Financial Management Guide

Financial Management
Introduction
Prof. Gnanendra M
Department of Management Studies
Christ University

 Finance may be defined as the art and science of
managing money
 Finance may be defined as the provision of
money at the time when it is needed
 Money is arm or a leg. You either use it or lose it
-Henry Ford

• The subject of finance has been traditionally classified
into two classes
1.Public Finance- deals with the requirements , receipts
and disbursements of funds in the government institutions
like states and central governments.
2. Private Finance- deals with the requirements , receipts
and disbursements of funds in case of an individual , a
profit seeking business organization and a non profit
organization.

1. Personal Finance
2. Business Finance
3. Finance of non Profit organizations
Personal Finance deals with the analysis of principles
involved in managing one‘s own daily need of funds.
Business finance deals with the principles , practices ,
procedures and problems concerning financial management
of profit making organizations engaged in the field of
industry , trade and commerce.

 The finance of non- profit organization is
concerned with the practices , procedures and
problem involved in financial management of
charitable, religious , educational , social and
the other similar organizations.

• Business finance as an activity or a process which is
concerned with acquisition of funds, use of funds and
distribution of profits by a business firm.
• Thus, Business finance usually deals with Financial Planning
, acquisition of funds , use and allocation of funds and
financial controls.

Business Finance can further be sub classified into three
categories
1. Sole – Proprietary Finance
2. Partnership Firm Finance
3. Corporation or Company Finance.
Corporate finance or broadly speaking business finance can
be defined as the process of raising, providing and
administrating of all money/ funds to be used in a
corporate ( Business) enterprise.

 Financial management is concerned with raising financial
resources and their effective utilization towards
achieving the organizational goals
 Financial management is concerned with use of
important economic resource, namely capital funds -
Solomon
 FM is mainly involves raising of funds and their effective
utilization with the objective of maximizing
shareholders‘ wealth

1. Financial Planning and successful promotion of an enterprise.
2. Acquisition of funds as and when required at the minimum
possible cost;
3. Proper use and allocation of Funds
4. Taking sound Financial decisions
5. Improving and profitability through financial controls
6. Increasing the wealth of the investors and the nation
7. Promoting and mobilising individual and corporate savings.

 Financial Management and Economics
 Financial Management and Accounting
 Financial Management and Mathematics
 Financial Management and Production Management
 Financial Management and Marketing
 Financial Management and Human Resource

 Financial Management may be broadly divided into
two parts such as:
 Profit maximization
 Wealth maximization.

 Profit earning is the main aim of every economic
activity.
 A business being an economic institution must earn
profit to cover its costs and provide funds for growth.
 No business can survive without earning profit
 Profit is a measure of efficiency of a business
enterprise.

 It leads to maximize the business operation for profit
maximization.
 It considers all the possible ways to increase the
profitability of the concern.
 It shows the entire position of the business concern.
 Profit maximization objectives help to reduce the risk
of the business.

 Main aim is earning profit.
 Profit is the parameter of the business operation.
 Profit reduces risk of the business concern.
 Profit is the main source of finance.
 Profitability meets the social needs also.

 Profit maximization leads to exploiting workers and
consumers.
 Profit maximization creates immoral practices such
as corrupt practice, unfair trade practice, etc.
 Profit maximization objectives leads to inequalities
among the stake holders such as customers,
suppliers, public shareholders, etc.

 It is vague: It creates some unnecessary opinion
regarding earning habits of the business concern.
 It ignores the time value of money: It leads
certain differences between the actual cash inflow
and net present cash flow during a particular period.
 It ignores risk: Risks may be internal or external
which will affect the overall operation of the
business concern.

 Wealth maximization is one of the modern approaches, which
involves latest innovations and improvements in the field of
the business concern.
 The term wealth means shareholder wealth or the wealth of
the persons those who are involved in the business concern.
 Wealth maximization is also known as value maximization or
net present worth maximization.
 This objective is an universally accepted concept in the field
of business.

• Stockholder‘s current wealth in a firm =
(Number of shares owned) × ( current stock price per share )
Symbolically Wo = NPO
 The higher the stock price per share the greater will be the
stockholder‘s wealth.
 Thus, a firm should aim at maximising its current stock price.
 The shares market price serves as a performance index or report card of
its progress.
 It also indicates how well management is doing on behalf of the
shareholder.
Maximum Utility refers to maximum stockholder‘s wealth
maximum stockholder‘s wealth refers to maximum CMP per share

 Wealth maximization is superior to the profit maximization because the
main aim of the business concern under this concept is to improve the
value or wealth of the shareholders.
 Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total
cost incurred for the business operation. It provides extract value of the
business concern.
 Wealth maximization considers both time and risk of the business
concern.
 Wealth maximization provides efficient allocation of resources.
 It ensures the economic interest of the society.

 Wealth maximization leads to prescriptive idea of the business
concern but it may not be suitable to present day business
activities.
 Wealth maximization creates ownership-management
controversy.
 Management alone enjoy certain benefits.
 The ultimate aim of the wealth maximization objectives is to
maximize the profit.
 Wealth maximization can be activated only with the help of the
profitable position of the business concern.

1. The objective of wealth maximization is not necessarily socially
desirable
2. There is some controversy as to whether the objective is to maximize
the stockholders wealth or the wealth of the firm which includes
other financial claimholders such as debenture holders , preferred
stockholder.
3. The objective of wealth maximization may also face difficulties when
ownership and management are separated as is the case in most of
the large corporate form of organizations.
4. When managers act as agents of the real owners , there is a possibility
for a conflict of interest between shareholders and the managerial
interests.

 Financial requirement of the business differs
from firm to firm.
 The nature of the requirements on the basis
of terms or period of financial requirement,
it may be
 Long term and
 Short-term financial requirements.

 Long-term financial requirement means the finance
needed to
 Acquire land and building
 Purchase of plant and machinery and
 Other fixed expenditure.
 Long term financial requirement is also called as fixed
capital requirements.
 Fixed capital is the capital, which is used to purchase the
fixed assets of the firms hence, it is also called a capital
expenditure.

 Equity Shares
 Preference Shares
 Debenture
 Long-term Loans
 Fixed Deposits

 Apart from the capital expenditure of the firms, the firms
should need certain expenditure like
 Procurement of raw materials, payment of wages, day-to-day
expenditures, etc.
 This kind of expenditure is to meet with the help of short-
term financial requirements which will meet the operational
expenditure of the firms.
 Short-term financial requirements are popularly known as
working capital.

 Bank Credit
 Customer Advances
 Trade Credit
 Factoring
 Public Deposits
 Money Market Instruments

 The term capital refers to the total investment of the company in
terms of money, and assets.
 It is also called as total wealth of the company.
 When the company is going to invest large amount of finance into the
business, it is called as capital.
 Capital is the initial and integral part of new and existing business
concern.
The capital requirements of the business concern may be classified into
two categories:
 Fixed capital
 Working capital.

