is equal to net working capital,
or simply "working capital," a more useful measure for balance sheet analysis.
BREAKING DOWN 'Gross Working Capital'. Gross working capital, in practice, is not useful. It is just one half of a picture
of a company's short-term financial health and ability to use short-term resources efficiently. The other half is current
liabilities. Gross working capital, or current assets, less current liabilities equate to working capital. When working
capital is positive, it means that current assets are greater than current liabilities. The preferred way to express positive
working capital is the ratio of current assets to current liabilities (i.e., > 1.0). If this ratio is not greater than 1.0, then it
may have trouble paying back its creditors in the short-term, whether a bank or supplier or other party to which the
company has financial obligations. Negative working capital may a sign of distress that could grow. Perhaps the
underlying problem is a decline in sales, which would reduce accounts receivable or force an accumulation in the
accounts payable account (part of current liabilities) as the company finds it more difficult to pay its bills on time. The
receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in
collecting debts on that credit. The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses
its assets.

Receivables turnover ratio can be calculated by dividing the net value of credit sales during a given period by the
average accounts receivable during the same period. Average accounts receivable can be calculated by adding the
value of accounts receivable at the beginning of the desired period to their value at the end of the period and dividing
the sum by two.The method for calculating receivables turnover ratio can be represented with the following formula:

The receivables turnover ratio is most often calculated on an annual basis, though it can also be calculated on a
quarterly or monthly basis. Receivable turnover ratio is also often called accounts receivable turnover, the accounts
receivable turnover ratio, or the debtor’s turnover ratio. BREAKING DOWN 'Receivables Turnover Ratio'. In essence, the
receivables turnover ratio indicates the efficiency with which a firm collects on the credit it issues to customers. Firms
that maintain accounts receivables are indirectly extending interest-free loans to their clients since accounts receivable
is money owed without interest. As such, because of the time value of money principle, a firm loses more money the
longer it takes to collect on its credit sales. To provide an example of how to calculate the receivables turnover ratio,
suppose that during 2017 Company A had $800,000 in net credit sales. Also suppose that on the first of January it had
$64,000 accounts receivable and that on December 31 it had $72,000 accounts receivable. With this information, one
could calculate the receivables turnover ratio for 2017 in the following way: average accounts receivable = ($64,000 +
$72,000) / 2 = $68,000 receivables turnover ratio = $800,000 / $68,000 = 11.76. This means that Company A collects its
receivables 11.76 times on average per year. This number also serves as an indicator of the number of accounts
receivable a company collects during a year. One can determine the average duration of accounts receivable during a
given year by dividing 365 by the receivables turnover ratio for that year. For this example, the average accounts
receivable turnover is 365 / 11.76 = 31.04 days. The average customer takes 31 days to pay his or her bills. If the
company had a 30-day policy for when payments should be made, then the average accounts receivable turnover
shows that the average customer makes payments late.

Interpreting 'Receivables Turnover Ratio'. A high receivables turnover ratio can imply a variety of things about a
company. It may suggest that a company operates on a cash basis, for example. It may also indicate that the company’s
collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay
off their debts quickly. A high ratio can also suggest that the company has a conservative policy regarding its extension
of credit. This can often be a good thing, as this filters out customers who may be more likely to take a long time in
paying their debts. On the other hand, a company’s policy may be too conservative if it is too tight in extending credit,
which can drive away potential customers and give business to competitors. In this case, a company may want to
loosen policies to improve business, even though it may reduce its receivables turnover ratio. A low ratio, in a similar
way, can also suggest a few things about a company, such as that the company may have poor collecting processes, a
bad credit policy or none at all, or bad customers or customers with financial difficulty. Theoretically, a low ratio can
also often mean that the company has a high amount of cash receivables for collection from its various debtors, should
it improve its collection processes. Generally, however, a low ratio implies that the company should reassess its credit
policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. Uses of
'Receivables Turnover Ratio'. The receivables turnover ratio has several important functions other than simply
assessing whether or not a company has issues collecting on credit. Though this offers important insight, it does not tell
the whole story. For example, if one were to track a company’s receivables turnover ratio over time, it would say much
more about the company’s history with issuing and collecting on credit than a single value can. By looking at the
progression, one can determine if the company’s receivables turnover ratio is trending in a certain direction or if there
are certain recurring patterns. What is more, by tracking this ratio over time alongside earnings, one may be able to
determine whether a company’s credit practices are helping or hurting the company’s bottom line.

While this ratio is useful for tracking a company’s accounts receivable turnover history over time, it may also be used to
compare the accounts receivable turnover of multiple companies. If two companies are in the same industry and one
has a much higher receivables turnover ratio than the other, it may prove to be the safer investment.

Limitations of 'Receivables Turnover Ratio'.Like any metric attempting to gauge the efficiency of a business, the
receivables turnover ratio comes with a set of limitations that are important for any investor to consider before using it.
One important thing to consider is that companies will sometimes use total sales instead of net sales when calculating
their ratio, which generally inflates the turnover ratio. While this is not always necessarily meant to be deliberately
misleading, one should generally try to ascertain how a company calculates their ratio before accepting it at face value,
or otherwise should calculate the ratio independently. Another important consideration is that accounts receivable can
vary dramatically over the course of the year. This means that if one picks a start and end point for calculating the
receivables turnover ratio arbitrarily, the ratio may not reflect the true climate of the company’s issuing of and
collection on credit. As such, the beginning and ending values selected when calculating the average accounts
receivable should be carefully picked so as to represent the year well. In order to account for this, one could take an
average of accounts receivable from each month during a twelve-month period. It is also important to note that
comparisons of different companies’ receivables turnover ratios should only be made when the companies are in the
same industry, and ideally when they have similar business models and revenue numbers as well. Companies of
different sizes may often have very different capital structures, which can greatly influence turnover calculations, and
the same is often true of companies in different industries. The receivables turnover ratio is not particularly useful in
comparing companies with significant differences in the proportion of sales that are credit, as determining the
receivables turnover ratio of a company with a low proportion of credit sales does not indicate much about that
company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also does not
usually indicate much of importance. Lastly, a low receivables turnover ratio might not necessarily indicate that the
company’s issuing of credit and collecting of debt is lacking. If, for example, distribution messes up and fails to get the
right goods to customers, customers may not pay, which would also decrease the company’s receivables turnover ratio.

Cash Management Cash is a key part of working capital management. Companies need to carry sufficient levels of cash
in order to ensure they can meet day-to-day expenses. Cash is also required to be held as a cushion against unplanned
expenditure, to guard against liquidity problems. It is also useful to keep cash available in order to be able to take
advantage of market opportunities. The cost of running out of cash may include not being able to pay debts as they fall
due which can have serious operational repercussions, including the winding up of the company if it consistently fails to
pay bills as they fall due. However, if companies hold too much cash then this is effectively an idle asset, which could be
better invested and generating profit for the company.

Balancing Act. The firm faces a balancing act between liquidity and profitability.

Cash budgets and cash flow forecasts. Cash forecast. A cash forecast is an estimate of cash receipts and payments for a
future period under existing conditions. Every type of cash inflow and receipt, along with their timings, must be
forecast. Cash receipts and payments differ from sales and cost of sales in the income statement because: not all cash
receipts or payments affect the income statement, some income statement items are derived from accounting
conventions and are not cash flows, the timing of cash receipts and payments does not coincide with the income
statement accounting period

Cash budget. A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking
any action necessary to bring the forecast into line with the overall business plan. Cash budgets are used to: assess and
integrate operating budgets ,plan for cash shortages and surpluses, compare with actual spending. Companies are likely
to prepare a cash budget as part of the annual master budget, but then to continually prepare revised cash forecasts
throughout the year, as a means of monitoring and managing cash flows.
Proforma cash forecast. Preparing a cash flow forecast from working capital ratios Working capital ratios can be used
to forecast future cash requirements, by using the working capital ratios to work out the working capital requirement.
This technique can be used to help forecast overall cash flow.

Treasury management. Treasury management is heavily concerned with liquidity and covers the following activities:
banking and exchange, cash and currency management, investment in short-term assets, risk and insurance, raising
finance. All treasury management activities are concerned with managing the liquidity of a business, the importance of
which to the survival and growth of a business cannot be over-emphasised.

Need for a treasury department. The functions carried out by the treasurer have always existed, but have been
absorbed historically within other finance functions. A number of reasons may be identified for the modern
development of separate treasury departments: size and internationalization of companies: these factors add to both
the scale and the complexity of the treasury functions, size and internationalisation of currency, debt and security
markets: these make the operations of raising finance, handling transactions in multiple currencies and investing, much
more complex. They also present opportunities for greater gains, sophistication of business practice: this process has
been aided by modern communications, and as a result the treasurer is expected to take advantage of opportunities for
making profits or minimising costs which did not exist a few years ago. For these reasons, most large international
corporations have moved towards setting up a separate treasury department. Treasury departments tend to rely
heavily on new technology for information.

Responsibilities of a treasury management function; The treasurer will generally report to the finance director, with a
specific emphasis on borrowing and cash and currency management. The treasurer will have a direct input into the
finance director's management of debt capacity, debt and equity structure, resource allocation, equity strategy and
currency strategy. The treasurer will be involved in investment appraisal, and the finance director will often consult the
treasurer in matters relating to the review of acquisitions and divestments, dividend policy and defence from takeover.
Short-term investment and borrowing solutions A company must choose from a range of options to select the most
appropriate source of investment/funding. Short-term cash investments; Short-term cash investments are used for
temporary cash surpluses. To select an investment, a company has to weigh up three potentially conflicting objectives
and the factors surrounding them: Liquidity: the cash must be available for use when needed. Safety: no risk of loss
must be taken. Profitability: subject to the above, the aim is to earn the highest possible after-tax returns. Each of the
three objectives raises problems.

The liquidity problem; At first sight this problem is simple enough. If a company knows that it will need the funds in
three days (or weeks or months), it simply invests them for just that period at the best rate available with safety. The
solution is to match the maturity of the investment with the period for which the funds are surplus. However there are
a number of factors to consider: The exact duration of the surplus period is not always known. It will be known if the
cash is needed to meet a loan instalment, a large tax payment or a dividend. It will not be known if the need is
unidentified, or depends on the build-up of inventory, the progress of construction work, or the hammering out of an
acquisition deal.

The safety problem; Safety means there is no risk of capital loss. Superficially this again looks simple. The concept
certainly includes the absence of credit risk. For example, the firm should not deposit with a bank which might
conceivably fail within the maturity period and thus not repay the amount deposited. However, safety is not necessarily
to be defined as certainty of getting the original investment repaid at 100% of its original home currency value. If the
purpose for which the surplus cash is held is not itself fixed in the local currency, then other criteria of safety may
apply.

The profitability probl The profitability objective looks deceptively simple at first: go for the highest rate of return
subject to the overriding criteria of safety and liquidity. However, here there are complications. Short-term borrowing.
Short-term cash requirements can also be funded by borrowing from the bank. There are two main sources of bank
lending: bank overdraft, bank loans.

Bank overdrafts. A common source of short-term financing for many businesses is a bank overdraft. These are mainly
provided by the clearing banks and represent permission by the bank to write cheques even though the firm has
insufficient funds deposited in the account to meet the cheques. An overdraft limit will be placed on this facility, but
provided the limit is not exceeded, the firm is free to make as much or as little use of the overdraft as it desires. The
bank charges interest on amounts outstanding at any one time, and the bank may also require repayment of an
overdraft at any time. The advantages of overdrafts are the following. Flexibility as they can be used as required.
Cheapness as interest is only payable on the finance actually used, usually at 2-5% above base rate (and all loan interest
is a tax deductible expense). The disadvantages of overdrafts are as follows. Overdrafts are legally repayable on
demand. Normally, however, the bank will give customers assurances that they can rely on the facility for a certain time
period, say six months. Security is usually required by way of fixed or floating charges on assets or sometimes, in
private companies and partnerships, by personal guarantees from owners. Interest costs vary with bank base rates. This
makes it harder to forecast and exposes the business to future increases in interest rates.

Bank loans. Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed rate of
interest. They are less flexible and more expensive than overdrafts but provide greater security. A bank loan represents
a formal agreement between the bank and the borrower, that the bank will lend a specific sum for a specific period
(one to seven years being the most common). Interest must be paid on the whole of this sum for the duration of the
loan. This source is, therefore, liable to be more expensive than the overdraft and is less flexible but, on the other hand,
there is no danger that the source will be withdrawn before the expiry of the loan period. Interest rates and
requirements for security will be similar to overdraft lending.

Cash management models. Cash management models are aimed at minimising the total costs associated with
movements between a company's current account (very liquid but not earning interest) and their short-term
investments (less liquid but earning interest). The models are devised to answer the questions: at what point should
funds be moved? how much should be moved in one go?

The Baumol cash management model. Baumol noted that cash balances are very similar to inventory levels, and
developed a model based on the economic order quantity(EOQ).Assumptions: cash use is steady and predictable cash
inflows are known and regular, day-to-day cash needs are funded from current account, buffer cash is held in short-
term investments.The formula calculates the amount of funds to inject into the current account or to transfer into
short-term investments at one time: where: CO = transaction costs (brokerage,commission, etc.) D = demand for cash
over the period ,CH = cost of holding cash.The model suggests that when interest rates are high, the cash balance held
in non-interest-bearing current accounts should be low. However its weakness is the unrealistic nature of the
assumptions on which it is based.

Example using the Baumol model A company generates $10,000 per month excess cash, which it intends to invest in
short-term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs
associated with each separate investment of funds is constant at $50. Required: (a)What is the optimum amount of
cash to be invested in each transaction? (b)How many transactions will arise each year? (c)What is the cost of making
those transactions pa? (d)What is the opportunity cost of holding cash pa?

Solution: The Miller-Orr cash management model The Miller-Orr model is used for setting the target cash balance for a
company. The diagram below shows how the model works over time. The model sets higher and lower control limits, H
and L, respectively, and a target cash balance, Z. When the cash balance reaches H, then (H-Z) dollars are transferred
from cash to marketable securities, i.e. the firm buys (H-Z) dollars of securities. Similarly when the cash balance hits L,
then (Z-L) dollars are transferred from marketable securities to cash. The lower limit, L is set by management
depending upon how much risk of a cash shortfall the firm is willing to accept, and this, in turn, depends both on access
to borrowings and on the consequences of a cash shortfall. The formulae for the Miller-Orr model are: Return point =
Lower limit + (1/3 × spread) Spread = 3 [ (3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3 Note:
variance and interest rates should be expressed in daily terms. Variance = standard deviation squared.

Example using the Miller-Orr model. The minimum cash balance of $20,000 is required at Miller-Orr Co,and transferring
money to or from the bank costs $50 per transaction. Inspection of daily cash flows over the past year suggests that the
standard deviation is $3,000 per day, and hence the variance (standard deviation squared) is $9 million. The interest
rate is 0.03% per day. Calculate: (i)the spread between the upper and lower limits (ii) the upper limit (iii)the return
point. Solution: (i)Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3 = $31,200 (ii) Upper limit = 20,000 + 31,200 = $51,200
(iii)Return point = 20,000 + 31,200/3 = $30,400

Relevance and Irrelevance Theories of Dividend…Dividend is that portion of net profits which is distributed among the
shareholders. The dividend decision of the firm is of crucial importance for the finance manager since it determines the
amount to be distributed among shareholders and the amount of profit to be retained in the business. Retained
earnings are very important for the growth of the firm. Shareholders may also expect the company to pay more
dividends. So both the growth of company and higher dividend distribution are in conflict. So the dividend decision has
to be taken in the light of wealth maximisation objective. This requires a very good balance between dividends and
retention of earnings.

A financial manager may treat the dividend decision in the following two ways: 1) As a long term financing decision:-
When dividend is treated as a source of finance, the firm will pay dividend only when it does not have profitable
investment opportunities. But the firm can also pay dividends and raise an equal amount by the issue of shares. But this
does not make any sense. 2) As a wealth maximisation decision:- Payment of current dividend has a positive impact on
the share price. So to maximise the price per share, the firm must pay more and more dividends.

4.2 Dividend and Valuation; There are conflicting opinions as far as the impact of dividend decision on the value of the
firm. According to one school of thought, dividends are relevant to the valuation of the firm. Others opine that
dividends does not affect the value of the firm and market price per share of the company.

Relevant Theory; If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case
a change in the dividend payout ratio will be followed by a change in the market value of the firm. If the dividend is
relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which gives highest market value
per share.

4.3 Walter’s Model (Relevant Theory);Prof. James E Walter argues that the choice of dividend payout ratio almost
always affects the value of the firm. Prof. J. E. Walter has very scholarly studied the significance of the relationship
between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy which maximises the
wealth of shareholders. Walter’s model is based on the following assumptions: 1) The firm finances its entire
investments by means of retained earnings only. 2) Internal rate of return (R) and cost of capital (K) of the firm remains
constant. 3) The firms’ earnings are either distributed as dividends or reinvested internally. 4) The earnings and
dividends of the firm will never change. 5) The firm has a very long or infinite life.

Walter’s formula to determine the price per share is as follows: P = , P = market price per share. D = dividend per share.
E = earnings per share. R = internal rate of return. K = cost of capital. According to the theory, the optimum dividend
policy depends on the relationship between the firm’s internal rate of return and cost of capital. If R>K, the firm should
retain the entire earnings, whereas it should distribute the earnings to the shareholders in case the R<K. The rationale
of R>K is that the firm is able to produce more return than the shareholders from the retained earnings.

Walter’s view on optimum dividend payout ratio can be summarised as below: a) Growth Firms (R>K):- The firms having
R>K may be referred to as growth firms. The growth firms are assumed to have ample profitable investment
opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own.
So optimum payout ratio for growth firm is 0%.

b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is
equal to that of shareholders. In this case dividend policy will not have any influence on the price per share. So there is
nothing like optimum payout ratio for a normal firm. All the payout ratios are optimum.

c) Declining Firm (R<K):- If the company earns a return which is less than what shareholders can earn on their
investments, it is known as declining firm. Here it will not make any sense to retain the earnings. So entire earnings
should be distributed to the shareholders to maximise price per share. Optimum payout ratio for a declining firm is
100%. So according to Walter, the optimum payout ratio is either 0% (when R>K) or 100% (when R<K).
4.4 Gordon’s Model; Another theory, which contends that dividends are relevant, is the Gordon’s model. This model
which opines that dividend policy of a firm affects its value is based on the following assumptions: a) The firm is an all
equity firm (no debt). b) There is no outside financing and all investments are financed exclusively by retained earnings.
c) Internal rate of return (R) of the firm remains constant. d) Cost of capital (K) of the firm also remains same regardless
of the change in the risk complexion of the firm. e) The firm derives its earnings in perpetuity. f) The retention ratio (b)
once decided upon is constant. Thus the growth rate (g) is also constant (g=br). g) K>g. h) A corporate tax does not
exist.

Gordon used the following formula to find out price per share; P = , P = price per share, K = cost of capital, E1 = earnings
per share, b = retention ratio, (1-b) = payout ratio, g = br growth rate (r = internal rate of return)

According to Gordon, when R>K the price per share increases as the dividend payout ratio decreases. When R<K the
price per share increases as the dividend payout ratio increases. When R=K the price per share remains unchanged in
response to the change in the payout ratio.

Thus Gordon’s view on the optimum dividend payout ratio can be summarised as below: 1) The optimum payout ratio
for a growth firm (R>K) is zero. 2) There no optimum ratio for a normal firm (R=K). 3) Optimum payout ratio for a
declining firm R<K is 100%. Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter.
This similarity is due to the similarities of assumptions of both the models.

Gordon revised this basic model later to consider risk and uncertainty. Gordon’s model, like Walter’s model, contends
that dividend policy is relevant. According to Walter, dividend policy will not affect the price of the share when R = K.
But Gordon goes one step ahead and argues that dividend policy affects the value of shares even when R=K. The crux of
Gordon’s argument is based on the following 2 assumptions. 1. Investors are risk averse and 2. They put a premium on
a certain return and discount (penalise) uncertain return.

The investors are rational. Accordingly they want to avoid risk. The term risk refers to the possibility of not getting the
return on investment. The payment of dividends now completely removes any chance of risk. But if the firm retains the
earnings the investors can expect to get a dividend in the future. But the future dividend is uncertain both with respect
to the amount as well as the timing. The rational investors, therefore prefer current dividend to future dividend.
Retained earnings are considered as risky by the investors. In case earnings are retained, therefore the price per share
would be adversely affected. This behaviour of investor is described as “Bird in Hand Argument”. A bird in hand is
worth two in bush. What is available today is more important than what may be available in the future. So the rational
investors are willing to pay a higher price for shares on which more current dividends are paid. Therefore the discount
rate (K) increases with retention rate. This is shown below.

4.5 Modigliani-Miller Model; (Irrelevance theory); According to MM, the dividend policy of a firm is irrelevant, as it does
not affect the wealth of shareholders. The model which is based on certain assumptions, sidelined the importance of
the dividend policy and its effect thereof on the share price of the firm. According to the theory the value of a firm
depends solely on its earnings power resulting from the investment policy and not influenced by the manner in which
its earnings are split between dividends and retained earnings.

Assumptions: 1. Capital markets are perfect:- Investors are rational information is freely available, transaction cost are
nil, securities are divisible and no investor can influence the market price of the share. 2. There are no taxes:- No
difference between tax rates on dividends and capital gains. 3. The firm has a fixed investment policy which will not
change. So if the retained earnings are reinvested, there will not be any change in the risk of the firm. So K remains
same. 4. Floatation cost does not exist.

The substance of MM arguments may be stated as below:1. If the company retains the earnings instead of giving it out
as dividends, the shareholders enjoy capital appreciation, which is equal to the earnings, retained. If the company
distributes the earnings by the way of dividends instead of retention, the shareholders enjoy the dividend, which is
equal to the amount by which his capital would have been appreciated had the company chosen to retain the earnings.
Hence, the division of earnings between dividends and retained earnings is irrelevant from the point of view of
shareholders.
Modigliani- Miller Theory on Dividend Policy. Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’
notion. According to this concept, investors do not pay any importance to the dividend history of a company and thus,
dividends are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be important in the valuation of a company.

CRUX OF MODIGLIANI-MILLER MODEL Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller
in 1961. They were the pioneers in suggesting that dividends and capital gains are equivalent when an investor
considers returns on investment. The only thing that impacts the valuation of a company is its earnings, which is a
direct result of the company’s investment policy and the future prospects. So, according to this theory, once the
investment policy is known to the investor, he will not need any additional input on the dividend history of the
company. The investment decision is, thus, dependent on the investment policy of the company and not on the
dividend policy.

Modigliani – Miller theory goes a step further and illustrates the practical situations where dividends are not relevant
to investors. Irrespective of whether a company pays a dividend or not, the investors are capable enough to make their
own cash flows from the stocks depending on their need for the cash. If the investor needs more money than the
dividend he received, he can always sell a part of his investments to make up for the difference. Likewise, if an investor
has no present cash requirement, he can always reinvest the received dividend in the stock. Thus, the Modigliani –
Miller theory firmly states that the dividend policy of a company has no influence on the investment decisions of the
investors. This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic, the dividends
distribution to shareholders is offset by the external financing. Due to the distribution of dividends, the price of the
stock decreases and will nullify the gain made by the investors because of the dividends. This theory also implies that
the cost of debt is equal to the cost of equity as the cost of capital is not affected by the leverage. ASSUMPTIONS OF
THE MODEL. Modigliani – Miller theory is based on the following assumptions: PERFECT CAPITAL MARKETS This theory
believes in the existence of ‘perfect capital markets’. It assumes that all the investors are rational, they have access to
free information, there are no floatation or transaction costs and no large investor to influence the market price of the
share. NO TAXES. There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the same
rate. FIXED INVESTMENT POLICY The company does not change its existing investment policy. This means that new
investments that are financed through retained earnings do not change the risk and the rate of required return of the
firm. NO RISK OF UNCERTAINTY All the investors are certain about the future market prices and the dividends. This
means that the same discount rate is applicable for all types of stocks in all time periods. VALUATION FORMULA AND
ITS DENOTATIONS Modigliani – Miller’s valuation model is based on the assumption of same discount rate/rate of
return applicable to all the stocks. P1 = P0 * (1 + k) – D. Where, P1 = market price of the share at the end of a period, P0
= market price of the share at the beginning of a period, k = cost of capital, D = dividends received at the end of a
period

EXPLANATION OF MODIGLIANI – MILLER’S MODEL. Modigliani – Miller’s model can be used to calculate the market
price of the share at the end of a period, if the original share price, dividends received and the cost of capital is known.
The assumption that the same discount rate is applicable to all stocks is important. The original price of the stock is Rs.
150. The discount rate applicable to the company is 10%. The company had declared Rs. 10 as dividends in a year.
Calculate the market price of the share at the end of one year using the Modigliani – Miller’s model. Here, P0 = 150, k =
10%, D = 10. Market price of the stock = P1 = 150 * (1 + .10) – 10 = 150 *1.1 – 10 = 155.

CRITICISM OF MODIGLIANI MILLER’S MODEL. Modigliani – Miller theory on dividend policy suffers from the following
limitations: Perfect capital markets do not exist. Taxes are present in the capital markets. According to this theory,
there is no difference between internal and external financing. However, if the flotation costs of new issues are
considered, it is false. This theory believes that the shareholder’s wealth is not affected by the dividends. However,
there are transaction costs associated with the selling of shares to make cash inflows. This makes the investors prefer
dividends.mThe assumption of no uncertainty is unrealistic. The dividends are relevant under the certain conditions as
well.

Summary Modigliani – Miller theory of dividend policy is an interesting and a different approach to the valuation of
shares. It is a popular model which believes in the irrelevance of the dividends. However, the policy suffers from various
important limitations and thus, is critiqued regarding its assumptions. Gordon’s Theory on Dividend Policy Gordon’s
theory on dividend policy is one of the theories believing in the ‘relevance of dividends’ concept. It is also called as
‘Bird-in-the-hand’ theory that states that the current dividends are important in determining the value of the firm.
Gordon’s model is one of the most popular mathematical models to calculate the market value of the company using
its dividend policy.

CRUX OF GORDON’S MODEL Myron Gordon’s model explicitly relates the market value of the company to its dividend
policy. The determinants of the market value of the share are the perpetual stream of future dividends to be paid, the
cost of capital and the expected annual growth rate of the company.

RELATION OF DIVIDEND DECISION AND VALUE OF A FIRM; The Gordon’s theory on dividend policy states that the
company’s dividend payout policy and the relationship between its rate of return (r) and the cost of capital (k) influence
the market price per share of the company. Relationship between r and k Increase in Dividend Payout, r>kPrice
per share decreases, r<k Price per share increases, r=k No change in the price per share

ASSUMPTIONS OF GORDON’S MODEL. Gordon’s model is based on the following assumptions:1. NO DEBT, The model
assumes that the company is an all equity company, with no proportion of debt in the capital structure.2. NO EXTERNAL
FINANCING. The model assumes that all investment of the company is financed by retained earnings and no external
financing is required. CONSTANT IRR The model assumes a constant Internal Rate of Return (r), ignoring the diminishing
marginal efficiency of the investment.3. CONSTANT COST OF CAPITAL. The model is based on the assumption of a
constant cost of capital (k), implying the business risk of all the investments to be the same. PERPETUAL EARNINGS.
Gordon’s model believes in the theory of perpetual earnings for the company. CORPORATE TAXES. Corporate taxes are
not accounted for in this model. CONSTANT RETENTION RATIO The model assumes a constant retention ratio (b) once it
is decided by the company. Since the growth rate (g) = b*r, the growth rate is also constant by this logic. K>G. Gordon’s
model assumes that the cost of capital (k) > growth rate (g). This is important for obtaining the meaningful value of the
company’s share. VALUATION FORMULA OF GORDON’S MODEL AND ITS DENOTATIONS Gordon’s formula to calculate
the market price per share (P) is P = {EPS * (1-b)} / (k-g). Where, P = market price per share, EPS = earnings per share,
b= retention ratio of the firm, (1-b) = payout ratio of the firm, k = cost of capital of the firm, g = growth rate of the firm
= b*r

Explanation. The above model indicates that the market value of the company’s share is the sum total of the present
values of infinite future dividends to be declared. The Gordon’s model can also be used to calculate the cost of equity, if
the market value is known and the future dividends can be forecasted. The EPS of the company is Rs. 15. The market
rate of discount applicable to the company is 12%. The dividends are expected to grow at 10% annually. The company
retains 70% of its earnings. Calculate the market value of the share using Gordon’s model. Here, E = 15 b = 70% k = 12%
g = 10% Market price of the share = P = {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225

IMPLICATIONS OF GORDON’S MODEL. Gordon’s model believes that the dividend policy impacts the company in
various scenarios as follows: GROWTH FIRM A growth firm’s internal rate of return (r) > cost of capital (k). It benefits
the shareholders more if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio
for growth firms is zero. NORMAL FIRM. A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does
not make any difference if the company reinvested the dividends or distributed to its shareholders. So, there is no
optimum dividend payout ratio for normal firms. However, Gordon revised this theory later and stated that the
dividend policy of the firm impacts the market value even when r=k. Investors will always prefer a share where more
current dividends are paid. DECLINING FIRM. The internal rate of return (r) < cost of the capital (k) in the declining
firms. The shareholders are benefitted more if the dividends are distributed rather than reinvested. So, the optimum
dividend payout ratio for declining firms is 100%. CRITICISM OF GORDON’S MODEL. Gordon’s theory on dividend policy
is criticized mainly for the unrealistic assumptions made in the model. CONSTANT INTERNAL RATE OF RETURN AND
COST OF CAPITAL. The model is inaccurate in assuming that r and k always remain constant. A constant r means that
the wealth of the shareholders is not optimized. A constant k means the business risks are not accounted for while
valuing the firm.

