Corporate finance book_ppt_y_hj_rkrjg2g

Corporate Finance

S. No Reference No Particulars SlideFrom-To

1 Chapter 1 An Introduction to Finance 4-172 Chapter 2 Time Value of Money 18-413 Chapter 3 Capital Budgeting 42-754 Chapter 4 Sources of Finance 76-955 Chapter 5 Capital Structure Management 96-1296 Chapter 6 Leverages 130-1537 Chapter 7 Dividend Policy 154-1778 Chapter 8 Working Capital Management 178-212

9 Chapter 9 Receivables and Inventory Management

213-231

10 Chapter 10 Budget and Budgeting 232-245

Course Introduction

• Corporate finance is the area of finance that deals with the arrangement of funds for the capital structure of corporations and managerial actions for increasing the value for the shareholders.

• This course offers a market-oriented framework for analysing the major types of financial decisions taken by corporations.

• Corporate finance explains topics such as capital budgeting, capital structure, working capital management, dividend policy, asset valuation, the operation and efficiency of financial markets, etc. and explains the responsibilities of a financial officer, chief financial officer, treasurer, controller, etc.

• Corporate finance provides a framework of the concepts and tools used to analyse financial decisions based on fundamental principles of modern financial theory.

Chapter 1: An Introduction to

Finance

Chapter IndexS. No Reference No Particulars Slide

From-To

1 Learning Objectives 6

2 Topic 1 Concept of Finance 7

3 Topic 2 Scope of Finance 8

4 Topic 3 Functions of Finance 9

5 Topic 4 Concept of Financial Management

10

6 Topic 5 Objectives of Financial Management

11-12

7 Topic 6 Analysing Financial Business Decisions

13-14

8 Let’s Sum Up 15

• Explain the concept, scope and functions of finance• Describe the concept of financial management• Explain the objectives of financial management, such as profit

maximisation, wealth maximisation, and value maximisation• Analyse financial business decisions through cost-volume-profit analysis

and break-even analysis

Concept of Finance

• Finance can be defined from the corporate and business point of view. • Corporate finance involves the financial decisions that an organisation

makes in its daily business operations. • It aims to utilise the capital, which the organisation has, to make more

money while simultaneously reducing risks of certain decisions. • Thus, business decisions that involve the decision pertaining to

identification of sources of capital for funding corporations are corporate financial decisions.

• Business finance, on the other hand, encompasses various activities and disciplines concerning the management of money and other valuable assets.

Scope of Finance

• An organisation needs finance to acquire assets, manufacture goods, offer high quality services, procure raw materials, pay its employees and invest in development and expansion projects.

• It is required in various areas of an organisation, which are:

Production

Marketing

Human Resource

Research and Development

Functions of Finance

The functions of finance are majorly influenced by four types of decisions, which are as follows:

Investment Decision

Financing Decision

Dividend Decision

Liquidity Decision

Concept of Financial Management

• According to J.C. Van Horne, “Financial Management is concerned with the acquisition, financing, and management of assets with some overall goal in mind.”

• Financial Management can be defined as the function involved in the management of financial resources.

• There are three major elements of financial management, which are as follows: Financial planning

Financial control

Financial decision-making

1. Objectives of Financial Management

• The main objective of financial management is to increase the profit of the organisation.

• The objectives of financial management are:

Profit Maximisation

Wealth Maximisation

Value Maximisation

2. Objectives of Financial Management

• Profit maximisation: This is required for organisation’s survival, meeting the other organisational objectives, measuring growth, and measuring efficiency.

• Wealth maximisation: The aim of wealth maximisation approach is to maximise the wealth of shareholders by increasing Earning Per Share (EPS).

• Value maximisation: It can be defined as the managerial function involved in the appreciation of the long-term market value of an organisation. The total value of an organisation comprises of all the financial assets, such as Equity shares , Preference Shares, and warrants and it increases when the value of its shares increases in the market.

1. Analysing Financial Business Decisions

• When decisions are taken regarding the allocation of an organisation’s financial resources in the most efficient manner, it is called financial business decision.

• Before investing in a project, the organisation needs to determine the feasibility of every available option.

• Before investing in the project, it needs to estimate the cost of manufacturing garment.

• Further, it needs to decide the probable profit from the project. If the cost incurred in manufacturing the garment is less than the expected profit, then it would be feasible for the organisation to go ahead with the project.

• This process of determining the feasibility of a project is known as financial analysis.

2. Analysing Financial Business Decisions

• A feasibility study includes the detailed analysis of a project or investment avenue in order to predict the results of a specific future course of action.

• An organisation can perform financial analysis by using various tools, which are:

Cost-Volume-Profit Analysis

Break-Even Analysis

Marginal Costing

Margin of Safety

Let’s Sum Up

• Corporate finance involves the financial decisions that an organisation makes in its daily business operations.

• Financial management determines the future strategies related to expansion, diversification, joint venture, and mergers and acquisitions.

• The Cost-Volume-Profit (CVP) analysis determines the change in profit with respect to changes in sales volume and cost.

• BEP refers to a point where total cost is equal to total revenue of an organisation.

• Margin of Safety (MOS) means the difference between actual sales volume and the sales volume at BEP.

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Chapter 2: Time Value of Money

Chapter Index



2 Topic 1 Time Value of Money 21-23

3 Topic 2 Future Value of Cash Flow 24-35

4 Topic 3 Present Value of Cash Flow 36-38

5 Let’s Sum Up 39

• Explain the concept of time value of money• Discuss the future value of cash flow • Explain the present value of cash flow

1. Time Value of Money

• Time value of money analyses the value of a unit of money at various times.

• This is because the money received in future involves risk and money available at present offers investment opportunities.

• For example, a person has an option to receive Rs.1000 now or after one year. The person would prefer Rs.1000 now because he/she can invest the money and earn interest on it. However, after one year it may be possible that the individual would not receive Rs.1000 because of uncertain future. Moreover, it may be possible that the value of money depreciates over time. Hence, in such a case, Rs.1000 received at present is more valuable than Rs.1000 received after one year.


A person values the money available at present due to the following reasons:• Investment options: It indicates the various ways in which money can be

invested. Interest and growth can be possible on the invested money and hence, the amount of money available today is more valuable than in the future.

• Priority for consumption: It points to the fact that individuals give priority to consumption over investment. This is because they think that the future investments are uncertain. They are of the opinion that in future, the value of money may depreciate due to inflation; therefore, they prefer to have money available at present rather than at a future date.


• Risk factor: It indicates that risk and uncertainty is always linked with money to be received in future as the market conditions are volatile in nature. Various factors, such as inflation, recession, and government policies may influence the value of money to be received in future date. Hence, the organisation or individual prefers to avail money in the present. The time value of money is estimated in two ways: future value of cash flow and present value of cash flow, which are discussed in detail in the next few sections.

1. Future Value of Cash Flow

• The future value of cash flow is defined as a technique that calculates the value of cash at a fixed time in future at a specific compound interest rate.

• If an individual purchases some investment policies then he/she considers the future value of initial investment and returns earned on it.

• Since, the future investments involve risk; the individual compares the risk factor with total future value of the investment, i.e. the initial investment along with the returns.

• If the future value is greater than the risk associated with the investment, the investment is considered to be favourable.


Future Value of Single Cash Flow• The future value of single cash flow is defined as the valuation of an

amount of money at a particular period of time in future. • It depends on the rate of compound interest earned on the amount of

money invested, i.e. if the rate of compound interest is high then the future value of single cash flow is also higher.

• Generally, people calculate future value of single cash flow while investing in saving schemes, bonds, mutual funds, and derivative markets.


Future Value of Single Cash Flow• The mathematical formula used to calculate future value of single cash

flow is as follows:FVn = P (1+i)n

Where,– FVn = Amount at the end of n years– P = Principal at the beginning of the year– i = Rate of interest– n = Number of years


Future Value of Single Cash Flow• Illustration: Assume Mr. Amjad invests Rs.10000 at the interest rate of 5

per cent compounded annually for three years in a business. • At the end of first year, he gets Rs.10500, which is considered as the

principal for the next year. • At the end of the second year, he receives Rs.11025, which is considered

as the principal for the third year. • Finally, he gets Rs.11576.25, which is the total amount received by him at

the end of third year and is the future value of single cash flow.


Future Value of Single Cash Flow• Calculation of Future Value of Single Cash Flow:

Year 1 2 3

Principal (original) amount 10000 10500 11025

Rate of interest 0.05 0.05 0.05

Interest amount 500 525 551.25

New principal 10000 10500 11025

Future value 10500 11025 11576.25


Future Value of Single Cash Flow• Illustration: Assume Mr. Yashwant has invested Rs.100 at the interest rate

of 8% compounded semi-annually for two years in a business. • He receives 4% interest compounded semi-annually four times in two

years.


Future Value of Single Cash Flow• Calculation: The calculation of future value of Rs.100 at the end of two

years are a shown in Table:Year 6 months 1 year 18 months 2 years

Initial amount 100 104 108.16 112.48

Rate of interest 0.04 0.04 0.04 0.04

Interest amount 4 4.16 4.32 4.50

New principal 100 104 108.16 112.48

Future value 104 108.16 112.48 117


Future Value of Annuity• A fixed amount of cash paid or received at a regular interval of time is

called annuity. • For example, the fixed amount of premium paid at regular intervals by an

individual on insurance policy is called annuity. • If an individual buys property, such as house or land, on instalments then

annuity helps in calculating the monthly instalments paid by the individual. • The calculation of future value of annuity helps the investors to estimate

the amount of return on investment and compare the risk and returns linked with the investment.


Future Value of Annuity• Illustration: Mr. K. K. Prasad deposits Rs. 100 for five years at the interest

rate of 5 % compounded annually in a bank. • It suggests that deposited amount would increase at the rate of 5 per cent

compounded annually for the next four years.• The amount at the end of first year would become principal for the next

year and this process continues for the next three years. • In the fifth year, no interest would be generated as Mr. Prasad would

withdraw the money.