 Capitalization refers to the process of determining the
quantum of funds that a firm needs to run its business.
 Capitalization is only the par value of share capital and
debenture and it does not include reserve and surplus.
According to Guthman and Dougall, “capitalization is the
sum of the par value of stocks and bonds outstanding‖.

Capitalization may be classified into the
following three important types based on its
nature:
 Over Capitalization
 Under Capitalization
 Water Capitalization

 Over capitalization refers to the company which possesses
an excess of capital in relation to its activity level and
requirements.
 In simple means, over capitalization is more capital than
actually required and the funds are not properly used.
 According to Bonneville, Dewey and Kelly, over
capitalization means, “when a business is unable to earn
fair rate on its outstanding securities”.

A company is earning a sum of Rs. 50,000 and the rate of
return expected is 10%. This company will be said to be
properly capitalized. Suppose the capital investment of
the company is Rs. 60,000, it will be over capitalization to
the extent of Rs. 1,00,000. The new rate of earning would
be:
50,000/60,000×100=8.33%
When the company has over capitalization, the rate of
earnings will be reduced from 10% to 8.33%.

 Over issue of capital by the company.
 Borrowing large amount of capital at a higher rate of
interest.
 Providing inadequate depreciation to the fixed assets.
 Excessive payment for acquisition of goodwill.
 High rate of taxation.
 Under estimation of capitalization rate.

 Reduce the rate of earning capacity of the shares.
 Difficulties in obtaining necessary capital to the business
concern.
 It leads to fall in the market price of the shares.
 It creates problems on re-organization.
 It leads under or misutilisation of available resources.

 Efficient management can reduce over
capitalization.
 Redemption of preference share capital
which consists of high rate of dividend.
 Reorganization of equity share capital.
 Reduction of debt capital.

 Under capitalization is the opposite concept of over
capitalization and it will occur when the company‘s actual
capitalization is lower than the capitalization as warranted by
its earning capacity.
 Under capitalization is not the so called inadequate capital.
 Under capitalization can be defined by Gerstenberg, “a
corporation may be under capitalized when the rate of
profit is exceptionally high in the same industry”.

 Under estimation of capital requirements.
 Under estimation of initial and future earnings.
 Maintaining high standards of efficiency.
 Conservative dividend policy.
 Desire of control and trading on equity.

 It leads to manipulate the market value of shares.
 It increases the marketability of the shares.
 It may lead to more government control and higher
taxation.
 Consumers feel that they are exploited by the company.
 It leads to high competition.

 Under capitalization can be compensated with the help of fresh
issue of shares.
 Increasing the par value of share may help to reduce under
capitalization.
 Under capitalization may be corrected by the issue of bonus
shares to the existing shareholders.
 Reducing the dividend per share by way of splitting up of shares.

 If the stock or capital of the company is not mentioned by
assets of equivalent value, it is called as watered stock.
 In simple words, watered capital means that the realizable
value of assets of the company is less than its book value.
According to Hoagland’s definition, “A stock is said to be
watered when its true value is less than its book value.”

 Acquiring the assets of the company at high
price.
 Adopting ineffective depreciation policy.
 Worthless intangible assets are purchased at
higher price.

 Watered stock is an asset with an artificially-inflated
value.
 The term is most commonly used to refer to a form of
securities fraud common under older corporate laws
that placed a heavy emphasis upon the par value of
stock.
 Stock that is issued with a value much greater than the
value of the issuing company's assets.
 Watered stock can be caused by excessive stock dividends,
overvalued assets and/or large operating losses.

 If the founders of Company XYZ invested
$10 million in the company and then decided
to take the company public by selling 50
million shares priced at $3 (a $150 million
market capitalization), analysts might say
that Company XYZ is issuing watered stock.

 Excessive buying and selling of stocks by a broker on an
investor's behalf in order to increase the commission
the broker collects.
 This situation has been known to arise when brokers are
pressured to place a newly issued security underwritten
by a firm's investment banking arm.
 A situation in which a company is growing its sales faster
than it can finance them. This usually leads to enormous
accounts payable or accounts receivable and a lack of
working capital to finance operations.

 There is significant increase in turnover.
 Increase in current assets is rapid.
 Stock turnover the debtors turnover might slow down, in which case
the rate of increase in stocks and debtors would be even greater than
the increase in sales.
 Payment to creditors is pushed to increase length.
 Short term loans are exceeding the limits and firm tries to negotiate
increased limits.
 The current and quick ratio falls
 The firm leads to liquid deficit situation where current liabilities are
greater than current assets.

 Effective debt management and credit control can help
you avoid overtrading, by ensuring that you get paid
more efficiently and have the cash to pay suppliers and
staff.
 In addition to managing debt more effectively and
improving credit control, you should also think about
changing some or all of your business practices

 Under-trading is the reverse of over-trading.
 It means keeping funds idle and not using them properly.
 This is due to the under employment of assets of the
business, leading to the fall of sales and results in
financial crises.
 This makes the business unable to meet its commitments
and ultimately leads to forced liquidation.

 The symptoms in this case would be a very
high current ratio and very low turnover
ratio.
 Under-trading is an aspect of over-
capitalization and leads to low profit.

 Reduction in profits
 Reduction in the rates of return on capital
employed
 Loss of Goodwill
 Fall in the prices of the shares in the market

 Capital structure refers to the kinds of securities and
the proportionate amounts that make up capitalization.
 It is the mix of different sources of long-term sources
such as equity shares, preference shares, debentures,
long-term loans and retained earnings.
 Capital structure is the permanent financing of the
company represented primarily by long-term debt and
equity.

 The term financial structure is different from the
capital structure.
 Financial structure shows the pattern total financing.
 It measures the extent to which total funds are
available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.

Financial Structures Capital Structures
1. It includes both long-term
and short-term sources of
funds
1. It includes only the long-term
sources
of funds.
2. It means the entire liabilities
side of the balance sheet.
2. It means only the long-term
liabilities of the company.
3. Financial structures consist
of all sources of capital.
3. It consist of equity,
preference and retained
earning capital.
4. It will not be more important
while determining the of value
of the firm.
4. It is one of the major
determinations of the value of
the firm.

From the following information, calculate the capitalization, capital
structure and financial structures.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000

 Cost Principle
 Risk Principle
 Control Principle
 Flexibility Principle
 Timing Principle

 Optimum capital structure is the capital structure at which
the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.
 Optimum capital structure may be defined as the capital
structure or combination of debt and equity, that leads to
the maximum value of the firm.

 This is done by maximizing market value of the
shares and minimizing the cost of capital of a
firm.
 An optimal capital structure is that proportion
of debt and equity, which fulfils this objective of
a firm.
 Thus an optimal capital structure tries to
optimize two variables at the same time: cost of
capital and market value of shares.