NO EXTERNAL FINANCING. Gordon’s belief of all investments being financed by retained earnings is faulty. This reflects
sub-optimum investment and dividend policies.
Summary. Gordon’s theory of dividend policy is one of the prominent theories in the valuation of the company. Though
it comes with its own limitations, it is a widely accepted model to determine the market price of the share using the
forecasted dividends.

Capital Structure; What is a 'Capital Structure'.The capital structure is how a firm finances its overall operations and
growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure. BREAKING DOWN 'Capital Structure'. A firm's capital
structure can be a mixture of long-term debt, short-term debt, common equity and preferred equity. A company's
proportion of short- and long-term debt is considered when analyzing capital structure. When analysts refer to capital
structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a
company is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore
poses greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt vs. Equity. Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to
issue debt because of the tax advantages. Interest payments are tax-deductible. Debt also allows a company or
business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to
access. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does
not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the
company as a part owner.

Debt-to-Equity Ratio as a Measure of Capital Structure. Both debt and equity can be found on the balance sheet. The
assets listed on the balance sheet are purchased with this debt and equity. Companies that use more debt than equity
to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with
more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio
and/or an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure
can lead to lower growth rates. It is the goal of company management to find the optimal mix of debt and equity, also
referred to as the optimal capital structure. Analysts use the D/E ratio to compare capital structure. It is calculated by
dividing debt by equity. Savvy companies have learned to incorporate both debt and equity into their corporate
strategies. At times, however, companies may rely too heavily on external funding, and debt in particular. Investors can
monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's peers. 1. Long-
Term Debt To Capitalization ...2. Leverage Ratio. 3. Capitalization Ratios 4. Debt Load. 5. Financial Structure. 6.
Long Term Debt To Total Assets ...7. Net Debt. 8. Total Debt to Total Assets. 9. Secured Debt. Long-Term
Debt To Capitalization Ratio. The long-term debt to capitalization ratio is a ratio showing the financial leverage of a
firm, calculated by dividing long-term debt by the amount of capital available:

A variation of the traditional debt-to-equity ratio, this value computes the proportion of a company's long-term debt
compared to its available capital. By using this ratio, investors can identify the amount of leverage utilized by a specific
company and compare it to others to help analyze the company's risk exposure as generally, companies that finance a
greater portion of their capital via debt are considered riskier than those with lower leverage ratios. BREAKING DOWN
'Long-Term Debt To Capitalization Ratio' The choice between using long-term debt and other forms of capital, namely
preferred and common stock or categorically called equity, is a balancing act to build a financing capital structure with
lower cost and less risk. Long-term debt can be advantageous if a company anticipates strong growth and ample
profitability that can help ensure on-time debt repayments. Lenders collect only their due interest and do not
participate in profit sharing among equity holders, making debt financing sometimes a preferred funding source. On
the other hand, long-term debt may be risky when a company already struggles with its business, and the financial
strain imposed by the debt burden may well lead to insolvency.

Cost of Capital. Contrary to intuitive understanding, using long-term debt can actually help lower a company's total cost
of capital. Borrowing terms are stipulated independent of a company's future business and financial performance. In
other words, if a company turns out to be highly profitable, it does not need to pay the lender anything more than what
the borrowing interest rate calls for and can keep the rest of the profits to itself. When a company's existing owners
finance their capital with equity, they must share its available profits proportionately with all other equity holders.
Although a company does not need to worry about returning capital to equity holders, the cost of using the safer equity
capital is never cheap. A leverage ratio is any one of several financial measurements that look at how much capital
comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage
ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing
the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.

BREAKING DOWN 'Leverage Ratio'. Too much debt can be dangerous for a company and its investors. However, if a
company's operations can generate a higher rate of return than the interest rate on its loans, then the debt is helping
to fuel growth in profits. Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other
hand, too few debt can also raise questions. A reluctance or inability to borrow may be a sign that operating margins
are simply too tight.

Capitalization Ratios. Capitalization ratios are indicators that measure the proportion of debt in a company’s capital
structure. Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio and total debt to
capitalization ratio. The formula for each of these ratios is shown below.Debt-Equity ratio = Total Debt / Shareholders'
Equity. Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity). Total Debt to
Capitalization = Total Debt / (Total Debt + Shareholders' Equity) While a high capitalization ratio can increase the return
on equity because of the tax shield of debt, a higher proportion of debt increases the risk of bankruptcy for a company.
Also known as leverage ratios.

BREAKING DOWN 'Capitalization Ratios'. For example, consider a company with short-term debt of $5 million, long-
term debt of $25 million and shareholders’ equity of $50 million. The company’s capitalization ratios would be
computed as follows: Debt-Equity ratio = ($5 million + $25 million) / $50 million = 0.60 or 60%. Long-term Debt to
Capitalization = $25 million / ($25 million + $50 million) = 0.33 or 33%. Total Debt to Capitalization = ($5 million + $25
million) / ($5 million + $25 million + $50 million) = 0.375 or 37.5%. The acceptable level of capitalization ratios for a
company depends on the industry in which it operates. Companies in sectors such as utilities, pipelines and
telecommunications – which are capital intensive and have predictable cash flows – will typically have capitalization
ratios on the higher side. Conversely, companies with relatively few assets that can be pledged as collateral, in sectors
like technology and retail, will have lower levels of debt and therefore lower capitalization ratios.

The acceptable level of debt for a company is dependent on its whether its cash flows are adequate to service such
debt. The interest coverage ratio, another popular leverage ratio, measures the ratio of a company’s earnings before
interest and taxes (EBIT) to its interest expense. A ratio of 2, for instance, indicates the company generates $2 for every
dollar in interest expense. As with all ratios, a company’s capitalization ratios should be tracked over time to identify if
they are stable. They should also be compared with similar ratios of peer companies, to ascertain the company’s
leverage position relative to its peers.

Debt Load; The amount of debt or leverage that a company is carrying on its books. The amount of debt a firm is
carrying can be found in the company's balance sheet, which most firms provide on a quarterly basis. Companies may
incur this debt for numerous reasons such as expanding their business or making an acquisition. BREAKING DOWN
'Debt Load' A very useful insight into the financial health of a company is to compare the amount of debt a company is
carrying to the assets or equity the company has. Dividing the total debt a company has by the total assets a company
has gives what is called a debt ratio. A low debt ratio is usually a sign of a healthy company.

Financial Structure. Financial structure refers to the specific mixture of long–term debt and equity that a company uses
to finance its operations. The composition directly affects the risk and value of the associated business. The financial
manager must decide how much money should be borrowed and the best mixture of debt and equity to obtain, and he
must find the least expensive sources of funds for the company. BREAKING DOWN 'Financial Structure' Like the capital
structure, the financial structure is divided into the amount of the company's cash flow that goes to creditors and the
amount that goes to shareholders. Each business has a different mixture depending on its needs and expenses.
Therefore, each company has its own particular debt-equity (D/E) ratio. For example, a company could issue bonds and
use the proceeds to buy stock, or it could issue stock and use the proceeds to pay its debt. Financial Structure Versus
Capital Structure While a capital structure and a financial structure both include information regarding long-term
financing and common stock, preferred stock and retained earnings, it does not include any information regarding
short-term debt obligations. A financial structure does include both long-term and short-term obligations in its
calculation. In this regard, the capital structure can be seen as a subset of the financial structure that is more geared
toward long-term analysis, while the financial structure provides more reliable information regarding the business's
current circumstances.

Long Term Debt To Total Assets Ratio. The long term debt to total assets ratio is a measurement representing the
percentage of a corporation's assets financed with loans or other financial obligations lasting more than one year. The
ratio provides a general measure of the long-term financial position of a company, including its ability to meet financial
requirements for outstanding loans. BREAKING DOWN 'Long Term Debt To Total Assets Ratio' A year-over-year
decrease in long term debt to total assets ratio may suggest a company is progressively becoming less dependent on
debt to grow its business. The calculation for the long-term debt to total assets ratio is: long-term debt / total assets =
long-term debt to total asset ratio.Example of Long-Term Debt to Asset Ratio. For example, if a company has $100,000
in total assets with $40,000 in long-term debt, its long-term debt to total asset ratio is $40,000/$100,000 = 0.4 or 40%.
This ratio indicates that the company has 40 cents of long-term debt for each dollar it has in assets. In order to compare
the overall leverageposition of the company, investors look at comparable firms and the historical changes in this ratio.
Net Debt Net debt shows a business's overall financial situation by subtracting the total value of a company's liabilities
and debts from the total value of its cash, cash equivalents and other liquid assets, a process called netting. All the
information necessary to determine a company's net debt can be found on its balance sheet.Net Debt = (Short-Term
Debt + Long-Term Debt) - Cash and Cash Equivalents. BREAKING DOWN 'Net Debt' The net debt figure is used as an
indication of a business's ability to pay off all its debts if they became due simultaneously on the day of calculation,
using only its available cash and highly liquid assets.

Total Debt to Total Assets. Total debt to total assets is a leverage ratio that defines the total amount of debt relative to
assets. This metric enables comparisons of leverage to be made across different companies. The higher the ratio, the
higher the degree of leverage (DoL) and, consequently, financial risk. The total debt to total assets is a broad ratio that
includes long-term and short-term debt (borrowings maturing within one year), as well as all assets – tangible and
intangible.

BREAKING DOWN 'Total Debt to Total Assets'. Total debt to total assets is a measure of the company's assets that are
financed by debt, rather than equity. This leverage ratio shows how a company has grown and acquired its assets over
time. Investors use the ratio to not only evaluate whether the company has enough funds to meet its current debt
obligations, but to also assess whether the company can pay a return on their investment. Creditors use the ratio to see
how much debt the company already has and if the company has the ability to repay its debt, which will determine
whether additional loans will be extended to the firm.

Secured Debt. Secured debt is debt backed or secured by collateral to reduce the risk associated with lending, such as a
mortgage. If the borrower defaults on repayment, the bank seizes the house, sells it and uses the proceeds to pay back
the debt. Assets backing debt or a debt instrument are considered security, which is why unsecured debt is considered
a riskier investment. BREAKING DOWN 'Secured Debt'. There are two primary ways a company can raise capital: debt
and equity. Equity is ownership and implies a promise of future earnings, but if the company falters, the investor may
lose her principal. Lured by the prospect of better growth opportunities, investors in equity have the implicit backing of
the company but no real claim on company assets. Indeed, equity holders get paid last in case of bankruptcy. Debt, on
the other hand, implies a promise of repayment and has a higher degree of seniority in the case of bankruptcy. As a
result, debt holders are not as concerned about future earnings as they are about liquidation value. Within the world of
debt, there is one particular class of securities that has a higher seniority than unsecured debt vehicles: secured debt
vehicles.

Secured Debt. In general, lenders are more concerned about the value of company assets than earnings quality because
in the case of earnings decline, the company can sell assets. This is the informal course of action when firms are facing
bankruptcy; however, some debt is contractually backed by specific assets. This debt is referred to as secured debt.
Secured debt is a formal contract backed by assets that can be sold as collateral if the firm defaults on the loan. Due to
its low risk profile, secured debt is favored among those companies with poor credit. Secured debt allows the borrower
to shift the lender's focus to the liquidation value of assets rather than the borrower's creditworthiness.
Examples of Secured Debt. The most commonly cited example of a secured loan is a mortgage. Other examples include
the service provided by pawn shops or the factoring of receivables. Pawn shops give the borrower a loan based on the
value of whatever that borrower is willing to pawn. In this way, secured debt is at the foundation of the pawn shop
business model. Many firms also make a habit of receiving funding through the financing of accounts receivable. If the
company cannot make the payment, the lender can use customer receipts and promissory notes to secure repayment.
Other examples include car loans and home equity lines of credit, also referred to as HELOCs

Capital Structure or Leverage Ratio. Capital structure refers to the degree of long term financing of a business concern
as in the form of debentures, preference share capital and equity share capital including reserves and surplus. There
should be a proper mix between debt capital and equity capital. Capital structure is otherwise called as leverage.

Formulae to Calculate Capital Structure or Leverage Ratios. Capital structure ratios are calculated to test the long term
financial position of the business concern. The followings ratios are calculated to analyze the capital structure of the
business concern. 1. Capital Gearing Ratio, Financial Leverage, Operating Leverage, Combined Leverage. 2. Debt Equity
Ratio. 3. Total Investment to Long Term Liabilities 4. Ratio of Fixed Assets to Funded Debt. 5. Ratio of Current Liabilities
to Proprietors’ Funds. 6. Ratio of Reserves to Equity Capital.

Capital Gearing Ratio. This ratio shows the relationship prevailing between equity share capital including reserves and
surplus and preference share capital along with fixed interest bearing loans for long term. If equity share capital
including reserves and surplus is less when compared with preference share capital and fixed interest bearing loans for
long term, there is a high gearing and vice versa. The followings formulae are used to calculate Capital Gearing Ratio.
Capital Gearing Ratio = (Equity Share Capital + Reserves and Surplus) / (Preference Share Capital+ Fixed Interest bearing
loans) or Capital Gearing Ratio = Fixed Income bearing Funds / Equity Shareholders’ Fund or Capital Gearing Ratio =
Fixed Income bearing Funds / Total Capital Employed. Leverage may be classified as financial leverage, operating
leverage and combined leverage.

Financial Leverage or Trading on Equity. Financial leverage is the using of equity share capital and preference share
capital along with long term fixed interest bearing debt. The company can use long term fixed interest bearing debt
very effectively. If so, the earnings of more than fixed interest is available only to the equity shareholders. In this way,
the returns to equity share holders is increased. It means that the earnings of equity shareholders is increased by
effective use of long term fixed interest bearing debt. It is known as trading on equity. Financial leverage can be
calculated as. Financial leverage = Earnings Before Interest and Tax / (Earnings Before Interest and Tax — Interest and
Preference Dividend). Operating leverage can be calculated as. Operating leverage = (Sales — Variable Cost) / Earnings
Before Interest and Tax. Combined leverage can be calculated as. Combined leverage = Financial Leverage x Operating
Leverage. Total Investment to Long Term Liabilities. This ratio is calculated by the following formula. = (Shareholders’
Funds+ Long Term Liabilities) / Long Term Liabilities. High ratio is preferable. Ratio of Fixed Assets to Funded Debt. This
ratio is calculated by the following formula. = Fixed Assets / Funded Debt .Ratio of Current Liabilities to Proprietors’
Funds. This ratio is calculated by the following formula. = Current Liabilities / Proprietors’ Funds. Ratio of Reserves to
Equity Capital. This ratio indicates the level of profits retained within the business as reserve for future growth. This
ratio is calculated by the following formula.= Reserves / Equity Share Capital x 100. High ratio is preferable.

Miscellaneous Ratios. The different types of ratios are analysed under various headings. Even though, some other ratios
are also developed by experts and analysts. Such types of ratios are presented below.

Finance Expense Ratio = Financial Expenses / Net Sales x 100. Rate of Dividend = Dividends / Paidup Capital x 100. Ratio
of Disposable Profit to Paid up Capital = Disposable Profit / Paid up Capital x 100

Rate of Ploughing Back of Profits or Rate of Retention = Rate of Dividend — Ratio of Disposable Profit to paid up
Capital. Dividend Cover Ratio = Profit After Interest and Tax / Dividend. Dividend cover ratio reveals the ability of the
business concern to maintain the dividend in future. Current Assets Turnover Ratio = Cost of Sales or Net Sales /
Current Assets. Owned Capital Turnover Ratio = Cost of Sales or Net Sales / Shareholders’ Fund. Ratio of Tangible Assets
to Total Debts = Tangible Assets / Total Debt

Here, Tangible Assets = Total Assets — Intangible assets

Trading on equity. Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred
stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates
a profit through this financing technique, its shareholders earn a greater return on their investments. In this case,
trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its
shareholders earn a reduced return because of this activity. Many companies use trading on equity rather than
acquiring more equity capital, in an attempt to improve their earnings per share. Trading on equity has two primary
advantages: Enhanced earnings. It may allow an entity to earn a disproportionate amount on its assets. Favorable tax
treatment. In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.
However, trading on equity also presents the possibility of disproportionate losses, since the related amount of interest
expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. The concept
is especially dangerous in situations where a company relies upon short-term borrowings to fund its operations, since a
sudden spike in short-term interest rates may cause its interest expense to overwhelm earnings, resulting in immediate
losses. This risk can be mitigated through the use of interest rate swaps, where a company swaps its variable interest
payments for the fixed interest payments of another entity. Thus, trading on equity can earn outsized returns for
shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations. In short, earnings
are likely to become more variable when a trading on equity strategy is pursued. Because of the increased variability in
earnings, a side effect of trading on equity is that the recognized cost of stock options increases. The reason is that
option holders are more likely to cash in their options when earnings spike, and since trading on equity leads to more
variable earnings, the options are more likely to earn a higher return for their holders. The trading on equity concept is
more likely to be employed by professional managers who do not own a business, since the managers are interested in
increasing the value of their stock options with this aggressive financing technique. A family-run business is more
interested in long-term financial stability, and so is more likely to avoid the concept. Example of Trading on Equity Able
Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is
not using financial leverage at all, since it incurred no debt to buy the factory. Baker Company uses $100,000 of its own
cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using
financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its
investment. Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its
original investment. Similar Terms. Trading on equity is also known as financial leverage, investment leverage, and
operating leverage Trading on Equity: Meaning, Effects (with Examples) | Financial Management. Meaning: Trading on
equity is the financial process of using debt to produce gain for the residual owners. The practice is known as trading on
equity because it is the equity shareholders who have only interest (or equity) in the business income. The term owes
its name also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by the
owners. Trading feature here is simply one of taking advantage of the permanent stock investment to borrow funds on
reasonable basis. When the amount of borrowing is relatively large in relation to capital stock, a company is said to be
‘trading on this equity’ but where borrowing is comparatively small in relation to capital stock, the company is said to
be trading on thick equity.

Effects of Trading on Equity: Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any
fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of
trading on equity larger the magnitude of debt in capital structure, the higher is the variation in EPS given any variation
in EBIT. Solution:.Impact on trading on equity, will be reflected in earnings per share available to common stock
holders. To calculate the EPS in each of the four alternatives EBIT has to be first of all calculated.

Proposal A

Rs. Proposal B

Rs. Proposal C Rs. Proposal D Rs.

EBIT 1,20,000 1,20,000 1,20,000 1,20,000

Less; interest 25,000 60,000

Earnings before taxes 11,20,000 95,000 60,000 1,20,000

Less; taxes @ 50% 60,000 47,100 30,000 60,000

Earnings after taxes 60,000 47,500 30,000 60,000

Less; Preferred stock

dividend 25,000

Earnings available to 60,000 47,500 ,30,000 35,000

common stock holders 20,000 15,000 10,000 15,000

No. of common shares

EPS Rs. 3.00 3.67 3.00 2.33

Effects of trading on equity can be explained with the help of the following example. Example: Prakash Company is
capitalized with Rs. 10, 00,000 dividends in 10,000 common shares of Rs. 100 each. The management wishes to raise
another Rs. 10, 00,000 to finance a major programme of expansion through one of four possible financing plans. Then
management A) may finance the company with all common stock, B). Rs. 5 lakhs in common stock and Rs. 5 lakhs in
debt at 5% interest, C) all debt at 6% interest or D) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with
5-4 dividend. The company’s existing earnings before interest and taxes (EBIT) amounted to Rs. 12,00,000, corporation
tax is assumed to be 50% Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75% common
stock and 25% debt, would be the most favourable with respect to earnings per share. It may further be noted that
proportion of common stock in total capitalisation is the same in both the proposals B and D but EPS is altogether
different because of induction of preferred stock. While preferred stock dividend is subject to taxes whereas interest on
debt is tax deductible expenditure resulting in variation in EPS in proposals B and D, with a 50% tax rate the explicit cost
of preferred stock is twice the cost of debt.

Calculation of Point of Indifference | Capital Structure. After reading this article you will learn about Calculation of Point
of Indifference. The EPS, earnings per share, ‘equivalency point’ or ‘point of indifference’ refers to that EBIT, earnings
before interest and tax, level at which EPS remains the same irrespective of different alternatives of debt-equity mix At
this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-
even level of EBIT for alternative financial plans. The equivalency or point of indifference can be calculated
algebraically, as below:

Where, X = Equivalency Point or Point of Indifference or Break Even EBIT Level. I1 = Interest under alternative financial
plan 1. I2 = Interest under alternative financial plan 2. T = Tax Rate. PD = Preference Dividend S1 = Number of equity
shares or amount of equity share capital under alternative 1. S2 = Number of equity shares or amount of equity share
capital under alternative 2. The point of indifference can also be determined by preparing the EBIT chart or range of
earnings chart. This chart shows the expected earnings per share (EPS) at various levels of earnings before interest and
tax (EBIT) which may be plotted on a graph and straight line representing the EPS at various levels of EBIT may be
drawn. The point where this line intersects is known as point of indifference or break-even point.

Illustration 1: A project under consideration by your company requires a capital investment of Rs. 60 lakhs. Interest on
term loan is 10% p.a. and tax rate is 50% Calculate the point of indifference for the project, if the debt-equity ratio
insisted by the financing agencies is 2:1:

Solution: As the debt equity ratio insisted by the financing agencies is 2:1, the company has two alternative financial
plans: (i) Raising the entire amount of Rs. 60 lakhs by the issue of equity shares, thereby using no debt, and (ii) Raising
Rs. 40 lakhs by way of debt and Rs. 20 lakh by issue of equity share capital. Calculation of point of Indifference:
Where, X = Point Indifference I1 = Interest under alternative 1, i.e. .0 I2 = Interest under alternative 2, i.e. 10/100 × 40 =
4, T = Tax rate, i.e. 50% or .5. PD = Preference Divided, i.e. O as there are no preference shares.S1 = Amount of equity
capital under alternative 1, i.e. 60. S2 = Amount of equity capital under alternative 2, i.e. 20. Substituting the values:

Thus, EBIT, earnings before interest and tax, at point of indifference is Rs. 6 lakhs. At this level (6 lakh) of EBIT, the
earnings on equity after tax will be 5% p.a. irrespective of alternative debt-equity mix when the rate of interest on debt
is 10% p, a. From the figure given on next page, we find that the equivalency point (point of indifference) or the break-
even level of EBIT is Rs. 6 lakhs. In case, the firm has EBIT level below Rs. 6 lakhs then equity financing is preferable to
debt financing; but if the EBIT is higher than Rs. 6 lakhs then debt financing; but if the EBIT is higher than Rs. 6 lakhs
then debt financing is better.

Illustration 2: A new project under consideration requires a capital outlay of Rs. 600 lakhs for which the funds can
either be raised by the issue of equity shares of Rs. 100 each or by the issue of equity shares of the value of Rs. 400
lakhs and by the issue of 15% loan of Rs. 200 lakhs. Find out the indifference level of EBIT given the tax rate at 50%:

Solution: Thus, the indifferent level of EBIT is Rs. 90 lakhs. At this level of EBIT, the earnings per share (EPS) under both
the plans would be the same. Indifference EBIT - Capital Structure of Corporations Indifference Earnings Before Interest
& Taxes (Indifference EBIT) is the point of the capital structure where the corporation does not care about whether
they issue new debt, have no debt and 100% equity or have a combination of both debt & equity. From the graph
below, you can determine that the Indifference EBIT point is where the With Debt Capital Structure Line intersects with
the No Debt Capital Structure Line. Any point to the left of Indifference EBIT is risky debt while any point to the right of
Indifference EBIT is good debt (interest expense that is tax deductible).

Indifference EBIT Example ABC Corp. currently has 200,000 shares outstanding on the stock market with the current
price being $20. The Board of Directors of the Corp want to incur a debt of $1 million by issuing junk bonds that have a
coupon interest rate of 9% annually. At what point of EBIT would the Corp. be indifferent to having debt or NO debt?
Solution: Current Capital Structure = $20 x 200,000 shares = $4,000,000 Equity. New Capital Structure = $3,000,000
Equity & $1,000,000 Debt - Current Stock Price Remains at $20. - To attain $3,000,000 of Equity, the # of shares =
150,000. Annual Interest Expense Coupon Payments = 9% x 1,000,000 = $90,000

No Debt With Debt

Indifference EBIT EBIT - 0

200,000 = EBIT - 90,000

150,000

Indifference EBIT 150,000 EBIT = 200,000 (EBIT - 90,000)

150,000 EBIT = 200000EBIT - 18000000000

18000000000 = 200,000 EBIT - 150,000 EBIT

18000000000 = 50,000 EBIT

EBIT = 18000000000 / 50,000

EBIT = $360,000

Interpretation of EBIT. At a point where Earnings Before Interest & Taxes is $360,000, ABC Corp. will not care whether it
has any outstanding debt issues, NO debt or a combination of both because at this point, the value of the Capital
Structure is NOT affected. It is important to have an understanding of your capital structure. Your capital structure
consists of the combination of debt and equity as reflected on the Blance Sheet. The combination of debt and equity is
reflective of your risk. Higher levels of debt equate to higher levels of risk. This can eventually cripple a company over
the long term. However, too much equity can also be costly since equity carries a higher cost than debt. So the goal is
to find the right balance or mix that grows the company at an acceptable level of risk.

One way of determining the right mix of capital is to measure the impacts of different financing plans on Earnings Per
Share (EPS). The objective is to find the level of EBIT (Earnings Before Interest Taxes) where EPS does not change; i.e.
the EBIT Breakeven. At the EBIT Breakeven, EPS will be the same under each financing plan we have under
consideration. As a general rule, using financial leverage will generate more EPS where EBIT is greater than the EBIT
Breakeven. Using less leverage will generate more EPS where EBIT is less than EBIT Breakeven. EBIT Breakeven is
calculated by finding the point where alternative financing plans are equal according to the following formula:

(EBIT - I) x (1.0 - TR) / Equity number of shares after implementing financing plan.

I: Interest Expense TR: Tax Rate Formula assumes no preferred stock.

The formula is calculated for each financing plan. For example, you may be considering issuing more stock under Plan A
and incurring more debt under Plan B. Each of these plans will have different impacts on EPS. You want to find the right
plan that helps maximize EPS, but still manage risks within an acceptable range. EBIT-EPS Analysis can help find the
right capital mix for high returns and low costs of capital.

How is EBIT breakeven affected by leverage and financing plans? A: To finance its operations, a corporation raises
capital by borrowing money or selling shares of company ownership to the public. A corporation can only remain viable
if it generates sufficient earnings to offset the costs associated with its financing – after all, some of its revenue needs
to be paid out to stockholders, bondholders and other creditors. Thus, the composition of a corporation's financing
plans has a significant impact on how much operating income it needs to generate.