Future Value of Annuity• The calculation of future value of annuity is as follows:• FVAn = Rs. 100 (1.05)4 + Rs. 100 (1.05)3 + Rs. 100 (1.05)2 + Rs. 100 (1.05)1

+ Rs. 100• FVAn = Rs. 100 (1.216) + Rs. 100 (1.158) + Rs. 100 (1.103) + Rs. 100

(1.050) + Rs. 100• FVAn = Rs. 121.55 + Rs. 115.76 + Rs. 110.25 + Rs. 105.50 + Rs. 100

• FVAn = Rs. 553.05


Future Value of Annuity• The compounding value of annuity of Rs. 100 at the rate of 5 per cent are

as follows:


Future Value of Annuity• The mathematical formula to calculate the future value of annuity is as follows:

FVA5 = A (1+i) 4 + A (1+i) 3 + A (1+i) 2 + A (1+i) + A

= A [(1+i) 4 + (1+i) 3 + (1+i) 2 + (1+i) + 1]= A [(1+i) 4– 1/i]

• When the time period extended to n years, the equation can be re-written as:FVAn = P [(1+i) n – 1/i]

• Where,– FVAn = Future Value of Annuity of cash flow– P =Principal at the beginning of the year– i = Rate of interest– n = Number of years

1. Present Value of Cash Flow

Present Value of Single Cash Flow• The present value of single cash flow enables to determine the present

value of future cash flow. • The present value of cash flow is generally lesser than the future value of

cash flow. • Thus, it can be established that in future value of cash flow, there is always

some appreciation in the value of money. However, in present value of cash flow, there is always some depreciation in the value of money.


Present Value of Annuity• Illustration: Mr. P. K. Chandra lends Rs. 100 at interest rate of 5 per cent

for five years. What would be the present value of annuity? • The present value of Rs. 100 received at the end of first year is P =

100/1.05 = Rs. 95.23, at the end of second year is P = 100/(1.05)2 = Rs. 90.70, at the end of third year is P=100/ (1.05)3= Rs. 86.38, at the end of the fourth year is P =100/ (1.05)4 = Rs. 82.27 and after five year it would be 100/ (1.05)5 = Rs. 78.35.

• Therefore, the sum of the present value at the end of each year comprises the present value of annuity of Rs. 100 at the end of five years.


Future Value of Annuity• The discounting value of annuity of cash flow of Rs. 100 at the rate of 5 per

cent is as follows:

Let’s Sum Up

• Time value of money analyses the value of a unit of money at various times.

• The time value of money is estimated in two ways: future value of cash flow and present value of cash flow.

• The future value of cash flow is defined as a technique that calculates the value of cash at a fixed time in future at a specific compound interest rate.

• The future value of single cash flow is defined as the valuation of an amount of money at a particular period of time in future.

• The present value of annuity is the sum of total present value of single cash flow over the year.

• The present value of annuity is also called discounting value of annuity.

Post Your Query


Chapter 3: Capital Budgeting


From-To


2 Topic 1 Concept of Capital Budgeting 45-49

3 Topic 2 Techniques of Capital Budgeting

50-62

4 Topic 3 Project Selection and Evaluation

63-65

5 Topic 4 Capital Budgeting Problems 66-67

6 Topic 5 Capital Rationing 68-69

7 Topic 6 Sensitivity Analysis in Capital Budgeting

70-72

8 Let’s Sum Up 73

• Describe the concept of capital budgeting• Explain various techniques of capital budgeting • Discuss project selection and evaluation• Explain the capital budgeting problems • Describe capital rationing • Explain sensitivity analysis in capital budgeting

1. Concept of Capital Budgeting

• Capital budgeting can be defined as a process of allocating the resources of the organisation in the long-term investment projects to generate profit.

• Capital budget is prepared, implemented, and reviewed continuously by the organisation. Some of the important aspects of capital budgeting are as follows:– It affects the competitive position of the organisation in the long run– It needs a large sum of capital because it comprises investment in

long-term assets– It refers to one time process that cannot be either reversed or

withdrawn– It consists of the risk element as it is futuristic in approach


• The significance of capital budgeting is as follows:– Long-term Applications: It implies that capital budgeting decisions

are useful for an organisation in the long run as these decisions have a direct impact on the cost structure and future prospects of the organisation. Moreover, these decisions affect the organisation’s growth rate. Hence, an organisation has to take capital decisions carefully..

– Competitive Position of an Organisation: It means an organisation can plan its investment in various fixed assets via capital budgeting. Moreover, capital investment decisions help the organisation to estimate its future profits. All these decisions have a major impact on the competitive position of an organisation.


– Cash Forecasting: It indicates that an organisation needs sufficient funds for its investment decisions. With the help of capital budgeting, an organisation is aware of the required amount of cash, thus, ensuring availability of cash at the right time. This further helps the organisation to achieve its long-term goals.

– Maximisation of Wealth: It means that the long-term investment decisions of an organisation helps in protecting the interest of shareholders in the organisation. If an organisation has invested in a planned manner, shareholders would also be interested to invest in the organisation and in this way, the wealth of the organisation can be maximised.


Process of Capital Budgeting• Decisions regarding the capital budgeting and investment are very

important for a firm as it is on the basis of these decisions that matters related to the risk, growth and profitability of an organisation are taken.

• This process is also known as ‘investment decision making’ or ‘planning capital expenditure’.

• Capital budgeting helps organisations to utilise its capital in the best way, expecting the best returns from it.


Process of Capital Budgeting• Organisations perform capital budgeting in the following five steps:

Implementing capital budgeting

Selecting the projects

Determining cash flow

Evaluating the opportunities

Exploring the opportunities

1. Techniques of Capital Budgeting

Various techniques to evaluate capital budgeting:


Traditional Techniques (ARR; payback Period Method)• Traditional methods of capital budgeting only determine the profitability of

an investment project, ignoring the time factor completely. • The two traditional methods used in the evaluation of capital budgeting are:• Average Rate of Return (ARR): Also known as accounting rate of return,

this method is based on the basic concepts of bookkeeping and uses accounting information to evaluate capital budgeting.

• ARR =


Traditional Techniques (ARR; payback Period Method)• Illustration: Let us assume that an organisation invests Rs. 1, 20,000 on

an average in a year in a project. • The average annual revenue received by the organisation from the project

is Rs. 1,50,000. Calculate the ARR of the project.• Solution:• Average annual profit = Average annual revenue- average annual cost =

1,50,000 – 1,20,000 = 30,000. • ARR = = 25%.


Traditional Techniques (ARR; payback Period Method)• Payback Period Method: This method uses the qualitative approach to

evaluate capital budgeting. Payback period refers to the time in which the initial cash outflow of a project is expected to be recovered from the cash inflows generated by the project. It is one of the simplest investment appraisal techniques.

• The mathematical formula to calculate the payback period is as follows:•


Traditional Techniques (ARR; payback Period Method)• Illustration: Let us assume that the total investment required throughout

the lifetime of a project is Rs. 150,000 and the project will give an annual return of Rs. 30,000. Calculate the payback period.

• Solution: • The payback period of the project would be = 1, 50,000/30,000 = 5 Years.


Discounted Cash Flow Techniques • Discounted cash flow techniques help in determining the time value of

money of a project. The following are the techniques to determine the discounted cash flow:

• Net Present Value Method (NPV): It is the difference between the present value of cash inflows and cash outflows in a given project. This method is also used to evaluate the profitability of a project. The formula to calculate NPV is as follows:

• NPV = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 +…..+ Cn/(1+r)n – I0


Discounted Cash Flow Techniques The steps involved in calculating the NPV of a project:

Finding out NPV

Calculating the Present Value of Cash Flows

Estimating the Required Rate of Return

Forecasting Cash Flows


Discounted Cash Flow Techniques The following are the advantages of using the NPV method: • Accurate profitability measurement: It takes into account all the cash

flows that occur throughout the life-time of a project to provide exact profitability measures. The accurate measurement of the profitability of a project helps in maximising the shareholders’ wealth.

• Value-additivity: This refers to the principle that the net present value of a set of independent projects is equal to the sum of the net present values of the individual project. It is determined by adding the present values of all the cash flows.


Discounted Cash Flow Techniques • Internal Rate of Return Method: It is used to determine the discount

rate that makes the NPVs of all cash flows arising out of any project equal to zero.

• This method does not take into account any external factors, such as inflation.

• IRR also denotes the interest rate at which the NPVs of all expenses made on a project (cash outflow) equals to the NPVs of all the benefits or income arising out of the project (cash inflow).

• IRR is one of the time-based methods to analyse the capital investment decisions.


Discounted Cash Flow Techniques • There are alternative ways to calculate IRR, the simplest of these methods

is as follows:1. Estimate the value of r (discount rate) and calculate the NPV of the

project at that value.2. If NPV is close to zero then IRR is equal to r.3. If NPV is greater than 0 then increase r and go to step 5.4. If NPV is smaller than 0 then decrease r and go to step 5.5. Recalculate NPV using the new value of r and go back to step 2.


Time-framed Methods (Profitability Index, Net Terminal Value Method) • The time-framed methods take into consideration the time factor while

evaluating capital budgeting. These methods are:– Profitability Index: It is the ratio of the present value of the cash

inflow to the present value of the cash outflow. The profitability index method is based on the time value of money and is intended to maximise the wealth of the shareholders. The mathematical formula to calculate profitability index is as follows:

– Profitability Index =


Time-framed Methods (Profitability Index, Net Terminal Value Method) • Illustration: If the present value of cash inflows in a project is ` 7,50,000

and the present value of the cash outflows is Rs.3,00,000, then calculate the profitability index.

• Solution: The profitability index would be = Rs.7, 50,000/Rs.3,00,000 = 2.5.

• Profitability index is very similar to the NPV method as it also measures the difference between cash inflow and cash outflow in an organisation.

• The profitability index should be greater than one for the selection of a project. This method is also used to measure the relative cash surplus of an organisation by comparing the cash inflow and outflow.


Time-framed Methods (Profitability Index, Net Terminal Value Method) • Net Terminal Value Method: In this method, the returns generated from

a project are further reinvested in the same project. In other words, the cash inflow is reused in the project till it is completed.

1. Project Selection and Evaluation

• Project selection and evaluation are among the key financial decision-making processes in an organisation.

• These decisions affect the profitability and competitiveness of the organisation in the long run.

• The organisation selects only those projects for which NPV and IRR values are positive.

• There are two types of projects in an organisation: independent projects and mutually exclusive projects.


• Types of projects are:


• Independent Projects: These projects are independent of other projects handled by the organisation. The selected independent project should meet the minimum required standards and norms set by the organisation, such as its NPV should be greater than zero and IRR should exceed the expected rate of return.