 Leverage
 Cost of Capital
 Nature of the business
 Size of the company
 Legal requirements
 Requirement of investors
 Government policy

 capital structure theory refers to a
systematic approach to financing business
activities through a combination of equities
and liabilities.
 Competing capital structure theories
explore the relationship between debt
financing, equity financing and the market
value of the firm

 It is the mix of Net Income approach and Net Operating
Income approach.
 Hence, it is also called as intermediate approach.
 According to the traditional approach, mix of debt and
equity capital can increase the value of the firm by
reducing overall cost of capital up to certain level of debt.
 Traditional approach states that the Ko decreases only
within the responsible limit of financial leverage and when
reaching the minimum level, it starts increasing with
financial leverage.

 There are only two sources of funds used by a firm; debt
and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.

 Net income approach suggested by the Durand.
 According to this approach, the capital structure
decision is relevant to the valuation of the firm.
 In other words, a change in the capital structure
leads to a corresponding change in the overall
cost of capital as well as the total value of the
firm.

 There are no corporate taxes.
 The cost of debt is less than the cost of
equity.
 The use of debt does not change the risk
perception of the investor.

 Another modern theory of capital structure,
suggested by Durand. This is just the opposite
to the Net Income approach.
 According to this approach, Capital Structure
decision is irrelevant to the valuation of the
firm.
 The market value of the firm is not at all
affected by the capital structure changes.

 The overall cost of capital remains constant;
 There are no corporate taxes;
 The market capitalizes the value of the firm
as a whole;

 Modigliani and Miller approach states that the
financing decision of a firm does not affect the
market value of a firm in a perfect capital
market.
 In other words MM approach maintains that the
average cost of capital does not change with
change in the debt weighted equity mix or
capital structures of the firm.

 There is a perfect capital market.
 There are no retained earnings.
 There are no corporate taxes.
 The investors act rationally.
 The dividend payout ratio is 100%.
 The business consists of the same level of
business risk.

 Earnings per share (EPS) is the portion of a
company's profit allocated to each
outstanding share of common stock.
 Earnings per share serves as an indicator of a
company's profitability.
Net Income = Profit After Taxes

XYZ Ltd. decides to use two financial plans and
they need Rs. 50,000 for total investment.
Particulars Plan A Plan B
Debenture (interest at 10%) 40,000 10,000
Equity share (Rs. 10 each) 10,000 40,000
Total investment needed 50,000 50,000
Number of equity shares 1,000 4,000
The earnings before interest and tax are assumed
at Rs. 5,000, and 12,500. The tax rate is 50%.
Calculate the EPS.

XYZ Ltd is an established company which requires more funds of
Rs.30,00,000 for its expansion scheme, apart from the original
equity capital of Rs.30,00,000 at Rs.100 per share.
The Director has the following options to raise the additional funds:
i)All equity shares
ii) Rs.10,00,000 in equity shares and balance in 8% debentures
iii) All in the form of debentures carrying an interest rate of 8%
iv) Rs.10,00,000 in 12% preference shares and the balance in
equity shares
The expected EBIT is Rs.8,00,000 and the tax rate applicable is 50%.
Advise the company by analyzing the options.

ABC company has currently an all equity capital structure consisting
of 15, 000 equity shares of Rs. 100 each. The management is
planning to raise another Rs 25 lakhs to finance a major
programme of expansion and is considering three alternative
methods of financing:
i. To issue 25, 000 equity shares of Rs 100 each.
ii. To issue 25,000, 8% debentures of Rs. 100 each
iii. To issue 25,000, 8% Preference shares of Rs. 100 each.The
company‘s expected earnings before interest and taxes will be
Rs.8 lakhs. Assuming a corporate tax rate of 50% , determine the
earnings per share ( EPS) in each alternative and comment which
alternative is best and Why ?

AB Ltd. Needs Rs. 10,00,000 for expansion. The expansion is expected to
yield an annual EBIT of Rs. 1,60,000. In choosing a financial plan, AB LTd.
has an objective of maximizing earning per share. It is considering the
possibility of issuing equity shares and raising debt of Rs 1,00,000 or
4,00,000 or 6,00,00. The current market price per share is Rs.25 and its
expected to drop to Rs.20 if the funds are borrowed in excess of Rs
5,00,000.
Funds can be borrowed at the rates indicated below.
 Upto Rs1,00,000 at 8%
 Over Rs. 1,00,000 upto Rs.5,00,000 at 12%
 Over Rs. 5,00,000 AT 18%
Assume a tax rate of 50%. Determine the EPS for the three financing
alternatives and suggest the scheme which would meet the objective of
the management.

A company‘s capital structure consists of the following:
Equity shares of Rs.100 each Rs.20 lakhs
Retained earnings Rs.10 lakhs
9% preference shares Rs.12 lakhs
7% debentures Rs.8 lakhs
----------------
50,00,000
The company earns 12% on its capital. The income-tax rate is 50%. The
company requires a sum of Rs.25 lakh to finance its expansion
programme for which the following alternatives are available to it:
i) Issue of 20,000 equity shares at a premium of Rs.25 per share.
ii) Issue of 10% preference shares and
iii) Issue of 8% debentures
It is estimated that the P/E ratios in the cases of equity, preference and
debenture financing would be 21.4 , 17 and 15.7 respectively.
Which of the three financing alternatives would you recommend and why?

The EPS, ‗equivalency point‘ or ‗point of indifference‘
refers to that EBIT level at which EPS remains the same
irrespective of different alternatives of debt- equity mix at
this level of EBIT ,
The rate of return on capital employed is equal to the cost
of debt and this is also known as break even level of EBIT for
alternative financial plans.

Point of indifference =
 Where, X = Equivalency Point or Point of Indifference or Break Even EBIT Level.
 I1 = Interest under alternative financial plan 1.
 I2 = Interest under alternative financial plan 2.
 T = Tax Rate
 PD = Preference Dividend
 S1 = Number of equity shares or amount of equity share capital under alternative 1.
 S2 = Number of equity shares or amount of equity share capital under alternative 2.

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

As the debt equity ratio insisted by the financing agencies
is 2:1, the company has two alternative financial plans:
(i) Raising the entire amount of Rs. 60 lakhs by the issue of
equity shares, thereby using no debt, and
(ii) Raising Rs. 40 lakhs by way of debt and Rs. 20 lakh by
issue of equity share capital.
Calculation of point of Indifference:

 Where, X = Point Indifference
 I1 = Interest under alternative 1, i.e. .0
 I2 = Interest under alternative 2, i.e. 10/100 × 40 = 4
 T = Tax rate, i.e. 50% or .5
 PD = Preference Divided, i.e. O as there are no preference
shares.
 S1 = Amount of equity capital under alternative 1, i.e. 60.
 S2 = Amount of equity capital under alternative 2, i.e. 20.

 Thus, EBIT, earnings before interest and tax,
at point of indifference is Rs. 6 lakhs. At this
level (6 lakh) of EBIT, the earnings on equity
after tax will be 5% p.a. irrespective of
alternative debt-equity mix when the rate of
interest on debt is 10% p, a.