Corporate Financing and Financial Leverage Corporations often leverage their assets by borrowing money to increase
production and, by extension, earnings. Financial leverage comes from any capital issue that carries a fixed interest
payment, such as bonds or preferred stock. Issuing common stock would not be considered a form of financial
leverage, because the required return on equity (ROE) is not fixed and because dividend payments can be suspended,
unlike the interest on loans. One common formula for calculating financial leverage is called the degree of financial
leverage (DFL). This formula reflects the proportional change in net income after a change in the corporation's capital
structure. Changes in DFL can result from either a change in the total amount of debt or from a change in the interest
rate paid on existing debt. The accounting equation for DFL is either earnings before interest and taxes (EBIT) divided
by earnings before tax, or earnings per share (EPS) divided by EBIT.

Profitability and Earnings Before Interest and Taxes Earnings before interest and taxes measures all profits before
taking out interest and tax payments. This isolates the capital structure and focuses solely on how well a company turns
a profit. EBIT is one of the most commonly used indicators for measuring a business's profitability and is often used
interchangeably with "operating income." It does not take into consideration changes in the costs of capital. A
corporation can only enjoy an operating profit after it pays its creditors, however. Even if earnings dip, the corporation
still has interest payment obligations. A company with high EBIT can fall short of its break-even point if it is too
leveraged. It would be a mistake to focus solely on EBIT without considering the financial leverage. Rising interest costs
increase the firm's break-even point. This won't show up in the EBIT figure itself – interest payments don't factor into
operating income – but it affects the firm's overall profitability. It must record higher earnings to offset the extra capital
costs. Additionally, higher degrees of financial leverage tend to increase the volatility of the company's stock price. If
the company has granted any stock options, the added volatility directly increases the expense associated with those
options. This further damages the company's bottom line.
Financial Distress What is 'Financial Distress' Financial distress is a condition where a company cannot meet, or has
difficulty paying off, its financial obligations to its creditors, typically due to high fixed costs, illiquid assets or revenues
sensitive to economic downturns. A company under financial distress can incur costs related to the situation, such as
more expensive financing, opportunity costs of projects and less productive employees. Employees of a distressed firm
usually have lower morale and higher stress caused by the increased chance of bankruptcy, which would force them
out of their jobs.

'Financial Distress' Many warning signs may indicate a company is experiencing financial distress. Signs of Financial
Distress Poor profits indicate a company is not experiencing financial health. Struggling to break even indicates a
business cannot sustain itself from internal funds and needs to raise capital externally. This raises the company’s
business risk and lowers its creditworthiness with lenders, suppliers, investors and banks. Limiting access to funds
typically results in a company failing. Poor sales growth or decline indicates the market is not positively receiving a
company’s products or services based on its business model. When extreme marketing activities result in no growth,
the market may not be satisfied with the offerings, and the company may close down. Likewise, if a company offers
poor quality in its products or services, consumers start buying from competitors, eventually forcing a business to close
its doors. When debtors take too much time paying their debts to the company, cash flow may be severely stretched.
The business may be unable to pay its own liabilities. The risk is especially enhanced when a company has one or two
major customers.

Financial Distress in Large Financial Institutions One factor contributing to the financial crisis of 2007-2008 was the
government’s history of emergency loans to distressed financial institutions and markets believed “too big to fail.” This
history created an expectation for parts of the financial sector being protected against losses. The federal financial
safety net is supposed to protect large financial institutions and their creditors from failure and reduce systemic risk to
the financial system. However, federal guarantees may encourage imprudent risk-taking that can lead to instability in
the system the safety net is supposed to protect. Because the government safety net subsidizes risk-taking, investors
feeling protected by the government may be less likely to demand higher yields as compensation for assuming greater
risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected. Excessive risk-taking means
firms are more likely to experience distress and require bailouts for staying solvent. Additional bailouts may erode
market discipline further. Resolution plans, or living wills, may be an important method of establishing credibility
against bailouts. The government safety net may be a less-attractive option in times of financial distress. Distressed
Sale; When property, stocks or other assets are sold in an urgent manner, often at a loss. Distressed salesoften occur at
a loss because funds tied up in the asset are needed within a short period of time. The funds from these assets are
most often used to pay for debts, medical expenses or other emergencies. BREAKING DOWN 'Distressed Sale' Mortgage
borrowers who can no longer pay for their mortgaged property, may opt to sell their property in order to pay the
mortgage. Examples of situations where distressed sales occur include divorce, foreclosures and relocations.

Distress Price; When a firm chooses to mark down the price of an item or service instead of discontinuing the product
or service altogether. A distress price usually comes about in tough market conditions when the sale of a particular
product or service has slowed down dramatically and the company is unable to sell enough of it to cover the fixed costs
associated with doing business. BREAKING DOWN 'Distress Price' A company will sometimes choose to mark down an
item's price rather than discontinue operations completely because even at a distressed price, those revenues will help
with covering some of the fixed costs associated with running the business. However, if the item can not be sold at a
price greater than its variable cost of production, discontinuing the item is usually in the firm's best interests. Workout
Assumption; The assumption of an existing mortgage by a qualified, third-party borrower from a financially distressed
borrower. By having someone else assume the mortgage, the financially distressed borrower is relieved of its obligation
of repaying the mortgage. The assumption must be approved by the mortgagee. BREAKING DOWN 'Workout
Assumption' Foreclosure on a mortgage that is in default is an expensive and timely solution for the lender. If a
borrower's financial problems are temporary, a lender might be willing to find a temporary solution, such as a
forbearance agreement. If a borrower's financial problems are lasting, a workout assumption is one of several remedies
that can help the borrower avoid foreclosure. Other remedies include a mortgage short sale or a deed in lieu of
foreclosure.

Asset Deficiency; A situation where a company's liabilities exceed its assets. Asset deficiency is a sign of financial
distress and indicates that a company may default on its obligations to creditors and may be headed for bankruptcy.
Asset deficiency can also cause a publicly traded company to be delisted from a stock exchange. BREAKING DOWN
'Asset Deficiency' A company that has a chance at recovering financially may file for chapter 11 bankruptcy, under
which the company is restructured, continues to operate and attempts to regain profitability. In a worst-case scenario,
asset deficiency may force a company to liquidate, in order to pay off creditors and bondholders. The company will file
for chapter 7 bankruptcy and go completely out of business. In this situation, shareholders are the last to be repaid,
and they may not receive any money at all. Vulture Fund; A vulture fund is a fund that buys securities in distressed
investments, such as high-yield bonds in or near default, or equities that are in or near bankruptcy. BREAKING DOWN
'Vulture Fund' Vulture funds take extreme bets on distressed debt and high yield investing, also deploying legal actions
in their management strategies to obtain contracted payouts. These funds are typically managed by hedge funds using
various types of alternative strategies to obtain profits for their investors. Risk Shifting. Risk shifting is the transfer of
risk to another party. Risk shifting has many connotations, the most common being the tendency of a company or
financial institution facing financial distress to take on excessive risk. This high-risk behavior is typically undertaken with
the objective of generating high rewards to equity owners – who face little additional downside risk, but may garner
significant extra return – and has the effect of shifting risk from shareholders to debt holders. Risk shifting also occurs
when a company goes from offering a defined benefit plan to its employees, to a defined contribution plan. In this case,
the risk associated with pensions has shifted from the company to its employees. BREAKING DOWN 'Risk Shifting' Risk
shifting for a troubled company with significant debt occurs because, as its shareholders’ equity decreases, the stake of
debt holders in the enterprise increases. Thus, if the company takes on more risk, the potential extra profits accrue to
the shareholders, while the downside risk falls to the debt holders, which means that risk has shifted from the former
to the latter. A bankruptcy proceeding that provides financially distressed municipalities with protection from creditors
by creating a plan between the municipality and its creditors to resolve the outstanding debt. Municipalities include
cities, counties, townships and school districts. BREAKING DOWN 'Chapter 9' The purpose Chapter 9 is to negotiate a
repayment plan between the municipality and creditors, which can include reducing the outstanding debt or interest
rate, extending the term of the loan and refinancing debts. It is nearly impossible for a creditor to force the liquidation
of a municipality's assets. A municipality is defined by its state and is under state jurisdiction. The 10th Amendment
states that any powers not defined in the Constitution are reserved for the state. Bankruptcy proceedings are part of
the of the U.S. bankruptcy courts, which are under federal jurisdiction. Because bankruptcy proceedings are not a part
of the constitution, the federal courts cannot force a municipality to liquidate.

Mortgage Short Sale The sale of a property by a financially distressed borrower for less than the outstanding mortgage
balance due where the proceeds from the sale will be used to repay the lender. The lender then accepts the less-than-
full repayment of the mortgage (and the borrower is released from the mortgage obligation) in order to avoid what
would amount to larger losses for the lender if it were to foreclose on the mortgage. BREAKING DOWN 'Mortgage Short
Sale' A mortgage short sale is one of several options other than foreclosure that might be available to a financially
distressed borrower. Borrowers with temporary financial problems should try to negotiate a forbearance agreement
with their lender. For borrowers with more lasting financial problems, in addition to a mortgage short sale, a deed in
lieu of foreclosure or a short refinancemight be potential options in avoiding foreclosure.

Bailout. A bailout is a situation in which a business, an individual or a government offers money to a failing business to
prevent the consequences that arise from the business's downfall. Bailouts can take the form of loans, bonds, stocks or
cash. They may require reimbursement. Bailouts have traditionally occurred in industries or businesses that are
perceived as no longer being viable or are sustaining huge losses. BREAKING DOWN 'Bailout' Typically, companies in
need of bailout employ a large number of people, leading some people to believe that the economy would be unable to
sustain such a huge jump in unemployment if the business folded. Bailouts are normally only considered for companies
or industries whose bankruptcies could cause a severely adverse impact to the economy as a whole, and not just to the
industry. Financial Industry Bailout One of the biggest bailouts in history was the one offered by the U.S. government in
2008 to many of the largest financial institutions in the world that experienced severe losses resulting from the collapse
in the subprime mortgage market and resulting credit crisis. Banks, which had been providing an increasing number of
mortgages to borrowers with low credit scores, experienced massive loan losses as many of these mortgages went into
default. As well-known financial institutions such as Countrywide, Lehman Brothers and Bear Stearns began failing, the
government responded with the Troubled Asset Relief Program (TARP). The program authorized the government
purchase of up to $700 billion in toxic assets from the balance sheets of dozens of financial institutions. In the end,
TARP ended up disbursing more than $426 billion to financial institutions. Auto Industry Bailout During the 2008
financial crisis, automakers such as Chrysler and General Motors needed a taxpayer bailout of their own to stay solvent.
High gas prices at the time resulted in plummeting sales of these companies' SUVs and larger vehicles. The difficulty in
obtaining auto loans during the financial crisis further hampered auto sales. While intended for financial companies,
the two automakers ended up drawing roughly $17 billion from TARP to stay afloat. In June 2009, both Chrysler and
GM emerged from bankruptcy, and they remain among the larger auto producers today.In the early 1980s, Chrysler
was also in need of a bailout. The U.S. government stepped in and offered roughly $1.2 billion to the failing company.
By 1983, Chrysler was able to pay back the entire loan. The company operates today as Fiat Chrysler Automobiles.

MODULE II; INVESTMENT DECISIONS;

Business Investment Decision Evaluations: When you make an investment in your business, it's important to evaluate
the results. This will help you determine if it's an investment that you should repeat or if you should invest in a different
direction in the future. One of the most generally accepted and basic methods of evaluating a business investment
decision is to calculate the ROI (return on investment) of the action or expenditure. 1. Add up all costs associated with
the business investment decision you've made. For example, if you've made a decision to place an advertisement,
include the cost of designing and submitting the ad via the service you've chosen in the total cost of the investment. 2.
Identify the total income you've taken in as a direct result of making this investment based on sales reports. This can be
difficult to determine, which is why it's helpful to direct potential customers to a specific website or phone number, or
query customers at the point of purchase to track the source of those sales. 3. Subtract your cost from the total sales,
and then divide that figure by the total cost. This will give you your ROI. Multiply that number by 100 to get the ROI
percentage. 4. Examine the ROI percentage to evaluate whether you've made a productive and smart business
investment decision. A positive ROI indicates that the investment was worthwhile. 5. Continue to evaluate the business
investment over the next several months by calculating the ROI periodically. This calculation is valuable because it
allows you to evaluate your decisions based on how well you recuperate your costs; you can then continue to set clear
goals to either meet or exceed previous results. You should also evaluate the business investment by seeking feedback
from key parties who were involved. These include customers and sales personnel. This will allow you to get a fuller
view of what specifically did or did not work in your formula. If you plan to re-invest, you can make any adjustments
before going forward. The following points highlight the top seven methods used for the evaluation of investment
proposals. 1. Urgency Method: In many situations in the life of a business concern an ad hoc decision is needed in
respect of an investment expenditure. For instance, if a part of machine stops working leading to complete break¬down
and disruption in the production process, it will be justified to replace it immediately by new one even without
comparing the cost and future profit. Any decision on investment expenditure on the basis of urgency should be taken
only if it is fully warranted and justified. 2. Pay-Back Period Method: This is also known as ‘payoff and pay out’ method.
This method is employed to determine the number of years in which the capital expenditure incurred is expected to
pay for itself. This method describes in terms of period of time, the relationship between cash inflow and total amount
of invest¬ment. The pay-back period is the number of years during which the income is expected. The criterion here is
that the average income from a proposed investment be sufficient to cover investment within a period of time. It is
calculated by dividing investment by the amount of return per annum after charging taxation but before charging
depreciation. This period may be calculated by the following formula: Pay-back Period = Net Investment/Cash Inflow 3.
Unadjusted Return on Investment Method: This method is also called Accounting Rate of Return Method or Financial
Statement Method or Return on Investment or Average Rate of Return Method. Here the main feature is that the rate
of return is based on the figures for income and investment which are determined according to conventional
accounting concepts. The rate of return is expressed as a percentage of the earnings to the investment in a particular
project. There is no general agreement as to what constitutes investment and income. Income may be taken as the
average annual earnings, normal earnings or the earnings of the first year of the project. Investments may be taken as
the initial investment or the average outlay over the life of the investment. The rate of return on investment refers to
the rate of interest that will make the present value of future earnings just equal to the cost of investment. It may be
calculated according to any one of the following methods: (i) Annual Average Net Earning/Original Investment x 100. (ii)
Annual Average over Earning/Average Investment x 100. The term average annual net earnings is the average of the
earning over the whole of the economic life of the project. (iii) Increase in Expected Future Annual Net Earnings/Initial
Increase in required Investment x 100 The amount of average investment can be calculated according to any one of the
following methods: (i) Original Investment/2. (ii) Original Investment – Scrap Value of the Asset/2. (iii) Original
Investment + Scrap Value of the Asset/2 4. Net Present Value Method: The net present value method is one of the
discounted cash flow or time adjusted method. This is generally considered to be the best method for evaluating capital
investment proposals. In case of this method, cash inflows and cash outflows associated with each project are first
worked out. The net present value is the difference between the total present value of future cash inflows and the total
present value of future cash outflows. The equation for calculating net profit value in case of conven¬tional cash flows
can be as follows: where NPV = Net present value. R = Cash inflows at different time periods. K = Cost of capital I = Cash
outflows at different time periods. 5. Internal Rate of Return Method: This method is also called Time Adjusted Return
on Investment or Discounted Rate of Return. This method measures the rate of return which earnings are expected to
yield on investments. Internal rate of return is defined as the maximum rate of interest that could be paid for the
capital employed over the life of an investment without loss on the projects. The rate is similar to the effective rate of
interest calculated on debentures purchased or sold. This is calculated on the basis of the funds utilised from time to
time as opposed to the investment made at the beginning. This method incorporates the time value of money in the
investment calculation.The formula for the discounted rate of return is: C = the supply price of the asset. F = the future
cash flows. S = the salvage value of the asset in years, r = the discounted rate of return. 6. Terminal Value Method: This
method is based on the assumption that operating saving of each year is invested in another outlet at a certain rate of
return from the moment of its receipt till the end of the economic life of the projects. This method incorporates the
assumption about how the cash inflows are reinvested once they are received and thus avoids any influence of the cost
of capital on cash inflows. However, cash inflows of the last year of the project will not be reinvested. As such, the
compounded values of cash inflows should be determined as the basis of compounding factor which may be obtained
from com¬pound interest table or by the following formula: A =P (1+i)n where P=1 7. Benefit-Cost Ratio Method: This
method is based on time adjusted techniques and is also called Profitability Index or Desir¬ability Factor. The procedure
of deriving the benefit cost ratio criterion is the same as that of NPV. What is done is to divide the present value of
benefit by the present value of cost. The ratio between the two would give us the benefit-cost ratio which indicates
benefit per rupee of cost. The calculation of benefit-cost ratio is shown as follows: Benefit Cost Ratio (BCR) = Present
Value of Benefits/Present Value of Cost Payback Period . The payback period is the most basic and simple decision tool.
With this method, you are basically determining how long it will take to pay back the initial investment that is required
to undergo a project. In order to calculate this, you would take the total cost of the project and divide it by how much
cash inflow you expect to receive each year; this will give you the total number of years or the payback period. For
example, if you are considering buying a gas station that is selling for $100,000 and that gas station produces cash flows
of $20,000 a year, the payback period is five years. As you might surmise, the payback period is probably best served
when dealing with small and simple investment projects. This simplicity should not be interpreted as ineffective,
however. If the business is generating healthy levels of cash flow that allow a project to recoup its investment in a few
short years, the payback period can be a highly effective and efficient way to evaluate a project. When dealing with
mutually exclusive projects, the project with the shorter payback period should be selected. Net Present Value (NPV) .
The net present value decision tool is a more common and more effective process of evaluating a project. Perform a
net present value calculation essentially requires calculating the difference between the project cost (cash outflows)
and cash flows generated by that project (cash inflows). The NPV tool is effective because it uses discounted cash flow
analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future
cash flows. The term "present value" in NPV refers to the fact that cash flows earned in the future are not worth as
much as cash flows today. Discounting those future cash flows back to the present creates an apples to apples
comparison between the cash flows. The difference provides you with the net present value. The general rule of the
NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the
case of mutually exclusive projects, the project with the highest NPV should be accepted. Internal Rate of Return (IRR)
.The internal rate of return is a discount rate that is commonly used to determine how much of a return an investor can
expect to realize from a particular project. Strictly defined, the internal rate of return is the discount rate that occurs
when a project is break even, or when the NPV equals 0. Here, the decision rule is simple: choose the project where the
IRR is higher than the cost of financing. In other words, if your cost of capital is 5%, you don't accept projects unless the
IRR is greater than 5%. The greater the difference between the financing cost and the IRR, the more attractive the
project becomes. The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule
in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs
and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when
initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized
by businesses. Businesses often tend to value percentages more than numbers (i.e., an IRR of 30% versus an NPV of
$1,000,000 intuitively sounds much more meaningful and effective), as percentages are more impactful in measuring
investment success. Capital budgeting decision tools, like any other business formula, are certainly not perfect
barometers, but IRR is a highly-effective concept that serves its purpose in the investment decision making process. All
businesses require capital equipment (fixed assets) such as machinery, premises and vehicles. The purchase of such
assets is known as capital investment and is undertaken for the following reasons: i.To replace existing equipment
which is out-of-date or obsolete ii.To expand the productive capacity of the business iii. To reduce the production costs
per unit (i.e. to achieve economies of scale) iv. To produce new products and, therefore, break into new markets.
Capital investment, like all other business activities, involves an element of uncertainty, because expenditure is
incurred today in order to produce some benefit in the future. Investment appraisal techniques are designed to aid
decision-making regarding such investment projects. There are 3 methods which can be used to appraise any
investment project:

Payback Method. This is the simplest method of investment appraisal and is usually preferred by small businesses
because of its simplicity. Larger businesses may use it as a screening process before embarking on one of the more
complicated techniques. The payback period is the time taken for the equipment, (machinery etc.), to generate
sufficient net cash flow to pay for itself. For example: A manufacturing firm is considering investing £ 500,000 in new
machinery. The equipment is expected increase the firm's cashflow by £ 150,000 per year. How long is the payback
period ? After 1 year, the cashflow will be £ 150,000. After 2 years, the cashflow will be £ 300,000. After 3 years, the
cashflow will be £ 450,000. The firm will need £ 50,000 (or one third) of the cashflow from year 4 in order to reach the
payback point. Therefore, the payback period is 3 1/3 years (or 3 years, 4 months). Firms can use this technique in one
of two ways: Firstly, a firm could set an upper limit on the time allowed for payback, and any project which is not
expected to payback within this period is rejected. Secondly, when faced with a choice of projects, the payback method
can be used to rank projects according to the speed at which they payback. However, the payback method ignores the
following two important factors: The total return on the investment project (i.e. the earnings after payback).1.The
timing of the return prior to payback. The payback method clearly discriminates against projects which produce a slow
but substantial return, resulting in the danger that highly profitable projects will be rejected because of the delay in
producing a return (yield).Example: Each of the three alternative projects below involve an initial cost of £ 1 million,
and produce net cash flow as shown:

PROJECT YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

A £ 0m £ 0.5m £ 0.5m £ 0.5m £ 0.5m

B £ 0.5m £ 0.5m £ 0.5m £ 0m £ 0m

C £ 0m £ 0m £ 0.5m £ 1m £ 1m

Project A pays back in 3 years (£ 0 in year 1 + £ 0.5m in year 2 + £ 0.5m in year 3). Project B pays back in 2 years (£ 0.5m
in year 1 + £ 0.5m in year 2). Project C pays back in 3 1/2 years (£ 0 in year 1 + £ 0 in year 2 + £ 0.5m in year 3 + half of
the £ 1m in year 4). Using 'The Pay-back Method' to decide between these projects, project B would be selected. But if
you looked at the total revenue over the full life of each project, project C actually brings more cash into the business
and would be the better project to select. Average Rate of Return (A.R.R.) Method This method takes the total return
(yield) over the whole life of the asset into account and therefore overcomes one of the defects of the payback
method. In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost £ 1 million to
purchase, is expected to last 5 years, and will produce an annual net cash flow of £ 0.5 million. The total return (yield)
is: 5 x £ 0.5 million = £ 2.5 million If we now deduct the initial cost of investment (£ 1 million) we are left with a total
return (yield), net of the initial capital outlay, of £ 1.5 million. Annually, this works out at: When we express this annual
figure as a percentage of the original capital outlay we get the Average Rate of Return for the project:

To recap, the 4 steps for calculating the A.R.R. are: Add up the total forecasted net cash flow, Deduct the capital outlay
from this, Divide the resulting figure by the expected life (in years) of the capital, Express this annual figure as a
percentage of the capital outlay. As with the Payback method, we can use the A.R.R. in two ways. Firstly, the firm might
set a predetermined level and reject any project which has an expected A.R.R. less than this percentage. Secondly,
when faced with a choice of alternative projects, then the projects can be ranked by their A.R.R. Further examples. A
firm is considering three alternative investment projects. The maximum life of each asset is three years and the capital
outlay is £ 100,000 in each case. The table below depicts net cash flow in each of the three years:
PROJECT YEAR 1 YEAR 2 YEAR 3

A £ 50,000 £ 50,000 £ 50,000

B £ 100,000 £ 20,000 £0

C £0 £ 50,000 £ 140,000

Project A:Total forecasted net cash flow = £ 150,000. Total forecasted net cash flow - capital outlay = £ 50,000 £
16,666.67 (this is the amount of profit per year) 16.67%.. Project B: Total forecasted net cash flow = £ 120,000 Total
forecasted net cash flow - capital outlay = £ 20,000 £ 6,666.67 (this is the amount of profit per year) 6.67% Project C:
Total forecasted net cash flow = £ 190,000 Total forecasted net cash flow - capital outlay = £ 90,000 £ 30,000 (this is
the amount of profit per year) 30% The great defect of the A.R.R. method of investment appraisal is that it attaches no
importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is
received. Hence, a project may be favoured even though it only produces a return over a long period of time. The more
sophisticated methods of investment appraisal take the timing of the cash inflows into account, as well as the size of
the inflows. A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode
the real value of that sum of money over the year). This is where the notion of present value is used. Net Present Value
(N.P.V.) Method. The return on an investment comes in the form of a stream of earnings in the future. The N.P.V.
method of investment appraisal takes into account the size of the cash inflows over the life of the equipment, but also
makes adjustment for the timing of the money. A greater weighting (or importance) is given to the inflows of cash in
the earlier years. The weighting can be calculated from the following formula: A = the actual sum of money concerned.
r = the rate of discount (called the 'Discount factor'). n = the number of years. This enables us to calculate the present
value of money, net of operating costs, to be received in a certain number of years. Hence, £ 1000 in two years time, at
a 3% rate of discount, has a present value of: In examinations you will usually be given the discount factor, so that you
do not have to work it out! The present value of each year's cash inflow are then aggregated (this is called the
discounted cash flow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of present values
(minus the capital cost) is positive, then it is worthwhile proceeding with the project. If the resulting figure is negative,
then the project should not be undertaken. Example: In appraising a £ 300,000 investment project, a firm uses a
discount rate of 5%. The equipment will produce a cash inflow (net of operating costs) of £ 75,000 per year, over a five
year period. At the end of the five years, the firm expects to sell the equipment for £ 10,000. What is the Net Present
Value of the project?

Year cashflow Present Value

0 -£ 300,000 -£ 300,000

1 +£ 75,000 +£ 71,428.57

2 +£ 75,000 +£ 68,027.21

3 +£ 75,000 +£ 64,787.82

4 +£ 75,000 +£ 61,702.69

5 +£ 85,000 +£ 66,599.72

Year 0 is the present day (i.e. when the initial capital outlay is spent). The cashflow of £ 75,000 in year 1 has a present
value of: £ 71,428.57 The cashflow of £ 75,000 in year 2 has a present value of: £ 68,027.21 The process continues for
the remaining years. The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1 to
year 5). This figure is £ 332,546.01 The net present value is found by deducting the initial capital outlay from the
discounted cashflow. In other words: £ 332,546.01 - £ 300,000 = £ 32,546.01 Since this result is positive, then it is
advisable for the firm to go ahead with the investment project. If the result had been negative, then the investment
project should not be undertaken. Other Influencing Factors. There are many other factors that a business will need to
take into consideration when appraising an investment project, other than the financial (quantitative) factors.
Qualitative factors such as the objectives of the business must be considered at all times, as well as the effect upon the
employees of new machinery, new working practices and changes to their working conditions. The external
environment needs to be considered before any decision can be taken regarding a proposed investment project. These
factors include the state of the economy (e.g. it may be dangerous to attempt to expand during a recession, because
demand for products may be falling), pressure group activity, the level of technological progress in the industry (e.g.
competitors may already be using the new machinery), and any legislation (e.g. restricting the use of certain materials,
components). The effects of the actions of the business on the environment must also be taken into consideration,
since any external costs (e.g. pollution) will have a detrimental effect on the image and reputation of the business.
Finally, as with any investment decision, the business will also need to consider the amount of finance that is available
for expansion, and the effect that any borrowing to raise extra finance will have on the gearing ratio Certainty, Risk and
Uncertainty in Investment Decision. If a finance manager feels he knows exactly what the outcomes of a project would
be and is willing to act as if no alternative were in existence, he will be presumably acting under conditions of certainty.
Thus, certainty is a state of nature which arises when outcomes are known and determinate. Riskiness of an investment
project is defined as the variability of its cash flows from those that are expected. The greater the variability, the riskier
the project is said to be. In risky situations the probabilities of an event occurring are known and these probabilities are
objectively determinable. The main attribute of risk situation is that the event is repetitive in nature and possesses a
frequency distribution. This frequency distribution is used to draw inferences on the basis of objective statistical
technique. Thus, risk refers to a set of unique outcomes for a given event which can be assigned probabilities. In
contrast, when an event is not repetitive and unique in character and the finance manager is not sure about
probabilities themselves, uncertainty is said to prevail. Uncertainty is a subjective phenomenon. In such situation no
observations can be drawn from frequency distributions. Capital expenditure projects are often unique. The finance
manager may not have store of historical data to draw upon to see as to how the same project had fared in the past.
The outcomes in the state of uncertainty are too unsure to be assigned probabilities. It is worth noting that distinction
between risk and uncertainty is of academic interest only. Practically, no generally accepted methods exist. With the
introduction of risk factor, no company can afford to remain indifferent between two investment projects with varying
probability distributions, as exhibited in figure 20.1, although each investment proposal is expected to yield inflows of
Rs. 10,000 in its three-year life. A look at figure 20.1 will make it crystal clear that dispersion of the probability
distribution of expected cash flows for proposal B is greater than that for proposal A. Since the task is associated with
the deviation of actual outcome from that which was expected, proposal B is the riskier investment. This is why risk
factor should be given due importance in investment decision.