• Mutually Exclusive Projects: These projects are exclusive in the sense that their selection rules out the possibility to opt other projects. Suppose an organisation wants to buy a machine and has three contenders in line with different investment plans. The projects of all the three contenders are mutually exclusive; however, the organisation would select the contender who offers the most lucrative deal.

1. Capital Budgeting Problems

Ranking Conflicts in NPV and IRR• A project is considered profitable if its acceptance excludes the acceptance

of one or more projects. IRR methods may result in contradictions when: – Projects have different life expectancies.– Projects have different sizes of investments.– Projects whose cash flow may differ over time.

2. Capital Budgeting Problems

Multiple IRRS• There can be multiple IRRs when the sign of the cash flow is changed more

than once. • It is said that when a project has multiple IRRs, it may be more convenient

to compute the IRR of the project with the benefits reinvested.

1. Capital Rationing

• Capital rationing is a concept in which the management of an organisation restricts the approval of further projects to minimise the investment of capital.

• Such rationing decisions are taken by organisations when their financial condition is not very favourable or when they have already accepted many independent investment proposals.

• There are two types of capital rationing:

2. Capital Rationing

• Internal Capital Rationing: Here, the organisation stops taking projects due to internal factors. For example, managers are unable to select the approved profitable project due to limited funds.

• External Capital Rationing: Here, the organisation stops taking projects due to external factors. For example, suppose an organisation wants to raise capital from the market by issuing debentures but due to unstable market conditions, it fails to do so.

1. Sensitivity Analysis in Capital Budgeting

• Sensitivity analysis is done to analyse the degree of responsiveness of the dependent variable for a given change in any of the independent variables.

• 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.

• To find out the NPV or IRR of the project, the project managers need to make the accurate predictions of independent variables.

• Any change in the independent variables can change the NPV or IRR of the project.


• The following steps are performed to do a sensitivity analysis: 1. Identifying all the variables that affect the NPV or IRR of the project2. Establishing a mathematical relationship between the independent and dependent variables3. Studying and analysing the impact of the change in the variables


• Sensitivity analysis helps in providing different cash flow estimations in the following three circumstances: – Worst or pessimistic condition: It refers to the most unfavourable

economic situation for the project.– Normal condition: It refers to the most probable economic

environment for the project.– Optimistic condition: It indicates the most favourable economic

environment for the project.

Let’s Sum Up

• The capital budgeting can be defined as a process of allocating the resources of the organisation in the long-term investment projects to generate profit.

• Capital budgeting helps organisations to evaluate the expected rate of return on investments.

• Payback period method uses the qualitative approach to evaluate capital budgeting.

• Value-additivity is determined by adding the present values of all the cash flows. • The time-framed methods take into consideration the time factor while

evaluating capital budgeting. • Capital rationing is a concept in which the management of an organisation

restricts the approval of further projects to minimise the investment of capital.

Post Your Query


Chapter 4: Sources of Finance

Chapter Index

S. No Reference No

Particulars SlideFrom-To


2 Topic 1 Financial Market 79-81

3 Topic 2 Long-Term Sources of Finance 82

4 Topic 3 Medium-Term Sources of Finance

83-84

5 Topic 4 Short-Term Sources of Finance 85-86

6 Topic 5 Overseas Sources of Finance 87-92

Let’s Sum Up 93

• Explain the concepts of financial market, capital market and money market• Describe long-term sources of finance such as shares, debentures, term

loans and mezzanine debt• Discuss medium-term sources of finance such as lease finance, hire

purchase, venture capital, public deposits and retained earnings• Explain short-term sources of finance such as trade credit, customer

advances and instalment credit• Describe ADR, GDR and ECB

1. Financial Market

• A financial market is a place where investors trade securities and commodities. It acts as a forum through which demanders and suppliers of funds can perform business transactions.

• The structure of a financial market:

2. Financial Market

Capital Market• Capital market is a type of financial market where debt capital and equity

share capital are raised by different business enterprises. • It facilitates an organisation to raise funds for long-term projects. • Capital market can be classified into two types:

3. Financial Market

Money Market• Money market is a part of financial market in which short-term loans are

raised. • The maturity period of these loans is one year or less than one year. • In the money market, funds can be raised through treasury bills,

commercial papers, bank loans and asset-backed securities. Call money market

Treasury bills

Commercial papers

Certificate deposits

Long-term Sources of Finance

• Long-term financing is a mode of financing that is offered for more than one year.

• It is required by an organisation during establishment, expansion, technological innovation and research and development.

• In addition, long-term financing is required to finance long-term investment projects. Various sources of long-term finance are:

1. Medium-term Sources of Finance

• Medium-term finance is required by an organisation for a period of more than 1 year but less than 10 years.

• The organisation can avail medium-term finance through various sources, including lease finance and hire purchase, venture capital finance, public deposits and retained earnings.

• An organisation needs medium-term sources of finance for expansion, replacement of old plant and machinery, writing off short-term debts and technological upgrade.

2. Medium-term Sources of Finance

• The sources of medium-term finance:

Diffe

rent

Sou

rces

of M

ediu

m-

Term

Fina

nce

Lease Finance

Hire Purchase

Venture Capital

Public Deposits

Retained Earnings

1. Short-term Sources of Finance

• Short-term financing is aimed to meet the demand of current assets and current liabilities of an organisation.

• It helps in minimising the gap between current assets and current liabilities.

• There are different means to raise capital from the market for a small duration.

• Various agencies, such as commercial banks, co-operative banks, financial institutions and National Bank for Agriculture and Rural Development (NABARD), provide financial assistance to organisations.

2. Short-term Sources of Finance

• These agencies provide short-term financing in various forms:

Short-term Financing

Trade Credit Customer Advances Instalment credit

1. Overseas Sources of Finance

• Funds are raised by MNCs by determining the ideal capital structure (a mixture of debt and equity) of the organisation.

• The capital of an organisation mainly consists of issued shares or stocks, borrowed funds or debt, retained earnings and undistributed dividends.

• It is up to the strategy of the management to determine the proportion of the debt to be raised by borrowing and the proportion of equity to be raised from the market.

• MNCs can raise capital from the domestic market by offering equity shares in the domestic currency. They can also think about sourcing equity globally by offering shares in foreign countries in the currencies of the respective countries.


• The mechanism that is followed for the issue of shares in the international market is as follows:


ADR• ADR stands for American Depositary Receipt. • It is a share traded in the U.S. financial market by a non-U.S. organisation. • It is an indirect form of trading in the American market through the

depository receipts. • ADRs help the American investors in purchasing shares of the foreign

organisations in the same manner as that of the local organisations without any problem of cross-country and cross-currency transaction.

• ADRs are offered by a depository bank situated in the U.S. holding the shares of the foreign organisations.


ADR• ADRs issued by the depository bank can be categorised into three different

levels:– Level 1: It is the most basic type or the lowest level of ADRs that do

not fulfil the conditions for listing on the U.S. stock exchange. – Level 2: These are the depository receipts which are listed on the U.S.

stock exchange and traded through stock exchanges such as NASDAQ, NYSE and AMEX.

– Level 3: This is the most prestigious stage of ADRs in the U.S. financial market. This is the highest level that can be attained by a foreign organisation operating in the U.S. market.


GDR• GDR refers to Global Depositary Receipt. • These are same as ADRs but with the right to tap multiple markets by

issuing shares. • It is a DR offered by the depository bank of a country to a foreign

organisation to participate in the stock trading of that country. • GDR transactions are mostly denominated in US dollars. • These receipts provide an opportunity to emerging organisations to expand

their presence in the foreign countries by offering shares. The pricing policies of the GDRs are similar to that of the ordinary shares but differ in trading and settlement of the shares.


ECB• ECB or external commercial borrowing refers to an instrument used for

raising funds from foreign markets by companies and public sector undertakings (PSUs).

• It caters to the financial needs of large companies and PSUs and enables them to access foreign money.

• Buyer’s credit, supplier’s credit, commercial bank loans and security instruments are included in ECBs.

Let’s Sum Up

• Long-term finance is a form of finance, which is required to fund the projects with long-gestation period, while short-term finance is meant for projects that may need a few months to a year for completion.

• A financial market is a place where investors trade securities and commodities. It is composed of capital market and money market.

• Medium-term finance is required by an organisation for a period of more than 1 year but less than 10 years. The organisation can avail medium-term finance through various sources, including lease finance and hire purchase, venture capital finance, public deposits and retained earnings.

• Short-term financing helps in minimising the gap between current assets and current liabilities.

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Chapter 5: Capital Structure

Management

Chapter Index



2 Topic 1 Capital Structure Management

99-101

3 Topic 2 Capitalisation 102-104

4 Topic 3 Theories of Capital Structure Management

105-109

5 Topic 4 Cost of Capital 110-126

6 Let’s Sum Up 127

• Explain capital structure management • Discuss various factors, such as internal, external, and general affecting

capital structure management• Describe capitalisation, over capitalisation and under capitalisation• Explain various theories of capital structure management, such as net

income approach, Modigliani-Miller approach, and traditional approach• Describe the concept of cost of capital, and cost of preference and equity

capital• Explain cost of retained earnings, weighted average cost of capital, and

marginal cost of capital

1. Capital Structure Management

• A proportion of debt, preference, and equity capital in the overall capital of an organisation is called the capital structure.

• An ideal capital structure must maximise the overall value and minimise the cost of capital of an organisation.

• There are numerous factors, such as internal, external, and general factors that affect the capital structure of an organisation.

• Internal factors refer to the factors which affect the organisation by policies and decisions of management and board of directors.

• On the other hand, external factors are not influenced with management control. These factors are affected by the external decisions and environment, such as taxation policy, EXIM policy, interest rates, and government policies.


Internal Factors Affecting Capital Structure Management• Cost of Capital: It refers to the amount paid in the form of dividend and

interest. Generally, debt capital and equity capital forms the capital structure of an organisation.

• Control: It involves the decision-making power of equity shareholders, who are also referred as the owners of the organisation. Generally, in an organisation, major portion of decision-making power remains in the hands of owners.

• Risk: It refers to various uncertainties associated with raising different types of capital. Risk refers to the obligation of an organisation to pay returns to various sources of capital.


External Factors Affecting Capital Structure ManagementThe external factors, which affect the capital structure of an organisation, are as follows:

Interest Rates

Economic Condition

Policy of Lending Institutions

Statutory Restrictions

Taxation Policy

1. Capitalisation

• The process of determining long-term capital requirements of an organisation is termed as capitalisation.

