BY :VAIBHAV MALHOTRA EMAIL:vaibhav4u38@rediffmail.

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CH A P TE R O N E FI N A NC I AL M A N AG E ME NT : A N O V ER V IE W

Ques ti on : W hat d o y ou m ea n by fin an cia l man ag em en t ? Ans w er : Mea nin g o f Fin an cia l Ma nag e me nt : Th e p ri mar y t ask o f a Cha rt er ed Ac c o u nt ant is t o de al w it h fu nd s , 'M an ag em en t o f F un ds ' i s an i mp or t ant asp ect of fin an cial mana ge men t i n a b u si n e s s un de rt aking or an y ot he r in st it ut i on like ho spit al , art s oci et y , an d s o on . Th e t er m ' Finan cial M a nag em e nt ' ha s been d efi n ed di ff er e n t l y b y di ff er ent a ut h or s . Ac c or di n g t o S ol om o n " Finan cial M anag em ent i s c on cern ed w it h t he e ffi ci en t u se of a n i mp o rt ant ec on o mi c r es o u rce , n am el y c apit al fu nd s ." Ph i l l i p p at u s h as gi v en a m or e el a bor at e de finit io n of t he t e rm , a s , "Finan ci al M an ag em en t , i s c on ce rne d w it h t he mana ge rial de cisi on s t hat re s ult s i n t h e ac q ui si t i on an d finan cing of sh o rt an d l on g t e rm cr edit s f or t he fi rm ." Th u s , i t d e al s w i t h t he sit uat i on s t hat r eq ui re s ele ct i on o f spe cific p r ob l e m of s i ze an d g r ow t h o f a n ent e rpri se . Th e an al y sis of t he se deci si on s i s b as ed o n t h e exp ect ed in flo w s an d o ut fl ow s o f f un ds an d t heir ef fect on m an a geri al obj ect iv es . Th e m o st ac cept abl e d efinit i on o f financi al man a ge me n t i s t h at giv en b y S .C .K uch hal as , " Fina n cial mana ge men t deal s w i t h p roc u re me nt o f fu nd s a nd t h eir ef fe c t ive ut ilis at i on i n t h e b u si n es s ." Th u s , t h er e a re 2 basi c a sp ect s of fi nancial mana ge men t : 1) pr oc ur e m ent of fu nds : As f u n d s c an b e o b t aine d f r om di ffe re nt s o u rce s t h u s , t heir pro c ur em en t i s al w a y s c on si der ed a s a c om plex pr o ble m b y bu sin es s con cer n s . Th es e f un d s p r oc ur ed fr o m dif fe rent s o urc es ha ve di f fer ent chara ct eri st i cs i n t e r ms of ri sk , c ost and c ont r ol t hat a mana g er m ust con sid er w h i l e p r oc u ri n g f un d s . Th e f und s sh o ul d b e p r oc ur ed at minim u m co st , at a b al an c ed ri sk an d c ont r ol fa ct or s . F un d s rai se d b y i s s ue of eq uit y sh are s are t he be st f r o m ri sk p oint of vi ew f o r t h e c om p an y , as it ha s n o re p ay ment li abilit y e xc e pt on w inding up of t h e c o mp an y , b ut fr om c o s t point o f view , it is mo st exp ensi ve , a s di vi de n d e xp ect at ion s o f s hareh ol de rs ar e high er t han pre vail i n g i n t e re st ra t es a n d divi den d s a r e ap pr opri at ion of pr ofit s a nd not all ow e d a s ex p e n se un d er t he in c om e t ax act . Th e i s s ue o f n ew eq uit y sha re s ma y di l ut e t h e c on t r ol o f t h e e xi st ing sha reh ol der s . D eb e n t u re s are c omp arat iv el y c heap er sin ce t h e int ere st i s p aid o ut of p r o fi t s b e fo re t ax . B ut , t he y ent ail a high d eg re e of ri sk sin ce t h e y