Decision-making under Certainty: A condition of certainty exists when the decision-maker knows with reasonable
certainty what the alternatives are, what conditions are associated with each alternative, and the outcome of each
alternative. Under conditions of certainty, accurate, measurable, and reliable information on which to base decisions is
available. The cause and effect relationships are known and the future is highly predictable under conditions of
certainty. Such conditions exist in case of routine and repetitive decisions concerning the day-to-day operations of the
business.

Decision-making under Risk: When a manager lacks perfect information or whenever an information asymmetry exists,
risk arises. Under a state of risk, the decision maker has incomplete information about available alternatives but has a
good idea of the probability of outcomes for each alternative. While making decisions under a state of risk, managers
must determine the probability associated with each alternative on the basis of the available information and his
experience.

Decision-making under Uncertainty: Most significant decisions made in today’s complex environment are formulated
under a state of uncertainty. Conditions of uncertainty exist when the future environment is unpredictable and
everything is in a state of flux. The decision-maker is not aware of all available alternatives, the risks associated with
each, and the consequences of each alternative or their probabilities. The manager does not possess complete
information about the alternatives and whatever information is available, may not be completely reliable. In the face of
such uncertainty, managers need to make certain assumptions about the situation in order to provide a reasonable
framework for decision-making. They have to depend upon their judgment and experience for making decisions.
Modern Approaches to Decision-making under Uncertainty: There are several modern techniques to improve the
quality of decision-making under conditions of uncertainty. The most important among these are:(1) Risk analysis,(2)
Decision trees and(3) preference theory.

Risk Analysis: Managers who follow this approach analyze the size and nature of the risk involved in choosing a
particular course of action. For instance, while launching a new product, a manager has to carefully analyze each of the
following variables the cost of launching the product, its production cost, the capital investment required, the price that
can be set for the product, the potential market size and what percent of the total market it will represent. Risk analysis
involves quantitative and qualitative risk assessment, risk management and risk communication and provides managers
with a better understanding of the risk and the benefits associated with a proposed course of action. The decision
represents a trade-off between the risks and the benefits associated with a particular course of action under conditions
of uncertainty.

Decision Trees: These are considered to be one of the best ways to analyze a decision. A decision-tree approach
involves a graphic representation of alternative courses of action and the possible outcomes and risks associated with
each action. By means of a “tree” diagram depicting the decision points, chance events and probabilities involved in
various courses of action, this technique of decision-making allows the decision-maker to trace the optimum path or
course of action.

Preference or Utility Theory: This is another approach to decision-making under conditions of uncertainty. This
approach is based on the notion that individual attitudes towards risk vary. Some individuals are willing to take only
smaller risks (“risk averters”), while others are willing to take greater risks (“gamblers”). Statistical probabilities
associated with the various courses of action are based on the assumption that decision-makers will follow them. For
instance, if there were a 60 percent chance of a decision being right, it might seem reasonable that a person would take
the risk. This may not be necessarily true as the individual might not wish to take the risk, since the chances of the
decision being wrong are 40 percent. The attitudes towards risk vary with events, with people and positions.

Top-level managers usually take the largest amount of risk. However, the same managers who make a decision that
risks millions of rupees of the company in a given program with a 75 percent chance of success are not likely to do the
same with their own money. Moreover, a manager willing to take a 75 percent risk in one situation may not be willing
to do so in another. Similarly, a top executive might launch an advertising campaign having a 70 percent chance of
success but might decide against investing in plant and machinery unless it involves a higher probability of success.
Though personal attitudes towards risk vary, two things are certain. Firstly, attitudes towards risk vary with situations,
i.e. some people are risk averters in some situations and gamblers in others. Secondly, some people have a high
aversion to risk, while others have a low aversion. Most managers prefer to be risk averters to a certain extent, and
may thus also forego opportunities. When the stakes are high, most managers tend to be risk averters; when the stakes
are small, they tend to be gamblers.

Methods for Taking Investment Decisions under Risk. Some of the most important methods that are used for taking
investment decisions under risk are as follows: 1. Sensitivity Analysis 2. Scenario Analysis 3. Decision Tree Analysis 4.
Break-Even Analysis 5. Risk-Adjusted Discount Rate Method 6. Certainty-Equivalent Analysis. Risk refers to the deviation
of the financial performance of a project from the forecasted performance. One needs to forecast the cash flows and
other financial aspects while selecting a project. However, the actual financial performance of a project may not in
accordance to the forecasted performance. These risks can be decline in demand, uneven cash flow, and high inflation.
For example, an organization is planning to install a machine that would increase the production level of the
organization. However, the demand of the product may vary with the economic environment, for example, the demand
may be very high in economic boom and low if there is recession. Therefore, the organization may earn high income or
incur huge loss, depending on the business environment. However, different kinds of risks can be assessed up to a
certain limit. The risks can be assessed by using various methods that are shown in Figure-7:

1. Sensitivity Analysis: Forecasting plays an important role in project selection. For example, a project manager needs to
forecast the total cash flow of a project. The cash flow depends on the revenue earned and cost incurred in a project.
The revenue earned from the project depends on various factors, such as sales and market share. Similarly, if we want
to find out the NPV or IRR of the project, we need to make the accurate predictions of independent variables. Any
change in the independent variables can change the NPV or IRR of the project. In sensitivity analysis, we analyze the
degree of responsiveness of the dependent variable (here cash flow) for a given change in any of the dependent
variables (here sales and market share). In other words, sensitivity analysis is a method in which the results of a
decision are forecasted, if the actual performance deviates from the expected or assumed performance. Sensitivity
analysis basically consists of three steps, which are as follows: 1. Identifying all variables that affect the NPV or IRR of
the project.2. Establishing a mathematical relationship between the independent and dependent variables. 3. Studying
and analyzing the impact of the change in the variables Sensitivity analysis helps in providing different cash flow
estimations in three circumstances, which are as follows: a. Worst or Pessimistic Conditions: Refers to the most
unfavorable economic situation for the project b. Normal Conditions: Refers to the most probable economic
environment for the project. c. Optimistic Conditions: Indicates the most favorable economic environment for the
project .Let us consider the example given in Table-5: Now, the NPV of each of the projects can be calculated by using
the formula of NPV. The calculation of the NPV of project A is shown in Table-6: Similarly, the calculation of NPV of
project B is shown in Table-7: Therefore, we can see that the extent of loss in project B is less than that of project A but
the extent of profit in project B is more than that of project A. Therefore, the project manager should select project B.

2. Scenario Analysis: Scenario analysis is another important method of estimating risks involved in a project. It involves
assessing future uncertainness associated with a project and their outcomes. In this method, different probable
scenarios are analyzed and the associated outcomes are also determined. For example, you are going to undertake an
important project and have forecasted your cash flows accordingly. If your forecast goes wrong substantially, the future
of the whole project can be jeopardized. As discussed earlier, in sensitivity analysis, different factors of a project are
interdependent. Therefore, if any of the factors are disrupted, the whole forecast can be wrong. Scenario analysis helps
a project manager in preparing a framework where he/she can explore different kinds of risks associated with a project.
It is more complex as compared to sensitivity analysis. Scenario analysis needs sophisticated computer techniques to
effectively calculate a large number of probable scenarios and their respective outcomes. Scenario analysis is more
useful to a project manager than the sensitivity analysis as the former is more comprehensive and gives more insight
about a project. However, there are few disadvantages of this method, which are as follows: (a) Complex Process:
Involves difficult calculations as calculating the NPV of a project is not easy by following this method. The complexity of
the method makes it both costly and time consuming. (b) Difficulty in Assessing the Probability: Implies that it is very
difficult to estimate the possibility of different outcomes. Sometimes, in practical life, assessing future uncertainties is
not accurate.

3. Decision Tree Analysis: Decision tree analysis is one of the most effective methods of assessing risks associated in a
project. In this method, a decision tree is drawn for analyzing the risks associated in a project. A decision tree is the
representation of different probable decisions and their probable outcomes in a tree-like diagram. This method takes
into account all probable outcomes and makes the decision making process easier. Let us understand decision tree
analysis with the help of an example, X&Y Manufacturers has two projects, project A and project B. The two projects
need the initial investment of Rs. 25000 and Rs. 32000, respectively. According to an estimation, 35% probability of
project A to give a return is Rs. 46000 in next five years and 65% probability is that it may give a return of Rs. 42000 in
the same period. Similarly, 20% probability of project B to give a return of Rs. 55000 in next five years and 80%
probability is that it may give a return of Rs. 50000 in the same period. Now, if we express the problem in a decision
tree, we will get a tree-like diagram, which is shown in Figure-8: Now, the net value of each of the projects can be easily
calculated. The net value of the project A would be (46000×0.35) + (42000×0.65) -25000 = (16100+27300-25000)
=18400. Similarly, the net value of the project B would be (55000×.20) + (50000×.80)-32000 = 19000 Now, it is obvious
that the project B is more profitable for the organization. Therefore, the organization should continue with project B.
The advantages of decision tree analysis are as follows: (a) Detail Insight: Provide a detailed view of all the probable
outcomes associated with a project (b) Objective in Nature: Provides a clear evaluation of different alternative
decisions Following are the disadvantages of decision tree analysis: (a) Difficulty in Large Number of Decisions: Signifies
that if the expected life of the project is long and the number of outcomes are large in numbers, it is quite difficult to
draw a decision tree (b) Difficulty in Interdependent Decisions: Indicates that the calculation becomes very time
consuming and complicated in case the alternative decisions are interdependent

4. Break-Even Analysis: Break-even analysis is a widely used technique in project management. Break-even is a no profit
and no loss situation for a project. In break-even analysis, all costs associated with a project are divided into two heads,
fixed costs and variable costs. The total fixed cost and the total variable cost are then compared with the total return or
revenue of the project. In a break¬even scenario, the total of all fixed costs or variable costs in a project is equal to the
total revenue or return from the project. Therefore, a project can be said to have reached its break-even when it does
not have any profit or loss. The concept of breakeven point is explained in Figure-9: The different costs used in break-
even analysis are explained as follows: (a) Fixed Costs: Refer to the costs incurred at the initial stage of the project and
does not depend on the production level or operation level of the project. For example, cost of a machinery and rent.
(b) Variable Costs: Refer to the costs that depend on the volume of production. Wages and raw materials are the
examples of variable costs. (c) Total Cost: Refers to the sum total of fixed costs and variables costs. As shown in Figure-
9, at point P, the total cost is equal to the total revenue. Therefore, the project can be said to have achieved break even
at point P.

5. Risk-Adjusted Discount Rate Method: Risk-adjusted discount rate method refers to the adjustment of risk in
valuation model that is NPV. Risk-adjusted discount rate can be expressed as follows: d = 1/ 1+r+µ. Where, r = risk free
discount rate µ = risk probability. The preceding formula can be used for calculating risk-adjusted present value. For
example, if the expected rate of return after five years is equal to R5, then the risk-adjusted present value can be
determined with the help of the following formula. Present Value (PV) = 1/ (1+r+µ) 5 R5 .The calculation of risk-
adjusted NPV for nth year can be done with the help of following formula: Where, Rn = return in nth year. Co = original
cost of capital. By substituting the value of d, we get the following equation: Let us understand the calculation of risk-
adjusted discount rate with the help of an example. For example, a project, ABC cost Rs. 100 million to an organization.
The project is expected to give a return of Rs. 132 million in one year. The discount rate for project 18% and probability
of risk is 0.12. Find out whether the organization should accept the project ABC or not? Solution:The risk-adjusted NPV
for project ABC can be calculated as follows: Where, R = Rs. 132 million. Co = Rs. 100 million. r = 0.08. H = 0.12. After
substituting the given values of different variables, we get the risk-adjusted NPV that is equal to: NPV =
132/1+0.08+0.12 = 100. NPV = 10 million. Therefore, the organization is getting risk-free return of Rs. 10 million. If we
calculate NPV for the same project, it would be equal to: NPV = 132/1+0.08 = 100. NPV = 22.22 million. NPV and risk-
adjusted NPV both are greater than zero. Therefore, project is profitable and should be accepted. The advantages of
risk-adjusted discount rate method are as follows: (a) Changing discount rate by changing risk factor (µ) for different
time periods and amount of risk (b) Adjust the high risk of future by increasing the time duration for risk adjusted rate.
For example, the risk-adjusted discounted rate for 50th year is equal to: (c) Regarding as the easiest method for
evaluating projects in risk conditions .However, the disadvantage of risk-adjusted discount rate method is that it fails to
provide tool for measuring risk factor. Therefore, it is required to be supplemented with the method to calculate risk
factor.

6. Certainty-Equivalent Analysis:.Certainty-equivalent analysis is also used for the adjustment of NPV, thus, selecting or
rejecting a project. It is similar to risk- adjusted discount rate analysis. However, there is one difference between them.
In risk-adjusted discount rate analysis, the discount rate is adjusted while in certainty-equivalent analysis, expected
return is adjusted. Certainty-equivalent NPV can be, calculated with the help of the following formula: NPV= aRn/ (1+ r)
n-C0. Where, a= certainty- equivalent coefficient .The value of a can be determined with the help of following formula:
α = Rn/Rn* Where, Rn = Expected certain return. Rn* = Expected risky return. For example, between two projects P and
Q, P is risky but gives Rs. 100 million of return after one year. However, Q is risk-free but gives Rs. 90 million of return
after one year. The investment for project P is Rs. 70 million and for Q it is Rs. 73 million. The risk-free discount rate is
10%. In such a case, two projects are equal for the investor. This implies that risk-free project Q is equivalent to risky
project P. Therefore, certainty-equivalent coefficient would be: α = 90/100. α = 0.9 The certainty-equivalent NPV for
project P would be:NPV= α Rn/ (1 + r) n –C0. NPV = 0.9 * 100/ (1+0.1) -70. NPV = 12 million. The certainty-equivalent
NPV for project Q would be:NPV = Rn/ (1+r) n – C0. NPV = 90/ (1+0.1) – 73. NPV = 9 million. The project P yields more
with less investment as compared to project Q. Therefore, project P would be selected. The Impact of Inflation on
Management Decisions. This article is from a paper delivered before a symposium of the Academy of Political Science
at Columbia University, November 11, 1974, under the overall topic of "Inflation, Fiscal, Social and Economic Impacts."
Data herein on the 1974-75 recession have worsened since this paper was given. Recession, I submit, is the unwanted
offspring of inflation. Inflation is of course the all too familiar problem of too much money (demand) chasing too few
goods (supply), with the upshot of prices and expectations everywhere tending to rise higher and higher. How should
business managers cope with inflation? This paper seeks answers to that question. To do so we should define our
terms. What is management? What is business? And what is at stake in the onslaught of inflation? A reading of Peter
Drucker’s new book, Management: Tasks, Responsibilities, Practices, leads me to the following in answer to the
question, What is management? The answer is manifold. Management is planning. Management is organization.
Management is responsibility. Management is profitability. It is also leadership, discipline, practice, performance,
accounting, marketing, tasks, communication and information. Management is — in the final analysis — decision-
making. But making decisions on whose behalf? Management’s? The employees’? The shareholders’? The
community’s? The business’ as a whole? Not really. For what is business? Business is service. Or, to put it baldly,
business is a hired servant. Hired by whom? The consumer. Yes, business is guided ‘by profitability, by its own self-
interest; yet it is subject to the sovereignty of the consumer. As Ludwig von Mises pointed out, "Production for profit is
necessarily production for use, as profits can only be earned by providing the consumers with those things they most
urgently want to use." So the test of a manager’s decisions is profitability — the extent to which he increases revenues
and cuts costs. Business management is profit management. Consumers reward efficient management with profits and
penalize inefficient management with losses. Now, what is at stake when we weigh the impact of inflation on
management? Remember that business — or, more broadly, the private sector — is the principal source of jobs: Of our
total labor force of about 94 million, government furnishes only 16.5 million jobs. This includes more than two million
members of the armed forces. With 5.5 million presently unemployed, this means that business, including agriculture
and the professions, furnishes the remainder — around 72 million jobs. Business is also the source of most economic
output. Thus it generates the bulk of real income in our society — food, clothing, shelter, transportation, medicine,
information, and the like. So what is at stake in the onslaught of inflation? Nothing less than the survival of the business
system itself. Note that while I tick off the inflationary distortions on management decisions, I reserve the greatest
distortion until last — the possibility of a sharp recession or even a depression. Managers can get a fast overview of the
problem of coping with soaring prices by simply noting how the process of inflation distorts the traditional functions of
money. Impact on Functions of Money .Money, we were told in Economics 101, is first and foremost a medium of
exchange. Quite obviously, then, under inflation the purchasing and employment managers will find that, economize
though they may, more and more money is required to buy the same amount of goods and services, including labor.
The pricing manager also must be quick on his feet to avoid a cost-price squeeze; hence he must seek to keep his prices
ahead of costs as far as competition and other factors allow. Ironically, money has become such a "hot potato" that
some managers, especially those involved in international transactions, don’t want to hold it and prefer goods instead.
Indeed, some managers trade raw materials for finished goods and vice versa. Thus, through swap arrangements, they
alleviate shortages while retreating from money as a medium of exchange. Too, Eco. 101 reminded us money has a
store of value function —the retention of purchasing power over time. Inflation, however, is a thief of that power. The
financial manager is thereby under pressure to put his liquid assets to work as rapidly as possible. Bluntly, he must
hedge against inflation, balancing his choice of investments between yield and risk. He will also seek to expedite the
collection of accounts receivable, exacerbating the general squeeze on liquidity. Again, money is a standard of value —
a unit of account, a yardstick for relative prices. Inflation similarly distorts this function of money by shrinking this key
accounting measurement. A dollar is no longer a dollar over time; it is no longer predictable; it no longer permits
accurate economic calculation; it is 80¢ or 700 or 60¢ and so on, depending on the length of time and the pace of
inflation; and all historical financial records thus call for careful interpretation. The usual tool to accomplish such
interpretation is the concept of constant dollars which allows some comparability among accounting periods. I say
"some comparability" for changes in the Consumer Price Index, the Wholesale Price Index and the GNP Implicit Price
Deflator can still not be considered scientific measurements of inflation. Inflation is notoriously uneven, with some
prices advancing rapidly, some moderately and some lagging behind. Constant dollars are an especially inadequate tool
for multinational corporations. They use different currencies, each with a different history of inflation. Also, rates of
inflation and rates of exchange in money markets vary, rendering translation of foreign currencies into U.S. dollars for
consolidated financial statements much more difficult. Lastly, Eco. 101 assigned a fourth function to money—a
standard for deferred payments. One of inflation’s most bitter repercussions is that it warps all debtor-creditor
relations. In other words, money as a standard for deferred payments has all too often become a shrinking standard.
The borrower is thereby able to repay his debt with cheaper money than that he initially borrowed. In other words,
inflation fleeces the creditor. This hard fact of our inflationary era means financial managers have to adjust their
lending activities, such as acquiring commercial paper and certificates of deposit. By the same token, financial
managers have to adjust their borrowing activities, such as getting bank lines of credit and issuing corporate bonds.
Lending or borrowing, financial managers should recognize that the largest single element in the height of interest
rates today is the level of inflation, currently at a two-digit level. The foregoing section points up some current
monetary distortions. My purpose in this paper is to give some perspective to the management side of inflation and to
detail some ramifications of the impact of inflation on the decision process. In particular, I wish to briefly examine the
distortions of inflation in the decision areas of profits, inventory, capital investment, wages, international operations,
price controls and the business cycle. The overriding distortion is informational. Good decisions are dependent upon
good information. Much if not most of that information, however, is undermined both quantitatively and qualitatively
by inflation. It therefore behooves managers to seek to correct, as best they can, their information for inflation.

Impact of Inflation on Profit Calculations. In 1974 people in high places have been charging that corporate profits are
"excessive," "unconscionable" and even "obscene." These adjectives sound hollow against the backdrop of a disastrous
stock market. The words sound even more hollow when corrections of profit figures are made for inflation. Dramatic
results are obtained with three major corrections: 1. Under depreciation of plant and equipment, due to depreciation
allowances based on original cost rather than replacement cost. This practice has long led to a general overstatement
of corporate profits, with consequent overpayment of corporate income taxes and even overpayment of dividends.
These result in diminution of potential capital formation. Tax authorities have recognized this problem and have dealt
with it to some extent by setting up investment tax credits and accelerated depreciation methods. Financial managers
have taken advantage of these provisions to varying degrees. Yet these provisions have proven to be inadequate in
view of our two-digit inflation. Both tax authorities and financial managers would be well advised to recognize this
depreciation deficiency and the drag it imposes on economic growth — on the economy as a whole and on each
individual enterprise. The average age of American plant and equipment continues to lag behind that of our major
industrial competitors overseas, and behind what is needed to meet the expectations of our growing population. So
still more realistic and competitive depreciation methods are clearly needed.

2. Allowance for the inflation that has diminished the profit dollar. Inflation has eroded the purchasing power of the
dollar by more than 40 per cent since 1965. So on this count alone, and despite more than a trillion dollars (in today’s
prices) poured into plant and equipment, corporate profits have shown but minor increases since 1965 in real terms.
For as sensible is the conversion of money wages into real wages, so financial managers can sensibly convert money
profits into real profits. To be sure, second quarter results in 1974 were about 25 per cent ahead of those of the second
quarter of 1973. But price controls came off completely April 30, 1974, allowing many firms to catch up with true
supply and demand. Moreover, if the spectacular gains of some basic materials industries are excluded, along with the
atypical profits of the auto industry, the bulk of industrial companies made only a moderate increase of 10 to 11 per
cent in the first half of 1974 — just about equal to the rate of inflation. In any event, corporate financial and public
relations managers may want to deflate their profit figures and remind the public of the corporate return in real terms.
Yet these managers are frequently reluctant to do so, beholden as they are to shareholders and given to pointing with
pride to "record" profits. The economy therefore suffers because of management’s desire to show good earnings
during an inflationary era.

3. Overstatement of profits because of the understatement of inventory values. Some authorities call inventory gains
"phantom profits," which disappear the moment inventory is replaced. The magnitude of inventory profits can be seen
in the Commerce Department calculations of $37.9 billion annual rate in the second quarter of 1974, up from $31
billion in the first quarter and $20 billion a year earlier. For perspective, after-tax corporate profits ran at a seasonally
adjusted annual rate of $85.6 billion in the second quarter of 1974, up only $500 million from the first quarter, despite
$6.9 billion of inventory profits. To put their own corporate profits in a truer light, quite a few financial managers are
switching from first-in, first-out (FIFO) to last-in, first-out (LIFO) for more accurate inventory valuation. It’s about time.
In an editorial on October 1, 1974, the Wall Street Journalcriticized those financial managers who got caught up in the
earnings-per-share mystique and used FIFO to that end. With rising inventory prices, FIFO permitted higher reported
earnings all right, but it also permitted —in fact, required — higher taxes on those earnings. Indeed, FIFO thereby
fostered less capital to invest for long run returns. Capital markets don’t ignore such unrealistic accounting. The Journal
referred to a study by Shyam Sunder, an accounting professor at the University of Chicago graduate business school, in
which 118 LIFO firms listed on the New York Stock Exchange outperformed the market in stock price appreciation by
4.7 per cent. Economist George Terborgh of the Machinery and Allied Products Institute in Washington, D.C. has made
all three of the foregoing adjustments to 1973 corporate profits. He found that such adjusted profits came to less than
60 per cent of what they were in 1965. Retained earnings, he found, were down even more significantly; they were but
around $3 billion, or 16 per cent of what they were in 1965. The portent for real capital investment and real economic
growth in the immediate future is hence not very great, mainly because of the disastrous inflation we have been
incurring for the past two years.

Impact on Inventory Planning. Inflation also muddies inventory planning, as can be gathered from my references to
LIFO-FIFO accounting methods. Ideally, the inventory-sales ratio should be kept as low as feasible so as to minimize the
cost of storage and the cost of money tied up in inventory. But inflation creates all manner of uncertainties because of
rising prices in raw materials, semi-finished and finished goods. As these prices rise, purchasing managers naturally
undergo temptations to "beat the gun" by accelerating their forward buying. The purchasing manager of course realizes
that his cost of storage and tied-up money will thereby go up. But he may hold that these costs are more than offset by
being able to obtain inventory at lower prices than he could later. Too, with a surge of buying he may also begin to
worry about availability and delivery delays. So, he inadvertently adds to speculative activity and puts pressure on
prices, as he accelerates his forward buying. With all this, however, his inventory-sales ratio may not advance if other
purchasing managers adopt the same hedging behavior and also increase their forward buying; the result is that as his
inventory climbs, so do his sales. This would be especially true if the purchasing manager is in a basic materials industry.
But such inventory build-up behavior, stimulated by surging demand, tends to be short-lived. For on this score alone,
inflation may be contributing to a key factor in the business cycle — inventory buildups, which can lead to a boom, and
inventory liquidations, which can lead to a bust. Ironically, the liquidations in effect contribute to deflationary pressures
on the very price-inflated commodities and goods that brought on the inventory build-up in the first place.

Impact on Capital Planning. In like manner, inflation disrupts capital planning. Business may be good and the backlog
long, but the long-run outlook remains unclear. The planning manager is thus put in the same quandary as the
purchasing manager. On the one hand, he doesn’t want to tie up his financial resources in the fixed costs of under-
utilized plant and equipment and incur the burden of unnecessary overhead. On the other hand, he is lured by the
possibility of obtaining capacity at a significantly lower cost than he could in later stages of inflation; and, he hopes,
maybe his order backlog won’t evaporate. This quandary is especially visible in the basic materials industries such as
energy, metals, paper, chemicals, and so on. These industries are extremely capital-intensive. Moreover, because these
industries lend themselves to significant economies of scale and require long lead times for new facility construction,
new capacity demands tend to come in lumps rather than in evenly spaced-out requirements. The process is
exacerbated by inflation and the business cycle which give wider swings and a feast-famine aspect to the capital goods
industry. This aspect is inherent in the capital goods industry anyway, as the accelerator theory of J. M. Clark
demonstrates. This theory says that a change in demand for consumer goods tends to have an accelerated change in
the demand for capital goods, assuming that the economy is operating at full capacity. Inflation accentuates the
problem of the accelerator by giving exaggerated indications of consumer and capital goods demand. Inflation and the
business cycle itself seem to be initiated by credit expansion and artificially low interest rates, both aided and abetted
by the central bank. The low interest rates give businessmen false signals of genuine capital availability made possible
by savings when the fact of the matter is usually a central bank speedup of money supply growth. The speedup
provides the familiar scenario of too much money chasing too few goods, winding up in "stagflation" — a combination
of inflation, extremely high interest rates and economic stagnation. (The cyclical process is spelled out more fully at the
close of this paper.) The scenario comes at a bad time. Capital formation has lagged for a long time in America. The
American economy must modernize and expand its plant and equipment to accommodate its growing labor force, to
reach its energy and ecological goals and to compete in an increasingly competitive one-world economy. International
competitiveness has been rising at the same time that the U.S. has been lagging behind its major overseas competitors
in the pace of investment. Here are comparative rates of capital investment for 1973, using gross private domestic
investment as a percentage of GNP: United States 16 per cent West Germany 26 per cent France 28 per
cent Japan 37 per cent So U.S. capital needs are enormous. The New York Stock Exchange has just completed a
careful technical study on the capital needs and savings potential of the U.S. economy through 1985. The study aimed
at developing realistic projections of U.S. capital supply and demand over the next 12 years. For this period the study
came up with the following quantitative conclusion: Saving potential $4,050,000,000,000. Capital requirements —
4,700,000,000,000 (650,000,000,000). In other words, the numbers suggest that the present estimated saving potential
in the American economy through 1985 — from all domestic sources — is slightly better than $4 trillion. At the same
time, capital demand or requirements will possibly hit a grand total of $4.7 trillion, or more than three times the rate of
the previous twelve years in current dollars. The painful indicated capital gap — fraught with human misery — is hence
estimated at $650 billion or $54 billion a year. Continued inflation can only compound this problem, impeding, as it
does, the two critical processes involved in capital formation: saving and investing.