• It involves the procurement of capital from various sources including shares, debentures, and reserve funds.

• An organisation can come across two situations:

Situations of Capitalisation

Over-capitalisation

Under-capitalisation

2. Capitalisation

Over-capitalisation• Over-capitalisation is a situation when an organisation raises more capital

than its requirements. • A major portion of capital remains unutilised in such cases. The major

causes of over-capitalisation are as follows:

Inadequate Provision for Depreciation

High Promotion Cost

Purchase of Assets at Higher Prices

Liberal Dividend Policy

3. Capitalisation

Under-capitalisation• Undercapitalisation refers to the situation when an organisation does not

have sufficient capital to carry out its normal business operations and repay its creditors.

• This situation generally occurs when an organisation does not generate enough cash flows or is not able to access financing options such as debt or equity.

• When an organisation cannot generate sufficient capital over time, it increases its chances of becoming bankrupt by losing its debt repayment ability.

1. Theories of Capital Structure Management

• Capital structure management is the need of a business at each and every phase of its life cycle.

• There are various theories of managing capital structure of an organisation:


Net Income Approach• David Durand proposed in this theory that, “there exists a direct

relationship between the capital structure and valuation of the firm and cost of capital.”

• The net income approach can be explained as follows:


Net Operating Income Approach• David Durand, states that “the valuation of the firm and its cost of capital

are independent of its capital structure”. • The concept of net operating income approach:


Modigliani-Miller Approach• Modigliani-Miller approach also takes risk factor into consideration while

determining the capital structure. • According to this approach, the value of the organisation and cost of capital

are independent from its capital structure. • As per the Modigliani-Miller approach, if the organisation raises more debt

capital as compared to equity capital, it implies that the organisation is running on high risk.

• If the organisation pays higher dividends to the equity shareholders, overall cost of capital increases. It is important to note at this point of time that the organisation raised more debt capital to reduce the cost of capital.


Traditional Approach• In this approach, when debt capital is introduced up to a certain limit, it is

assumed that debt capital would increase EPS by decreasing overall cost of capital and increasing the value of an organisation.

• The graphical representation of the traditional approach:

1. Cost of Capital

• Cost of capital is a rate at which an organisation raises capital to invest in various projects.

• The basic motive of an organisation is to raise any kind of capital to invest in its various projects for earning profit.

• Further, out of that profit, the organisation pays interest and dividend as a return on the sources of capital.

• The amount paid as interest and dividend is considered as cost of capital. • From the investors’ point of view, cost of capital is the rate of return, which

investors expect from the capital invested by them in the organisation.

2. Cost of Capital

The significance of cost of capital is as follows:• Capital Budgeting Decision: It refers to the decision, which helps in

calculating profitability of various investment proposals.• Capital Requirement: It refers to the extent to which fund is required by

an organisation at different stages, such as incorporation stage, growth stage, and maturity stage. When an organisation is in its incorporation stage or growth stage, it raises more of equity capital as compared to debt capital. The evaluation of cost of capital increases the profitability and solvency of an organisation as it helps in analysing cost efficient financing mix.

3. Cost of Capital

• Optimum Capital Structure: It refers to an appropriate capital structure in which total cost of capital would be least. Optimal capital structure suggests the limit of debt capital raised to reduce the cost of capital and enhance the value of an organisation.

• Resource Mobilisation: It enables an organisation to mobilise its fund from non-profitable to profitable areas. The resource mobilisation helps in reducing risk factor as an organisation can shut down its unproductive projects and move the resources to productive ones to earn profit.

• Determination of Method of Financing: When an organisation requires additional finance, the finance manager opts for a capital source, which bears the minimum cost of capital.

4. Cost of Capital

• Cost of capital can be measured by using various methods:

5. Cost of Capital

Cost of Debt Capital• Formulae to calculate cost of debt are as follows:1. When the debt is issued at par (it includes both redeemable and irredeemable

cases)KD = [(1 – T) * R] * 100

Where, KD = Cost of debt, T = Tax rate, R = Rate of interest on debt capital, KD = Cost of debt capital

2. Debt issued at premium or discount when debt is irredeemable

KD = [ ((1 – T) X I) / (NP) 100]

KD = [I/NP * (1 – T) * 100]

Where, I = Annual Interest Payments, NP = Net proceeds of debt, KD = Cost of debt capital, T = Tax rate

6. Cost of Capital

Cost of Preference Capital• Cost of preference capital is the sum of amount of dividend paid and

expenses incurred for raising preference shares. • The dividend paid on preference shares is not deducted from tax, as

dividend is an appropriation of profit and not considered as an expense. • Cost of redeemable preference shares:

Kp = {D + (P-NP) / n} / {(P+NP) / 2}

• Where, KP = Cost of preference share, D = Annual preference dividend, P = Redeemable value of debt, NP = Net proceeds of debt, n = Numbers of years of maturity

7. Cost of Capital

Cost of Equity Capital• The dividend on equity shares varies depending upon the profit earned by

an organisation. There are various approaches to calculate cost of equity capital:

8. Cost of Capital

Cost of Equity CapitalDividend Price Approach: The dividend price approach describes the investors’ view before investing in equity shares. According to this approach, investors have certain minimum expectations of receiving dividend even before purchasing equity shares. An investor calculates present market price of the equity shares and their rate of dividend. The dividend price approach can be mathematically calculated by using the following formula:

KE = (D /P) * 100

Where, D = Dividend per share P = Market price per share andKE = Cost of equity capital

9. Cost of Capital

Cost of Equity CapitalEarnings Price Ratio Approach: According to the earnings price ratio approach, an investor expects that a certain amount of profit must be generated by an organisation. Investors do not always expect that the organisation distribute dividend on a regular basis. Sometimes, they prefer that the organisation invests the amount of dividend in further projects to earn profit, which in turn increases the value of its shares in the market.

The formula to calculate cost of capital through the earnings price ratio approach is:

KE = E/MP; where,

E = Earnings per share

MP = Market price of share

10. Cost of Capital

Cost of Equity CapitalDividend Price Plus Growth Approach: The dividend price plus growth approach refers to an approach in which the rate of dividend grows with the passage of time. In the dividend price plus growth approach, investors not only expect dividend but regular growth in the rate of dividend. The growth rate of dividend is assumed to be equal to the growth rate in EPS and market price per share. The cost of capital can be calculated mathematically by using the following formula:

KE = [(D/MP) + G] * 100

where,

D = Expected dividend per share, at the end of period

G = Growth rate in expected dividends

MP=Market Price of Share

11. Cost of Capital

Cost of Equity CapitalRealised Yield Approach: In the realised yield approach, an investor expects to earn the same amount of dividend, which the organisation has paid in past few years. In this approach, the growth in dividend is not considered as major factors for deciding the cost of capital.

According to the realised yield approach, cost of capital can be calculated mathematically by using the following formula:

KE = [(P+D)/p] - 1

Where;

P = Price at the end of the period,

p = Price per share today

12. Cost of Capital

Cost of Equity CapitalCapital Asset Price Model (CAPM): CAPM helps in calculating the expected rate of return from a share of equivalent risk in the capital market. The computation of cost of capital using CAPM is based on the condition that the required rate of return on any share should be equal to the sum of risk less rate of interest and premium for the risk:

E = R1 + β {E (R2) – R1}, where;

E = Expected rate of return on asset

β = Beta coefficient of assets

R1 = Risk free rate of return

E (R2) = Expected return from market portfolio

13. Cost of Capital

Cost of Equity CapitalBond Yield Plus Risk Premium Approach: The bond yield plus risk premium approach states that the cost on equity capital should be equal to the sum of returns on long-term bonds of an organisation and risk premium given on equity shares. The risk premium is paid on equity shares because they carry high risk. Mathematically, the cost of capital is calculated as:

Cost of equity capital= Returns on long-term bonds + Risk premium or

Ke = Kd + RP

14. Cost of Capital

Cost of Equity CapitalGordon Model: Myron Gordon developed the Gordon model to calculate the cost of equity capital. As per this model, an investor always prefers less risky investment as compared to more risky investment. According to the Gordon model, cost of capital can be calculated mathematically by using the following formula:

P = E (1 – b)/K – br, where;

P = Price per share at the beginning of the year

E = Earnings per share at the end of the year

b = Fraction of retained earnings, K = Rate of return required by shareholders

r = Rate of return earned on investments made by the organisation, g = br

15. Cost of Capital

Cost of Retained Earnings• Retained earnings refer to the part of the profit that is kept as a reserve. • Though it is a part of the profit, but it is not distributed as dividend. These are

kept to finance long-term as well as short-term projects of the organisation. • It is argued that the retained earnings do not cost anything to the

organisation. • It is debated that there is no obligation either formal or implied, to earn any

profit by investing retained earnings. • However, it is not correct because the investors expect that if the

organisation is not distributing dividend and keeping a part of profit as reserves then it should invest the retained earnings in profitable projects.

16. Cost of Capital

Weighted Average Cost of CapitalWeighted average cost of capital can be calculated mathematically by using the following formula:

Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR * R)

Where;

E = Proportion of equity capital in capital structure

P = Proportion of preference capital in capital structure

D = Proportion of debt capital in capital structure

KR = Cost of proportion of retained earnings in capital structure

R = Proportion of retained earnings in capital structure

17. Cost of Capital

Marginal Cost of CapitalMarginal cost of capital refers to the cost of additional capital required by an organisation to finance the investment proposals. It is calculated by first estimating the cost of each source of capital based on the market value of the capital. In simpler terms, the marginal cost of capital is calculated in the same manner as the weighted average cost of capital is calculated, adding additional capital to the total cost of capital:

Marginal Cost of Capital = KE {E/(E + D + P + R)} + KD {D/(E +D + P

+ R)} + KP {P/(E + D + P R)} + KR {R/(E + D + P + R)}

Let’s Sum Up

• A proportion of debt, preference, and equity capital in the overall capital of an organisation is called the capital structure.

• There are numerous factors, such as internal, external, and general factors that affect the capital structure of an organisation.

• External factors refer to the factors which cannot be controlled by internal decisions and policies of an organisation.

• The process of determining long-term capital requirements of an organisation is termed as capitalisation.

• Under-capitalisation refers to a situation in which an organisation earns exceptionally high profits as compared to the other organisations operating in the same industry.