 From the figure given, we find that the
equivalency point (point of indifference) or the
break-even level of EBIT is Rs. 6 lakhs.
 In case, the firm has EBIT level below Rs. 6 lakhs
then equity financing is preferable to debt
financing; but if the EBIT is higher than Rs. 6
lakhs then debt financing is better.

A new project under consideration requires a
capital outlay of Rs.600 lacs for which the
funds can either be raised by the issue of
equity shares of Rs100 each or by the issue of
equity shares of the value of Rs.400 lacs and
by the issue of 15% loan of Rs 200lacs. Find
out the indifference level of EBIT given the
tax rate at 50%.

Inference:
Thus, the indifferent level of EBIT is Rs. 90 lakhs. At this
level of EBIT, the earnings per share (EPS) under both the
plans would be the same.

 Cost of capital is the rate of return that a firm must earn
on its project investments to maintain its market value and
attract funds.
 Cost of capital is the required rate of return on its
investments which belongs to equity, debt and retained
earnings.
 If a firm fails to earn return at the expected rate, the
market value of the shares will fall and it will result in the
reduction of overall wealth of the shareholders.

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

 Capital Budgeting Decision
 Capital Structure Decision
 Evolution of Financial Performance
 Other Financial Decisions
 Market value of share,
 Earning capacity of securities etc

Computation of cost of capital consists of two
important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital

 It refers to the cost of each specific sources
of finance like:
 Cost of equity
 Cost of debt
 Cost of preference share
 Cost of retained earnings

COST OF EQUITY
 Cost of equity capital is the rate at which
investors discount the expected dividends of the
firm to determine its share value.
 Conceptually the cost of equity capital (Ke)
defined as the ―Minimum rate of return that a
firm must earn on the equity financed portion of
an investment project in order to leave
unchanged the market price of the shares‖.

 Dividend price (D/P) approach
 Dividend price plus growth (D/P + g) approach
 Earning price (E/P) approach
 Realized yield approach.

 Flotation costs are incurred by a publicly traded company when it
issues new securities, and includes expenses such as underwriting
fees, legal fees and registration fees.
 Companies must consider the impact these fees will have on how
much capital they can raise from a new issue.
 Flotation costs, expected return on equity, dividend payments
and the percentage of earnings the company expects to retain
are all part of the equation to calculate a company's cost of new
equity.

 The cost of equity capital will be that rate of
expected dividend which will maintain the
present market price of equity shares.
 Dividend price approach can be measured
with the help of the following formula:
Ke = D
NP/MP
Ke = Cost of equity capital
D = Dividend per equity share
NP = Net proceeds of an equity share
MP = Market Price of Equity Share

 A company issues 10,000 equity shares of Rs.
100 each at a premium of 10%. The company
has been paying 25% dividend to equity
shareholders for the past five years and
expects to maintain the same in the future
also. Compute the cost of equity capital. Will
it make any difference if the market price of
equity share is Rs. 175?

 The cost of equity is calculated on the basis of the expected
dividend rate per share plus growth in dividend. It can be
measured with the help of the following formula:

(a) A company plans to issue 10000 new shares of Rs. 100
each at a par. The floatation costs are expected to be 4%
of the share price. The company pays a dividend of Rs.
12 per share initially and growth in dividends is expected
to be 5%. Compute the cost of new issue of equity
shares.
(b) If the current market price of an equity share is Rs. 120.
Calculate the cost of existing equity share capital

 The current market price of the shares of A
Ltd. is Rs. 95. The floatation costs are Rs. 5
per share amounts to Rs. 4.50 and is
expected to grow at a rate of 7%. You are
required to calculate the cost of equity share
capital.

 Cost of equity determines the market price of the shares.
It is based on the future earning prospects of the equity.
The formula for calculating the cost of equity according to
this approach is as follows.
Ke = EPS
NP/MP
Ke = Cost of equity capital
EPS = Earning per share
Np = Net proceeds of an equity share

A firm is considering an expenditure of Rs. 75 lakhs for
expanding its operations. The relevant information is as
follows :
 Number of existing equity shares =10 lakhs
 Market value of existing share =Rs.100
 Net earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new
equity capital assuming that new shares will be issued at a
price of Rs. 92 per share and the costs of new issue will be
Rs. 2 per share.

 It is the easy method for calculating cost of
equity capital. Under this method, cost of
equity is calculated on the basis of return
actually realized by the investor in a
company on their equity capital.
Ke = PVf×D
Where,
Ke = Cost of equity capital.
PVƒ = Present value of discount factor.
D = Dividend per share.

 Cost of debt is the interest a company pays on its
borrowings.
 It is expressed as a percentage rate. In addition, cost of
debt can be calculated as a before-tax rate or an after-tax
rate.
 Because interest is deductible for income taxes, the cost
of debt is usually expressed as an after-tax rate.
 Debt may be issued at par, at premium or at discount and
also it may be perpetual or redeemable.

 Cost of Irredeemable Debt or Perpetual
Debt and
 Redeemable Debt

 Irredeemable debt is that debt which is not required to be
repaid during the lifetime of the company. Such debt
carries a coupon rate of interest.
 This coupon rate of interest represents the before tax cost
of debt.
 After tax cost of perpetual debt can be calculated by
adjusting the corporate tax with the before tax cost of
capital.
 The debt may be issued at par, at discount or at premium.
 The cost of debt is the yield on debt adjusted by tax rate.

Kd = I/NP (1 – t)
 Where, I = Annual interest payment,
 NP = Net proceeds from issue of debenture or
bond, and
 t = Tax rate.

(a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate
applicable to the company is 50%. Compute the cost of debt
capital.
(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%.
The tax rate applicable to the company is 60%. Compute the cost
of debt capital.
(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%.
The tax rate is 60%, compute the cost of debt capital.
(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%.
The costs of floatation are 2%. The tax rate applicable is 50%.
Compute the cost of debt-capital.
Calculate after tax cost of debt.

 For redeemable debentures, the maturity date is fixed
initially.
 The meaning redeemable denotes that the debentures
would be redeemed by the company at a fixed date or
after a specified period of notice.
 So, we take the average of Sale Value and Redeemable
value while calculating the cost of redeemable
debentures.

Kda = I(1-t) + 1/n (RV-NP)
½(RV+NP)
Where,
 I = Annual interest payable
 RV = Redeemable of debt
 Np = Net proceeds of the debenture
 n = Number of years to maturity
 Kdb = Cost of debt after tax.

 A company issues Rs. 20,00,000, 10%
redeemable debentures at a discount of 5%.
The costs of floatation amount to Rs. 50,000.
The debentures are redeemable after 8
years. Calculate before tax and after tax.
Cost of debt assuring a tax rate of 55%.

 Cost of preference share capital is the annual
preference share dividend by the net
proceeds from the sale of preference share.
 There are two types of preference shares
 Irredeemable and
 Redeemable.