Impact of Inflation on Wages. Wages constitute some three-quarters or more of all industrial costs, or much more than
most businessmen seem aware, inasmuch as a large fraction of this amount is paid indirectly in the form of purchased
goods and services. These goods and services, in other words, themselves embody much labor cost. The point is that
cost-push inflation is largely wage-push inflation. So, to quite an extent under the doctrine of "full employment," as
wages go so goes inflation. In any event, given the state of our relatively one-sided collective bargaining today in what
Sumner Slichter of Harvard called our "laboristic" economy, the industrial relations manager can not do a great deal to
soften the terms of the labor contract, other than to inform his opposite-number union negotiators of the state of the
industry and his company, the competitive realities and the stage of the business cycle. Also, he can advise top
management whether the company should accept a strike as a way of winning more amenable terms. With all this,
however, the traditional collective bargaining areas of wages, hours and working conditions will likely be set in contract
provisions not entirely to the industrial relations manager’s liking. Inflation tends to induce work laxity. Working
conditions, for example, may be characterized by restrictive work practices, which of course hamper labor productivity
improvement — practically the only source of real wage gains. Lessened productivity, in turn, contributes to the
inflationary situation of "too few goods." Some of these restrictive work practices are obvious and direct. For example,
size restrictions on the width of paint brushes and rollers, a 150-mile definition of a "day’s work" for trainmen, a limit
on the size of cargo slings used by longshoremen, a typographers union requirement that "bogus type" be set as an
offset to the use of advertising mats. Some restrictive work practices are indirect and not so obvious. For example,
hiring hall arrangements in some fields of employment and control of the labor market by limiting entrants to a
particular labor force such as construction. Importantly, too, the wages provision of the labor contract is similarly
inflationary when agreed-upon wage increases exceed productivity gains and worsen the unit labor cost picture of the
firm. The firm is thereby under pressure to recoup the added cost burden from its customers. It will unquestionably do
so if the union contract is in the industry pattern and if the banking system has in effect accommodated the higher
wages with greater demand. If the accommodation isn’t made, unemployment will likely expand. Even with such
accommodation, unemployment will still ultimately expand because of the additional demand pressures created by the
new money leading to uneconomic higher unit labor costs. Demand by employers is likely to falter anyway as inflation
brings about excessive minimum wages and labor union settlements over and above market demands. In any event,
the long-run correlation between increases in unit labor costs and the rate of inflation is unmistakable. At the same
time inflation tends to give management a cost-plus mentality with regard to these-settlements. If demand is rampant,
the employer may shrug his shoulders at the otherwise exorbitant wage demands, yield to them and raise his prices
accordingly — a scenario that works in the early stages of inflation. The scenario is accentuated by inflated expectations
on the union’s part. Not so many years ago a 4 or 5 per cent wage increase demand was workable. Now the teamsters
or the plumbers or the coal miners or the phone workers demand 20 to 30 per cent and settle for 10 to 15 per cent.
Thus in the third quarter of 1974, according to the Labor Department, the average wage increase for new major union
contracts came to 11.3 per cent, up from 10 per cent in the second quarter. These increases add fuel to expectations
and the inflationary process, in light of the historical postwar labor productivity improvement factor in the U.S. of
around three per cent a year. The process is exacerbated, I submit, by the use of cost-of-living escalator clauses. Some
five million members of the labor force are covered by such clauses and this number is growing. Escalator clauses tend
to be little engines of inflation since they push up wages and unit labor costs as "the Consumer Price Index rises, and
thereby tend to push prices and the CPI even higher, or create unemployment and pressure for monetary expansion. In
other words, the escalator clauses act as a built-in wage-price spiral as well as a built-in worker dis employing agent.

Impact on International Operations. Decisions in the international area are greatly influenced by inflation. Corporate
money managers, for example, have had to deal in recent years with "hot money" around the world. They have had to
hedge against threatened currencies to protect their accumulated investment funds from erosion because of inflation
or devaluation. Currencies have been not only devalued but upvalued, floated and repegged. The United States dollar
itself has undergone two devaluations since December 1971, causing quite a turmoil in the currency portfolio of
virtually every multinational corporation. Quite a few multinational corporations, including banks, have had to absorb
significant losses from currency fluctuations. A prime example is the Franklin National Bank failure. Corporate money
managers have therefore found it necessary to increase their hedging and swap arrangements to minimize these
losses. Again, the quadrupling of oil prices via the OPEC cartel has led to some second thoughts in corporate board-
rooms on industrial expansion projects here and abroad. Energy the world over has become not only very expensive,
but has become tied up in political problems involving its basic availability. Indeed, there is even a growing possibility of
further nationalization and expropriation, although this possibility is also brought about by general inflation and other
factors. The high cost of oil and almost every other basic commodity, including wheat, rice, sugar, zinc, tin, aluminum,
steel, and the like, has worsened the balance of payments positions of virtually every major industrial country. The
result is that these countries are now tending to discourage non-energy imports while pushing their exports harder to
offset higher oil prices. Accordingly, corporate money managers will probably find export credit financing sweetened by
government agencies in all the countries in which their companies do business, and new barriers to entry for the goods
they wish to import into those countries. The effect of all this is to increase trade restrictions — to narrow world
markets while ironically accelerating world competition. Another result stemming from the OPEC model is the incentive
for other developing nations to exploit the basic commodities with which they are blessed. The bauxite countries,
notably Jamaica and Guyana, have already sharply raised prices to the aluminum companies. Rumblings of like action
have been heard from the copper-producing, coffee-producing and tin-producing countries, among others. So we begin
to see how inflation more and more disrupts normal international economic relations for multinational corporations.
The years since World War II of harmonious trade and international division of labor, so conducive to world peace,
seem to be coming to an end. We are apparently entering an era of economic isolationism wrought by the
internationalization of runaway inflation.

Impact of Price Controls on Management. One impact of inflation is political — a tendency for governments to react to
inflation with wage and price controls. The irony of such government reaction is twofold: First, government itself is
overwhelmingly responsible for the inflation it seeks to correct; and second, wage and price controls treat symptoms,
not causes; they repress inflation, mask it, causing shortages and distortions while allowing inflationary forces to
become even more virulent. The period of the "New Economic Policy" from August 15, 1971 to April 30, 1974 is a case
in point. Corporate managers in this period generally experienced a cost-price squeeze. In other words, they found
their prices lagging behind their costs, chiefly labor and interest costs. In such a squeeze, many of them fled the
regulated domestic market and shipped to unregulated markets abroad. This situation merely worsened the distortions
in relative prices and the shortages endemic to the entire wage-price control era. Besides shortages, corporate
managers had to contend with rampant demand, shipment delays, quality lapses, multiplying bureaucratic
interferences and, ultimately, breakdown of the controls themselves. This breakdown in turn led to a rash of "catch-up"
wage and price increases, which haunt us down to this very hour. The controls led not only to a profit squeeze, but to a
capital investment squeeze. Many basic materials industries, for example, knew that they had exhausted their capacity
limits and that their backlogs could be measured not in months but in years. Yet they still could not set aside expansion
funds by the retained earnings route, with earnings so squeezed; they could not raise equity funds with their stock
prices so depressed; and they could not go to the bond market, with inflated interest rates reaching double-digit levels.
The upshot was that supply became tighter and tighter across the country.

Inflation and Business Cycle. Of critical concern to management is the turn of the business cycle. Should the company
expand operations or retrench? What lies ahead: boom or bust? Management is helpless in doing anything about the
cycle; like death and taxes it is there, stark and inexorable. Or so it seems. About all management can do is to try to
forecast the turn and act accordingly. But forecasting, even by elaborate computerized econometric models, has
proven woefully ineffective over recent years. It has shown itself to be anything but a science. It is an art, and a dubious
art at that, as the record of business forecasts sadly evidences. As Walter W. Heller, chairman of the Council of
Economic Advisers under Presidents Kennedy and Johnson, declared at the December 1973 meeting of the American
Economic Association meeting in New York: "Economists are distinctly in a period of re-examination. The energy crisis
caught us with our parameters down. The food crisis caught us, too. This was a year of infamy in inflation forecasting.
There are many things we really just don’t know." But why is it that practically the entire business community is
suddenly thrust into a huge crop of sharp profit setbacks or outright losses? Why is it that even blue-chip
managements, noted for their track record of achieving profits and shunning losses, suddenly find their order backlog
fading, the more so for capital goods managements? I believe inflation is at the root of the business cycle, as Ludwig
von Mises and 1974 Nobel Prize winner Friedrich von Hayek have long pointed out. Specifically, they have observed
that the appearance of the business cycle roughly coincided with the origins of the fractional reserve banking system
along with central banks. They have criticized credit expansion (not based upon actual savings) and the doctrine of easy
money —ready availability at artificially low interest rates. They have also criticized central banks for aiding and
abetting the process by pumping in additional bank reserves and becoming lenders of last resort. And they have
criticized central banks for becoming giant printing presses through monetizing government deficits. For management
the process looks like this. Credit expansion puts pressure on resource prices but profits boom. Capacity is strained, so
new capital expansion projects are launched. Cost-price squeezes develop. Inflation leaps ahead. Interest rates soar.
The stock market falls. Consumers retreat. Businesses fail, especially as their debt structure becomes unserviceable.
Expansion slows down, and the recession begins. The recession, if allowed to run its course and if inflation slows down,
becomes part of the cure. If these two criteria are not met, the recession can turn into a depression. In sum, the impact
of inflation on management decisions is all-pervasive. There is no handyescape hatch. Losses for management — and
for society! — are almost inevitable due to the deterioration of economic calculation, the increase of uncertainty, the
evaporation of purchasing power, the damages of recession. The best remedy for inflation is to get at its taproot —
deficit spending and excessive money creation. As good citizens, corporate managers might well remember the
observation of Dante: "The hottest places in hell are reserved for those who, in a period of moral crisis, maintain their
neutrality.

Protect Your Foreign Investments From Currency Risk Investing in foreign securities, while a good thing for your long-
term portfolio, continues to pose new threats for investors. As more people broaden their investment universe by
expanding into foreign stocks and bonds, they must also bear the risk associated with fluctuations in exchange rates.
Fluctuations in these currency values, whether the home currency or the foreign currency, can either enhance or
reduce the returns associated with foreign investments. Currency plays a significant role in investing; read on to
uncover potential strategies that might downplay its effects. Pros of Foreign Diversification There is simply no doubting
the benefits of owning foreign securities in your portfolio. After all, modern portfolio theory (MPT) has established that
the world's markets do not move in lockstep and that by mixing asset classes with low correlation to one another in the
appropriate proportions, risk can be reduced at the portfolio level, despite the presence of volatile underlying
securities. As a refresher, correlation coefficients range between -1 and +1. Anything less than perfect positive
correlation (+1) is considered a good diversifier. The correlation matrix depicted below demonstrates the low
correlation of foreign securities against domestic positions. Combining foreign and domestic assets together tends to
have a magical effect on long-term returns and portfolio volatility; however, these benefits also come with some
underlying risks. Risks of International Investments Several levels of investment risks are inherent in foreign investing:
political risk, local tax implications and exchange rate risk. Exchange rate risk is especially important, because the
returns associated with a particular foreign stock (or mutual fund with foreign stocks) must then be converted into U.S.
dollars before an investor can spend the profits. Let's break each risk down. Portfolio Risk The political climate of
foreign countries creates portfolio risks because governments and political systems are constantly in flux. This typically
has a very direct impact on economic and business sectors. Political risk is considered a type of unsystematic
riskassociated with specific countries, which can be diversified away by investing in a broad range of countries,
effectively accomplished with broad-based foreign mutual funds or exchange-traded funds (ETFs). Taxation. Foreign
taxation poses another complication. Just as foreign investors with U.S. securities are subject to U.S. government taxes,
foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are typically withheld at the
source country before an investor can realize any gains. Profits are then taxed again when the investor repatriates the
funds. Currency Risk. Finally, there's currency risk. Fluctuations in the value of currencies can directly impact foreign
investments, and these fluctuations affect the risks of investing in non-U.S. assets. Sometimes these risks work in your
favor, other times they do not. For example, let's say your foreign investment portfolio generated a 12% rate of return
last year, but your home currency lost 10% of its value. In this case, your net return will be enhanced when you convert
your profits to U.S. dollars, since a declining dollar makes international investments more attractive. But the reverse is
also true; if a foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the
returns of the foreign position. Minimizing Currency Risk Despite the perceived dangers of foreign investing, an investor
may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated,
hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in
this case a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future
date can lock in the current exchange rate by entering into an offsetting currency futures position. In the currency
markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors
can take long or short positions in their currency of choice, depending on how they believe that currency will perform.
For example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy
the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue
that the same speculator has taken a short position in the U.S. dollar. There are two possible outcomes with this
hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise
too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract
decreases. When you buy or sell a futures contract, as in our example above, the price of the good (in this case the
currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up
margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are
calculated each day. Currency hedging can also be accomplished in a different way. Rather than locking in a currency
price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up
buying the same currency, but in one scenario you do not pay for the asset up front.
Investing in the Currency Market The value of currencies fluctuates with the global supply and demand for a specific
currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price.
Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market
(forex for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is
conducted electronically in what is considered one of the largest liquid markets in the world. There are several ways to
invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up
their own accounts, or they can access currency investments through forex brokers. However, margined currency
trading is an extremely risky form of investment, and is only suitable for individuals and institutions capable of handling
the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served
acquiring them through funds or ETFs - and there are plenty to choose from. Some of these products make bets against
the dollar - some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an
ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that
currencies associated with high interest rates tend to rise in value relative to currencies associated with low interest
rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes
(historically, currency investing has been very tax-inefficient) and finding the appropriate allocation percentage. The
Bottom Line Investing in foreign stocks has a clear benefit in portfolio construction. However, foreign stocks also have
unique risk traits that U.S.-based stocks do not. As investors expand their investments overseas, they may wish to
implement some hedging strategies to protect themselves from ongoing fluctuations in currency values. Today, there is
no shortage of investment products available to help you easily achieve this goal.

What is a 'Real Option' A real option is a choice made available with business investment opportunities, referred to as
“real” because it typically references a tangible asset instead of financial instrument. Real options are choices a
company’s management makes to expand, change or curtail projects based on changing economic, technological or
market conditions. Factoring in real options impacts the valuation of potential investments, although commonly used
valuations, such as net present value (NPV), fail to account for potential benefits provided by real options. BREAKING
DOWN 'Real Option' Real options do not refer to a derivative financial instrument, but to actual choices or
opportunities of which a business may take advantage or may realize. For example, investing in a new manufacturing
facility may provide a company with real options of introducing new products, consolidating operations or making
other adjustments to changing market conditions. In the course of making the decision to invest in the new facility, the
company should consider of the real option value the facility provides. Other examples of real options include
possibilities for mergers and acquisitions (M&A) or joint ventures. The precise value of real options can be difficult to
establish or estimate. Real option value may be realized from a company undertaking socially responsible projects, such
as building a community center. By doing so, the company may realize a goodwill benefit that makes it easier to obtain
necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits.
In dealing with such real options, a company’s management team factors potential real option value into the decision-
making process, even though the value is necessarily somewhat vague and uncertain. Understanding the Basis of Real
Options Reasoning Real options reasoning is a heuristic – a rule of thumb allowing for flexibility and quick decisions in a
complex, ever-changing environment – based on logical financial choices. The real options heuristic is simply the
recognition of the value of flexibility and alternatives despite the fact that their value cannot be mathematically
quantified with any certainty. Thus, real options reasoning is based on logical financial options in the sense that those
financial options create a certain amount of valuable flexibility. Having financial options affords the freedom to make
optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management
choices to make investments can give companies real options to take additional actions in the future, based on existing
market conditions. In short, real options are about companies making decisions and choices that grant them the
greatest amount of flexibility and potential benefit in regard to possible future decisions or choices. Expansion Option
Expansion option is an embedded option that allows the firm that purchased a real option, which is a right to undertake
certain actions, to expand its operations in the future at little or no cost. An expansion option, unlike typical options
that obtain their value from an underlying security, receives its worth from the flexibility it provides to a company.
Once the initial stage of a capital project has been implemented, an expansion option holder can decide whether to
move forward with the project. In terms of real estate, expansion options provide tenants with the choice to add more
space to their living premises. BREAKING DOWN 'Expansion Option' For example, if a company is unsure as to whether
or not its newly introduced product will be successful in the market, it can purchase an expansion option. The
expansion option will allow the firm to assess the economic environment in the future and determine whether it is
profitable to continue developing the particular product. If the firm initially expected to produce 1,000 units five years,
exercising the expansion option would let them purchase additional equipment to increase capacity for a price which is
below market value. If economic conditions are good and expansion is desirable, the option will be exercised.
Otherwise, the expansion option expires. Back Fee A payment made to the writer of a compound option in the case
that the call option is exercised in order to obtain a put option. Back fee is a premium charged at the second portion of
the option, since a compound option is an option to purchase an option. BREAKING DOWN 'Back Fee' Compound
options are most commonly used by mortgage originators as a way to mitigate risk. The back fee is offered at a
premium, because it provides an investor with the ability to wait before executing an option. Call On A Put. One of the
four types of compound options, this is a call option on an underlying put option. If the option owner exercises the call
option, he or she receives a put option, which is an option that gives the owner the right but not the obligation to sell a
specific asset at a set price within a defined time period. The value of a call on a put changes in inverse proportion to
the stock price, i.e. it decreases as the stock price increases, and increases as the stock price decreases. Also known as a
split-fee option.

Options relating to project size[edit] Where the project's scope is uncertain, flexibility as to the size of the relevant
facilities is valuable, and constitutes optionality.[10] Option to expand: Here the project is built with capacity in excess
of the expected level of output so that it can produce at higher rate if needed. Management then has the option (but
not the obligation) to expand – i.e. exercise the option – should conditions turn out to be favourable. A project with the
option to expand will cost more to establish, the excess being the option premium, but is worth more than the same
without the possibility of expansion. This is equivalent to a call option. Option to contract : The project is engineered
such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future
expenditures constitutes option exercise. This is the equivalent to a put option, and again, the excess upfront
expenditure is the option premium. Option to expand or contract: Here the project is designed such that its operation
can be dynamically turned on and off. Management may shut down part or all of the operation when conditions are
unfavourable (a put option), and may restart operations when conditions improve (a call option). A flexible
manufacturing system(FMS) is a good example of this type of option. This option is also known as a Switching option.

Options relating to project life and timing[edit] Where there is uncertainty as to when, and how, business or other
conditions will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality.
Growth options are perhaps the most generic in this category – these entail the option to exercise only those projects
that appear to be profitable at the time of initiation. Initiation or deferment options: Here management has flexibility
as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until
market conditions are favorable. This constitutes an American styled call option. Option to abandon: Management may
have the option to cease a project during its life, and, possibly, to realise its salvage value. Here, when the present
value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the
exercising of a put option. This option is also known as a Termination option. Abandonment options are American
styled. Sequencing options: This option is related to the initiation option above, although entails flexibility as to the
timing of more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these
sequentially or in parallel. Here, observing the outcomes relating to the first project, the firm can resolve some of the
uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the
development of the other projects. If taken in parallel, management would have already spent the resources and the
value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy.
Related here is also the notion of Intraproject vs. Interproject options.

Options relating to project operation[edit] Management may have flexibility relating to the product produced and /or
the process used in manufacture. This flexibility constitutes optionality. Output mix options: The option to produce
different outputs from the same facility is known as an output mix option or product flexibility. These options are
particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good
are typically low, and management would wish to change to a different product quickly if required. Input mix options:
An input mix option – process flexibility – allows management to use different inputs to produce the same output as
appropriate. For example, a farmer will value the option to switch between various feed sources, preferring to use the
cheapest acceptable alternative. An electric utility, for example, may have the option to switch between various fuel
sources to produce electricity, and therefore a flexible plant, although more expensive may actually be more valuable.
Operating scale options: Management may have the option to change the output rate per unit of time or to change the
total length of production run time, for example in response to market conditions. These options are also known as
Intensity options. Given the above, it is clear that there is an analogy between real options and financial options,[11]
and we would therefore expect options-based modelling and analysis to be applied here. At the same time, it is
nevertheless important to understand why the more standard valuation techniques may not be applicable for ROV.[2]

Applicability of standard techniques[edit] ROV is often contrasted with more standard techniques of capital budgeting,
such as discounted cash flow (DCF) analysis / net present value (NPV).[2] Under this "standard" NPV approach, future
expected cash flows are present valued under the empirical probability measure at a discount rate that reflects the
embedded risk in the project; see CAPM, APT, WACC. Here, only the expected cash flows are considered, and the
"flexibility" to alter corporate strategy in view of actual market realizations is "ignored"; see below as well as Valuing
flexibility under Corporate finance. The NPV framework (implicitly) assumes that management is "passive" with regard
to their Capital Investment once committed. Some analysts account for this uncertainty by adjusting the discount rate,
e.g. by increasing the cost of capital, or the cash flows, e.g. using certainty equivalents, or applying (subjective)
"haircuts" to the forecast numbers, or via probability-weighting as in rNPV.[12][13][14] Even when employed, however,
these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to
appropriately adapt the risk adjustment.[15] By contrast, ROV assumes that management is "active" and can
"continuously" respond to market changes. Real options consider each and every scenario and indicate the best
corporate action in any of these contingent events.[16] Because management adapts to each negative outcome by
decreasing its exposure and to positive scenarios by scaling up, the firm benefits from uncertainty in the underlying
market, achieving a lower variability of profits than under the commitment/NPV stance. The contingent nature of
future profits in real option models is captured by employing the techniques developed for financial options in the
literature on contingent claims analysis. Here the approach, known as risk-neutral valuation, consists in adjusting the
probability distribution for risk consideration, while discounting at the risk-free rate. This technique is also known as
the certainty-equivalent or martingale approach, and uses a risk-neutral measure. For technical considerations here,
see below. Given these different treatments, the real options value of a project is typically higher than the NPV – and
the difference will be most marked in projects with major flexibility, contingency, and volatility.[17] (As for financial
options higher volatility of the underlying leads to higher value).

Options based valuation[edit] Although there is much similarity between the modelling of real options and financial
options,[11][18] ROV is distinguished from the latter, in that it takes into account uncertainty about the future
evolution of the parameters that determine the value of the project, coupled with management's ability to respond to
the evolution of these parameters.[19][20] It is the combined effect of these that makes ROV technically more
challenging than its alternatives. First, you must figure out the full range of possible values for the underlying asset....
This involves estimating what the asset's value would be if it existed today and forecasting to see the full set of possible
future values... [These] calculations provide you with numbers for all the possible future values of the option at the
various points where a decision is needed on whether to continue with the project...[18]When valuing the real option,
the analyst must therefore consider the inputs to the valuation, the valuation method employed, and whether any
technical limitations may apply.

Valuation inputs[edit] Given the similarity in valuation approach, the inputs required for modelling the real option
correspond, generically, to those required for a financial option valuation.[11][18][19] The specific application, though,
is as follows: The option's underlying is the project in question – it is modelled in terms of: Spot price: the starting or
current value of the project is required: this is usually based on management's "best guess" as to the gross value of the
project's cash flows and resultant NPV; Volatility: a measure for uncertainty as to the change in value over time is
required: the volatility in project value is generally used, usually derived via monte carlo simulation;[19][21] sometimes
the volatility of the first period's cash flows are preferred;[20]see further under Corporate finance for a discussion
relating to the estimation of NPV and project volatility. some analysts substitute a listed security as a proxy, using either
its price volatility (historical volatility), or, if options exist on this security, their implied volatility.[1] Dividends
generated by the underlying asset: As part of a project, the dividend equates to any income which could be derived
from real assets and paid to the owner. These reduce the appreciation of the asset. Option characteristics: Strike price:
this corresponds to any (non-recoverable) investment outlays, typically the prospective costs of the project. In general,
management would proceed (i.e. the option would be in the money) given that the present value of expected cash
flows exceeds this amount; Option term: the time during which management may decide to act, or not act,
corresponds to the life of the option. As above, examples include the time to expiry of a patent, or of the mineral rights
for a new mine. See Option time value. Note though that given the flexibility related to timing as described, caution
must be applied here. Option style and option exercise. Management's ability to respond to changes in value is
modeled at each decision point as a series of options, as above these may comprise, i.a.: the option to contract the
project (an American styled put option); the option to abandon the project (also an American put); the option to
expand or extend the project (both American styled call options); switching options or composite options which may
also apply to the project.

Valuation methods[edit] The valuation methods usually employed, likewise, are adapted from techniques developed
for valuing financial options.[22][23] Note though that, in general, while most "real" problems allow for American style
exercise at any point (many points) in the project's life and are impacted by multiple underlying variables, the standard
methods are limited either with regard to dimensionality, to early exercise, or to both. In selecting a model, therefore,
analysts must make a trade off between these considerations; see Option (finance) #Model implementation. The model
must also be flexible enough to allow for the relevant decision rule to be coded appropriately at each decision point.
Closed form, Black–Scholes-like solutions are sometimes employed.[20] These are applicable only for European styled
options or perpetual American options. Note that this application of Black–Scholes assumes constant — i.e.
deterministic — costs: in cases where the project's costs, like its revenue, are also assumed stochastic, then Margrabe's
formula can (should) be applied instead,[24][25] here valuing the option to "exchange" expenses for revenue.
(Relatedly, where the project is exposed to two (or more) uncertainties — e.g. for natural resources, price and quantity
— some analysts attempt to use an overall volatility; this, though, is more correctly treated as a rainbow
option,[20]typically valued using simulation as below.).The most commonly employed methods are binomial
lattices.[17][23] These are more widely used given that most real options are American styled. Additionally, and
particularly, lattice-based models allow for flexibility as to exercise, where the relevant, and differing, rules may be
encoded at each node.[18] Note that lattices cannot readily handle high-dimensional problems; treating the project's
costs as stochastic would add (at least) one dimension to the lattice, increasing the number of ending-nodes by the
square (the exponent here, corresponding to the number of sources of uncertainty). Specialised Monte Carlo Methods
have also been developed and are increasingly, and especially, applied to high-dimensional problems.[26] Note that for
American styled real options, this application is somewhat more complex; although recent research[27] combines a
least squares approach with simulation, allowing for the valuation of real options which are both multidimensional and
American styled; see Monte Carlo methods for option pricing #Least Square Monte Carlo. When the Real Option can be
modelled using a partial differential equation, then Finite difference methods for option pricing are sometimes applied.
Although many of the early ROV articles discussed this method,[28] its use is relatively uncommon today—particularly
amongst practitioners—due to the required mathematical sophistication; these too cannot readily be used for high-
dimensional problems. Various other methods, aimed mainly at practitioners, have been developed for real option
valuation. These typically use cash-flow scenarios for the projection of the future pay-off distribution, and are not
based on restricting assumptions similar to those that underlie the closed form (or even numeric) solutions discussed.
The most recent additions include the Datar–Mathews method[29][30] and the fuzzy pay-off
method.[31];Limitations[edit] The relevance of Real options, even as a thought framework, may be limited due to
market, organizational and / or technical considerations.[32] When the framework is employed, therefore, the analyst
must first ensure that ROV is relevant to the project in question. These considerations are as below.

Market characteristics[edit] As discussed above, the market and environment underlying the project must be one
where "change is most evident", and the "source, trends and evolution" in product demand and supply, create the
"flexibility, contingency, and volatility" [17] which result in optionality. Without this, the NPV framework would be
more relevant.