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Chapter 6: Leverages

Chapter Index



2 Topic 1 Concept of Leverage in Finance

133-140

3 Topic 2 Financial Leverage 141-143

4 Topic 3 Operating Leverage 144-147

5 Topic 4 Combined Leverage 148-150


• Explain the concept of leverage in finance• Describe financial leverage ratios• Discuss what operating leverage is• Explain the concept of combined leverage

1. Concept of Leverage in Finance

• In finance, leverage can be defined as the use of an optimal combination of debt capital to increase the return on equity capital; that is, Earning per Share (EPS).

• EPS is the portion of a firm's profit allocated to each outstanding share of common stock. It is an indicator of a firm's profitability.

• As the rate of interest on debt capital is fixed, the ratio of debt capital in the total capital affects the return on equity capital.

• An increase in debt capital may increase the profit of an organisation. • As EPS (dividend) is a part of organisation’s profit, it would also increase.

This relationship between the EPS and debt capital is explained through the concept of leverage.


• There are three types of leverages:

Types of Leverages

Financial Leverage

Operational Leverage

Combined Leverage


EBIT-EPS analysis• Earnings before Interest and Tax (EBIT), is an indicator of an organisation's

profitability. • It is calculated as revenue minus expenses, eliminating tax and interest

charges. EBIT is also referred to as "operating earnings"/"operating profit"/"operating income".

• The formula to calculate EBIT is as follows:EBIT = Revenue – COGS – Operating Expenses

• EBIT can be calculated by adding back interest and taxes to net income.


EBIT-EPS analysis• EBIT is a firm’s operating profit while EPS is the earnings per share, which

can be calculated as follows: EPS = Profit after Tax (PAT)/ Number of shares outstanding

PAT = EBIT – interest – taxes• The EPS would be as follows: EPS = ((EBIT-I)(1-t))/n

Where EBIT = Earnings before Interest and Tax I= Interest t = tax rate n = number of shares outstanding


EBIT-EPS analysis• Illustration: Suppose, an organisation wants to raise a total capital of Rs.

10,00,000. The organisation wants to use 75% debt and 25% equity capital. In order to raise the equity capital of Rs. 2,50,000 the organisation wants to issue 25,000 equity shares. The EBIT of the company is Rs. 2,40,000. The interest on debt is 15% per annum. Calculate the EPS. Assume that the tax rate is 0.5%.

• Solution: Total interest paid will be (10,00,000-2,50,000)*15/100 = Rs. 1,12,500.

• EPS = ((EBIT-I)(1-t))/n• EBIT = Rs. 2,40,000, I = 1,12,500, T = 0.05, n = 25,000.• EPS = ((2,40,000-1,12,500)(1-0.05))/25,000 = Rs. 4.85.


Break-even Analysis • Break-even point is the level of sales at which a firm’s total revenues are

exactly equal to total operating costs. • Break-even analysis is used by an organisation by a company to assess how

much it needs to sell in order to pay for an investment, or at what point expenses and revenue are equal. The break-even point is calculated as follows:

Q* = F/(P-V)

Where Q* = break-even quantity,F = fixed costsP = priceV = variable costs


Break-even Analysis Operating costs are divided into three categories:

Fixed Costs

Variable Costs

Semi-fixed/Semi-variable Costs


Break-even Analysis • Illustration: ABC company is involved in manufacturing a single product.

The company has invested Rs. 9, 00,000 as fixed cost. The variable cost is Rs. 450/unit. The company sells its products at Rs. 900/unit. Calculate the break-even production level.

• Solution: At break-even point: Sp * Q = Vp*Q + FC

900 × Q = 450× Q + 9,00,000900 Q = 450Q + 9,00,000450Q = 9, 00,000Q = 2000 units.

• Therefore, the company will achieve breakeven at 2,000 units.

1. Financial Leverage

• Financial leverage refers to a situation in which an organisation earns higher profit compared to the rate of interest it pays on the debt capital.

• The rate of interest on debt capital is also termed as the cost of debt capital.

• L.J. Gitman defines financial leverage as “the firms’ ability to use fixed financial charges to magnify the effects of changes in EBIT on the firms’ EPS.”

• Financial leverage is represented through different financial ratios, such as debt to equity ratio, and interest coverage ratio.


Benefits and Limitations of Financial Leverage• The benefits offered by financial leverage are as follows:

– Helps in increasing EPS when interest on debts is low– Reduces tax liability, as interest paid on debt is treated as expense– Reduces cost of capital, if the debt capital is raised on low rate of interest – Preserves the control of an organisation.

• The limitations of financial leverage are as follows:– Decreases return on equity in conditions when interest rates are high– Increases the liability to pay interest when profits fluctuates – Involves high risk as debts are raised by mortgaging the assets


• Illustration: PQR Ltd.’s equity share capital = Rs.2,00,000; 20% preference share capital = Rs. 2,00,000; 10% debentures = Rs. 1,50,000. The present EBIT is Rs.1, 00,000 and tax rate is 50%. Calculate PQR’s financial leverage.

• Solution: PQR’s financial leverage is calculated as follows: Particulars Amounts(Rs.)

EBIT 1,00,000

Less: Interest on debentures 15,000Less: Dividend on preference shares (Earnings before tax = 20000/(1 – 0.50) = 40000)

40,000

PBT 45,000Financial leverage (EBIT/PBT = 1,00,000/45,000 = 2.22) 2.22

1. Operating Leverage

• Operating leverage measures the effect of change in sales volume and operating capacity on EBIT.

• It indicates the variation in operating profit (or simply profit), which is directly proportional to sales volume.

• This implies that if the sales volume increase, profits would also increase. • As discussed, there are two main costs in an organisation, fixed cost and

variable cost. Fixed cost remains unchanged with the change in the volume of sales; while variable cost changes with the increase in volume of sales.


Significance of Operating Leverage • When there is high operating leverage, even a small rise in sales results in

significant increase in the EBIT. • Operating leverage arises when an organisation invests in fixed assets to

increase the sales volume and generate sufficient revenue for meeting its fixed and variable costs.

• As discussed, operating leverage indicates variations in operating profit. Therefore, operating profit is calculated using the following formula:

Operating Profit = [N (SP – VC)]/ [N (SP – VC) – FC]• Where, N = Number of units sold, SP = Selling price, VC = Variable cost,

FC = Fixed Cost


Benefits and Limitations of Operating Leverage• The benefits of operating leverage are as follows:

– Helps in increasing the profit of an organisation by increasing sales volume

– Reduces dependency on variable cost. – Reduces the overall cost of production, if the sales figure increases and

covers the entire fixed cost • The limitations of operating leverage are as follows:

– Helps only large-sized organisations as the concept of operating leverage is not applicable to new and small-sized organisations with insufficient fixed assets.


• Illustration: Calculate DOL from the following information: i. Sales = Rs.1,00,000ii. Fixed cost = Rs.70,000iii. Variable cost = Rs.20,000• Solution: The calculation of DOL is shown as follows: DOL = (SP –VC)/ (SP – VC – FC) = (100000 – 70000)/ (100000 – 70000 – 20000) = 3• Therefore, DOL is three times as compared to sales.

1. Combined Leverage

• Combined leverage refers to the combination of both operating and financial leverages.

• Combined leverage can be calculated by using the following formula:• Combined leverage = {(Sales – VC)/EBIT} × {EBIT/ (EBIT – Interest)} = (Sales – VC)/ (EBIT – Interest) = Operating leverage × Financial leverage• Degree of Combined Leverage (DCL) measures the relationship between

percentage changes in sales to percentage change in EPS. This relationship can be represented by using the following formula:

DCL = % change in EPS / % change in salesOr DCL = Contribution / (EBIT-I)


• The advantage of DCL is that it shows the effect of changes in sales on EPS.

• It proves useful when an organisation needs to choose a new project between various alternatives.

• The organisation can compare the DCL of different projects before arriving at a decision.

• If the DCL of a project is equal to one, that project is exposed to constant risk. In such a case, the profitability of the organisation would not be affected.

• Thus, the project may prove to be favourable.


• The advantage of DCL is that it shows the effect of changes in sales on EPS.

• It proves useful when an organisation needs to choose a new project between various alternatives.

• The organisation can compare the DCL of different projects before arriving at a decision.

• If the DCL of a project is equal to one, that project is exposed to constant risk. In such a case, the profitability of the organisation would not be affected.

• Thus, the project may prove to be favourable.

Let’s Sum Up

• Leverage can be defined as the use of an optimal combination of debt capital to increase the return on equity capital; that is, Earning per Share (EPS).

• EBIT-EPS analysis helps organisations to understand the effect on EPS resulting due to changes in EBIT under different financial combinations.

• Break-even point is the level of sales at which a firm’s total revenues are exactly equal to total operating costs.

• Operating leverage measures the effect of change in sales volume and operating capacity on EBIT.

• Combined leverage refers to the combination of both operating and financial leverages.

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Chapter 7: Dividend Policy

Chapter Index



2 Topic 1 Dividend Policy 157-159

3 Topic 2 Factors Determining Dividend Policy

160-165

4 Topic 3 Types of Dividend Policy 166-168

5 Topic 4 Approaches to Dividend Policy 169-172

6 Topic 5 Forms of Dividend Payment 173-174


• Summarise the concept of dividend and dividend policy• Explain the factors that affect that determine a dividend policy• Classify and explain the different types of dividend policy• Explain and exemplify the different forms of dividend payment

1. Dividend Policy

• Dividend policy refers to a policy under which the decisions related to the distribution of profit in the form of dividends to the shareholders is made.

• All financial policies play a crucial role in determining the value of the organisation on a long term basis and the dividend policy plays a key role in it.

• The dividend is usually in the form of cash but it may be in the form of shares as well.

• In this case the company gives the shareholders shares of the value of the dividend instead of cash.

• The dividends are paid out of the profits of the organisation and never from the capital of the company.

2. Dividend Policy

• The following factors are considered before devising a dividend policy. They are:– Fund availability: It means that the organisation must have sufficient

funds to distribute the dividends. – Shareholders expectations: The board of directors while deciding the

dividend policy must take into consideration the expectations of the shareholders also.

– Status quo factor: It refers to various factors that the organisation must consider while framing a dividend policy. Usually, the rate of dividend is proportional to the level of profits that is the rate of dividend increases when the profits increase and decreases when the profits drop.

3. Dividend Policy

• According to Professor I.M. Pandey, organisations need to answer a few questions before devising the dividend policy:– What are the preferences of shareholders: dividend income or capital

gain?– What are the levels of financial needs of the company?– What are the constraints on paying dividends?– Should the company follow a stable dividend policy?– What should be the form of dividend (i.e., cash or bonus shares)?