 These shares are issued for the life of the
company and are not redeemed.
 Cost of irredeemable preference shares can
be calculated as follows:
Kp = D/NP
 Kp = Cost of preference share
 D = Fixed preference dividend
 Np = Net proceeds of an Preference share

 XYZ Ltd. issues 20,000, 8% preference shares
of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference share
capital if these shares are issued (a) at par,
(b) at a premium of 10% and (c) of a
debentures of 6%.

 Redeemable preference shares are those that
are repaid after a specific period of time.
 Hence while calculating the cost of
redeemable preference shares, the period of
preference shares and redeemable value of
the preference shares must be given due
consideration.

Where,
 Kp = Cost of preference share
 Dp= Fixed preference share
 P = Par value of debt
 Np = Net proceeds of the preference share
 n = Number of maturity period.

 ABC Ltd. issues 20,000, 8% preference shares of Rs. 100
each. Redeemable after 8 years at a premium of 10%. The
cost of issue is Rs. 2 per share. Calculate the cost of
preference share capital.
 ABC Ltd. issues 20,000, 8% preference shares of Rs. 100
each at a premium of 5% redeemable after 8 years at par.
The cost of issue is Rs. 2 per share. Calculate the cost of
preference share capital.

 Retained earnings is one of the sources of finance for investment
proposal; it is different from other sources like debt, equity and
preference shares.
 Cost of retained earnings is the same as the cost of an equivalent
fully subscripted issue of additional shares, which is measured by
the cost of equity capital.
 Cost of retained earnings can be calculated with the help of the
following formula:
Where,
 Kr=Cost of retained earnings
 Ke=Cost of equity
 t=Tax rate
 b=Brokerage cost

 A firm‘s Ke (return available to shareholders)
is 10%, the average tax rate of shareholders
is 30% and it is expected that 2% is brokerage
cost that shareholders will have to pay while
investing their dividends in alternative
securities. What is the cost of retained
earnings?

 It is also called as weighted average cost of
capital and composite cost of capital.
 Weighted average cost of capital is the
expected average future cost of funds over
the long run found by weighting the cost of
each specific type of capital by its proportion
in the firms capital structure.

 The computation of the overall cost of capital (Ko) involves
the following steps.
 Assigning weights to specific costs.
 Multiplying the cost of each of the sources by the appropriate
weights.
 Dividing the total weighted cost by the total weights.
 The overall cost of capital can be calculated with the help
of the following formula;

Where,
 Ko = Overall cost of capital
 Kd = Cost of debt
 Kp = Cost of preference share
 Ke = Cost of equity
 Kr = Cost of retained earnings
 Wd= Percentage of debt of total capital
 Wp = Percentage of preference share to total capital
 We = Percentage of equity to total capital
 Wr = Percentage of retained earnings

 Weighted average cost of capital is
calculated in the following formula also:
Where,
 Kw = Weighted average cost of capital
 X = Cost of specific sources of finance
 W = Weight, proportion of specific sources of
finance.

ABC Ltd. has the following capital structure.
Rs.
Equity (expected dividend 12%) 10,00,000
10% preference 5,00,000
8% loan 15,00,000
You are required to calculate the weighted average cost of
capital, assuming 50% as the rate of income-tax, before
and after tax.

ABC Limited wishes to raise additional finance of Rs.10 Lakhs for meeting its
investment plans. It has Rs.2,10,000 in the form of retained earnings
available for investment purposes. The following are the further details:
(1) Debt/equity mix 30% / 70%
(2) Cost of debt
Upto Rs.1,80,000 10% (before tax)
Beyond Rs.1,80,000 16%( before tax)
(3) Earnings per share Rs.4
(4) Dividend pay out 50% of earnings.
(5) Expected growth rate in dividend 10%
(6) Current market price per share Rs.44
(7) Tax rate 50%
You are required :
 To determine the pattern for raising the additional finance.
 To determine the post-tax average cost of additional debt.
 To determine the cost of retained earnings and cost of equity, and
 Compute the overall weighted average after-tax cost of additional
finance

 Raj Ltd. is currently earning Rs. 2,00,000 and its
share is selling at a market price of Rs. 160. The
firm has 20,000 shares outstanding and has no
debt. The earnings of the firm are expected to
remain stable, and it has a payout ratio of 100%.
What is the cost of equity? If the firms earns 15%
rate of return on its investment opportunities
then what would be the firm‘s cost of equity if
the payout ratio is 60%?

 The term leverage refers to an increased means of
accomplishing some purpose.
 In the financial point of view, leverage refers to furnish the
ability to use fixed cost assets or funds to increase the
return to its shareholders.

 Operating leverage may be defined as the company‘s
ability to use fixed operating costs to magnify the effects
of changes in sales on its earnings before interest and
taxes.
 Operating leverage consists of two important costs viz.,
fixed cost and variable cost.
 When the company is said to have a high degree of
operating leverage if it employs a great amount of fixed
cost and smaller amount of variable cost.

 Operating leverage can be calculated with
the help of the following formula:
Operating Leverage =
Contribution
Operating Profit
Degree of Operating Leverage=
Percentage Change in Profit
Percentage Change in Sales

 From the following selected operating data,
determine the degree of operating leverage.
Which company has the greater amount of
business risk? Why?
Company A Company B
Rs. Rs.
Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000
Variable expenses as a percentage of sales are
50% for company A and 25% for company B.

 Operating leverage is one of the techniques to measure the
impact of changes in sales which lead for change in the profits of
the company.
 Operating leverage helps to identify the position of fixed cost and
variable cost
 Operating leverage measures the relationship between the sales
and revenue of the company during a particular period.
 Operating leverage helps to understand the level of fixed cost
which is invested in the operating expenses of business activities.
 Operating leverage describes the over all position of the fixed
operating cost

 Leverage activities with financing activities is called
financial leverage.
 Financial leverage represents the relationship between the
company‘s earnings before interest and taxes (EBIT) or
operating profit and the earning available to equity
shareholders.
 Financial leverage is defined as ―the ability of a firm to
use fixed financial charges to magnify the effects of
changes in EBIT on the earnings per share‖.

Financial leverage can be calculated with the help
of the following formula:
Financial Leverage = Operating Profit/EBIT
Profit Before Tax
Degree of Financial Leverage
= Percentage change in taxable Income
Percentage change in EBIT

 According to Gitmar, “financial leverage is
the ability of a firm to use fixed financial
changes to magnify the effects of change in
EBIT and EPS‖.
Financial Leverage = EBIT
EPS

A Company has the following capital structure.
Rs.
Equity share capital 1,00,000
10% Prof. share capital 1,00,000
8% Debentures 1,25,000
The present EBIT is Rs. 50,000. Calculate the
financial leverage assuring that the company
is in 50% tax bracket.

 Financial leverage helps to examine the relationship between EBIT and
EPS
 Financial leverage measures the percentage of change in taxable income
to the percentage change in EBIT.
 Financial leverage locates the correct profitable financial decision
regarding capital structure of the company.
 Financial leverage is one of the important devices which is used to
measure the fixed cost proportion with the total capital of the company.
 If the firm acquires fixed cost funds at a higher cost, then the earnings
from those assets, the earning per share and return on equity capital will
decrease.