have t o b e r ep ai d a s p er t h e t er ms of agr eem ent ; al so , t he int ere st pay me n t h a s t o b e mad e w het h er o r n ot t he c o mpan y m ake s pr ofit s . F un d s can al s o b e p r oc ur ed fr o m banks an d financi al i nst it ut i ons , t hey pr o vi d e f un d s s ub j ect t o c ert ain r est rict ive c ov enant s . T h es e co ven an t s re st ri ct fr eed o m o f t he b or ro w er t o rai s e l oan s fr o m ot her s o urc es . Th e re fo rm p ro ce s s i s al s o m ovi n g in dir ect io n of a cl o ser mo nit ori n g o f ' en d us e' of re s o ur ce s m obil ise d t hr o ug h c apit al mark et s . S uch r est ri ct i on s are es se n t i al f o r t he s af e t y of f un d s p ro vid ed by inst it ut i on s an d i n ve s t or s . Th er e a re ot her financi al in st r um ent s u se d fo r raisi ng fi n an ce e .g . co mm erci al pa pe r , d eep di sc o unt b on ds , et c . Th e financ e man a ge r h a s t o b al anc e t he av a ilabilit y o f f und s and t he re st rict i ve p r o vi si o n s t i ed w i t h s u ch f und s re s ult ing in lack of fl exibilit y . I n t h e gl ob al i se d c o mpet it iv e sce nari o , it is n ot en o u g h t o de pen d on av ai l ab l e w a ys of fi n a n ce b ut r es o u rc e m ob ilisat i on is t o b e un dert ak en t h r o ugh i n n o vat i v e w a y s or fi nancial pr od u ct s t ha t ma y me et t he ne ed s o f i n ve st o r s . M ul t i pl e opt i on co nve rt ible b o nd s c an be sight e d as an exa mp l e , f un d s c an b e rai se d in dig en o usl y a s al s o fr o m abr oad . F or eign Di r ect I n ve st men t (F DI ) an d F or ei gn I nst it ut i onal I nve s t or s (FI I ) ar e t w o ma jo r s o urc e s of fi n a n ce f ro m abr oa d al on g w it h Am eric an Dep o si t o r y Re cei p t s ( AD R ' s ) and Gl obal D ep osit or y Rec eipt s (GD R ' s ). The mech an i sm o f p r oc ur i n g f u n d s i s t o b e m o difie d in t he light o f req uir em en t s of f or ei gn i n ve st o rs . Pr oc u re ment o f f u nd s int e r a lia incl u de s : - I dent i f i cat i on o f s o ur ce s o f financ e - Det e rmi n at i on of fi n an ce mi x - R aisin g o f f un d s - Divi si on o f p r ofi t s b et w een divi den ds an d r et ent io n of pr o fit s i .e . int e rnal fu nd ge n er at i on . 2) e f fe ct i ve us e o f s u ch f unds : The fi nan c e man a ge r i s al s o re sp on sibl e f or e ff ect iv e ut ilis at io n o f f und s . He m ust p oi n t o ut si t uat i on s w he re f un ds are kept i dle or ar e u se d impr op erl y . Al l f un d s are p r oc u re d at a c e rt ain c o st and a ft er ent ailing a cert ain am o un t o f ri s k . I f t h e f un ds a re n o t ut ilis ed in t he m ann er s o t hat t hey g en e rat e an i n c om e h i gh er t ha n c o s t of pr o c ure me nt , t h ere i s n o meani n g i n r u n n i n g t h e b u si n es s . I t is an i mp ort ant c on sid er at ion i n divid en d d eci si on s al s o , t h u s , it is cr u cial t o emp lo y f un d s p r op erl y and pro fit ab l y . Th e f un d s are t o be e mpl o ye d i n t he mann er s o t hat t he co mpan y can p r o d u ce at i t s opt im u m l ev el w it ho ut enda ng eri ng it s financi al s ol v en c y . T h u s , fi n ancial impli c at ion s of e ach de cisi on t o i nv est in fix ed a ss et s ar e t o b e p r op erl y anal y se d . F o r t hi s , t h e f inan ce mana ge r m ust p o s se ss so u n d k n ow l e dg e of t echni q ue s o f capit al b udg e t ing and m ust k ee p i n vi ew t h e n eed of ad eq uat e w orkin g c apit al an d ens u re t hat w hile fi rm s en j o y an op t i m u m l ev el of w o r king c apit al t he y d o not k eep t oo m u ch f un d s b l o c ked i n i n vent ori e s , b o ok debt s , ca sh , et c . Fix ed a ss et s ar e t o fi n an ce d f r om m edi um or lo ng t erm f un ds , a nd not sh ort t e rm f un ds , as fi xe d a s set s can n ot b e s old i n sh ort t e rm i .e . w it hin a yea r , al so a l arg e a m o unt of f un ds w o uld b e bl ock ed in st oc k in hand as t h e c omp an y can n ot i mm ediat el y s ell it s fini sh ed g o o ds .