1. Factors Determining Dividend Policy

• There are various factors that influence the dividend policy of the organisation.

• They are grouped under two categories which are internal factors and the external factors.

• Internal factors are the factors which are internal to an organisation and can be controlled to a large extent.

• On the contrary, there are external factors that are external to an organisation and are not under the control of the organisation.


• Internal factors influencing dividend policy:– Stability of earnings: Ideally the profits should show a stable and

increasing trend. For an organisation having stable earnings the dividend policy will also be consistent and vice versa.

– Life stage of the organisation: If the organisation is in the introduction stage then it follows a conservative dividend policy, If the organisation is in the mature phase then it can follow a liberal dividend policy, and so on.

– Liquidity of funds: It is important to look at the cash available with the organisation and also the assets that the organisation holds and their convertibility to cash.


– Retained earnings: The organisation has to retain a part of profit that needs to be reinvested in the organisation to enhance its base i.e. for expansion and consolidation reasons and to enhance its financial position. The organisations of small size have a hard time finding sources of funds and therefore they follow a conservative dividend policy and keep a good share of the profit for reinvesting in the company.

– Information on previous dividend rates: It is a general practice to keep the share dividends at a rate that shows a consistent trend and they must be near to the average dividend returns paid by the organisation in the past. Therefore while deciding the rate of dividends the board of directors must keep in mind the trend of the dividends paid in the past.


– Consistency of Dividend Payout: The dividend payments to the shareholders must be consistent and preferably in an increasing trend over the years. It serves to motivate the investors to invest further in the organisation and thereby help in strengthening the goodwill of the organisation in the market.

– Shareholder’s tax situation: Stock holders prefer lower cash dividend because of higher tax to be paid on the dividend income.


• External factors affecting the dividend policy:– Business cycles: Every business organisation goes through stages

where they go through a boom period or period of low profits due to various reasons. The organisation follows generous policy and gives higher dividends in periods of boom. On the contrary an organisation follows a restrictive dividend policy during periods of low profits.

– Government policies: Government policies include the fiscal policy that relates to the taxes and subsidies, industrial, and labor policies. Any change in these policies has a direct impact on the organisation and its earnings.


– Statutory and legal requirements: For the organisations to function there are a set of established statutory and legal requirements which also play a significant role in deciding the dividend policy of the organisation.

– External obligations: When the organisation borrows funds from the external sources then it needs to pay the interest and/or principal amount. On the other hand, if the organisation does not borrow funds and uses its retained earnings in the business the organisation does not need to pay the interest and principal liabilities.

1. Types of Dividend Policy

• The dividend policy of the organisation is decided based on various factors and the dividend policy differs from organisation to organisation.

• There are five basic types of dividend policies:

Types of Dividend

Policy

Stable Dividend

Policy

Long-term Dividend

Policy

Regular and Extra Dividend

Policy

Irregular Dividend

Policy

Regular Stock Policy


• Stable dividend policy: Also called the constant-payout-ratio, under this policy the organisation gives dividend to the shareholders on a regular basis.

• Long-term dividend policy: Under this policy, the dividend is paid to the shareholders on a long term basis. Irrespective of the fact whether the organisation makes huge profits or losses the dividend is not paid regularly.

• Regular and extra dividend policy: Under this dividend policy, the organisation pays a fixed amount of dividend on a regular basis. In addition to this, an extra amount of dividend is paid to the shareholders in case the organisation earns abnormal profits.


• Irregular Dividend Policy: Under this dividend policy the dividend payout ratio keeps on changing and is not constant. The dividend per share depends on the profits earned by the organisation. This type of dividend policy is pursued by the organisations which have instable profits. This is the least preferred dividend policy from the perspective of the shareholders.

• Regular Stock Dividend Policy: Under this dividend policy the organisation gives dividend in the form of stocks instead of cash. It is a very strong method of maintaining the liquidity position of the organisation as the cash is not distributed as dividend. The organisation issues bonus shares instead of dividend in cash form.

1. Approaches to Dividend Policy

• There are two approaches that describe the relation between the dividend policy of the organisation and the value of the organisation.

• Firstly, there is irrelevance model supported by a section of economists who believe that the dividend policy has no impact on the value of the organisation.

• Secondly, there is the relevance model supported by a section of economists who believe that the decision regarding dividends has an impact on the value of the organisation.


Irrelevance Approach (Modigliani and Miller)• According to the irrelevance approach there is no relation between the

dividend policy and the value of an organisation. • This approach advocates that dividend is residual in nature which is paid after

paying the debt liabilities, corporate tax and other liabilities out of profit.• The economists who support the irrelevance approach argue that the decision

to pay the dividend depends upon the availability of investment opportunities. • In case there are some investment opportunities available to the organisation

then the profit is not distributed as dividends and reinvested in the business. • In the counter case, when there are no investment opportunities available the

dividend is distributed.


Irrelevance Approach (Modigliani and Miller)• Irrelevance approach can be represented mathematically as follows:

Po = (D1 + P1) / (1+Ke)• Where,

Po - Current Market PriceKe - Cost of Equity CapitalD1- Dividend received at the end of period 1P1- Market price of a share at the end of period 1


Relevance Approach (Walter and Gordon)• According to the relevance approach the dividend policy plays an important role

in determination of the value of an organisation.

• This approach assumes that the shareholders have preference for current consumption rather than future earnings which are quite uncertain and highly risky. The formula used to make dividend decision is as follows:

P = D/ (Key –g)

Or (D+(r/Ke)(E-D))/Ke

• P- Price of Equity Shares, D- Initial Dividend, E = Earnings per share, R = Rate of return on the company’s investments, Ke- Cost of Capital, g= Expected growth rate of the earnings

1. Forms of Dividend Payment

• An organisation has the option to pay dividend to its shareholders in the form of either cash or in form of bonus shares.

• The decision to pay either in cash or stock depends on the dividend policy and the existing economic con

• The different forms of dividend payment are:

Dividend

Cash Dividend

Stock Dividend

2. Forms of Dividend Payment

• Cash dividend: It is a type of dividend payment where the profits are distributed among the shareholders in form of cash or through cheque. The dividend rate is decided by the top management. An organisation is bound to fulfill all legal formalities of Companies Act, while making any dividend declaration. It should declare dividend as per Companies (Declaration of Dividend out of Reserves) Rules, 1975.

• Stock Dividend: It is a type of dividend that is paid in the form of bonus shares. It is also known as bonus issue. When an organisation wants to use the retain earnings for the purpose of reinvestment instead of paying cash dividend then this type of dividend is issued.

Let’s Sum Up

• Dividend policy refers to a policy under which the decisions related to the distribution of profit in the form of dividends to the shareholders are taken.

• Two approaches that describe the relation between the dividend policy of the organisation and the value of the organisation are the irrelevance model and the relevance model.

• The decision to invest the earnings or to distribute them is based on two parameters namely the return on the investment (r) and the cost of the capital (k).

• When r > k, in this case the profit is reinvested back in the business.• When r < k, then the profit is not invested further in the organisation.

Post Your Query


Chapter 8: Working Capital

Management


From-To


2 Topic 1 Concept of Working Capital Management

182-188

3 Topic 2 Principles of Working Capital Management

189-193

4 Topic 3 Factors Affecting Working Capital Management

194-198

5 Topic 4 Methods for Assessing Working Capital

199-202

Chapter Index


6 Topic 5 Financing of Working Capital Requirement

203-205

7 Topic 6 Asset Securitisation (Way for Raising the Working Capital)

206-207

8 Topic 7 Working Capital Factoring 208-209


• Learn the concept of working capital management• Discuss the principles of working capital management• Explain the factors affecting working capital management• Elaborate on financing of working capital requirement• Explain asset securitisation• Discuss working capital factoring

1. Concept of Working Capital Management

• Working capital management implies the process of controlling the flow of working capital in the organisation.

• There are two types of working capital namely gross working capital and net working capital.

• Gross working capital refers to the current assets of an organisation. • Current assets are those assets that can be converted into cash within one

year or less than one year. • These include bills receivables, stocks, sundry debtors, and cash in hand

and at bank. • A difference between current assets and current liabilities is net working

capital.


• Types of working capital are:

Types of Working Capital

Temporary Working Capital

Permanent Working Capital

Seasonal Working Capital

Special Working Capital


• Temporary working capital: The working capital that is required to produce extra units of products in case of excess demand is called temporary working capital. This is also known as fluctuating working capital. When the demand of the product increases, extra working capital is raised from short-term sources.

• Permanent working capital: The working capital that is needed for the smooth running of the business is called permanent working capital. This capital is required on a daily basis for production and payment of current liabilities. If an organisation fails to maintain permanent capital, it will cease to exist in the long run.


• Seasonal Working Capital: This is the capital required by organisations in seasonal industries that operate in a specific season and shut down or slow down their activities by the end of the season. Examples of seasonal industries are the umbrella and raincoat industries.

• Special Working Capital: This is the capital requirement of different sectors, such as primary, secondary, and tertiary, of an economy. The working capital requirement of primary sector is seasonal in nature. The secondary sector requires huge working capital for maintaining stock and paying salaries. The tertiary sector requires less working capital as compared to secondary sector as it renders services to conduct its business on a cash basis.


Need of Adequate Working Capital• Working capital is needed for long term success and run of a business • Investment in current assets represents a substantial portion of total

investment• Working capital helps an organisation to meet its current liabilities • Working capital helps in taking advantage of financial opportunities • Working capital ensures the smooth operating cycle of the business• Working capital speeds up the flow of funds for meeting the capital needs

of existing operations and thus, avoids the stagnation of funds Working capital strikes a balance between twin objectives namely liquidity and profitability


Working Capital and Cash Management • Working capital ensures that an organisation has an enough cash flow for

meeting the debt obligation and operating expenses. • The functions of cash management are as follows:

– Establish a reliable forecasting and reporting system. – Streamline the system of cash collection. – Achieve the optimum savings.

• Cash budget shows the estimated cash inflows and cash outflows over the planning horizon.

• It highlights the net cash position of an organisation.


Working Capital and Cash Management • The working capital is managed with the help of cash budget in the following

ways: – Coordinate the timings of cash needs: With the cash budget, it is easy

to identify the period when there can be shortage of cash or excessive cash requirement

– Plan the discounts: With the knowledge of excess cash, organisation can plan for dividend discounts (assessing the present value of a stock based on the growth rate of dividends), payment of debts and finance capital expansion

– Prevents accumulation of funds: Cash budget provides advance knowledge of the cash that has not been employed in operating activities.