Basis for
Comparison
Operating Leverage Financial Leverage
Meaning
Use of such assets in the
company's operations for which
it has to pay fixed costs is
known as Operating Leverage.
Use of debt in a company's
capital structure for which it
has to pay interest expenses is
known as Financial Leverage.
Measures Effect of Fixed operating costs. Effect of Interest expenses
Relates Sales and EBIT EBIT and EPS
Ascertained by Company's Cost Structure Company's Capital Structure
Preferable Low
High, only when ROCE is
higher
Formula DOL = Contribution / EBIT DFL = EBIT / EBT
Risk It give rise to business risk. It give rise to financial risk.

 When the company uses both financial and operating
leverage to magnification of any change in sales into a
larger relative changes in earning per share.
 Combined leverage is also called as composite leverage or
total leverage.
 Combined leverage express the relationship between the
revenue in the account of sales and the taxable income.

Combined leverage can be calculated with the
help of the following formulas:
Combined Leverage =
Operating Leverage × Financial Leverage
OR
Contribution X Operating Profit = Contribution
Operating profit PBT PBT

 The percentage change in a firm‘s earning per share (EPS)
results from one percent change in sales.
 This is also equal to the firm‘s degree of operating leverage
(DOL) times its degree of financial leverage (DFL) at a
particular level of sales.
Degree of contributed coverage = Percentage change in EPS
Percentage change in sales

 Kumar company has sales of Rs. 25,00,000.
Variable cost of Rs. 12,50,000 and fixed cost
of Rs. 50,000 and debt of Rs. 12,50,000 at 8%
rate of interest. Calculate combined
leverage.

 Calculate the operating, financial and combined leverage under
situations 1 and 2 and the financial plans for X and Y respectively from
the following information relating to the operating and capital structure
of a company, and also find out which gives the highest and the least
value ? Installed capacity is 5000 units. Annual Production and sales at
60% of installed capacity.
 Selling price per unit Rs. 25
 Variable cost per unit Rs. 15
Fixed cost:
 Situation 1 : Rs. 10,000
 Situation 2 : Rs. 12,000
Capital structure:
Financial Plan X (Rs.) Y (Rs.)
Equity 25,000 50,000
Debt (cost 10%) 50,000 25,000
75,000 75,000

 From the following information find out
operating, financial and combined leverages.
 Sales 1,00,000
 Variable Cost 60,000
 Fixed Cost 20,000
 Interest 10,000

Arvind Ltd. is having the following information.
Calculate financial leverage opening leverage
and combined leverage.
 Sales 50,000 units Rs. 10 each
 VC Rs. 6 Per Unit
 FC Rs. 1,00,000
 Interest 8 of 5,00,000

X Ltd. is having the following capital structure. Calculate
financial leverage, operating leverage and combined
leverage having two situations A and B and financial plans I
and II respectively.
 Capacity 1,500 units
 Production 1,200 units
 Selling Price Rs. 25
 Variable Cost Rs. 18
 Fixed Cost
 Situation I Rs. 1,400
 Situation II Rs. 2,400
Capital structure
Financial Plan A B
Equity 80,000 60,000
Debt 20,000 40,000

 ―capital budgeting is a long-term planning
for making and financing proposed capital
out lays.
 ―capital budgeting consists in planning
development of available capital for the
purpose of maximizing the long-term
profitability of the concern‖.

 The time value of money (TVM) is the idea
that money available at the present time is
worth more than the same amount in the
future due to its potential earning capacity.
 This core principle of finance holds that,
provided money can earn interest, any
amount of money is worth more the sooner
it is received.

 Huge investments
 Long-term
 Irreversible
 Long-term effect

 Identification of Various Investments
 Screening or Matching the Available Resources
 Evaluation of Proposals
 Fixing Property
 Final Approval
 Implementation
 Performance review of feedback

(A) Traditional methods (or Non-discount methods)
 Pay-back Period Methods
 Accounts Rate of Return
(B) Modern methods (or Discount methods)
 Discounted Pay Back Period
 Net Present Value Method
 Internal Rate of Return Method
 Profitability Index Method

 Pay-back period is the time required to
recover the initial investment in a project.
 It is one of the non-discounted cash flow
methods of capital budgeting.
Pay-back period = Initial investment
Annual cash inflows
Cash Flows : Profit Before Depreciation and
After Tax

Merits
 It is easy to calculate and simple to understand.
 Pay-back method provides further improvement over the accounting
rate return.
 Pay-back method reduces the possibility of loss on account of
obsolescence.
Demerits
 It ignores the time value of money.
 It ignores all cash inflows after the pay-back period.
 It is one of the misleading evaluations of capital budgeting.

1. Project cost is Rs. 30,000 and the cash inflows
are Rs. 10,000, the life of the project is 5
years. Calculate the pay-back period.
2. Calculate the payback period from the
following information: Cash outlay Rs. 50,000
and cash inflow Rs. 12,500.

3. A project costs Rs. 20,00,000 and yields
annually a profit of Rs. 3,00,000 after
depreciation @ 12½% but before tax at
50%. Calculate the pay-back period.

 Normally the projects are not having uniform
cash inflows. In those cases the pay-back
period is calculated, cumulative cash inflows
will be calculated and then interpreted.

1. Certain projects require an initial cash
outflow of Rs. 25,000. The cash inflows for
6 years are Rs. 5,000, Rs. 8,000, Rs.
10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.
Calculate PBP and suggest whether project
should be accepted or not.

2. From the following information, calculate
the pay-back periods for the 3 projects.
Which liquors Rs. 2,00,000 each? Suggest
most profitable project.
Year Project I Project II Project III
1 50,000 60,000 35,000
2 50,000 70,000 45,000
3 50,000 75,000 85,000
4 50,000 45,000 50,000
5 50,000 – 35,000

 Average rate of return means the average
rate of return or profit taken for considering
the project evaluation.
 This method is one of the traditional
methods for evaluating the project proposals

Return on investment =
Average profit × 100
Original investment
Cash Flows : Profit After Depreciation and Taxes

Merits
 It is easy to calculate and simple to understand.
 It is based on the accounting information rather than cash
inflow.
 It is not based on the time value of money.
 It considers the total benefits associated with the project.
Demerits
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.
 Different methods are used for accounting profit. So, it
leads to some difficulties in the calculation of the project.

A company has two alternative proposals. The
details are as follows:
Proposal I Proposal II
Automatic Machine Ordinary Machine
Cost of the machine Rs. 2,20,000 Rs. 60,000
Estimated life 5½ years 8 years
Estimated sales p.a. Rs. 1,50,000 Rs. 1,50,000
Costs :
Material 50,000 50,000
Labour 12,000 60,000
Variable Overheads 24,000 20,000
Compute the profitability of the proposals under the return on
investment method.