Ques ti on : E xpl ain t h e s c op e o f fi nan ci al man ag em en t ? Ans w er : Sc op e o f f in anc ial man ag em en t : A s o un d fi n a n ci al mana ge ment i s es se nt ial in all t ype o f finan cial or gani sat i on s - w h et h er p r ofi t o rient ed o r not , w he re f und s ar e in v olv ed and als o i n a c en t ral l y p l an n ed ec on o m y as als o in a ca pit alist s et - up . Fir ms , a s p e r t h e c o mm erci al hi st o r y , ha ve not l iq uidat e d b e ca us e t hei r t echn ol o g y w a s ob s ol et e or t heir pr o d uc t s ha d n o o r l ow d em and o r d u e t o an y ot h er fa ct o r , b ut d ue t o l ack o f fin ancial man age me nt . E ve n in bo om p eri od , w h e n a c om p an y mak es hi gh p ro fit s , t he re is d ange r o f liqui dat i o n , d ue t o b ad fi n anci al mana ge ment . T he main ca u s e of liqui dat i o n of s u ch c om p an i es is ov er - t ra ding o r o ver - exp andi ng w it ho ut an a deq uat e fi n an ci al b a se . Fi n an ci al man age ment opt im is es t he o ut p ut f r om t h e g iven inp ut of fu nd s a n d at t emp t s t o u se t he f un ds in a mo st p r od uct iv e ma nner . I n a co unt r y l i ke I n di a , w h er e r e so u rc es ar e s carc e an d de man d on f un ds ar e man y , t h e n e ed f or p ro p e r fi nanci al man age ment i s en or m o u s . I f pr op er t echniq ue s ar e u se d mo st of t he ent e rpri s es can r ed uc e t hei r capit al empl o y ed an d i mp r o ve ret urn on i nv est m ent . Th u s , as m en an d m achin e are pr op erl y ma n ag ed , fi n anc es ar e als o t o b e w el l m ana ged . I n n ew l y st a rt ed c omp anie s , it is im p ort ant t o h av e s o und fina ncial mana ge men t , a s i t e n s ur es t heir s urv ival , oft e n s uch c omp ani es ign or e s financi al man a ge me n t at t h eir ow n pe ril . E ven a sim ple act , lik e dep o si t i n g t h e ch eq ue s o n t he da y of t h eir rec eipt i s n ot p er f or me d . S u ch or gani sat i on s p a y h e av y i n t e re st ch ar ge s on b orr ow e d f und s , but a re t ard y in r eal i si n g t h ei r ow n d ebt o r s . Thi s i s du e t o t he f act t he y lack reali sat i on o f t h e c o n cep t of t ime v al ue of m on e y , it is n ot a ppre ciat ed t hat eac h val u e o f r up ee h a s t o b e mad e u se o f and t hat it h as a di re ct co st of ut i l i sat i on . I t m ust b e reali s ed t hat ke eping r up ee idl e ev en fo r a da y , re s ul t s i n t o l os s e s . A n on - p r ofit or gani sat io n ma y n ot b e ke en t o make p r o fi t , t ra di t i o n al l y , b ut it d oe s ne e d t o c ut d ow n it s c o s t and u se t he f un ds at i t s di sp o sal t o t he ir opt i m um capacit y . A s o und s e nse of financi al man a ge me n t h as t o be c ult ivat ed am on g o ur b ur ea uc rat s , admini st rat or s , en gi n eer s , e d ucat i oni st s a nd p ubli c at l arg e . U nles s t hi s i s don e , c ol o ss al w ast a ge o f t he capit al r es o ur ce s c ann ot b e a rr est e d .

Ques ti on : W hat ar e t he o bj e ct i ves of fin a nci al m ana ge m ent ? Ans w er : Obje ct i ves of fin an ci al ma nag e me nt : E f fi ci e n t fi n an ci al man age me nt req uir e s exi st enc e of s o me obj ect i v es or g oal s b eca u se j ud gm ent a s t o w het he r or n ot a f inancial deci si on i s ef fi ci en t i s t o b e mad e in light o f s om e ob ject iv e . T he t w o main obj ect i v es of fi n an ci al ma n ag em ent a re :

1) Pr o fi t Ma xi mis ati o n : I t is t radi t i o n al l y b ei n g ar g ue d , t hat t he o bject iv e o f a c om pa ny is t o ea rn pro fit , h en c e t h e ob j ect i ve of fin ancial m anag em ent is pr o fit maxi mi s at i on . Th u s , e ach al t e rnat iv e , is t o be s een b y t h e f ina nce mana ge r f r om t h e vi ew p oi n t of pr o fit ma ximi sat ion . B ut , it ca nnot b e t h e onl y o b je ct i ve of a c om p an y , it i s at b e st a limit e d obj ect iv e e lse a nu mbe r o f p ro b l e ms w ou l d ari se . S om e o f t hem ar e : a ) T he t erm p r o fi t i s va g ue and d o es n ot clari f y w hat exa ct ly it mean s . I t con ve y s di f fe ren t me an i n g t o dif fe rent p e opl e . b) Pr ofi t maxi mi sat i on h a s t o b e at t em p t ed w it h a rea lisat i on o f risk s inv olv ed . Th e re i s di r ect r el at io n b et w een ri sk a nd pr ofit ; high er t h e ri sk , highe r i s t h e p r o fi t . F or ma xi mi sin g p r ofit , risk is alt oget h er ign or ed , impl yin g t h at fi n an c e m an a ger ac cept s highl y risk y pr o po sal s als o . Pra c t ical l y , ri sk i s a v er y i mp ort ant fact or t o b e bal anc ed w it h pro fit obj ect i v e . c ) P r ofi t maxi mi s at i on i s an ob je ct ive n o t t aking int o a cc o unt t he t im e pat t ern of r et u rn s . E .g . P r op os al X gi v e s ret urn s high er t han t hat b y p ro p os al Y b u t , t h e t im e peri od i s sa y , 1 0 y ear s a n d 7 y ear s re sp ec t ivel y . Th u s , t he o ve r all pr o fit is onl y c on si de re d n ot t h e t i me pe ri od , n or t he fl ow of pr o fit . d ) P r ofi t maxi mi sat i on as an obj ect ive is t o o n arr ow , it fa ils t o t ak e int o acc o un t t h e s oci al c on si d erat i on s a nd ob lig at ion s t o va rio u s in t ere st s o f w ork er s , c on s u me r s , s oci et y , a s w ell a s et hical t ra de pr act ice s . I gno ring t hese f act o rs , a c o m p an y c ann ot s u rvi ve fo r l on g . P ro fit m axi misat i on at t he c ost o f s oci al an d m o ral obli gat i ons i s a s h ort sight e d p oli cy . 2) W eal t h m a xi mis a ti on : Th e c omp a n i es h a ving pr o fit ma ximi sat ion a s it s obj e ct ive , ma y ad opt p ol i ci es yi el di n g e x orbit ant p r ofit s in t he sh ort r un w hic h ar e unh eal t h y f or t h e gr o w t h , s ur viv al an d o v erall int er est s o f t he bu sin es s . A co mpan y ma y n ot u n dert ak e plann ed a nd p re scri be d sh ut - d ow ns of t he plant f or m ai n t en an ce , an d so on f or ma ximi sing pr o fit s in t he sh o rt r un . Th u s , t h e ob j ect i v e o f a fi r m sh o ul d b e t o maxi mis e it s v al ue or w ealt h . Acc or di n g t o V a n H o rne , "V al u e of a fir m i s re pre s ent ed b y t he mark et p ri ce o f t h e co mp an y ' s c o mm on st oc k .... ...t h e mark et pric e o f a firm ' s st o ck rep re se n t s t h e f oc al j u dg ment o f al l m ark et pa rt icipant s as t o w hat t h e val u e o f t h e p a rt i c ular fi rm is . I t t ake s int o a cc o unt pre sent as als o p r os p ect i v e f ut u re ear n ing s p er s har e , t he t i ming and ri sk of t he se earnin g , t h e di vi den d p ol i c y of t h e fir m a nd m an y ot he r fact o rs havi ng a beari ng on t h e ma rk et p ri c e o f st oc k . Th e ma rket p ric e se rv es as a per fo rm an c e i n dex o r r ep ort c ar d of t he f irm 's pr o gr es s . I t indi cat es h ow w ell man ag em en t i s doi n g on be half of st ockh ol de rs ." Sh are pr ices in t h e sha re ma rket , at a gi ven p oi nt of t ime , a r e t he re s ult o f a mixt ur e o f man y fact o r s , as g en e ral e con o mi c o ut l o ok , pa rt icul ar o ut l o ok o f t h e co mpan i es un d er c o n si d erat i on , t ech nic al fa ct o rs an d e ve n mas s ps ych ol o g y , b ut , t ak en on a l on g t e rm b asi s , t h e y re flect t he val ue , w hich vari o u s p art i e s , p ut o n t h e c o mpan y .