1. Principles of Working Capital Management

• There are four principles of working capital management that determine the relationship between profitability and risk, cost of capital and risk, cash inflow and cash outflow, and the contribution of current assets and net worth of an organisation.

• The principles of working capital management are:

Principles of Working Capital Management

Principle of Risk Variation

Principle of Cost of Capital

Principle of Equity Position

Principle of Maturity Payment


• Principle of Risk Variation: This principle helps in determining the relationship between risk and profitability associated with working capital management. (Risk here refers to the ability of an organisation to write-off its current liabilities.)

• The risk for the organisation may increase and profitability may decrease if the working capital increases by raising short-term loans.

• The organisation can increase its profitability by paying short-term loans. In such a case, its working capital and risk would decrease.

• Therefore, it can be stated that there is an inverse relationship between the risk and profitability of an organisation.


• Principle of Cost of Capital: According to this principle, there is an inverse relationship between the cost of capital and degree of risk.

• For example, if the debt capital increases, the cost of capital goes down, but the risk of paying return at the time of loss increases.

• This happens because the organisation does not pay dividends on equity at the time of loss.


• Principle of Equity Position: According to this principle, the amount of working capital employed in a current asset should positively influence the returns on equity and value of the organisation. The investment in current assets would increase the working capital of the organisation. The optimum amount, which should be invested in current assets to raise the equity position of the organisation, is calculated with the help of following two ratios:– Level of Current Assets = Current assets/Percentage of total assets– Level of Current Assets = Current assets/Percentage of total sales


• Principle of Maturity Payment: This principle states that an organisation should frame its policies in such a way so that its cash inflow would be sufficient to meet cash outflow.

• This facilitates the timely payment of short-term debts, which in turn enhances the goodwill and creditworthiness of an organisation.

1. Factors Affecting Working Capital Management

• The need of capital requirement depends on various factors that influence different organisations in different ways.

• The factors affecting working capital management are:Characteristics of BusinessLabour RequirementCost of Raw MaterialCredit PolicySeasonal VariationSales TurnoverDividend PolicyProfitability of the Organisation


• Characteristics of business: If the organisation is in a public utility business then it requires more working capital as most of the transactions are carried on a cash basis. However, a manufacturing organisation would require less working capital as majority of transactions would require credit.

• Labour requirement: It is the amount of labour required in the mode of production adopted by an organisation. There are two modes of production, such as labour intensive and capital intensive. If an organisation adopts labour intensive mode of production then it requires more working capital for wage payment. However, if an organisation adopts capital intensive mode of production then it requires less working capital.


• Cost of Raw Material: If an organisation requires expensive raw materials then more working capital is needed to carry out production. On the other hand, if an organisation needs low-priced raw materials then it requires less working capital. For example, iron and steel industries need more working capital as they require expensive raw materials as compared to the plastic industry that requires low-priced raw materials.

• Credit Policy: The agreement between an organisation and its suppliers for the purchase of raw materials. An organisation would require less working capital if the suppliers agree to provide raw materials on a credit basis. However, if the suppliers provide raw materials on a cash basis then the organisation would require more working capital.


• Seasonal Variation: Some products may have high demand in a particular season and moderate demand in other seasons. The working capital requirement of the organisation producing seasonal products is more in the peak season and less in other seasons.

• Sales Turnover: One of the most important factors affecting the requirement of working capital is the organisation’s sales turnover. A firm maintains current assets because they are needed to support the operational activation, which result in sales. The volume of sale and the size of the working capital are directly related to each other. As the volume of sales increases, the working capital investment increases and vice versa.


• Dividend policy: A shortage of working capital often acts as powerful reason for reducing a cash dividend.

• Profitability of the organisation: Adequate profit contributes to the generation of cash. High profitability allows organisations to plough back a part of the earnings into the business and build up on financial resources to internally fund the working capital needs.

1. Methods for Assessing Working Capital

Operating Cycle Method • The operating cycle is the time duration starting from the procurement of

raw materials and ending with the sales realisation.• The length and nature of operating cycle may differ as per the size and

nature of different organisations. • At different stages of operating cycle, the need of working capital varies. • Thus, operating activities create the necessity of working capital, which is

neither synchronised nor certain. • The longer the cycle, the greater is the need for operating cycle.


Operating Cycle Method • Calculation of operating cycle:a. Procurement of Raw Material b. Conversion/Process Timec. Average Time for Holding Finished Goods d. Average Collection Periode. Operating Cycle (a + b + c + d)• Operating cycles per year = 365/e• Working Capital Requirement = (Operating Expenses per

annum)/(Number of operating cycles per annum)


Maximum Permissible Bank Finance (MPBF) Method• MPBF method was suggested by Tandon Committee and relates to the

banking sector. • This method indicates the maximum level for holding the inventory and

receivables in each industry. • As per the Tandon Committee, organisations are discouraged from

accumulation of stocks of current assets and required to move towards the lean inventories and receivable levels.


Other Methods• Drawing power method: Drawing power implies the amount of funds that a

borrower is allowed to draw from the working capital limit allocated to him/her. Thus, working capital is analysed with the help of percentage allocated by the banks.

• Turnover method: Under this method, the working capital requirements are estimated at 25%. The banks can finance up to maximum extent of 20% of projected turnover. Balance 5% is net working capital which is brought in by borrower as his margin.

• Cash budget method: Under this method, the borrower submits the cash budget for future period and then the working capital is calculated.

1. Financing of Working Capital Requirement

• The decision to finance the working capital of an organisation is taken by the management after considering all the sources and applications of funds.

• The sources to finance working capital are as follows: – Bank credit: This refers to a short-term source of financing working

capital. The bank credit can take the forms of cash credit, bank overdrafts, and discounting of bill. In addition, bank credit is used to raise low amount of working capital for meeting daily needs. Generally, small organisations use bank credit to finance their working capital as their requirements are low. Bank credit is a type of secured loans (organisation has to mortgage their assets against these loans) and interest has to be paid on them till the time of maturity.


– Loans from financial institutions: This refers to a long-term source of financing working capital. Generally, large organisations need large amount of loans for long term. Such loans are provided by major financial institutions, such as ICICI and IDBI.

– Public deposits: Apart from the issue of shares and debentures, organisations may accept deposits from the public to finance its medium and short-term capital needs. This source is very popular among the public as organisations often offer interests at rates, which are higher than those offered by banks. Under this method, organisations can obtain funds directly from the public eliminating the financial intermediaries. The maturity period of a public deposit is more than one year and less than three years.


– Prepaid Income: This refers to the income that is received in the form of advance payments from distributors. Prepaid income is the most economical source to finance the working capital as the organisation does not need to pay interest to distributors on prepaid income.

– Retained Earnings: These are reserve funds that are maintained by an organisation. Retained earnings are the most reliable source of financing working capital as they can be raised at the time of need without any delay. The organisation has no obligation to mortgage its assets for using these funds.

1. Asset Securitisation (Way for Raising the Working Capital)

• Asset securitisation is the process of combining several individual assets and pooling them together so that investors may buy interests in the pool rather than in the individual assets.

• Owing to the high degree of predictability inherent in large groups, asset securitisation increases predictability of investments, lowers risks, and increases asset value.

• Securitisation of assets helps in funding and liquidity for wide range of consumer and business credit needs.

• This involves securitisation of residential and commercial mortgages, automobile loans, student’s loans, credit card financing and business trade receivables.

2. Asset Securitisation (Way for Raising the Working Capital)

• Asset securitisation enhances the liquidity in the market and acts as an important tool for raising funds. The salient features are as follows: – Asset backed security is issued through a special purpose entity – Issuing an asset backed security is asset sale rather than debt financing – The credit of asset backed security is derived from credit of underlying

assets • The benefits of securitisation for the organisations are as follows:

– Provides liquidity to organisation by covering illiquid assets into cash – Provides better asset liability management – Helps in recycling the assets easily – Improves transparency of the assets

1. Working Capital Factoring

• Factoring can be defined as a way to convert the accounts receivables (illiquid receivables) into money which can be further invested in the working capital.

• This is done by using factors such as banks, financial institutions that are ready to purchase these assets.

• As this helps in getting direct cash, this is also called working capital factoring. • This helps in growing the business by ensuring the capital needed as steady

flow of cash is ensured. • The process of working capital factoring involves a factor (bank, leasing

company) and a client (with receivables). • Working capital factoring gives an unlimited access to capital as the amount to

be borrowed with this method increases with increase in sales.

2. Working Capital Factoring

• Factoring involves the following parties: • The client: an organisation with receivables.• A factor: a financial service organisation/ bank.• Debtor: One who is creating the receivables.

• The benefits of factoring are as follows: • Increases liquidity by raising cash.• Provides access to capital at lower rate of cost. • Enhances the working capital of the organisation. • Transfer the credit risk of receivables to the factor from the firm.• Reduces the firm’s burden in setting up collection centers.

Let’s Sum Up

• Working capital management implies the process of controlling the flow of working capital in the organisation. There are two types of working capital namely gross working capital or net working capital.

• The operating cycle is time duration starting from the procurement of raw materials and ending with the sales realisation.

• MPBF method indicates the maximum level for holding the inventory and receivables in each industry.

• Asset securitisation is the process of creating securities by pooling together various cash flow producing financial assets, which are sold further to investors

• Factoring can be defined as way to convert the accounts receivables (illiquid receivables) into money which can be further invested in the working capital.

Post Your Query


Chapter 9: Receivables and

Inventory Management

Chapter Index



2 Topic 1 Concept of Receivables Management

217-218

3 Topic 2 Credit Policies and Credit Terms

219-221

4 Topic 3 Collection Policies 222

5 Topic 4 Concept of Inventory Management

223-224

Chapter Index


6 Topic 5 Tools and Techniques of Inventory Management

225

7 Topic 6 Reorder Point 226-227

8 Topic 7 Safety Stock 228


• Explain the concept of receivables management• List credit policies and credit terms• Discuss collection policies• Describe the concept of inventory management• List various tools and techniques of inventory management • Explain the concept of reorder point• Discuss safety stock

1. Concept of Receivables Management

• Receivables include the amount of money to be received by an organisation from its debtors.