Organizational considerations[edit] Real options are "particularly important for businesses with a few key
characteristics",[17] and may be less relevant otherwise.[20] In overview, it is important to consider the following in
determining that the RO framework is applicable: Corporate strategy has to be adaptive to contingent events. Some
corporations face organizational rigidities and are unable to react to market changes; in this case, the NPV approach is
appropriate. Practically, the business must be positioned such that it has appropriate information flow, and
opportunities to act. This will often be a market leader and / or a firm enjoying economies of scale and scope.
Management must understand options, be able to identify and create them, and appropriately exercise them.[8] This
contrasts with business leaders focused on maintaining the status quo and / or near-term accounting earnings. The
financial position of the business must be such that it has the ability to fund the project as, and when, required (i.e.
issue shares, absorb further debt and / or use internally generated cash flow); see Financial statement analysis.
Management must, correspondingly, have appropriate access to this capital. Management must be in the position to
exercise, in so far as some real options are proprietary (owned or exercisable by a single individual or a company) while
others are shared (can (only) be exercised by many parties).

Technical considerations[edit] Limitations as to the use of these models arise due to the contrast between Real Options
and financial options, for which these were originally developed. The main difference is that the underlying is often not
tradable – e.g. the factory owner cannot easily sell the factory upon which he has the option. Additionally, the real
option itself may also not be tradeable – e.g. the factory owner cannot sell the right to extend his factory to another
party, only he can make this decision (some real options, however, can be sold, e.g., ownership of a vacant lot of land is
a real option to develop that land in the future). Even where a market exists – for the underlying or for the option – in
most cases there is limited (or no) market liquidity. Finally, even if the firm can actively adapt to market changes, it
remains to determine the right paradigm to discount future claims

The difficulties, are then: As above, data issues arise as far as estimating key model inputs. Here, since the value or
price of the underlying cannot be (directly) observed, there will always be some (much) uncertainty as to its value (i.e.
spot price) and volatility (further complicated by uncertainty as to management's actions in the future). It is often
difficult to capture the rules relating to exercise, and consequent actions by management. Further, a project may have
a portfolio of embedded real options, some of which may be mutually exclusive.[8] Theoretical difficulties, which are
more serious, may also arise.[33] Option pricing models are built on rational pricing logic. Here, essentially: (a) it is
presupposed that one can create a "hedged portfolio" comprising one option and "delta" shares of the underlying. (b)
Arbitrage arguments then allow for the option's price to be estimated today; see Rational pricing #Delta hedging. (c)
When hedging of this sort is possible, since delta hedging and risk neutral pricing are mathematically identical, then risk
neutral valuation may be applied, as is the case with most option pricing models. (d) Under ROV however, the option
and (usually) its underlying are clearly not traded, and forming a hedging portfolio would be difficult, if not impossible.
Standard option models: (a) Assume that the risk characteristics of the underlying do not change over the life of the
option, usually expressed via a constant volatility assumption. (b) Hence a standard, risk free rate may be applied as the
discount rate at each decision point, allowing for risk neutral valuation. Under ROV, however: (a) managements' actions
actually change the risk characteristics of the project in question, and hence (b) the Required rate of return could differ
depending on what state was realised, and a premium over risk free would be required, invalidating (technically) the
risk neutrality assumption. These issues are addressed via several interrelated assumptions: As discussed above, the
data issues are usually addressed using a simulation of the project, or a listed proxy. Various new methods – see for
example those described above – also address these issues. Also as above, specific exercise rules can often be
accommodated by coding these in a bespoke binomial tree; see:.[18] The theoretical issues: To use standard option
pricing models here, despite the difficulties relating to rational pricing, practitioners adopt the "fiction" that the real
option and the underlying project are both traded: the so called, Marketed Asset Disclaimer (MAD) approach. Although
this is a strong assumption, it is pointed out that, interestingly, a similar fiction in fact underpins standard NPV / DCF
valuation (and using simulation as above). See:[1] and.[18] To address the fact that changing characteristics invalidate
the use of a constant discount rate, some analysts use the "replicating portfolio approach", as opposed to Risk neutral
valuation, and modify their models correspondingly.[18][25] Under this approach, (a) we "replicate" the cash flows on
the option by holding a risk free bond and the underlying in the correct proportions. Then, (b) since the cash flows of
the option and the portfolio will always be identical, by arbitrage arguments their values may (must) be equated today,
and (c) no discounting is required.

History[edit] Whereas business managers have been making capital investment decisions for centuries, the term "real
option" is relatively new, and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977.
It is interesting to note though, that in 1930, Irving Fisher wrote explicitly of the "options" available to a business owner
(The Theory of Interest, II.VIII). The description of such opportunities as "real options", however, followed on the
development of analytical techniques for financial options, such as Black–Scholes in 1973. As such, the term "real
option" is closely tied to these option methods. Real options are today an active field of academic research. Professor
Lenos Trigeorgis has been a leading name for many years, publishing several influential books and academic articles.
Other pioneering academics in the field include Professors Eduardo Schwartz, Graham Davis, Gonzalo Cortazar, Michael
Brennan, Han Smit, Avinash Dixitand Robert Pindyck (the latter two, authoring the pioneering text in the discipline). An
academic conference on real options is organized yearly (Annual International Conference on Real Options). Amongst
others, the concept was "popularized" by Michael J. Mauboussin, then chief U.S. investment strategist for Credit Suisse
First Boston.[17] He uses real options to explain the gap between how the stock market prices some businesses and the
"intrinsic value" for those businesses. Trigeorgis also has broadened exposure to real options through layman articles in
publications such as The Wall Street Journal.[16] This popularization is such that ROV is now a standard offering in
postgraduate finance degrees, and often, even in MBA curricula at many Business Schools. Recently, real options have
been employed in business strategy, both for valuation purposes and as a conceptual framework.[6][7] The idea of
treating strategic investments as options was popularized by Timothy Luehrman [34] in two HBR articles:[11] "In
financial terms, a business strategy is much more like a series of options, than a series of static cash flows". Investment
opportunities are plotted in an "option space" with dimensions "volatility" & value-to-cost ("NPVq"). Luehrman also co-
authored with William Teichner a Harvard Business School case study, Arundel Partners: The Sequel Project, in 1992,
which may have been the first business school case study to teach ROV.[35] Interestingly, and reflecting the
"mainstreaming" of ROV, Professor Robert C. Merton discussed the essential points of Arundel in his Nobel Prize
Lecture in 1997.[36] Arundel involves a group of investors that is considering acquiring the sequel rights to a portfolio
of yet-to-be released feature films. In particular, the investors must determine the value of the sequel rights before any
of the first films are produced. Here, the investors face two main choices. They can produce an original movie and
sequel at the same time or they can wait to decide on a sequel after the original film is released. The second approach,
he states, provides the option not to make a sequel in the event the original movie is not successful. This real option
has economic worth and can be valued monetarily using an option-pricing model. See Option (filmmaking).

What is 'Working Capital Management' Working capital management refers to a company's managerial accounting
strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities,
to ensure the most financially efficient operation of the company. The primary purpose of working capital management
is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-
term debt obligations. BREAKING DOWN 'Working Capital Management' Working capital management commonly
involves monitoring cash flow, assets and liabilities through ratio analysis of key elements of operating expenses,
including the working capital ratio, collection ratio and the inventory turnover ratio. Efficient working capital
management helps with a company's smooth financial operation, and can also help to improve the company's earnings
and profitability. Management of working capital includes inventory management and management of accounts
receivables and accounts payables.

Elements of Working Capital Management The working capital ratio, calculated as current assets divided by current
liabilities, is considered a key indicator of a company's fundamental financial health since it indicates the company's
ability to successfully meet all of its short-term financial obligations. Although numbers vary by industry, a working
capital ratio below 1.0 is generally indicative of a company having trouble meeting short-term obligations, usually due
to insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may
indicate a company is not making the most effective use of its assets to increase revenues. The collection ratio, also
known as the average collection period ratio, is a principal measure of how efficiently a company manages its accounts
receivables. The collection ratio is calculated as the number of days in an accounting period, such as one month,
multiplied by the average amount of outstanding accounts receivables, with that total then divided by the total amount
of net credit sales during the accounting period. The collection ratio calculation provides the average number of days it
takes a company to receive payment, in other words, to convert sales into cash. The lower a company's collection ratio,
the more efficient its cash flow. The final element of working capital management is inventory management. To
operate with maximum efficiency and maintain a comfortably high level of working capital, a company has to carefully
balance sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up
working capital for a long period of time before it is converted into cash. Companies typically measure how efficiently
that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as
revenues divided by inventory cost, reveals how rapidly a company's inventory is being sold and replenished. A
relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high
ratio indicates the efficiency of inventory ordering can be improved. Efficiency Ratio; The efficiency ratio is typically
used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the
turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory
and machinery. This ratio can also be used to track and analyze the performance of commercial and investment banks.
BREAKING DOWN 'Efficiency Ratio'Analysts use efficiency ratios, also known as activity ratios, to measure the
performance of a company's short-term or current performance. All of these ratios use numbers in a company's current
assets or current liabilities, quantifying the operations of the business. An efficiency ratio measures a company's ability
to use its assets to generate income. For example, an efficiency ratio often looks at aspects of the company, such as the
time it takes to collect cash from customers or the amount of time it takes to convert inventory to cash. This makes
efficiency ratios important, because an improvement in the efficiency ratios usually translates to improved
profitability.These ratios can be compared to peers in the same industry and can identify businesses that are better
managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed asset turnover,
sales to inventory, sales to net working capital, accounts payable to sales and stock turnover ratio. Efficiency Ratios for
Banks The efficiency ratio also applies to banks. For example, a bank efficiency ratio measures a bank's overhead as a
percentage of its revenue. Like the efficiency ratios above, this allows analysts to assess the performance of commercial
and investment banks. For a bank, an efficiency ratio is an easy way to measure the ability to turn assets into revenue.
Since a bank's operating expenses are in the numerator and its revenue is in the denominator, a lower efficiency ratio
means that a bank is operating better. I's believed that a ratio of 50% is the maximum optimal efficiency ratio. If the
efficiency ratio increases, it means a bank's expenses are increasing or its revenues are decreasing. An Example of
Efficiency Ratio For example, Bankwell Financial Group Inc. reported second quarter 2016 earnings on July 27, 2016.
The report stated that the financial group had an efficiency ratio of 57.1%, which was lower than the 63.2% ratio it
reported for the same quarter in 2015. This means the company's operations became more efficient; it increased its
assets by $80 million for the quarter.

Activity Ratios; Activity ratios measure a firm's ability to convert different accounts within its balance sheets into cash
or sales. Activity ratios measure the relative efficiency of a firm based on its use of its assets, leverage or other such
balance sheet items and are important in determining whether a company's management is doing a good enough job
of generating revenues and cash from its resources. BREAKING DOWN 'Activity Ratios' Companies typically try to turn
their production into cash or sales as fast as possible because this will generally lead to higher revenues, so analysts
perform fundamental analysis by using common ratios such as the total assets turnover ratio and inventory turnover.
Activity ratios measure the amount of resources invested in a company's collection and inventory management.
Because businesses typically operate using materials, inventory and debtors, activity ratios determine how well an
organization manages these areas. Activity ratios are one major category in which a ratio may be classified; other ratios
may be classified as measurements of liquidity, profitability or leverage. Activity ratios gauge an organization's
operational efficiency and profitability. Activity ratios are most useful when compared to competitor or industry to
establish whether an entity's processes are favorable or unfavorable. Activity ratios can form a basis of comparison
across multiple reporting periods to determine changes over time. The following activity ratios may be analyzed as
some of an organization's key performance indicators. Accounts Receivable Turnover Ratio The accounts receivable
turnover ratio determines an entity's ability to collect money from its customers. Total credit sales are divided by the
average accounts receivable balance for a specific period. This activity ratio calculates management's ability to receive
cash. A low ratio suggests a deficiency in the collection process. Merchandise Inventory Turnover Ratio The
merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting period.
The cost of goods sold is divided by the average inventory for a specific period. Higher calculations indicate inventory is
quickly converted into sales and cash. A useful way to use this activity ratio is to compare it to previous periods. Total
Assets Turnover Ratio The total assets turnover ratio take a look at how efficiently an entity uses its assets to make a
sale. Total sales are divided by total assets to see how proficient a business is at using its assets. Smaller ratios may
indicate that the company is holding higher levels of inventory instead of selling. Efficiency Ratio Activity Ratios Days
Working Capital Current Ratio Ratio Analysis Days Sales Of Inventory – DSI Cash Asset Ratio Gross Working Capital
Receivables Turnover Ratio Days Working Capital. Days working capital is an accounting and finance term used to
describe how many days it takes for a company to convert its working capital into revenue. It can be used in ratio and
fundamental analysis. When utilizing any ratio, it is important to consider how the company compares to similar
companies in the same industry. BREAKING DOWN 'Days Working Capital' .Working capital is a measure of liquidity,
and days working capital is a measure that helps to quantify this liquidity. The more days a company has of working
capital, the more time it takes to convert that working capital into sales. In other words, a high number is indicative of
an inefficient company and vice versa. Working Capital Working capital is calculated by subtracting current liabilities
from current assets. Current assets include cash, marketable securities, inventory, accounts receivable and other short-
term assets to be used within the year. Current liabilities include accounts payable and the current portion of long-term
debt. These are debts that are due within the year. The difference between the two represents the company's short-
term need for, or surplus of, cash. A positive working capital balance means current assets cover current liabilities. A
negative working capital balance means current liabilities are more than current assets.
Current Ratio. The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term
obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and
illiquid) relative to that company’s current total liabilities. The formula for calculating a company’s current ratio is:
Current Ratio = Current Assets / Current Liabilities. The current ratio is called “current” because, unlike some other
liquidity ratios, it incorporates all current assets and liabilities. The current ratio is also known as the working capital
ratio. BREAKING DOWN 'Current Ratio' The current ratio is mainly used to give an idea of a company's ability to pay
back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, accounts
receivable). As such, current ratio can be used to make a rough estimate of a company’s financial health. The current
ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash.
Companies that have trouble getting paid on their receivables or that have high inventory turnover can run into
liquidity problems if they are unable to alleviate their obligations. A ratio analysis is a quantitative analysis of
information contained in a company’s financial statements. Ratio analysis is used to evaluate various aspects of a
company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. Ratio analysis
is a cornerstone of fundamental analysis.BREAKING DOWN 'Ratio Analysis' When investors and analysts talk about
fundamental or quantitative analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the
performance and financial health of a company by using data from the current and historical financial statements. The
data retrieved from the statements is used to - compare a company's performance over time to assess whether the
company is improving or deteriorating; compare a company's financial standing with the industry average; or compare
a company to one or more other companies operating in its sector to see how the company stacks up. The days sales of
inventory value (DSI) is a financial measure of a company's performance that gives investors an idea of how long it
takes a company to turn its inventory (including goods that are a work in progress, if applicable) into sales. Generally, a
lower (or shorter) DSI is preferred, but it is important to note that the average DSI varies from one industry to another.
The DSI is calculated as: Days sales of inventory is also referred to as days inventory outstanding (DIO), days in
inventory (DII) or, simply, days inventory. BREAKING DOWN 'Days Sales Of Inventory - DSI' Days sales of inventory, or
days inventory, is one part of the cash conversion cycle, which represents the process of turning raw materials into
cash. The days sales of inventory is the first stage in that process. The other two stages are days sales outstanding
(DSO) and days payable outstanding (DPO). DSO measures how long it takes a company to receive payment on
accounts receivable, while the DPO measures how long it takes a company to pay off its accounts payable.

Cash Asset Ratio. The cash asset ratio is the current value of marketable securities and cash, divided by the company's
current liabilities. Also known as the cash ratio, the cash asset ratio compares the dollar amount of highly liquid assets
(such as cash and marketable securities) for every one dollar of short-term liabilities. This figure is used to measure a
firm's liquidity or its ability to pay its short-term obligations. Ideal ratios will be different for different industries and for
different sizes of corporations, and for many other reasons. BREAKING DOWN 'Cash Asset Ratio'. The cash asset ratio is
similar to the current ratio, except that the current ratio includes current assets such as inventories in the numerator.
Some analysts believe that including current assets makes it difficult to convert them into usable funds for debt
obligations. The cash asset ratio is a much more accurate measure of a firm's liquidity. For example, if a firm had
$130,000 in marketable securities, $110,000 in cash and $200,000 in current liabilities, the cash asset ratio would be
(130,000+110,000)/200,000 = 1.20. Ratios greater than 1 demonstrate a firm's ability to cover its current debt, but
ratios that are too high might indicate that a company is not allocating enough resources to grow its business.

Gross Working Capital. Gross working capital is the sum of all of a company's current assets (assets that are convertible
to cash within a year or less). Gross working capital includes assets such as cash, accounts receivable, inventory, short-
term investments and marketable securities. Gross working capital less current liabilities is equal to net working capital,
or simply "working capital," a more useful measure for balance sheet analysis. BREAKING DOWN 'Gross Working
Capital'. Gross working capital, in practice, is not useful. It is just one half of a picture of a company's short-term
financial health and ability to use short-term resources efficiently. The other half is current liabilities. Gross working
capital, or current assets, less current liabilities equate to working capital. When working capital is positive, it means
that current assets are greater than current liabilities. The preferred way to express positive working capital is the ratio
of current assets to current liabilities (i.e., > 1.0). If this ratio is not greater than 1.0, then it may have trouble paying
back its creditors in the short-term, whether a bank or supplier or other party to which the company has financial
obligations. Negative working capital may a sign of distress that could grow. Perhaps the underlying problem is a
decline in sales, which would reduce accounts receivable or force an accumulation in the accounts payable account
(part of current liabilities) as the company finds it more difficult to pay its bills on time. The receivables turnover ratio is
an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting debts on that credit.
The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses its assets. Receivables turnover
ratio can be calculated by dividing the net value of credit sales during a given period by the average accounts receivable
during the same period. Average accounts receivable can be calculated by adding the value of accounts receivable at
the beginning of the desired period to their value at the end of the period and dividing the sum by two. The method for
calculating receivables turnover ratio can be represented with the following formula: The receivables turnover ratio is
most often calculated on an annual basis, though it can also be calculated on a quarterly or monthly basis. Receivable
turnover ratio is also often called accounts receivable turnover, the accounts receivable turnover ratio, or the debtor’s
turnover ratio. BREAKING DOWN 'Receivables Turnover Ratio'. In essence, the receivables turnover ratio indicates the
efficiency with which a firm collects on the credit it issues to customers. Firms that maintain accounts receivables are
indirectly extending interest-free loans to their clients since accounts receivable is money owed without interest. As
such, because of the time value of money principle, a firm loses more money the longer it takes to collect on its credit
sales. To provide an example of how to calculate the receivables turnover ratio, suppose that during 2017 Company A
had $800,000 in net credit sales. Also suppose that on the first of January it had $64,000 accounts receivable and that
on December 31 it had $72,000 accounts receivable. With this information, one could calculate the receivables
turnover ratio for 2017 in the following way: average accounts receivable = ($64,000 + $72,000) / 2 = $68,000
receivables turnover ratio = $800,000 / $68,000 = 11.76. This means that Company A collects its receivables 11.76 times
on average per year. This number also serves as an indicator of the number of accounts receivable a company collects
during a year. One can determine the average duration of accounts receivable during a given year by dividing 365 by
the receivables turnover ratio for that year. For this example, the average accounts receivable turnover is 365 / 11.76 =
31.04 days. The average customer takes 31 days to pay his or her bills. If the company had a 30-day policy for when
payments should be made, then the average accounts receivable turnover shows that the average customer makes
payments late.

Interpreting 'Receivables Turnover Ratio'. A high receivables turnover ratio can imply a variety of things about a
company. It may suggest that a company operates on a cash basis, for example. It may also indicate that the company’s
collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay
off their debts quickly. A high ratio can also suggest that the company has a conservative policy regarding its extension
of credit. This can often be a good thing, as this filters out customers who may be more likely to take a long time in
paying their debts. On the other hand, a company’s policy may be too conservative if it is too tight in extending credit,
which can drive away potential customers and give business to competitors. In this case, a company may want to
loosen policies to improve business, even though it may reduce its receivables turnover ratio. A low ratio, in a similar
way, can also suggest a few things about a company, such as that the company may have poor collecting processes, a
bad credit policy or none at all, or bad customers or customers with financial difficulty. Theoretically, a low ratio can
also often mean that the company has a high amount of cash receivables for collection from its various debtors, should
it improve its collection processes. Generally, however, a low ratio implies that the company should reassess its credit
policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. Uses of
'Receivables Turnover Ratio'. The receivables turnover ratio has several important functions other than simply
assessing whether or not a company has issues collecting on credit. Though this offers important insight, it does not tell
the whole story. For example, if one were to track a company’s receivables turnover ratio over time, it would say much
more about the company’s history with issuing and collecting on credit than a single value can. By looking at the
progression, one can determine if the company’s receivables turnover ratio is trending in a certain direction or if there
are certain recurring patterns. What is more, by tracking this ratio over time alongside earnings, one may be able to
determine whether a company’s credit practices are helping or hurting the company’s bottom line. While this ratio is
useful for tracking a company’s accounts receivable turnover history over time, it may also be used to compare the
accounts receivable turnover of multiple companies. If two companies are in the same industry and one has a much
higher receivables turnover ratio than the other, it may prove to be the safer investment. Limitations of 'Receivables
Turnover Ratio'.Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes
with a set of limitations that are important for any investor to consider before using it. One important thing to consider
is that companies will sometimes use total sales instead of net sales when calculating their ratio, which generally
inflates the turnover ratio. While this is not always necessarily meant to be deliberately misleading, one should
generally try to ascertain how a company calculates their ratio before accepting it at face value, or otherwise should
calculate the ratio independently. Another important consideration is that accounts receivable can vary dramatically
over the course of the year. This means that if one picks a start and end point for calculating the receivables turnover
ratio arbitrarily, the ratio may not reflect the true climate of the company’s issuing of and collection on credit. As such,
the beginning and ending values selected when calculating the average accounts receivable should be carefully picked
so as to represent the year well. In order to account for this, one could take an average of accounts receivable from
each month during a twelve-month period. It is also important to note that comparisons of different companies’
receivables turnover ratios should only be made when the companies are in the same industry, and ideally when they
have similar business models and revenue numbers as well. Companies of different sizes may often have very different
capital structures, which can greatly influence turnover calculations, and the same is often true of companies in
different industries. The receivables turnover ratio is not particularly useful in comparing companies with significant
differences in the proportion of sales that are credit, as determining the receivables turnover ratio of a company with a
low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with
those that have a high proportion of credit sales also does not usually indicate much of importance. Lastly, a low
receivables turnover ratio might not necessarily indicate that the company’s issuing of credit and collecting of debt is
lacking. If, for example, distribution messes up and fails to get the right goods to customers, customers may not pay,
which would also decrease the company’s receivables turnover ratio.

Cash Management Cash is a key part of working capital management. Companies need to carry sufficient levels of cash
in order to ensure they can meet day-to-day expenses. Cash is also required to be held as a cushion against unplanned
expenditure, to guard against liquidity problems. It is also useful to keep cash available in order to be able to take
advantage of market opportunities. The cost of running out of cash may include not being able to pay debts as they fall
due which can have serious operational repercussions, including the winding up of the company if it consistently fails to
pay bills as they fall due. However, if companies hold too much cash then this is effectively an idle asset, which could be
better invested and generating profit for the company. Balancing Act. The firm faces a balancing act between liquidity
and profitability.

Cash budgets and cash flow forecasts. Cash forecast. A cash forecast is an estimate of cash receipts and payments for a
future period under existing conditions. Every type of cash inflow and receipt, along with their timings, must be
forecast. Cash receipts and payments differ from sales and cost of sales in the income statement because: not all cash
receipts or payments affect the income statement, some income statement items are derived from accounting
conventions and are not cash flows, the timing of cash receipts and payments does not coincide with the income
statement accounting period Cash budget. A cash budget is a commitment to a plan for cash receipts and payments for
a future period after taking any action necessary to bring the forecast into line with the overall business plan. Cash
budgets are used to: assess and integrate operating budgets ,plan for cash shortages and surpluses, compare with
actual spending. Companies are likely to prepare a cash budget as part of the annual master budget, but then to
continually prepare revised cash forecasts throughout the year, as a means of monitoring and managing cash flows.
Proforma cash forecast. Preparing a cash flow forecast from working capital ratios Working capital ratios can be used
to forecast future cash requirements, by using the working capital ratios to work out the working capital requirement.
This technique can be used to help forecast overall cash flow. Treasury management. Treasury management is heavily
concerned with liquidity and covers the following activities: banking and exchange, cash and currency management,
investment in short-term assets, risk and insurance, raising finance. All treasury management activities are concerned
with managing the liquidity of a business, the importance of which to the survival and growth of a business cannot be
over-emphasised. Need for a treasury department. The functions carried out by the treasurer have always existed, but
have been absorbed historically within other finance functions. A number of reasons may be identified for the modern
development of separate treasury departments: size and internationalization of companies: these factors add to both
the scale and the complexity of the treasury functions, size and internationalisation of currency, debt and security
markets: these make the operations of raising finance, handling transactions in multiple currencies and investing, much
more complex. They also present opportunities for greater gains, sophistication of business practice: this process has
been aided by modern communications, and as a result the treasurer is expected to take advantage of opportunities for
making profits or minimising costs which did not exist a few years ago. For these reasons, most large international
corporations have moved towards setting up a separate treasury department. Treasury departments tend to rely
heavily on new technology for information. Responsibilities of a treasury management function
 The treasurer will generally report to the finance director, with a specific emphasis on borrowing and cash and
currency management. The treasurer will have a direct input into the finance director's management of debt capacity,
debt and equity structure, resource allocation, equity strategy and currency strategy. The treasurer will be involved in
investment appraisal, and the finance director will often consult the treasurer in matters relating to the review of
acquisitions and divestments, dividend policy and defence from takeover. Short-term investment and borrowing
solutions A company must choose from a range of options to select the most appropriate source of
investment/funding. Short-term cash investments; Short-term cash investments are used for temporary cash surpluses.
To select an investment, a company has to weigh up three potentially conflicting objectives and the factors surrounding
them: Liquidity: the cash must be available for use when needed. Safety: no risk of loss must be taken. Profitability:
subject to the above, the aim is to earn the highest possible after-tax returns. Each of the three objectives raises
problems. The liquidity problem At first sight this problem is simple enough. If a company knows that it will need the
funds in three days (or weeks or months), it simply invests them for just that period at the best rate available with
safety. The solution is to match the maturity of the investment with the period for which the funds are surplus.
However there are a number of factors to consider: The exact duration of the surplus period is not always known. It will
be known if the cash is needed to meet a loan instalment, a large tax payment or a dividend. It will not be known if the
need is unidentified, or depends on the build-up of inventory, the progress of construction work, or the hammering out
of an acquisition deal.