N or mal l y t h i s val u e i s a f un ct io n , o f : - t he lik el y rat e o f ea rn i n g s p er s har e o f t h e c o mpan y ; an d - t he c ap i t al i s at i on r at e . Th e l i kel y r at e of ea rnin gs pe r sha re (E P S ) de pen ds up on t h e as se s sm en t a s t o t h e p r ofi t abl y a c omp a ny is g oin g t o ope rat e in t h e fut ur e o r w h at i t i s l i k el y t o e arn aga inst e ach of it s o rdin ar y sh are s . Th e ca p i t al i s at i on rat e re fle ct s t h e likin g o f t he inv est or s o f a co mpan y . I f a c o mp an y e arn s a hi gh r at e of ea rnin gs pe r sha re t hr o u gh it s ri sk y op er at i on s o r ri sk y fi nanci ng pat t e rn , t h e in ve st o rs w ill not l o ok up on it s sh a re w i t h f av o ur . T o t hat ext ent , t he m a rket val u e of t he sha re s of s u ch a c o mp an y w i l l b e l ow . An eas y w ay t o det e rmin e t h e capit al i s at i on rat e i s t o st art w it h fix ed d e po sit int er e st rat e of banks , inve st o r w o ul d w an t a h i gh er r et u rn i f h e i nve st s in sha re s , a s t he ri sk incre as es . How m uch h i gh er ret urn i s exp e ct ed , de pen ds on t h e ri sk s inv olv ed i n t h e p a rt i cul ar sh a re w hich i n t urn de pen ds on co mpan y polici e s , p a st re c ord s , t yp e o f b u sin es s a nd c on fid enc e c o m mand ed b y t he ma n ag em en t . Th u s , cap i t ali sat i on rat e i s t he c um ul at ive r es ult o f t he a s se s sm en t of t h e va ri o u s sh are ho lde r s r e gar ding t h e risk an d ot he r qualit at i v e fact or s o f a c o mpan y . I f a c o mpan y inv est s it s f un ds in risk y vent ur es , t h e i n v e st o rs w i l l p ut in t h eir m o ne y i f t he y g et high e r r et u rn as co mpa red t o t h at f r om a l ow ri sk sha re . Th e m ark et v al u e o f a s har e i s t h u s , a f unct i on o f e arni ngs pe r sha re an d cap i t al i sa t i on r at e . Sinc e t he pro fit m axi mis at ion c rit eria cann ot b e ap p l i ed i n re al w orld sit uat i on s b eca u se of it s t e ch nical limit at ion t h e fi n an c e m an a ger of a co m pan y ha s t o en s ur e t hat his deci si on s a re s u ch t h at t h e m ark et va l ue of t he sh are s o f t h e co mpan y is maxi m um i n t h e l on g r un . Th i s im plie s t hat t he financi al p olic y has t o be s uch t h at i t o p t i mi s e s t h e E P S , ke eping in view t he ri sk and ot her fact or s . Th u s , w eal t h m axi mi s at i on i s a b et t er ob je ct ive f or a c o mm erci al un dert ak i n g as c om p are d t o r et urn and risk . Th e re i s a gr ow i n g em pha sis on s ocial an d ot he r obli g at ion s of an ent erp ri s e . I t can n ot b e den i ed t hat in t h e ca s e of und ert akin gs , esp ecial l y t h o s e i n t h e p ub l i c sect or , t he qu est i on o f w e alt h m aximi sat i on is t o b e se en i n c on t ext of s oci al a nd ot h er obli gat i ons of t he ent erp ris e . I t m ust b e un der st o o d t hat finan ci al d eci sio n makin g i s rel at ed t o t he ob je ct i ve s o f t h e b usi n e ss . Th e financ e m ana ger ha s t o en s ur e t hat t here is a p o si t i v e i m p act of ea ch financi al d eci sio n on t he f u rt heran ce of t he b u si n e s s ob j ect i v es . On e of t he main obj ect iv e o f an und e rt aking ma y be t o " p r ogr e ssi vel y b ui l d up t he capabili t y t o und ert ak e t h e de sign a nd dev el op men t o f ai rcr aft en gine s , h elic opt er s , et c ." A financ e mana ge r in s uch ca se s w i l l al l oc at e f un d s in a w a y t h at t his obj ect iv e i s a chiev ed alt ho ugh s uch an a l l ocat i on ma y n ot ne c es sa ril y m axi mis e w e alt h.