2. The machine cost Rs. 1,00,000 and has
scrap value of Rs. 10,000 after 5 years.
The net profits before depreciation and
taxes for the five years period are to be
projected that Rs. 20,000, Rs. 24,000, Rs.
30,000, Rs. 26,000 and Rs. 22,000. Taxes
are 50%. Calculate pay-back period and
accounting rate of return.

 Net present value method is one of the modern methods
for evaluating the project proposals.
 In this method cash inflows are considered with the time
value of the money.
 Net present value describes as the summation of the
present value of cash inflow and present value of cash
outflow.
 Net present value is the difference between the total
present value of future cash inflows and the total present
value of future cash outflows.

Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive
projects.
4. It helps to achieve the maximization of shareholders‘ wealth.
Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective
lives.

The following is the formula for calculating
NPV:
 where
 Ct = net cash inflow during the period t
 Co = total initial investment costs
 r = discount rate, and
 t = number of time periods
Cash Flows : Profits before depreciation and
after taxation

The following are the cash inflows and outflows of a certain
project.
Year Outflows Inflows
0 1,75,000 -
1 50,000 35,000
2 45,000
3 65,000
4 85,000
5 50,000
The salvage value at the end of 5 years is Rs. 50,000. Taking
the cutoff rate as 10%,
calculate net present value.
Year 1 2 3 4 5
P.V. 0.909 0.826 0.751 0.683 0.621

From the following information you can learn after tax and
depreciation concept. Calculate NPV
Initial Outlay Rs. 1,00,000
Estimated life 5 Years
Scrap Value Rs. 10,000
Profit after tax :
End of year 1 Rs. 6,000
2 Rs. 14,000
3 Rs. 24,000
4 Rs. 16,000
5 Nil
Depreciation has been calculated under straight line method. The
cost of capital may be taken at 10%. P.a. is given below.
Year 1 2 3 4 5
PV factor 0.909 0.826 0.751 0.683 0.621

 From the following information, calculate the net present
value of the two project and suggest which of the two
projects should be accepted a discount rate of the two.
Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1,000 Rs. 2,000
The profits before depreciation and after taxation (cash
flows) are as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Project x (Rs) 5,000 10,000 10,000 3,000 2,000
Project y (Rs) 20,000 10,000 5,000 3,000 2,000
Note : The following are the present value factors @ 10% p.a.
Year 1 2 3 4 5 6
Factor 0.909 0.826 0.751 0.683 0.621 0.564

A company has to choose one of the following
two actually exclusive machine. Both the
machines have to be depreciated. Calculate
NPV.
Cash inflows
Year Machine X Machine Y
0 –20,000 –20,000
1 5,500 6,200
2 6,200 8,800
3 7,800 4,300
4 4,500 3,700
5 3,000 2,000

 Internal rate of return is time adjusted
technique and covers the disadvantages of the
traditional techniques.
 Internal rate of return (IRR) is the
interest rate at which the net present value of
all the cash flows (both positive and negative)
from a project or investment equal zero.
 Internal rate of return is used to evaluate the
attractiveness of a project or investment.

IRR = A + (C-O) * (B-A)
(C-D)
A = Lower trial rate
B = Higher trial rate
C = PV of Lower trial rate
D = PV of Higher trial rate
O = Original Investment/Initial Invesment

Merits
 It consider the time value of money.
 It takes into account the total cash inflow and outflow.
 It does not use the concept of the required rate of return.
 It gives the approximate/nearest rate of return.
Demerits
 It involves complicated computational method.
 It produces multiple rates which may be confusing for
taking decisions.
 It is assume that all intermediate cash flows are reinvested
at the internal rate of return.

A company has to select one of the following two
projects:
Project A Project B
Cost Rs.22,000 20,000
Cash inflows:
Year 1 12,000 2,000
Year 2 4,000 2,000
Year 3 2,000 4,000
Year 4 10,000 20,000
Using the Internal Rate of Return method suggest
which is Preferable.

A machine cost Rs. 1,25,000. The cost of capital is 15%. The net
cash inflows are as under:
Year Rs.
1 25,000
2 35,000
3 50,000
4 40,000
5 25,000
Calculate internal rate of return and suggest whether the project
should be accepted of cost.

Which project will be selected under NPV and IRR?
A B
Cash outflow 2,00,000 3,00,000
Cash inflows at the end of
1 Year 60,000 40,000
2 Year 50,000 50,000
3 Year 50,000 60,000
4 Year 40,000 90,000
5 Year 30,000 1,00,000
Cost of capital is 10%.

SP Limited company is having two projects, requiring a capital outflow
of Rs. 3,00,000. The expected annual income after depreciation but
before tax is as follows:
Year Rs.
1 9,000
2 80,000
3 70,000
4 60,000
5 50,000
Depreciation may be taken as 20% of original cost and taxation at 50% of
net income:
You are required to calculated
(a) Pay-back period (b) Net present value
(c) According rate of return
(e) Internal rate of return.

Dividend Policy
&
Management of working
capital

 The Dividend Policy is a financial decision that
refers to the proportion of the firm‘s earnings to
be paid out to the shareholders.
 Here, a firm decides on the portion of revenue
that is to be distributed to the shareholders as
dividends or to be ploughed back into the firm.
 The amount of earnings to be retained back
within the firm depends upon the availability of
investment opportunities.

1. Regular dividend policy: in this type of
dividend policy the investors get dividend
at usual rate. Here the investors are
generally retired persons or weaker section
of the society who want to get regular
income. This type of dividend payment can
be maintained only if the company has
regular earning.

2. Stable dividend policy: here the payment of
certain sum of money is regularly paid to the
shareholders. It is of three types:
a) Constant dividend per share: here reserve fund is
created to pay fixed amount of dividend in the year
when the earning of the company is not enough. It is
suitable for the firms having stable earning.
b) Constant pay out ratio: it means the payment of
fixed percentage of earning as dividend every year.
c) Stable rupee dividend + extra dividend: it means
the payment of low dividend per share constantly +
extra dividend in the year when the company earns
high profit.

3. Irregular dividend: as the name suggests
here the company does not pay regular
dividend to the shareholders. The company
uses this practice due to following reasons:
 Due to uncertain earning of the company.
 Due to lack of liquid resources.
 The company sometime afraid of giving
regular dividend.
 Due to not so much successful business.

4. No dividend: the company may use this
type of dividend policy due to requirement
of funds for the growth of the company or
for the working capital requirement.

 A bonus share is a free share of stock given
to current shareholders in a company, based
upon the number of shares that the
shareholder already owns While the issue of
bonus shares increases the total number of
shares issued and owned, it does not change
the value of the company.

Advantages
(a) It is sign of continued normal operations of the company.
(b) It stabilises the market value of shares.
(c) It creates confidence among the investors.
(d) It provides a source of livelihood to those investors who view dividends
as a source of funds to meet day-to-day expenses.
(e) It meets the requirements of institutional investors who prefer
companies with stable dividends.
(f) It improves the credit standing and makes financing easier.
(g) It results in a continuous flow to the national income stream and thus
helps in the stabilisation of national economy.