The safety problem. Safety means there is no risk of capital loss. Superficially this again looks simple. The concept
certainly includes the absence of credit risk. For example, the firm should not deposit with a bank which might
conceivably fail within the maturity period and thus not repay the amount deposited. However, safety is not necessarily
to be defined as certainty of getting the original investment repaid at 100% of its original home currency value. If the
purpose for which the surplus cash is held is not itself fixed in the local currency, then other criteria of safety may
apply. The profitability probl The profitability objective looks deceptively simple at first: go for the highest rate of return
subject to the overriding criteria of safety and liquidity. However, here there are complications. Short-term borrowing.
Short-term cash requirements can also be funded by borrowing from the bank. There are two main sources of bank
lending: bank overdraft, bank loans. Bank overdrafts. A common source of short-term financing for many businesses is
a bank overdraft. These are mainly provided by the clearing banks and represent permission by the bank to write
cheques even though the firm has insufficient funds deposited in the account to meet the cheques. An overdraft limit
will be placed on this facility, but provided the limit is not exceeded, the firm is free to make as much or as little use of
the overdraft as it desires. The bank charges interest on amounts outstanding at any one time, and the bank may also
require repayment of an overdraft at any time. The advantages of overdrafts are the following. Flexibility as they can be
used as required. Cheapness as interest is only payable on the finance actually used, usually at 2-5% above base rate
(and all loan interest is a tax deductible expense). The disadvantages of overdrafts are as follows. Overdrafts are legally
repayable on demand. Normally, however, the bank will give customers assurances that they can rely on the facility for
a certain time period, say six months. Security is usually required by way of fixed or floating charges on assets or
sometimes, in private companies and partnerships, by personal guarantees from owners. Interest costs vary with bank
base rates. This makes it harder to forecast and exposes the business to future increases in interest rates. Bank loans.
Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed rate of interest. They
are less flexible and more expensive than overdrafts but provide greater security. A bank loan represents a formal
agreement between the bank and the borrower, that the bank will lend a specific sum for a specific period (one to
seven years being the most common). Interest must be paid on the whole of this sum for the duration of the loan. This
source is, therefore, liable to be more expensive than the overdraft and is less flexible but, on the other hand, there is
no danger that the source will be withdrawn before the expiry of the loan period. Interest rates and requirements for
security will be similar to overdraft lending. Cash management models. Cash management models are aimed at
minimising the total costs associated with movements between a company's current account (very liquid but not
earning interest) and their short-term investments (less liquid but earning interest). The models are devised to answer
the questions: at what point should funds be moved? how much should be moved in one go? The Baumol cash
management model. Baumol noted that cash balances are very similar to inventory levels, and developed a model
based on the economic order quantity(EOQ).Assumptions: cash use is steady and predictable cash inflows are known
and regular, day-to-day cash needs are funded from current account, buffer cash is held in short-term investments.The
formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at
one time: where: CO = transaction costs (brokerage,commission, etc.) D = demand for cash over the period CH = cost of
holding cash.The model suggests that when interest rates are high, the cash balance held in non-interest-bearing
current accounts should be low. However its weakness is the unrealistic nature of the assumptions on which it is based.
Example using the Baumol model A company generates $10,000 per month excess cash, which it intends to invest in
short-term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs
associated with each separate investment of funds is constant at $50. Required: (a)What is the optimum amount of
cash to be invested in each transaction? (b)How many transactions will arise each year? (c)What is the cost of making
those transactions pa? (d)What is the opportunity cost of holding cash pa? Solution: The Miller-Orr cash management
model The Miller-Orr model is used for setting the target cash balance for a company. The diagram below shows how
the model works over time. The model sets higher and lower control limits, H and L, respectively, and a target cash
balance, Z. When the cash balance reaches H, then (H-Z) dollars are transferred from cash to marketable securities, i.e.
the firm buys (H-Z) dollars of securities. Similarly when the cash balance hits L, then (Z-L) dollars are transferred from
marketable securities to cash. The lower limit, L is set by management depending upon how much risk of a cash
shortfall the firm is willing to accept, and this, in turn, depends both on access to borrowings and on the consequences
of a cash shortfall. The formulae for the Miller-Orr model are: Return point = Lower limit + (1/3 × spread) Spread = 3 [
(3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3 Note: variance and interest rates should be
expressed in daily terms. Variance = standard deviation squared. Example using the Miller-Orr model. The minimum
cash balance of $20,000 is required at Miller-Orr Co,and transferring money to or from the bank costs $50 per
transaction. Inspection of daily cash flows over the past year suggests that the standard deviation is $3,000 per day,
and hence the variance (standard deviation squared) is $9 million. The interest rate is 0.03% per day. Calculate: (i)the
spread between the upper and lower limits (ii) the upper limit (iii)the return point. Solution: (i)Spread = 3 (3/4 × 50×
9,000,000/0.0003)1/3 = $31,200 (ii) Upper limit = 20,000 + 31,200 = $51,200 (iii)Return point = 20,000 + 31,200/3 =
$30,400

Relevance and Irrelevance Theories of Dividend; Dividend is that portion of net profits which is distributed among the
shareholders. The dividend decision of the firm is of crucial importance for the finance manager since it determines the
amount to be distributed among shareholders and the amount of profit to be retained in the business. Retained
earnings are very important for the growth of the firm. Shareholders may also expect the company to pay more
dividends. So both the growth of company and higher dividend distribution are in conflict. So the dividend decision has
to be taken in the light of wealth maximisation objective. This requires a very good balance between dividends and
retention of earnings.

A financial manager may treat the dividend decision in the following two ways: 1) As a long term financing decision:-
When dividend is treated as a source of finance, the firm will pay dividend only when it does not have profitable
investment opportunities. But the firm can also pay dividends and raise an equal amount by the issue of shares. But this
does not make any sense. 2) As a wealth maximisation decision:- Payment of current dividend has a positive impact on
the share price. So to maximise the price per share, the firm must pay more and more dividends.

4.2 Dividend and Valuation. There are conflicting opinions as far as the impact of dividend decision on the value of the
firm. According to one school of thought, dividends are relevant to the valuation of the firm. Others opine that
dividends does not affect the value of the firm and market price per share of the company.

Relevant Theory. If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case
a change in the dividend payout ratio will be followed by a change in the market value of the firm. If the dividend is
relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which gives highest market value
per share. 4.3 Walter’s Model (Relevant Theory) Prof. James E Walter argues that the choice of dividend payout ratio
almost always affects the value of the firm. Prof. J. E. Walter has very scholarly studied the significance of the
relationship between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy which
maximises the wealth of shareholders. Walter’s model is based on the following assumptions: 1) The firm finances its
entire investments by means of retained earnings only. 2) Internal rate of return (R) and cost of capital (K) of the firm
remains constant. 3) The firms’ earnings are either distributed as dividends or reinvested internally. 4) The earnings and
dividends of the firm will never change. 5) The firm has a very long or infinite life. Walter’s formula to determine the
price per share is as follows: P = P = market price per share. D = dividend per share. E = earnings per share. R = internal
rate of return. K = cost of capital. According to the theory, the optimum dividend policy depends on the relationship
between the firm’s internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings, whereas
it should distribute the earnings to the shareholders in case the R<K. The rationale of R>K is that the firm is able to
produce more return than the shareholders from the retained earnings. Walter’s view on optimum dividend payout
ratio can be summarised as below: a) Growth Firms (R>K):- The firms having R>K may be referred to as growth firms.
The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a
return which is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%.
b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is
equal to that of shareholders. In this case dividend policy will not have any influence on the price per share. So there is
nothing like optimum payout ratio for a normal firm. All the payout ratios are optimum. c) Declining Firm (R<K):- If the
company earns a return which is less than what shareholders can earn on their investments, it is known as declining
firm. Here it will not make any sense to retain the earnings. So entire earnings should be distributed to the
shareholders to maximise price per share. Optimum payout ratio for a declining firm is 100%. So according to Walter,
the optimum payout ratio is either 0% (when R>K) or 100% (when R<K).

4.4 Gordon’s Model. Another theory, which contends that dividends are relevant, is the Gordon’s model. This model
which opines that dividend policy of a firm affects its value is based on the following assumptions: a) The firm is an all
equity firm (no debt). b) There is no outside financing and all investments are financed exclusively by retained earnings.
c) Internal rate of return (R) of the firm remains constant. d) Cost of capital (K) of the firm also remains same regardless
of the change in the risk complexion of the firm. e) The firm derives its earnings in perpetuity. f) The retention ratio (b)
once decided upon is constant. Thus the growth rate (g) is also constant (g=br). g) K>g. h) A corporate tax does not
exist. Gordon used the following formula to find out price per share P = P = price per share K = cost of capital E1 =
earnings per share b = retention ratio (1-b) = payout ratio g = br growth rate (r = internal rate of return). According to
Gordon, when R>K the price per share increases as the dividend payout ratio decreases. When R<K the price per share
increases as the dividend payout ratio increases. When R=K the price per share remains unchanged in response to the
change in the payout ratio. Thus Gordon’s view on the optimum dividend payout ratio can be summarised as below: 1)
The optimum payout ratio for a growth firm (R>K) is zero. 2) There no optimum ratio for a normal firm (R=K). 3)
Optimum payout ratio for a declining firm R<K is 100%. Thus the Gordon’s Model’s is conclusions about dividend policy
are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models. Bird in Hand
Argument. (Dividends and Uncertainty). Gordon revised this basic model later to consider risk and uncertainty.
Gordon’s model, like Walter’s model, contends that dividend policy is relevant. According to Walter, dividend policy will
not affect the price of the share when R = K. But Gordon goes one step ahead and argues that dividend policy affects
the value of shares even when R=K. The crux of Gordon’s argument is based on the following 2 assumptions. 1.
Investors are risk averse and 2. They put a premium on a certain return and discount (penalise) uncertain return. The
investors are rational. Accordingly they want to avoid risk. The term risk refers to the possibility of not getting the
return on investment. The payment of dividends now completely removes any chance of risk. But if the firm retains the
earnings the investors can expect to get a dividend in the future. But the future dividend is uncertain both with respect
to the amount as well as the timing. The rational investors, therefore prefer current dividend to future dividend.
Retained earnings are considered as risky by the investors. In case earnings are retained, therefore the price per share
would be adversely affected. This behaviour of investor is described as “Bird in Hand Argument”. A bird in hand is
worth two in bush. What is available today is more important than what may be available in the future. So the rational
investors are willing to pay a higher price for shares on which more current dividends are paid. Therefore the discount
rate (K) increases with retention rate. This is shown below.

4.5 Modigliani-Miller Model. (Irrelevance theory).According to MM, the dividend policy of a firm is irrelevant, as it does
not affect the wealth of shareholders. The model which is based on certain assumptions, sidelined the importance of
the dividend policy and its effect thereof on the share price of the firm. According to the theory the value of a firm
depends solely on its earnings power resulting from the investment policy and not influenced by the manner in which
its earnings are split between dividends and retained earnings. Assumptions: 1. Capital markets are perfect:- Investors
are rational information is freely available, transaction cost are nil, securities are divisible and no investor can influence
the market price of the share. 2. There are no taxes:- No difference between tax rates on dividends and capital gains. 3.
The firm has a fixed investment policy which will not change. So if the retained earnings are reinvested, there will not
be any change in the risk of the firm. So K remains same. 4. Floatation cost does not exist. The substance of MM
arguments may be stated as below: If the company retains the earnings instead of giving it out as dividends, the
shareholders enjoy capital appreciation, which is equal to the earnings, retained. If the company distributes the
earnings by the way of dividends instead of retention, the shareholders enjoy the dividend, which is equal to the
amount by which his capital would have been appreciated had the company chosen to retain the earnings. Hence, the
division of earnings between dividends and retained earnings is irrelevant from the point of view of shareholders.
Modigliani- Miller Theory on Dividend Policy. Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’
notion. According to this concept, investors do not pay any importance to the dividend history of a company and thus,
dividends are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be important in the valuation of a company.

CRUX OF MODIGLIANI-MILLER MODEL Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller
in 1961. They were the pioneers in suggesting that dividends and capital gains are equivalent when an investor
considers returns on investment. The only thing that impacts the valuation of a company is its earnings, which is a
direct result of the company’s investment policy and the future prospects. So, according to this theory, once the
investment policy is known to the investor, he will not need any additional input on the dividend history of the
company. The investment decision is, thus, dependent on the investment policy of the company and not on the
dividend policy. Modigliani – Miller theory goes a step further and illustrates the practical situations where dividends
are not relevant to investors. Irrespective of whether a company pays a dividend or not, the investors are capable
enough to make their own cash flows from the stocks depending on their need for the cash. If the investor needs more
money than the dividend he received, he can always sell a part of his investments to make up for the difference.
Likewise, if an investor has no present cash requirement, he can always reinvest the received dividend in the stock.
Thus, the Modigliani – Miller theory firmly states that the dividend policy of a company has no influence on the
investment decisions of the investors. This theory also believes that dividends are irrelevant by the arbitrage argument.
By this logic, the dividends distribution to shareholders is offset by the external financing. Due to the distribution of
dividends, the price of the stock decreases and will nullify the gain made by the investors because of the dividends. This
theory also implies that the cost of debt is equal to the cost of equity as the cost of capital is not affected by the
leverage. ASSUMPTIONS OF THE MODEL. Modigliani – Miller theory is based on the following assumptions: PERFECT
CAPITAL MARKETS This theory believes in the existence of ‘perfect capital markets’. It assumes that all the investors are
rational, they have access to free information, there are no floatation or transaction costs and no large investor to
influence the market price of the share. NO TAXES. There is no existence of taxes. Alternatively, both dividends and
capital gains are taxed at the same rate. FIXED INVESTMENT POLICY The company does not change its existing
investment policy. This means that new investments that are financed through retained earnings do not change the risk
and the rate of required return of the firm. NO RISK OF UNCERTAINTY All the investors are certain about the future
market prices and the dividends. This means that the same discount rate is applicable for all types of stocks in all time
periods. VALUATION FORMULA AND ITS DENOTATIONS Modigliani – Miller’s valuation model is based on the
assumption of same discount rate/rate of return applicable to all the stocks. P1 = P0 * (1 + k) – D. Where, P1 = market
price of the share at the end of a period, P0 = market price of the share at the beginning of a period, k = cost of capital,
D = dividends received at the end of a period

EXPLANATION OF MODIGLIANI – MILLER’S MODEL. Modigliani – Miller’s model can be used to calculate the market
price of the share at the end of a period, if the original share price, dividends received and the cost of capital is known.
The assumption that the same discount rate is applicable to all stocks is important. The original price of the stock is Rs.
150. The discount rate applicable to the company is 10%. The company had declared Rs. 10 as dividends in a year.
Calculate the market price of the share at the end of one year using the Modigliani – Miller’s model. Here, P0 = 150, k =
10%, D = 10 Market price of the stock = P1 = 150 * (1 + .10) – 10 = 150 *1.1 – 10 = 155.

CRITICISM OF MODIGLIANI MILLER’S MODEL. Modigliani – Miller theory on dividend policy suffers from the following
limitations: Perfect capital markets do not exist. Taxes are present in the capital markets. According to this theory,
there is no difference between internal and external financing. However, if the flotation costs of new issues are
considered, it is false. This theory believes that the shareholder’s wealth is not affected by the dividends. However,
there are transaction costs associated with the selling of shares to make cash inflows. This makes the investors prefer
dividends.mThe assumption of no uncertainty is unrealistic. The dividends are relevant under the certain conditions as
well. Summary Modigliani – Miller theory of dividend policy is an interesting and a different approach to the valuation
of shares. It is a popular model which believes in the irrelevance of the dividends. However, the policy suffers from
various important limitations and thus, is critiqued regarding its assumptions.

Gordon’s Theory on Dividend Policy Gordon’s theory on dividend policy is one of the theories believing in the
‘relevance of dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are
important in determining the value of the firm. Gordon’s model is one of the most popular mathematical models to
calculate the market value of the company using its dividend policy. CRUX OF GORDON’S MODEL Myron Gordon’s
model explicitly relates the market value of the company to its dividend policy. The determinants of the market value
of the share are the perpetual stream of future dividends to be paid, the cost of capital and the expected annual
growth rate of the company. RELATION OF DIVIDEND DECISION AND VALUE OF A FIRM The Gordon’s theory on
dividend policy states that the company’s dividend payout policy and the relationship between its rate of return (r) and
the cost of capital (k) influence the market price per share of the company. Relationship between r and k Increase in
Dividend Payout, r>k Price per share decreases, r<k Price per share increases, r=k No change in the price per
share

ASSUMPTIONS OF GORDON’S MODEL. Gordon’s model is based on the following assumptions:NO DEBT, The model
assumes that the company is an all equity company, with no proportion of debt in the capital structure. NO EXTERNAL
FINANCING. The model assumes that all investment of the company is financed by retained earnings and no external
financing is required. CONSTANT IRR The model assumes a constant Internal Rate of Return (r), ignoring the diminishing
marginal efficiency of the investment.

CONSTANT COST OF CAPITAL. The model is based on the assumption of a constant cost of capital (k), implying the
business risk of all the investments to be the same. PERPETUAL EARNINGS. Gordon’s model believes in the theory of
perpetual earnings for the company. CORPORATE TAXES. Corporate taxes are not accounted for in this model.
CONSTANT RETENTION RATIO The model assumes a constant retention ratio (b) once it is decided by the company.
Since the growth rate (g) = b*r, the growth rate is also constant by this logic. K>G. Gordon’s model assumes that the
cost of capital (k) > growth rate (g). This is important for obtaining the meaningful value of the company’s share.
VALUATION FORMULA OF GORDON’S MODEL AND ITS DENOTATIONS Gordon’s formula to calculate the market price
per share (P) is P = {EPS * (1-b)} / (k-g). Where, P = market price per share, EPS = earnings per share, b= retention ratio
of the firm, (1-b) = payout ratio of the firm, k = cost of capital of the firm, g = growth rate of the firm = b*r. Explanation.
The above model indicates that the market value of the company’s share is the sum total of the present values of
infinite future dividends to be declared. The Gordon’s model can also be used to calculate the cost of equity, if the
market value is known and the future dividends can be forecasted. The EPS of the company is Rs. 15. The market rate
of discount applicable to the company is 12%. The dividends are expected to grow at 10% annually. The company
retains 70% of its earnings. Calculate the market value of the share using Gordon’s model. Here, E = 15 b = 70% k = 12%
g = 10% Market price of the share = P = {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225

IMPLICATIONS OF GORDON’S MODEL. Gordon’s model believes that the dividend policy impacts the company in
various scenarios as follows: GROWTH FIRM A growth firm’s internal rate of return (r) > cost of capital (k). It benefits
the shareholders more if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio
for growth firms is zero. NORMAL FIRM. A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does
not make any difference if the company reinvested the dividends or distributed to its shareholders. So, there is no
optimum dividend payout ratio for normal firms. However, Gordon revised this theory later and stated that the
dividend policy of the firm impacts the market value even when r=k. Investors will always prefer a share where more
current dividends are paid. DECLINING FIRM. The internal rate of return (r) < cost of the capital (k) in the declining
firms. The shareholders are benefitted more if the dividends are distributed rather than reinvested. So, the optimum
dividend payout ratio for declining firms is 100%. CRITICISM OF GORDON’S MODEL. Gordon’s theory on dividend policy
is criticized mainly for the unrealistic assumptions made in the model. CONSTANT INTERNAL RATE OF RETURN AND
COST OF CAPITAL. The model is inaccurate in assuming that r and k always remain constant. A constant r means that
the wealth of the shareholders is not optimized. A constant k means the business risks are not accounted for while
valuing the firm. NO EXTERNAL FINANCING. Gordon’s belief of all investments being financed by retained earnings is
faulty. This reflects sub-optimum investment and dividend policies. Summary. Gordon’s theory of dividend policy is one
of the prominent theories in the valuation of the company. Though it comes with its own limitations, it is a widely
accepted model to determine the market price of the share using the forecasted dividends.
Capital Structure; What is a 'Capital Structure'.The capital structure is how a firm finances its overall operations and
growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure. BREAKING DOWN 'Capital Structure'. A firm's capital
structure can be a mixture of long-term debt, short-term debt, common equity and preferred equity. A company's
proportion of short- and long-term debt is considered when analyzing capital structure. When analysts refer to capital
structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a
company is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore
poses greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt vs. Equity. Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to
issue debt because of the tax advantages. Interest payments are tax-deductible. Debt also allows a company or
business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to
access. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does
not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the
company as a part owner. Debt-to-Equity Ratio as a Measure of Capital Structure. Both debt and equity can be found
on the balance sheet. The assets listed on the balance sheet are purchased with this debt and equity. Companies that
use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company
that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said,
a high leverage ratio and/or an aggressive capital structure can also lead to higher growth rates, whereas a
conservative capital structure can lead to lower growth rates. It is the goal of company management to find the optimal
mix of debt and equity, also referred to as the optimal capital structure. Analysts use the D/E ratio to compare capital
structure. It is calculated by dividing debt by equity. Savvy companies have learned to incorporate both debt and equity
into their corporate strategies. At times, however, companies may rely too heavily on external funding, and debt in
particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the
company's peers.1.Long-Term Debt To Capitalization ...2. Leverage Ratio 3.Capitalization Ratios. 4. Debt Load. 5.
Financial Structure. 6. Long Term Debt To Total Assets ...7.Net Debt. 8. Total Debt to Total Assets. 9. Secured Debt.
Long-Term Debt To Capitalization Ratio. The long-term debt to capitalization ratio is a ratio showing the financial
leverage of a firm, calculated by dividing long-term debt by the amount of capital available:

A variation of the traditional debt-to-equity ratio, this value computes the proportion of a company's long-term debt
compared to its available capital. By using this ratio, investors can identify the amount of leverage utilized by a specific
company and compare it to others to help analyze the company's risk exposure as generally, companies that finance a
greater portion of their capital via debt are considered riskier than those with lower leverage ratios. BREAKING DOWN
'Long-Term Debt To Capitalization Ratio' The choice between using long-term debt and other forms of capital, namely
preferred and common stock or categorically called equity, is a balancing act to build a financing capital structure with
lower cost and less risk. Long-term debt can be advantageous if a company anticipates strong growth and ample
profitability that can help ensure on-time debt repayments. Lenders collect only their due interest and do not
participate in profit sharing among equity holders, making debt financing sometimes a preferred funding source. On
the other hand, long-term debt may be risky when a company already struggles with its business, and the financial
strain imposed by the debt burden may well lead to insolvency.

Cost of Capital. Contrary to intuitive understanding, using long-term debt can actually help lower a company's total cost
of capital. Borrowing terms are stipulated independent of a company's future business and financial performance. In
other words, if a company turns out to be highly profitable, it does not need to pay the lender anything more than what
the borrowing interest rate calls for and can keep the rest of the profits to itself. When a company's existing owners
finance their capital with equity, they must share its available profits proportionately with all other equity holders.
Although a company does not need to worry about returning capital to equity holders, the cost of using the safer equity
capital is never cheap. A leverage ratio is any one of several financial measurements that look at how much capital
comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage
ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing
the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.
BREAKING DOWN 'Leverage Ratio'. Too much debt can be dangerous for a company and its investors. However, if a
company's operations can generate a higher rate of return than the interest rate on its loans, then the debt is helping
to fuel growth in profits. Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other
hand, too few debt can also raise questions. A reluctance or inability to borrow may be a sign that operating margins
are simply too tight.

Capitalization Ratios. Capitalization ratios are indicators that measure the proportion of debt in a company’s capital
structure. Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio and total debt to
capitalization ratio. The formula for each of these ratios is shown below.Debt-Equity ratio = Total Debt / Shareholders'
Equity. Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity). Total Debt to
Capitalization = Total Debt / (Total Debt + Shareholders' Equity) While a high capitalization ratio can increase the return
on equity because of the tax shield of debt, a higher proportion of debt increases the risk of bankruptcy for a company.
Also known as leverage ratios. BREAKING DOWN 'Capitalization Ratios'. For example, consider a company with short-
term debt of $5 million, long-term debt of $25 million and shareholders’ equity of $50 million. The company’s
capitalization ratios would be computed as follows: Debt-Equity ratio = ($5 million + $25 million) / $50 million = 0.60 or
60%. Long-term Debt to Capitalization = $25 million / ($25 million + $50 million) = 0.33 or 33%. Total Debt to
Capitalization = ($5 million + $25 million) / ($5 million + $25 million + $50 million) = 0.375 or 37.5%. The acceptable
level of capitalization ratios for a company depends on the industry in which it operates. Companies in sectors such as
utilities, pipelines and telecommunications – which are capital intensive and have predictable cash flows – will typically
have capitalization ratios on the higher side. Conversely, companies with relatively few assets that can be pledged as
collateral, in sectors like technology and retail, will have lower levels of debt and therefore lower capitalization ratios.
The acceptable level of debt for a company is dependent on its whether its cash flows are adequate to service such
debt. The interest coverage ratio, another popular leverage ratio, measures the ratio of a company’s earnings before
interest and taxes (EBIT) to its interest expense. A ratio of 2, for instance, indicates the company generates $2 for every
dollar in interest expense. As with all ratios, a company’s capitalization ratios should be tracked over time to identify if
they are stable. They should also be compared with similar ratios of peer companies, to ascertain the company’s
leverage position relative to its peers.

Debt Load; The amount of debt or leverage that a company is carrying on its books. The amount of debt a firm is
carrying can be found in the company's balance sheet, which most firms provide on a quarterly basis. Companies may
incur this debt for numerous reasons such as expanding their business or making an acquisition. BREAKING DOWN
'Debt Load' A very useful insight into the financial health of a company is to compare the amount of debt a company is
carrying to the assets or equity the company has. Dividing the total debt a company has by the total assets a company
has gives what is called a debt ratio. A low debt ratio is usually a sign of a healthy company.

Financial Structure. Financial structure refers to the specific mixture of long–term debt and equity that a company uses
to finance its operations. The composition directly affects the risk and value of the associated business. The financial
manager must decide how much money should be borrowed and the best mixture of debt and equity to obtain, and he
must find the least expensive sources of funds for the company. BREAKING DOWN 'Financial Structure' Like the capital
structure, the financial structure is divided into the amount of the company's cash flow that goes to creditors and the
amount that goes to shareholders. Each business has a different mixture depending on its needs and expenses.
Therefore, each company has its own particular debt-equity (D/E) ratio. For example, a company could issue bonds and
use the proceeds to buy stock, or it could issue stock and use the proceeds to pay its debt. Financial Structure Versus
Capital Structure While a capital structure and a financial structure both include information regarding long-term
financing and common stock, preferred stock and retained earnings, it does not include any information regarding
short-term debt obligations. A financial structure does include both long-term and short-term obligations in its
calculation. In this regard, the capital structure can be seen as a subset of the financial structure that is more geared
toward long-term analysis, while the financial structure provides more reliable information regarding the business's
current circumstances.

Long Term Debt To Total Assets Ratio. The long term debt to total assets ratio is a measurement representing the
percentage of a corporation's assets financed with loans or other financial obligations lasting more than one year. The
ratio provides a general measure of the long-term financial position of a company, including its ability to meet financial
requirements for outstanding loans. BREAKING DOWN 'Long Term Debt To Total Assets Ratio' A year-over-year
decrease in long term debt to total assets ratio may suggest a company is progressively becoming less dependent on
debt to grow its business. The calculation for the long-term debt to total assets ratio is: long-term debt / total assets =
long-term debt to total asset ratio.Example of Long-Term Debt to Asset Ratio. For example, if a company has $100,000
in total assets with $40,000 in long-term debt, its long-term debt to total asset ratio is $40,000/$100,000 = 0.4 or 40%.
This ratio indicates that the company has 40 cents of long-term debt for each dollar it has in assets. In order to compare
the overall leverageposition of the company, investors look at comparable firms and the historical changes in this ratio.
Net Debt Net debt shows a business's overall financial situation by subtracting the total value of a company's liabilities
and debts from the total value of its cash, cash equivalents and other liquid assets, a process called netting. All the
information necessary to determine a company's net debt can be found on its balance sheet.Net Debt = (Short-Term
Debt + Long-Term Debt) - Cash and Cash Equivalents. BREAKING DOWN 'Net Debt' The net debt figure is used as an
indication of a business's ability to pay off all its debts if they became due simultaneously on the day of calculation,
using only its available cash and highly liquid assets.

Total Debt to Total Assets. Total debt to total assets is a leverage ratio that defines the total amount of debt relative to
assets. This metric enables comparisons of leverage to be made across different companies. The higher the ratio, the
higher the degree of leverage (DoL) and, consequently, financial risk. The total debt to total assets is a broad ratio that
includes long-term and short-term debt (borrowings maturing within one year), as well as all assets – tangible and
intangible. BREAKING DOWN 'Total Debt to Total Assets'. Total debt to total assets is a measure of the company's
assets that are financed by debt, rather than equity. This leverage ratio shows how a company has grown and acquired
its assets over time. Investors use the ratio to not only evaluate whether the company has enough funds to meet its
current debt obligations, but to also assess whether the company can pay a return on their investment. Creditors use
the ratio to see how much debt the company already has and if the company has the ability to repay its debt, which will
determine whether additional loans will be extended to the firm.