Ques ti on : W hat ar e t he f un cti ons of a F in anc e Ma nag er ? Ans w er :

Fun cti ons of a F ina nc e Man ag er : Th e t w i n as p ect s , p ro c ur em ent and ef fe ct ive ut ilisat ion o f f und s are cr uci al t a sk s f ac ed b y a fin ance m an age r . Th e finan cial mana ge r i s req uir ed t o l o ok i n t o t h e fi n ancial impli ca t ions of an y de cisi on in t he fi rm . Th u s all d eci si on s i n v ol v e man age me nt o f f und s und er t h e p u r view of t he financ e man a ge r . A l arg e n u mbe r o f d eci si ons in vol ve s ubst an t ial o r mat eri al ch an g es i n val ue of f un ds pr oc u red or em pl o yed . Th e fi nanc e mana ge r , h as t o ma n age f un d s in s uc h a w ay s o a s t o m ake t heir opt im u m ut i l i s at i on a n d t o e ns u re t heir pr oc u re ment in a w a y t hat t he risk , c o st an d c on t r ol ar e p ro pe rl y bal anc ed un de r a gi ven sit uat i on . He ma y n ot , b e c on c ern ed w i t h t he d eci si ons , t hat d o n ot af fe c t t he b asic financi al man a ge me n t an d st r uct ur e . Th e n at ure of j ob o f an a cc o unt ant and fin anc e m a nage r i s diff er en t , an a cc o un t an t 's j ob i s prim aril y t o r ec or d t he b u sine ss t ransa ct i on s , p r ep a r e fi n an ci al st at em en t s s how in g r e s ult s o f t he or gani sat i on f or a gi ven p e ri od and it s fi nancial c ondit i on at a gi ven point o f t i m e . He i s t o rec o rd va ri o us hap pening s in m onet ar y t erm s t o ens u re t h at a ss et s , l i ab i l i t i es , in co me s an d e xpe ns es ar e pr op erl y gr o upe d , cl a s si fi ed a n d di scl o se d in t he fi nancial st at e ment s . Ac c o u nt ant is n ot c on ce rn e d w i t h man ag em ent of f u nds t hat is a sp eciali se d t a sk a nd in m od ern t i me s a c o mp l e x on e . Th e finan ce mana ge r or c ont r olle r h as a t ask en t i rel y di ff er en t fr om t hat of an acc o unt ant , he is t o ma nage f un d s . S om e o f t h e i mp o rt an t deci si on s a s re ga r ds fina nce ar e as f oll ow s : 1) Es ti mat ing t he r eq uir e m ents of fun ds : A b u sin e ss r eq uir es f un ds f or l ong t erm p urp o se s i .e . i n ve st men t i n fixe d a s s et s a nd s o on . A ca r ef ul e st imat e of s u ch f un d s i s re q ui red t o be ma de . An as se s sm ent ha s t o b e ma de reg ardi n g req ui re me n t s of w o rking capit a l inv ol ving , e st im at io n o f am o unt of f un d s b l oc ked i n c ur ren t as s et s and t ha t likel y t o b e gen erat ed f or sh ort p eri o ds t h r o ug h c ur ren t li abilit ie s . F or eca st ing t he req ui r eme nt s o f fu nd s i s d on e b y u se of t ech ni q ue s o f b u d get ar y c ont r ol a nd l ong r ang e p l a n n i n g . E st i m at e s of r eq ui r em en t s of f u n d s c a n b e m a d e on l y i f a l l t h e phy sic al a ct i vi t i es of t h e org anis at ion ar e fo re ca st ed . The y ca n be t ranslat e d i n t o m on e t ary t er ms . 2) D e cis i on r egar din g cap ita l s tr u ctur e : Onc e t he r eq uir em e nt s of f un ds i s est im at ed , a de ci si o n re ga rdin g v ari o u s s o ur ce s fr om w he re t h e f u nd s w ou ld b e rai se d i s t o b e t ak en . A pr op er mix o f t he v ari o u s s o ur ce s i s t o be w ork ed o ut , e ach s o ur ce o f f und s inv o lve s dif fer ent i ss u e s f or con sid er at i on . Th e fi n an ce m anag er ha s t o ca re f ull y l o ok int o t he exi st ing capit al st r uct u re an d s ee h ow t he vari o u s pro p os als of rai sing f un ds w ill aff ect i t . He i s t o mai n t ai n a p r ope r b alan ce b et w een lo ng an d sh ort t er m fu nd s a n d t o en s ur e t h at s uf ficie nt l ong - t erm f un d s a re rai se d in o rd er t o financ e fi x ed as s et s an d ot h e r l on g - t er m inve st me nt s and t o p ro vid e f or per man en t n e ed s o f w orki n g c apit al . I n t he ov er all v ol um e of lon g - t er m fu nd s , h e i s t o mai n t ai n a p r op er balan c e b et w een ow n and loan f un d s and t o se e t h at t h e ov er al l c apit alis at ion o f t he c o mpan y is s uch , t hat t he co mpan y i s ab l e t o p ro c ur e f und s at min im um c ost and is abl e t o t ol erat e sh ock s o f l ean p er i o ds . Al l t h es e deci si on s a re kn ow n a s ' finan cing deci si on s' .