Disadvantages
(a) Uncertainty of earnings.
(b) Unsuccessful business operations.
(c) Lack of liquid resources.
(d) Fear of adverse effects of regular dividends
on the financial standing of the company.

(i) Type of Industry
(ii) Age of Corporation
(iii) Extent of share distribution
(iv) Need for additional Capital
(v) Business Cycles
(vi) Changes in Government Policies
(vii) Trends of profits
(viii) Taxation policy
(ix) Future Requirements
(x) Cash Balance

 ―Working Capital is the amount of funds
necessary to cover the cost of operating the
enterprises‖.
 ―Working Capital refers to a firm‘s
investment in short-term assets, cash, short-
term securities, accounts receivables and
inventories‖.

Working capital can be classified or understood with the help of the
following two important concepts.
Gross Working Capital
 Gross Working Capital is the general concept which determines
the working capital concept. Thus, the gross working capital is
the capital invested in total current assets of the business
concern.
 Gross Working Capital is simply called as the total current assets
of the concern.
GWC = CA

 Net Working Capital
 Net Working Capital is the specific concept, which,
considers both current assets and current liability of the
concern.
 Net Working Capital is the excess of current assets over
the current liability of the concern during a particular
period.
 If the current assets exceed the current liabilities it is said
to be positive working capital; it is reverse, it is said to be
Negative working capital.
NWC = CA – CL

Current Assets
 Cash in Hand
 Cash at Bank
 Bills Receivable
 Sundry Debtors
 Short-term Loans Advances
 Inventories
 Prepaid Expenses
 Accrued Income

Current Liability
 Bills Payable
 Sundry Creditors
 Outstanding Expenses
 Short-term Loans and Advances
 Dividend Payable
 Bank Overdraft
 Provision for Taxation

 Purchase of raw materials and spares
 Payment of wages and salary
 Day-to-day expenses
 Provide credit obligations

 Nature of business
 Production cycle
 Business cycle
 Production policy
 Credit policy
 Growth and expansion
 Availability of raw materials
 Earning capacity

 Permanent Working Capital
 Temporary Working Capital
 Semi Variable Working Capital

 The working capital cycle (WCC) is the amount of time it
takes to turn the net current assets and current liabilities
into cash.
 The longer the cycle is, the longer a business is tying up
capital in its working capital without earning a return on
it.
 Therefore, companies strive to reduce its working capital
cycle by collecting receivables quicker or sometimes
stretching accounts payable.

Operating cycle consists of the following
important stages:
1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)

Each component of the operating cycle can be
calculated by the following formula:
1. R = Average Stock of Raw Material
Average Raw Material Consumption Per Day
2. W= Average Work in Process Inventory
Average Cost of Production Per Day
3. F = Average Finished Stock Inventory
Average Cost of Goods Sold Per Day
4. D= Average Book Debts
Average Credit Sales Per Day
5. C = Average Trade Creditors .
Average Credit Purchase Per Day

Amount of Working Capital required =
Total operating cost
Number of operating
cycles in a year

From the following information extracted from the books of a
manufacturing company, compute the operating cycle in days and
the amount of working capital required:
Period Covered 365 days
Average period of credit allowed by suppliers 16 days
Average Total of Debtors Outstanding 480
Raw Material Consumption 4,400
Total Production Cost 10,000
Total Cost of Sales 10,500
Sales for the year 16,000
Value of Average Stock maintained:
Raw Material 320
Work-in-progress 350
Finished Goods 260

Prepare an estimate of working capital requirement from the
following information of a trading concern.
 Projected annual sales 10,000 units
 Selling price Rs. 10 per unit
 Percentage of net profit on sales 20%
 Average credit period allowed to customers 8 Weeks
 Average credit period allowed by suppliers 4 Weeks
 Average stock holding in terms of sales requirements 12 Weeks
 Allow 10% for contingencies

Prepare an estimate of working capital
requirement from the following information of a
trading concern.
 Projected annual sales Rs. 6,50,000
 Percentage of net profit on sales 25%
 Average credit period allowed to debtors 10 Weeks
 Average credit period allowed by creditors 4 Weeks
 Average stock holding in terms of sales requirements 8
Weeks
 Allow 20% for contingencies

Selva and Co. desires to purchase a business and has consulted you
and one point on which you are to advise them is the average
amount of working capital which will be required in the first
year‘s working.
You have given the following estimates and instructed to add 10%
to your computed figure to allow for contingencies.
 Amount blocked up for stocks: Figures for the year
 Stocks of finished product 3,000
 Stocks of stores, materials, etc., 5,000
 Average credit given:
 Inland sales 4 weeks credit 2,60,000
 Export sales— 1 1/2 weeks credit 65,000
 Lag in payment of wages and other outputs
 Wages— 1 1/2 month 24,000
 Stocks of materials, etc.— 1 1/2 month 36,000

 Rent, Royalties, etc.—4 months 8,000
 Clerical staff— 1 1/2 month 60,000
 Manager— 1/2 month 4,000
 Miscellaneous expenses— 1 1/2 month 36,000
 Payment in advance
 Sundry Expenses (paid quarterly in advance) 6,000
 Undrawn profit on the average throughout the year 9,000
State your calculations for the average amount of working capital
required.

A performa cost sheet of a company provides the following particulars:
Elements of Cost Amt. Per Unit (Rs.)
Raw Materials 140
Direct Labours 60
Overheads 70
Total Cost 270
Profit 30
Selling Price 300
Further particulars available are:
 Raw materials are in stock on an average for one month. Materials are in
process on an average for half a month. Finished goods are in stock on an
average for one month.
 Credit allowed by suppliers is one month – credit allowed to customers is
two months. Lag in payment of wages is 1 1/2 weeks. Lag in payment of
overhead expenses is one month. One fourth of the output is sold against
cash. Cash in hand and at bank is expected to be Rs. 50,000.

 You are required to prepare a statement showing the
working capital needed to finance, a level of activity of
2,40,000 units of production. You may assume that
production is carried on evenly throughout the year; wages
and overhead accrue similarly and a time
period of 4 weeks is equivalent to a month.
 Note: Year = 4×12 = 48 weeks

The board of directors of Aravind mills limited request you to
prepare a statement showing the working capital requirements
for a level of activity of 30,000 units of output for the year. The
cost structure for the company‘s product for the above
mentioned activity level is given below.
Cost per Unit (Rs.)
Materials 20
Direct labour 5
Overheads 15
Total 40
Profit 10
Selling price 50

 Past experience indicates that raw materials are held in
stock, on an average for 2 months.
 Work in progress (100% complete in regard to materials
and 50% for labour and overheads) will be half a month‘s
production.
 Finished goods are in stock on an average for 1 month.
 Credit allowed to suppliers: 1 month.
 Credit allowed to debtors: 2 months.
 A minimum cash balance of Rs 25,000 is expected to be
maintained.
Prepare a statement of working capital requirements.

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