Secured Debt. Secured debt is debt backed or secured by collateral to reduce the risk associated with lending, such as a
mortgage. If the borrower defaults on repayment, the bank seizes the house, sells it and uses the proceeds to pay back
the debt. Assets backing debt or a debt instrument are considered security, which is why unsecured debt is considered
a riskier investment. BREAKING DOWN 'Secured Debt'. There are two primary ways a company can raise capital: debt
and equity. Equity is ownership and implies a promise of future earnings, but if the company falters, the investor may
lose her principal. Lured by the prospect of better growth opportunities, investors in equity have the implicit backing of
the company but no real claim on company assets. Indeed, equity holders get paid last in case of bankruptcy. Debt, on
the other hand, implies a promise of repayment and has a higher degree of seniority in the case of bankruptcy. As a
result, debt holders are not as concerned about future earnings as they are about liquidation value. Within the world of
debt, there is one particular class of securities that has a higher seniority than unsecured debt vehicles: secured debt
vehicles. Secured Debt. In general, lenders are more concerned about the value of company assets than earnings
quality because in the case of earnings decline, the company can sell assets. This is the informal course of action when
firms are facing bankruptcy; however, some debt is contractually backed by specific assets. This debt is referred to as
secured debt. Secured debt is a formal contract backed by assets that can be sold as collateral if the firm defaults on
the loan. Due to its low risk profile, secured debt is favored among those companies with poor credit. Secured debt
allows the borrower to shift the lender's focus to the liquidation value of assets rather than the borrower's
creditworthiness. Examples of Secured Debt. The most commonly cited example of a secured loan is a mortgage. Other
examples include the service provided by pawn shops or the factoring of receivables. Pawn shops give the borrower a
loan based on the value of whatever that borrower is willing to pawn. In this way, secured debt is at the foundation of
the pawn shop business model. Many firms also make a habit of receiving funding through the financing of accounts
receivable. If the company cannot make the payment, the lender can use customer receipts and promissory notes to
secure repayment. Other examples include car loans and home equity lines of credit, also referred to as HELOCs

Capital Structure or Leverage Ratio. Capital structure refers to the degree of long term financing of a business concern
as in the form of debentures, preference share capital and equity share capital including reserves and surplus. There
should be a proper mix between debt capital and equity capital. Capital structure is otherwise called as leverage.

Formulae to Calculate Capital Structure or Leverage Ratios. Capital structure ratios are calculated to test the long term
financial position of the business concern. The followings ratios are calculated to analyze the capital structure of the
business concern. 1. Capital Gearing Ratio, Financial Leverage, Operating Leverage, Combined Leverage. 2. Debt Equity
Ratio. 3. Total Investment to Long Term Liabilities 4. Ratio of Fixed Assets to Funded Debt. 5. Ratio of Current Liabilities
to Proprietors’ Funds.
6. Ratio of Reserves to Equity Capital. Capital Gearing Ratio. This ratio shows the relationship prevailing between equity
share capital including reserves and surplus and preference share capital along with fixed interest bearing loans for long
term. If equity share capital including reserves and surplus is less when compared with preference share capital and
fixed interest bearing loans for long term, there is a high gearing and vice versa. The followings formulae are used to
calculate Capital Gearing Ratio. Capital Gearing Ratio = (Equity Share Capital + Reserves and Surplus) / (Preference
Share Capital+ Fixed Interest bearing loans) or Capital Gearing Ratio = Fixed Income bearing Funds / Equity
Shareholders’ Fund or Capital Gearing Ratio = Fixed Income bearing Funds / Total Capital Employed. Leverage may be
classified as financial leverage, operating leverage and combined leverage.

Financial Leverage or Trading on Equity. Financial leverage is the using of equity share capital and preference share
capital along with long term fixed interest bearing debt. The company can use long term fixed interest bearing debt
very effectively. If so, the earnings of more than fixed interest is available only to the equity shareholders. In this way,
the returns to equity share holders is increased. It means that the earnings of equity shareholders is increased by
effective use of long term fixed interest bearing debt. It is known as trading on equity. Financial leverage can be
calculated as. Financial leverage = Earnings Before Interest and Tax / (Earnings Before Interest and Tax — Interest and
Preference Dividend). Operating leverage can be calculated as. Operating leverage = (Sales — Variable Cost) / Earnings
Before Interest and Tax. Combined leverage can be calculated as. Combined leverage = Financial Leverage x Operating
Leverage. Total Investment to Long Term Liabilities. This ratio is calculated by the following formula. = (Shareholders’
Funds+ Long Term Liabilities) / Long Term Liabilities. High ratio is preferable. Ratio of Fixed Assets to Funded Debt. This
ratio is calculated by the following formula. = Fixed Assets / Funded Debt .Ratio of Current Liabilities to Proprietors’
Funds. This ratio is calculated by the following formula. = Current Liabilities / Proprietors’ Funds. Ratio of Reserves to
Equity Capital. This ratio indicates the level of profits retained within the business as reserve for future growth. This
ratio is calculated by the following formula.= Reserves / Equity Share Capital x 100

High ratio is preferable.

Miscellaneous Ratios. The different types of ratios are analysed under various headings. Even though, some other ratios
are also developed by experts and analysts. Such types of ratios are presented below. Finance Expense Ratio = Financial
Expenses / Net Sales x 100. Rate of Dividend = Dividends / Paidup Capital x 100. Ratio of Disposable Profit to Paid up
Capital = Disposable Profit / Paid up Capital x 100 Rate of Ploughing Back of Profits or Rate of Retention = Rate of
Dividend — Ratio of Disposable Profit to paid up Capital. Dividend Cover Ratio = Profit After Interest and Tax / Dividend.
Dividend cover ratio reveals the ability of the business concern to maintain the dividend in future. Current Assets
Turnover Ratio = Cost of Sales or Net Sales / Current Assets. Owned Capital Turnover Ratio = Cost of Sales or Net Sales /
Shareholders’ Fund. Ratio of Tangible Assets to Total Debts = Tangible Assets / Total Debt Here, Tangible Assets = Total
Assets — Intangible assets

Trading on equity. Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred
stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates
a profit through this financing technique, its shareholders earn a greater return on their investments. In this case,
trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its
shareholders earn a reduced return because of this activity. Many companies use trading on equity rather than
acquiring more equity capital, in an attempt to improve their earnings per share. Trading on equity has two primary
advantages: Enhanced earnings. It may allow an entity to earn a disproportionate amount on its assets. Favorable tax
treatment. In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.
However, trading on equity also presents the possibility of disproportionate losses, since the related amount of interest
expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. The concept
is especially dangerous in situations where a company relies upon short-term borrowings to fund its operations, since a
sudden spike in short-term interest rates may cause its interest expense to overwhelm earnings, resulting in immediate
losses. This risk can be mitigated through the use of interest rate swaps, where a company swaps its variable interest
payments for the fixed interest payments of another entity. Thus, trading on equity can earn outsized returns for
shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations. In short, earnings
are likely to become more variable when a trading on equity strategy is pursued. Because of the increased variability in
earnings, a side effect of trading on equity is that the recognized cost of stock options increases. The reason is that
option holders are more likely to cash in their options when earnings spike, and since trading on equity leads to more
variable earnings, the options are more likely to earn a higher return for their holders. The trading on equity concept is
more likely to be employed by professional managers who do not own a business, since the managers are interested in
increasing the value of their stock options with this aggressive financing technique. A family-run business is more
interested in long-term financial stability, and so is more likely to avoid the concept. Example of Trading on Equity Able
Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is
not using financial leverage at all, since it incurred no debt to buy the factory. Baker Company uses $100,000 of its own
cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using
financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its
investment. Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its
original investment. Similar Terms. Trading on equity is also known as financial leverage, investment leverage, and
operating leverage Trading on Equity: Meaning, Effects (with Examples) | Financial Management. Meaning: Trading on
equity is the financial process of using debt to produce gain for the residual owners. The practice is known as trading on
equity because it is the equity shareholders who have only interest (or equity) in the business income. The term owes
its name also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by the
owners. Trading feature here is simply one of taking advantage of the permanent stock investment to borrow funds on
reasonable basis. When the amount of borrowing is relatively large in relation to capital stock, a company is said to be
‘trading on this equity’ but where borrowing is comparatively small in relation to capital stock, the company is said to
be trading on thick equity.

Effects of Trading on Equity: Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any
fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of
trading on equity larger the magnitude of debt in capital structure, the higher is the variation in EPS given any variation
in EBIT. Solution:.Impact on trading on equity, will be reflected in earnings per share available to common stock
holders. To calculate the EPS in each of the four alternatives EBIT has to be first of all calculated.

Proposal A

Rs. Proposal B

Rs. Proposal C Rs. Proposal D Rs.

EBIT 1,20,000 1,20,000 1,20,000 1,20,000

Less; interest 25,000 60,000

Earnings before taxes 11,20,000 95,000 60,000 1,20,000

Less; taxes @ 50% 60,000 47,100 30,000 60,000

Earnings after taxes 60,000 47,500 30,000 60,000

Less; Preferred stock

dividend 25,000

Earnings available to 60,000 47,500 ,30,000 35,000

common stock holders 20,000 15,000 10,000 15,000

No. of common shares

EPS Rs. 3.00 3.67 3.00 2.33

Effects of trading on equity can be explained with the help of the following example. Example: Prakash Company is
capitalized with Rs. 10, 00,000 dividends in 10,000 common shares of Rs. 100 each. The management wishes to raise
another Rs. 10, 00,000 to finance a major programme of expansion through one of four possible financing plans. Then
management A) may finance the company with all common stock, B). Rs. 5 lakhs in common stock and Rs. 5 lakhs in
debt at 5% interest, C) all debt at 6% interest or D) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with
5-4 dividend. The company’s existing earnings before interest and taxes (EBIT) amounted to Rs. 12,00,000, corporation
tax is assumed to be 50% Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75% common
stock and 25% debt, would be the most favourable with respect to earnings per share. It may further be noted that
proportion of common stock in total capitalisation is the same in both the proposals B and D but EPS is altogether
different because of induction of preferred stock. While preferred stock dividend is subject to taxes whereas interest on
debt is tax deductible expenditure resulting in variation in EPS in proposals B and D, with a 50% tax rate the explicit cost
of preferred stock is twice the cost of debt.

Calculation of Point of Indifference | Capital Structure. After reading this article you will learn about Calculation of Point
of Indifference. The EPS, earnings per share, ‘equivalency point’ or ‘point of indifference’ refers to that EBIT, earnings
before interest and tax, level at which EPS remains the same irrespective of different alternatives of debt-equity mix At
this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-
even level of EBIT for alternative financial plans. The equivalency or point of indifference can be calculated
algebraically, as below: Where, X = Equivalency Point or Point of Indifference or Break Even EBIT Level. I1 = Interest
under alternative financial plan 1. I2 = Interest under alternative financial plan 2. T = Tax Rate. PD = Preference
Dividend S1 = Number of equity shares or amount of equity share capital under alternative 1. S2 = Number of equity
shares or amount of equity share capital under alternative 2. The point of indifference can also be determined by
preparing the EBIT chart or range of earnings chart. This chart shows the expected earnings per share (EPS) at various
levels of earnings before interest and tax (EBIT) which may be plotted on a graph and straight line representing the EPS
at various levels of EBIT may be drawn. The point where this line intersects is known as point of indifference or break-
even point.

Illustration 1: A project under consideration by your company requires a capital investment of Rs. 60 lakhs. Interest on
term loan is 10% p.a. and tax rate is 50% Calculate the point of indifference for the project, if the debt-equity ratio
insisted by the financing agencies is 2:1: Solution: As the debt equity ratio insisted by the financing agencies is 2:1, the
company has two alternative financial plans: (i) Raising the entire amount of Rs. 60 lakhs by the issue of equity shares,
thereby using no debt, and (ii) Raising Rs. 40 lakhs by way of debt and Rs. 20 lakh by issue of equity share capital.
Calculation of point of Indifference: Where, X = Point Indifference I1 = Interest under alternative 1, i.e. .0 I2 = Interest
under alternative 2, i.e. 10/100 × 40 = 4, T = Tax rate, i.e. 50% or .5. PD = Preference Divided, i.e. O as there are no
preference shares.S1 = Amount of equity capital under alternative 1, i.e. 60. S2 = Amount of equity capital under
alternative 2, i.e. 20. Substituting the values:

Thus, EBIT, earnings before interest and tax, at point of indifference is Rs. 6 lakhs. At this level (6 lakh) of EBIT, the
earnings on equity after tax will be 5% p.a. irrespective of alternative debt-equity mix when the rate of interest on debt
is 10% p, a. From the figure given on next page, we find that the equivalency point (point of indifference) or the break-
even level of EBIT is Rs. 6 lakhs. In case, the firm has EBIT level below Rs. 6 lakhs then equity financing is preferable to
debt financing; but if the EBIT is higher than Rs. 6 lakhs then debt financing; but if the EBIT is higher than Rs. 6 lakhs
then debt financing is better. Illustration 2: A new project under consideration requires a capital outlay of Rs. 600 lakhs
for which the funds can either be raised by the issue of equity shares of Rs. 100 each or by the issue of equity shares of
the value of Rs. 400 lakhs and by the issue of 15% loan of Rs. 200 lakhs. Find out the indifference level of EBIT given the
tax rate at 50%:

Solution: Thus, the indifferent level of EBIT is Rs. 90 lakhs. At this level of EBIT, the earnings per share (EPS) under both
the plans would be the same. Indifference EBIT - Capital Structure of Corporations Indifference Earnings Before Interest
& Taxes (Indifference EBIT) is the point of the capital structure where the corporation does not care about whether
they issue new debt, have no debt and 100% equity or have a combination of both debt & equity. From the graph
below, you can determine that the Indifference EBIT point is where the With Debt Capital Structure Line intersects with
the No Debt Capital Structure Line. Any point to the left of Indifference EBIT is risky debt while any point to the right of
Indifference EBIT is good debt (interest expense that is tax deductible). Indifference EBIT Example ABC Corp. currently
has 200,000 shares outstanding on the stock market with the current price being $20. The Board of Directors of the
Corp want to incur a debt of $1 million by issuing junk bonds that have a coupon interest rate of 9% annually. At what
point of EBIT would the Corp. be indifferent to having debt or NO debt? Solution: Current Capital Structure = $20 x
200,000 shares = $4,000,000 Equity. New Capital Structure = $3,000,000 Equity & $1,000,000 Debt - Current Stock Price
Remains at $20. - To attain $3,000,000 of Equity, the # of shares = 150,000. Annual Interest Expense Coupon Payments
= 9% x 1,000,000 = $90,000

No Debt With Debt

Indifference EBIT EBIT - 0

200,000 = EBIT - 90,000

150,000

Indifference EBIT 150,000 EBIT = 200,000 (EBIT - 90,000)

150,000 EBIT = 200000EBIT - 18000000000

18000000000 = 200,000 EBIT - 150,000 EBIT

18000000000 = 50,000 EBIT

EBIT = 18000000000 / 50,000

EBIT = $360,000

Interpretation of EBIT. At a point where Earnings Before Interest & Taxes is $360,000, ABC Corp. will not care whether it
has any outstanding debt issues, NO debt or a combination of both because at this point, the value of the Capital
Structure is NOT affected. It is important to have an understanding of your capital structure. Your capital structure
consists of the combination of debt and equity as reflected on the Blance Sheet. The combination of debt and equity is
reflective of your risk. Higher levels of debt equate to higher levels of risk. This can eventually cripple a company over
the long term. However, too much equity can also be costly since equity carries a higher cost than debt. So the goal is
to find the right balance or mix that grows the company at an acceptable level of risk.

One way of determining the right mix of capital is to measure the impacts of different financing plans on Earnings Per
Share (EPS). The objective is to find the level of EBIT (Earnings Before Interest Taxes) where EPS does not change; i.e.
the EBIT Breakeven. At the EBIT Breakeven, EPS will be the same under each financing plan we have under
consideration. As a general rule, using financial leverage will generate more EPS where EBIT is greater than the EBIT
Breakeven. Using less leverage will generate more EPS where EBIT is less than EBIT Breakeven. EBIT Breakeven is
calculated by finding the point where alternative financing plans are equal according to the following formula: (EBIT - I)
x (1.0 - TR) / Equity number of shares after implementing financing plan.

I: Interest Expense TR: Tax Rate Formula assumes no preferred stock. The formula is calculated for each financing plan.
For example, you may be considering issuing more stock under Plan A and incurring more debt under Plan B. Each of
these plans will have different impacts on EPS. You want to find the right plan that helps maximize EPS, but still manage
risks within an acceptable range. EBIT-EPS Analysis can help find the right capital mix for high returns and low costs of
capital. How is EBIT breakeven affected by leverage and financing plans? A: To finance its operations, a corporation
raises capital by borrowing money or selling shares of company ownership to the public. A corporation can only remain
viable if it generates sufficient earnings to offset the costs associated with its financing – after all, some of its revenue
needs to be paid out to stockholders, bondholders and other creditors. Thus, the composition of a corporation's
financing plans has a significant impact on how much operating income it needs to generate.
Corporate Financing and Financial Leverage Corporations often leverage their assets by borrowing money to increase
production and, by extension, earnings. Financial leverage comes from any capital issue that carries a fixed interest
payment, such as bonds or preferred stock. Issuing common stock would not be considered a form of financial
leverage, because the required return on equity (ROE) is not fixed and because dividend payments can be suspended,
unlike the interest on loans. One common formula for calculating financial leverage is called the degree of financial
leverage (DFL). This formula reflects the proportional change in net income after a change in the corporation's capital
structure. Changes in DFL can result from either a change in the total amount of debt or from a change in the interest
rate paid on existing debt. The accounting equation for DFL is either earnings before interest and taxes (EBIT) divided
by earnings before tax, or earnings per share (EPS) divided by EBIT.

Profitability and Earnings Before Interest and Taxes Earnings before interest and taxes measures all profits before
taking out interest and tax payments. This isolates the capital structure and focuses solely on how well a company turns
a profit. EBIT is one of the most commonly used indicators for measuring a business's profitability and is often used
interchangeably with "operating income." It does not take into consideration changes in the costs of capital. A
corporation can only enjoy an operating profit after it pays its creditors, however. Even if earnings dip, the corporation
still has interest payment obligations. A company with high EBIT can fall short of its break-even point if it is too
leveraged. It would be a mistake to focus solely on EBIT without considering the financial leverage. Rising interest costs
increase the firm's break-even point. This won't show up in the EBIT figure itself – interest payments don't factor into
operating income – but it affects the firm's overall profitability. It must record higher earnings to offset the extra capital
costs. Additionally, higher degrees of financial leverage tend to increase the volatility of the company's stock price. If
the company has granted any stock options, the added volatility directly increases the expense associated with those
options. This further damages the company's bottom line.

Financial Distress What is 'Financial Distress' Financial distress is a condition where a company cannot meet, or has
difficulty paying off, its financial obligations to its creditors, typically due to high fixed costs, illiquid assets or revenues
sensitive to economic downturns. A company under financial distress can incur costs related to the situation, such as
more expensive financing, opportunity costs of projects and less productive employees. Employees of a distressed firm
usually have lower morale and higher stress caused by the increased chance of bankruptcy, which would force them
out of their jobs. BREAKING DOWN 'Financial Distress' Many warning signs may indicate a company is experiencing
financial distress.

Signs of Financial Distress Poor profits indicate a company is not experiencing financial health. Struggling to break even
indicates a business cannot sustain itself from internal funds and needs to raise capital externally. This raises the
company’s business risk and lowers its creditworthiness with lenders, suppliers, investors and banks. Limiting access to
funds typically results in a company failing. Poor sales growth or decline indicates the market is not positively receiving
a company’s products or services based on its business model. When extreme marketing activities result in no growth,
the market may not be satisfied with the offerings, and the company may close down. Likewise, if a company offers
poor quality in its products or services, consumers start buying from competitors, eventually forcing a business to close
its doors. When debtors take too much time paying their debts to the company, cash flow may be severely stretched.
The business may be unable to pay its own liabilities. The risk is especially enhanced when a company has one or two
major customers. Financial Distress in Large Financial Institutions One factor contributing to the financial crisis of 2007-
2008 was the government’s history of emergency loans to distressed financial institutions and markets believed “too
big to fail.” This history created an expectation for parts of the financial sector being protected against losses. The
federal financial safety net is supposed to protect large financial institutions and their creditors from failure and reduce
systemic risk to the financial system. However, federal guarantees may encourage imprudent risk-taking that can lead
to instability in the system the safety net is supposed to protect. Because the government safety net subsidizes risk-
taking, investors feeling protected by the government may be less likely to demand higher yields as compensation for
assuming greater risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected. Excessive
risk-taking means firms are more likely to experience distress and require bailouts for staying solvent. Additional
bailouts may erode market discipline further. Resolution plans, or living wills, may be an important method of
establishing credibility against bailouts. The government safety net may be a less-attractive option in times of financial
distress. Distressed Sale; When property, stocks or other assets are sold in an urgent manner, often at a loss. Distressed
salesoften occur at a loss because funds tied up in the asset are needed within a short period of time. The funds from
these assets are most often used to pay for debts, medical expenses or other emergencies. BREAKING DOWN
'Distressed Sale' Mortgage borrowers who can no longer pay for their mortgaged property, may opt to sell their
property in order to pay the mortgage. Examples of situations where distressed sales occur include divorce,
foreclosures and relocations.

Distress Price; When a firm chooses to mark down the price of an item or service instead of discontinuing the product
or service altogether. A distress price usually comes about in tough market conditions when the sale of a particular
product or service has slowed down dramatically and the company is unable to sell enough of it to cover the fixed costs
associated with doing business. BREAKING DOWN 'Distress Price' A company will sometimes choose to mark down an
item's price rather than discontinue operations completely because even at a distressed price, those revenues will help
with covering some of the fixed costs associated with running the business. However, if the item can not be sold at a
price greater than its variable cost of production, discontinuing the item is usually in the firm's best interests. Workout
Assumption; The assumption of an existing mortgage by a qualified, third-party borrower from a financially distressed
borrower. By having someone else assume the mortgage, the financially distressed borrower is relieved of its obligation
of repaying the mortgage. The assumption must be approved by the mortgagee. BREAKING DOWN 'Workout
Assumption' Foreclosure on a mortgage that is in default is an expensive and timely solution for the lender. If a
borrower's financial problems are temporary, a lender might be willing to find a temporary solution, such as a
forbearance agreement. If a borrower's financial problems are lasting, a workout assumption is one of several remedies
that can help the borrower avoid foreclosure. Other remedies include a mortgage short sale or a deed in lieu of
foreclosure. Asset Deficiency; A situation where a company's liabilities exceed its assets. Asset deficiency is a sign of
financial distress and indicates that a company may default on its obligations to creditors and may be headed for
bankruptcy. Asset deficiency can also cause a publicly traded company to be delisted from a stock exchange. BREAKING
DOWN 'Asset Deficiency' A company that has a chance at recovering financially may file for chapter 11 bankruptcy,
under which the company is restructured, continues to operate and attempts to regain profitability. In a worst-case
scenario, asset deficiency may force a company to liquidate, in order to pay off creditors and bondholders. The
company will file for chapter 7 bankruptcy and go completely out of business. In this situation, shareholders are the last
to be repaid, and they may not receive any money at all. Vulture Fund; A vulture fund is a fund that buys securities in
distressed investments, such as high-yield bonds in or near default, or equities that are in or near bankruptcy.
BREAKING DOWN 'Vulture Fund' Vulture funds take extreme bets on distressed debt and high yield investing, also
deploying legal actions in their management strategies to obtain contracted payouts. These funds are typically
managed by hedge funds using various types of alternative strategies to obtain profits for their investors. Risk Shifting.
Risk shifting is the transfer of risk to another party. Risk shifting has many connotations, the most common being the
tendency of a company or financial institution facing financial distress to take on excessive risk. This high-risk behavior
is typically undertaken with the objective of generating high rewards to equity owners – who face little additional
downside risk, but may garner significant extra return – and has the effect of shifting risk from shareholders to debt
holders. Risk shifting also occurs when a company goes from offering a defined benefit plan to its employees, to a
defined contribution plan. In this case, the risk associated with pensions has shifted from the company to its
employees. BREAKING DOWN 'Risk Shifting' Risk shifting for a troubled company with significant debt occurs because,
as its shareholders’ equity decreases, the stake of debt holders in the enterprise increases. Thus, if the company takes
on more risk, the potential extra profits accrue to the shareholders, while the downside risk falls to the debt holders,
which means that risk has shifted from the former to the latter. A bankruptcy proceeding that provides financially
distressed municipalities with protection from creditors by creating a plan between the municipality and its creditors to
resolve the outstanding debt. Municipalities include cities, counties, townships and school districts. BREAKING DOWN
'Chapter 9' The purpose Chapter 9 is to negotiate a repayment plan between the municipality and creditors, which can
include reducing the outstanding debt or interest rate, extending the term of the loan and refinancing debts. It is
nearly impossible for a creditor to force the liquidation of a municipality's assets. A municipality is defined by its state
and is under state jurisdiction. The 10th Amendment states that any powers not defined in the Constitution are
reserved for the state. Bankruptcy proceedings are part of the of the U.S. bankruptcy courts, which are under federal
jurisdiction. Because bankruptcy proceedings are not a part of the constitution, the federal courts cannot force a
municipality to liquidate. Mortgage Short Sale The sale of a property by a financially distressed borrower for less than
the outstanding mortgage balance due where the proceeds from the sale will be used to repay the lender. The lender
then accepts the less-than-full repayment of the mortgage (and the borrower is released from the mortgage obligation)
in order to avoid what would amount to larger losses for the lender if it were to foreclose on the mortgage. BREAKING
DOWN 'Mortgage Short Sale' A mortgage short sale is one of several options other than foreclosure that might be
available to a financially distressed borrower. Borrowers with temporary financial problems should try to negotiate a
forbearance agreement with their lender. For borrowers with more lasting financial problems, in addition to a
mortgage short sale, a deed in lieu of foreclosure or a short refinancemight be potential options in avoiding
foreclosure. Bailout. A bailout is a situation in which a business, an individual or a government offers money to a failing
business to prevent the consequences that arise from the business's downfall. Bailouts can take the form of loans,
bonds, stocks or cash. They may require reimbursement. Bailouts have traditionally occurred in industries or businesses
that are perceived as no longer being viable or are sustaining huge losses. BREAKING DOWN 'Bailout' Typically,
companies in need of bailout employ a large number of people, leading some people to believe that the economy
would be unable to sustain such a huge jump in unemployment if the business folded. Bailouts are normally only
considered for companies or industries whose bankruptcies could cause a severely adverse impact to the economy as a
whole, and not just to the industry. Financial Industry Bailout One of the biggest bailouts in history was the one offered
by the U.S. government in 2008 to many of the largest financial institutions in the world that experienced severe losses
resulting from the collapse in the subprime mortgage market and resulting credit crisis. Banks, which had been
providing an increasing number of mortgages to borrowers with low credit scores, experienced massive loan losses as
many of these mortgages went into default. As well-known financial institutions such as Countrywide, Lehman Brothers
and Bear Stearns began failing, the government responded with the Troubled Asset Relief Program (TARP). The
program authorized the government purchase of up to $700 billion in toxic assets from the balance sheets of dozens of
financial institutions. In the end, TARP ended up disbursing more than $426 billion to financial institutions. Auto
Industry Bailout During the 2008 financial crisis, automakers such as Chrysler and General Motors needed a taxpayer
bailout of their own to stay solvent. High gas prices at the time resulted in plummeting sales of these companies' SUVs
and larger vehicles. The difficulty in obtaining auto loans during the financial crisis further hampered auto sales. While
intended for financial companies, the two automakers ended up drawing roughly $17 billion from TARP to stay afloat.
In June 2009, both Chrysler and GM emerged from bankruptcy, and they remain among the larger auto producers
today.In the early 1980s, Chrysler was also in need of a bailout. The U.S. government stepped in and offered roughly
$1.2 billion to the failing company. By 1983, Chrysler was able to pay back the entire loan. The company operates today
as Fiat Chrysler Automobiles.