3) I n ves tm en t de cis i on : F un d s pr oc u red fr om di ff er ent s o u rce s h av e t o b e inve st ed i n va ri o u s ki n ds of as s et s . Lo ng t erm f un d s a re us ed i n a p r oje ct fo r fix ed an d al s o c u rren t as s et s . T he inv e st ment o f f und s i n a pro ject i s t o be mad e a ft er ca re f ul as s es sm ent of v ari o u s p ro j ect s t hr o u gh capit al bu dg et i n g . A p a rt of l on g t e rm f un ds i s al s o t o b e k ept f o r fina ncing w orkin g c ap i t al r eq u i rem en t s . As s et m an age ment p oli cie s ar e t o be lai d dow n re gar di n g v ari o u s i t e ms of c ur rent as set s , in ve nt or y p oli cy is t o be det er mi n ed b y t h e p r o d uct i o n an d finan ce mana ge r , w hil e k eepin g in mind t h e req ui re men t of p r o d uct io n an d f ut ure pri ce e st imat e s o f raw mat eri al s an d a vai l a b i l i t y o f f und s . 4) D i vid en d de cis io n : Th e fi nan ce man ag er i s c once rn ed w it h t he deci si on t o p a y or d ecl ar e divi den d . He i s t o a s sist t h e t o p ma nage ment in d eci di n g a s t o w h at am o unt of di vid en d sh o uld be paid t o t he sha reh ol der s an d w h at am o unt b e ret ain ed b y t he c omp an y , it inv olv es a larg e n u mb e r o f c on si d erat i on s . E c on omi call y spe aking , t he a mo u nt t o be ret aine d o r b e p a i d t o t h e shar eh old er s s ho ul d d ep end o n w h et her t he co mpan y or sh are h ol der s can mak e a mo re p r ofit abl e u se of r es o ur ce s , als o co n si de rat i o n s l i ke t r en d o f ea rning s , t he t r end o f sha re m arket price s , r eq ui r em en t of f un d s f o r f ut u re gr ow t h , c ash fl ow sit ua t ion , t a x po sit ion of s h ar e h ol der s , an d s o on t o b e k ept in mind . Th e p ri n ci p al f un ct i on of a finan ce mana ge r r elat e s t o dec isi on s reg ardi n g p r oc u re m en t , i n ve st m ent and divid end s . 5) S upp ly of fun ds to all par ts o f th e or g an is ati on or cas h ma na ge me nt : The fi nan c e man a ge r h a s t o en s ure t hat all s ect i ons i .e . bra n che s , fact o ri e s , un i t s or de p art me nt s o f t he org anisat i on ar e s uppli e d w it h adeq u at e f un d s . Sec t i on s h a ving e xce s s f un ds c ont rib ut e t o t he c ent ral po ol f or us e i n ot h er sect i on s t hat n ee ds f un ds . An ad eq uat e s uppl y of cash at al l p oi n t s of t i me i s a bs ol ut el y e s s ent ial f o r t he s m o ot h fl ow of bu sin es s op er at i on s . E ven i f o ne o f t h e m any br anch es i s sh ort o f f und s , t he w h ol e b us i n e s s ma y b e i n d ang er , t h u s , ca sh mana ge me nt and ca sh disb u rs em en t p ol i ci e s a re i mp o rt ant w it h a vi ew t o s up pl ying adeq u at e fu nd s at al l t i m es an d p oi n t s in an or gani sat io n . I t sh o ul d en s u re t hat t h ere is n o ex ce s si v e ca sh . 6) E v alu ati ng f ina nc i al per f or m an ce : M a nage ment c ont r ol s y st em s ar e u s uall y b a sed on fi n an ci al anal y sis , e .g . R OI (ret urn on in ve st ment ) s y st em of di visi o n al co n t rol . A f i n an ce ma nag er has t o c onst ant l y re v iew t he financi al p er f orm an c e of va ri o u s unit s of t he or gani sat i on . Ana ly sis of t he financi al p er f orm an c e h el p s t he man ag e ment f or as se s sing h ow t he f un ds are ut il i se d i n v ari o u s di vi si on s and w hat c an b e d on e t o i mpr o ve it . 7) Fi nan ci al n eg oti at ions : Fi na nce m ana ger ' s maj o r t im e i s ut i lise d in carr yi n g o ut n eg ot i a t i on s w i t h fina ncial in st it ut io ns , ba nks an d publi c dep o si t o rs . H e h as t o f urn i sh a l ot o f in f or mat ion t o t he se inst it ut io ns an d per s on s i n o rd er t o e n s ur e t h at rais ing o f f un ds is w it hin t he st a t ut es . Ne g ot iat i on s f or o ut s i de fi n an cing oft en r eq uir es s peci alis ed s kills .

