Corporate finance book_ppt_y_hj_rkrjg2g

S. No Reference No Particulars Slide
From-To
1 Chapter 1 An Introduction to Finance 4-17
2 Chapter 2 Time Value of Money 18-41
3 Chapter 3 Capital Budgeting 42-75
4 Chapter 4 Sources of Finance 76-95
5 Chapter 5 Capital Structure Management 96-129
6 Chapter 6 Leverages 130-153
7 Chapter 7 Dividend Policy 154-177
8 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 Index
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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Corporate finance book_ppt_y_hj_rkrjg2g

Chapter 2:
Time Value of Money

Chapter Index
From-To
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.

• 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

• 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.

• 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

• 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.

• 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.

• 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.

• 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

• The compounding value of annuity of Rs. 100 at the rate of 5 per cent are as
follows:

• 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.

• 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.

Chapter Index
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 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
× 100

• 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 =
30,000
1,20,000
× 100 = 25%.

• 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:
•

• 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
• NPV = t=1
n Ct
(1+r)n − I0

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

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.

• 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.

• 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 =
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤

• 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.

• 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 project
2. Establishing a mathematical relationship between the independent and
dependent variables
3. 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.

Chapter Index
From-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:
DifferentSourcesofMedium-
TermFinance
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.

Chapter 5:
Capital Structure
Management

Chapter Index
From-To
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 Management
The 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
Dividend 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 and
KE = Cost of equity capital

9. Cost of Capital
Earnings 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
Dividend 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
Realised 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
Capital 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
Bond 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
Gordon 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 Capital
Weighted 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 Capital
Marginal 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.

Chapter Index
From-To
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 costs
P = price
V = 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 + 9,00,000
900 Q = 450Q + 9,00,000
450Q = 9, 00,000
Q = 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 15,000
Less: Dividend on preference shares (Earnings before tax =
20000/(1 – 0.50) = 40000)
40,000
PBT 45,000
Financial 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.1,00,000
ii. Fixed cost = Rs.70,000
iii. 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 sales
Or 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.

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 Index
From-To
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 Price
Ke - Cost of Equity Capital
D1- Dividend received at the end of period 1
P1- 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.

Chapter 8:
Working Capital
Management

Chapter Index
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
From-To
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 Business
Labour Requirement
Cost of Raw Material
Credit Policy
Seasonal Variation
Sales Turnover
Dividend Policy
Profitability 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 Time
c. Average Time for Holding Finished Goods
d. Average Collection Period
e. 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.

Chapter 9: Receivables and
Inventory Management

Chapter Index
From-To
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
From-To
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.

Chapter 10:
Budget and Budgeting

Chapter Index
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
Performa
nce
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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