• In other words, receivables encompass all debts (even if they are not currently due), unsettled transactions, or various other monetary obligations owed to an organisation by its debtors or customers.

• Receivables are recorded in the balance sheet of an organisation. • They provide a number of benefits to an organisation, such as enhanced

sales volume and increased profits. • An organisation invests in receivables through a trade credit policy with an

aim to expand the customer base and survive in the competitive business environment.

2. Concept of Receivables Management

Objectives of Receivables Management• The primary objective of receivables management is to maximise the

returns on investments and minimise the risk of bad debts. Apart from this, the following are some other objectives of receivables management:– To maintain a proper balance between profitability and risk associated

with receivables. – To sell goods on credit by issuing receivables when an organisation has

sufficient money to meet daily expenses without any constraints. – To survive in the competitive market by increasing credit sales.

1. Credit Policies and Credit Terms

• The credit policy of an organisation encompasses a set of written guidelines that state the terms and conditions related to offering goods on credit; credit criteria for customers; procedure to be adopted for the collection; actions to be taken in case of debtors’ inability.

• The credit policy of any organisation has two important elements: credit standards and credit analysis.

• After establishing credit standards and creditworthiness of customers, the organisation needs to define the credit terms for extending trade credit.

• Credit terms have two important components: – Credit period – Cash discount


Credit Period• Credit period refers to a time span within which debtors or customers are allowed

to pay for their purchases. This period generally varies from 15-60 days. • The formula for calculating the effect of the credit period on the residual income:

ΔRI = [ΔS (1 - V) - ΔSbn] (1 - t) – k ΔI where,

ΔI = (ACPn - ACPo) [So/360] + V (ACPn) ΔS/360

• Where, ΔRI = Changes in residual income, ΔS = Increase in sales, V = Ratio of variable costs to sales, bn = Bad debts loss ratio on new sales, t = Corporate tax

rate, k = Post-tax cost of capital, ΔI = Increase in receivables investment, ACPn =

New average collection period (after enhancing the credit period), ACPo = Old average collection period.


Cash Discount• Organisations provide cash discounts to customers in order to induce them

to make prompt payments. • For example, credit terms of 2/10, net 30 means that a discount of 2%

would be offered if the payment is made by the 10th day; otherwise the full payment is due on the 30th day. The effect of cash discount on residual income may be estimated by the following formula:

ΔRI = [ΔS (1 - V) - ΔDIS] (1 - t) + k ΔI• Where, ΔS = Increase in sales, V = Ratio of variable, k = Cost of capital, ΔI

= Savings in receivables investment, ΔDIS = Increase in discount cost

Collection Policies

• An effective collection policy leads to short average collection period, reduction in the percentage of bad debts, and increase in collection expenses.

• The collection policy of an organisation aims at the following:– Timely collection of receivables. – Monitoring the state of receivables– Giving reminders to customers whose due date is approaching– Reminding customers about the legal action that can be taken against

overdue payments – Taking a legal action against overdue accounts

1. Concept of Inventory Management

• The word inventory refers to the stock possessed by an organisation. • It is broadly classified into three types, namely raw materials, work-in-

progress, and finished goods. • Raw materials are the components used for manufacturing final products. • Work-in-progress represents goods that are required at the intermediate

stages of production. • Finished goods are final products that are ready for sale. • Inventory management is a process of monitoring and controlling the level

of stock available in an organisation. • It prevents situations like excessive inventory or shortage of inventory by

taking into consideration the factors that influence inventory levels.

2. Concept of Inventory Management

Objectives of Inventory Management• The main objective of inventory management is to ensure a smooth flow of

production process in the organisation. • Apart from this, the following are the other objectives of inventory

management: – To meet a sudden rise in demand– To optimise investments in inventory – To organise and schedule production activities – To manage replenishment orders

Tools and Techniques of Inventory Management

• An organised approach should be followed to inventory management for balancing out the anticipated costs and benefits of holding inventories.

• There are various techniques practiced by the finance manager to manage inventories:

Stock Levels

VED Analysis

FSN Analysis

Just in Time (JIT) Inventory Management

ABC System

Economic Order Quantity (EOQ) Model

1. Reorder Point

• Reorder point refers to the level of inventory that triggers an order for replenishing the current inventory.

• In simple words, a reorder point can be defined as the level of inventory when a fresh order should be placed with suppliers for procuring additional inventory.

• The reorder point is based on the following assumptions:– The usage inventory is constant on a daily basis.– The lead-time to procure inventory is fixed.– The formula for determining the reorder point is as follows:

Reorder point = Lead time in days * Average daily usage of inventory

2. Reorder Point

• Illustration: A manufacturing plant has estimated that 1,20,000 units of its products will be sold in the next year. The processing cost of an order is Rs. 10 and the plant incurs Rs. 0.6 as carrying cost for one unit. The lead time for an order is 3 days. Calculate the (a) Economic Order Quantity (EOQ) and Reorder point.(Assume 300-day year).

• Solution: EOQ = =√ (2×1,20,000×10)/0.6=2,000 units • Reorder point = Daily usage* Lead time• Daily usage = 1,20,000/300 = 400 units• Reorder point = 400*3 = 1,200 units.

Safety Stock

• Safety stock can be defined as the minimum additional inventory to serve as a safety margin or buffer to meet an unanticipated increase in demand.

• The formula to calculate the level of safety stock is as follows: (Maximum usage rate – Average usage rate) * Lead time

• Where, the usage rate is the rate at which inventory is used in the organisation.

• The safety stock is maintained to avoid the situations of shortage of stock, which is also known as stock out.

• If the lead time and usage rate change frequently, the organisation may face a situation of stock out.

• In such a situation, complete protection against stock-out is required by maintaining a large safety stock.

Let’s Sum Up

• Receivables management, also called credit management, is a technique of reducing and mitigating bad debt risks by having insight into creditworthiness of debtors and customers.

• The primary objective of receivables management is to maximise the returns on investments and minimise the risk of bad debts.

• Inventory management is a process of monitoring and controlling the level of stock available in an organisation. Reorder point refers to the level of inventory that triggers an order for replenishing the current inventory.

• Safety stock can be defined as the minimum additional inventory to serve as a safety margin or buffer to meet an unanticipated increase in demand.

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Chapter 10: Budget and Budgeting


From-To


2 Topic 1 Concept of Budget 235

3 Topic 2 Types of Budget 236-237

4 Topic 3 Budgeting as Tool of Cost Control 238

5 Topic 4 Advantages and Limitations of Budgeting

239

6 Topic 5 Zero-Based Budgeting (ZBB) 240

7 Topic 6 Rolling Budget 241

8 Topic7 Cash Budget 242


Discuss the concept of budget

Describe different types of budget

State advantages and limitations of budgeting

Define zero-based budgeting

Explain rolling budget

Describe cash budget

Concept of Budget

• Budget can be defined as a quantitative statement developed to ascertain the funds required for various projects and the income that would be generated from them. In simple words, budget helps in allocating the income to various expenses.

• The main objectives behind preparing budget in organisations are:– Ensuring better co-ordination among the activities of various

departments– Spotting and correcting deviations by periodically comparing the actual

performance with budgeted performance– Maintaining a two-way communication in all the levels of management

to reduce the gap between actual and budgeted performance

1. Types of Budget

• Budget is generally divided into four types:

Types of Budgets

Performance

Budget

Fixed Budget

Flexible Budget

Incremental Budget

2. Types of Budget

• Performance Budget: Performance budget is the collection of all the activities carried out in the organisation along with their outcomes.

• Fixed Budget: It is usually a short-term budget as it does not consider variations that may occur in the long run.

• Flexible Budget: Flexible budget is the one that can be altered depending upon different activity levels of the organisation.

• Incremental Budget: In incremental budget, extra amount is summed up to the previous budget on yearly basis. Incremental budget is prepared by keeping actual performance of preceding year as a base.

Budgeting as Tool of Cost Control

• By providing quantitative statement, budgeting helps an organisation not just in arranging resources and funds, but also helps in cost controlling too. Generally a budget comprises of the following:

Profit Planning (Pro-forma Income Statement)

Cash Budgeting

Balance Sheet Forecasting

Advantages and Limitations of Budgeting

• Advantages of budgeting:– It helps in problem-solving in a disciplined manner.– It helps an organisation in planning and arranging resources.– It ensures the availability of fund at the time of need.– It enhances the goodwill of an organisation.

• Limitations of budgeting:– Forecasts only quantitative data.– Budgeting is impacted by external factors beyond the control of an

organisation.– Requires high cost that makes the budgeting difficult for small

organisations.

Zero-Based Budgeting (ZBB)

• Zero-Based Budgeting (ZBB) is a process of production planning that requires each departmental head to justify their entire budget in a detailed form.

• In ZBB, every cost element of various activities is analysed and justified every time when a new budget is prepared.

• In ZBB, no base budget is considered or referred for preparing a new budget.

• Moreover, various activities are arranged according to their priority and the cost of each activity is forecasted on the basis of certain facts.

• The cost involved in all the activities is subjected to verification.

Rolling Budget

• Rolling budget is prepared by making changes in a given budget at a fixed interval of time.

• The changes can be made on monthly, quarterly, half yearly or annual basis.

• Thus, it can be stated that rolling budget has a scope of amendments at any period of time.

• The rolling budget is prepared for a very short period of time. • It is very useful for industries that are facing swift changes and require

forecasting for a short interval of time. • For example, in most of the cases, an IT organisation faces swift changes

due to frequent enhancements in technology.

Cash Budget

• Cash budgets are generally prepared by analysing cash inflow and outflow of an organisation.

• These budgets help in ensuring the sound liquid position of an organisation for the payment of short-term liabilities and help the organisation in avoiding situations in which there is idle cash or shortage of cash. The cash budget is generally divided into four sections:

Receipts Section

Payment Section

Cash Flow Section

Financing Section

Let’s Sum Up

Budget can be defined as a quantitative statement developed to ascertain the funds required for various projects and the income that would be generated from them.

The process of preparing the budget of an organisation is known as budgeting. It is used to assess overall funds required to finance various projects of the organisation.

Zero-Based Budgeting (ZBB) is a process of production planning that requires each departmental head to justify their entire budget in a detailed form.

Rolling budget is prepared by making changes in a given budget at a fixed interval of time.

Cash budgets are generally prepared by analysing cash inflow and outflow of an organisation.

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Leadership & Management

Corporate finance book_ppt_y_hj_rkrjg2g