8) Ke ep ing i n to uc h wi th s t oc k e x ch ang e qu ot ati ons a nd b eh av ior of s har e pr ic es : I t i n v ol ve s a n al y sis of maj o r t rend s in t he st ock mark et an d ju dgin g t h ei r i mp act on sh are pri ce s o f t h e c o mpan y ' s sha re s .

Ques ti on : W hat ar e t he var i ous me th ods and t oo ls us e d f or fi n anc ial man ag em en t ? Ans w er : Fi n an ce ma n age r u se s va ri o us t o ol s t o di sch ar ge his f unct i on s a s reg ard s fi n a n ci al ma n age ment . I n t he ar ea o f fi nanci ng t h er e a re va ri o us met h od s t o p r oc ur e f un ds f ro m l on g as al s o sh ort t erm so u rc es . Th e financ e man a ge r h a s t o d eci de an opt i m u m ca pit al st r uct u re t hat can cont rib ut e t o t h e ma xi mi sat i on of s har eh o lder ' s w e alt h . Fina nci al le ve rag e or t radi n g on e q ui t y i s a n i m p ort ant m et h od b y w hic h a fin an ce mana ge r ma y in cr eas e t h e r et ur n t o c o mm on sh ar eh old er s . F or e val uat i on o f capit al p r op o s als , t he fina nce ma n age r u se s capit al b u dget i n g t e ch n i q ue s as pa yb ac k , int e rnal rat e of ret ur n , net pre sen t val u e , p r o fi t ab i l i t y i nd ex , a ver ag e r at e of r et u rn . I n t he a rea of cu rr ent a ss et s man a gem en t , he us es m et hod s t o che ck ef fici ent ut ilisat i on of c ur re n t r es o u rc es at t h e ent er pri se ' s di sp os al . An ent erp ri se can incre as e i t s p r o fi t ab i l i t y w i t h o ut af fect ing it s liq uidit y b y an e ffi cient mana ge men t o f w or ki n g c apit al . F o r in st ance , in t he a re a of w orkin g capit al m an a ge men t , ca sh mana ge ment ma y be ce nt r ali sed or d e cent ral i se d ; ce n t ral i s ed met h od i s c on sid ere d a b et t er t ool of man agin g t he ent e rp ri s e' s l i q ui d r es o u rce s . I n t he ar ea o f di vid end d eci si on s , a fir m is fac ed w i t h t h e p r o b l em of de clar at ion or p ost p onin g decl ar at ion o f divid en d , a p ro b l e m of i n t er nal finan cing . F or e val uat i on o f an ent erp ri se ' s per f or manc e , t her e are va ri o us met h od s , a s r at i o an al y si s . Thi s t echniq u e is us ed b y all c onc e rned per s on s . Di f fe ren t rat i o s se rvi n g dif fer ent obj ect iv es . An inv e st or us e s vari o u s rat i o s t o ev al uat e t h e pr ofit abilit y o f inv e st ment in a part ic ular co mpan y . Th e y e n ab l e t h e i nv est or , t o j u dge t he pr ofit abilit y , s ol venc y , liqui dit y an d g r ow t h asp ect s o f t h e f irm . A s h o rt - t erm cr edit or is m or e int ere st ed i n t h e l i q ui di t y as pect o f t he fi r m , an d it is p os sibl e by a st ud y of liq ui di t y rat i os - c u rren t rat i o , q uick rat i o s , et c . T he main c o ncern of a financ e man a ge r i s t o p r ovi de ad eq uat e fu nd s fr om b est p o s si ble s o urc e , at t he ri gh t t i me an d at mi n i m um c o st an d t o en s ur e t hat t h e fu nd s s o acq uir ed ar e p ut t o b est p o s sibl e u se . F u nds fl ow a nd ca sh fl ow st at em en t s an d p r oj ect ed fi n ancial st at e ment s he lp a l ot in t his re gar d .

Ques ti on : Dis cus s th e r ol e o f a f ina nc e m anag er ? Ans w er : I n t h e mo d ern en t e rpri se , a fi na nce man age r oc c upi es a k e y po sit ion , h e b ei n g on e of t h e d yna mic me mbe r of c or po rat e m anag erial t eam . Hi s r ol e , i s b e c omi n g m or e a nd m or e p er vasi ve an d sign ificant in s olvin g c o mp l e x man age ri al p r oble m s . T ra dit ionall y , t he r ol e o f a financ e

mana ge r w as c on fi n ed t o rai sing f un ds f r om a n umb er of s o ur ces , b ut d ue t o r ec en t d ev el op m en t s i n t he s oci o - ec o no mic and p olit ical s cena rio t hro ug h o ut t h e w orl d , h e i s pla ce d in a c ent ral po sit i on in t he or gani sat i on . He i s r e sp on si b le f o r shapin g t he fo rt u ne s o f t he e nt erpri se and i s i n v ol ved i n t h e m o st vit al d eci si on o f al lo cat io n of ca p it al like mer ge rs , a cq ui si t i on s , et c . A finan ce ma n age r , as ot her m emb er s of t he co rp orat e t ea m c an n ot b e a ve rs e t o t h e fast de vel op me nt s , a ro un d hi m a n d h as t o t ake n ot e o f t h e ch ang es in o r der t o t ake rel ev ant st ep s in view of t h e d yn a mi c ch an g es in circ u m st ance s . E .g . int r o d uct ion o f E u r o as a sin gl e c u rr en c y of E ur op e i s an int e r nat ional le vel cha ng e , h avin g impact on t h e co rp o rat e fi n anc ial pl an s a nd p oli cie s w orl d - w ide . D om e st i c d ev el o p m ent s as e me rgen ce of fina ncial s ervi ce s sect or s an d SE B I as a w at ch d og f o r in ve s t or p r ot ect i on a nd re gul at ing bo d y of cap i t al ma rk et s i s co nt rib ut ing t o t he imp o rt ance of t he fi nanc e mana ge r' s j ob . B a n k s an d fi n ancial in st it ut ion s w e re t he maj o r s o ur ce s o f financ e , m on op ol y w as t h e st at e of a ffai r s of I ndian b usi ne ss , sha reh ol der s sat i sfa c t i on w a s n ot t he pr o mot e r 's c onc ern a s mo st of t he co mpan i es , w e re cl o sel y h el d . D ue t o t he op enin g o f e c on om y , co mpet i t i o n i n c re as ed , s el l e r 's m ark et is being c on vert e d int o b u yer ' s mark et . De vel op men t of i n t er net h as br o u ght new c halle nge s bef or e t h e mana ge rs . I n di an c o n cern s n o l on ger ha v e t o c om pet e onl y n at ionall y , it is facin g i n t e rn at i on al c om p et it ion . Th u s a ne w era i s u she re d d urin g t he rec ent ye ar s , i n fi n a n ci al mana ge ment , s peciall y , w it h t he de vel op ment of fin an ci al t o ol s , t e ch n i q ue s , in st r um ent s a nd pr od u ct s . Als o du e t o incre asi n g emp h a si s on p ub l ic s ect o r un d ert aking s t o be s elf - s upp o rt ing and t he i r dep en den ce on capit al ma rket f or f un d req ui re men t s an d t he incre asi n g si g n i fi c an ce o f l i b erali sat i on , glo balis at ion an d de reg ul at ion .

Ques ti on : Dr a w a t y pic al or gan is at io n c har t hi ghl igh tin g th e fin an ce fun ct io n o f a c om pa ny ? Ans w er : Th e fi n an ce f un ct i on i s t h e sa me in all ent e rpri s es , de t ails m a y diff er , b ut maj o r feat ur e s a re univ er sal in nat ur e . The fin ance f unct i on occ u pi e s a si gn i fi ca n t p o si t i o n in an o rg anisat i on and is n ot t he re sp on si b i l i t y of a s ol e e xec ut i ve . The imp ort ant asp ect s of fin ance mana ge r a re t o car ri ed on b y t op man ag eme nt i .e . man agin g dir ect o r , chair man , b oa rd o f di re ct or s . The b oa rd of di rect or s t ak e s d e cisi on s inv olvin g fi n an c i al c on si d erat i on s , t he fin ancial c ont r olle r i s b asica ll y meant f or a ssi st i n g t h e t op mana ge ment and ha s a n i mp ort a nt rol e o f cont rib ut i n g t o g o o d de ci si on m aking on iss u e s in v olvin g all f u nct ional area s o f b usi n e ss . H e i s t o b rin g o ut fi nan cial im plicat i on s of a ll de cisi on s and mak e t h e m un d er st o od . H e ma y be called a s t he fi nanci al c ont r olle r , vice- p re si d en t (f i n an ce ) , ch i ef acc o unt a nt , t rea s ur er , or b y a ny ot h er de signat i on , b ut h as t h e p ri mar y r es p onsi bilit y o f p er f ormi ng fi nance fu nct io n s . H e i s t o di s ch arg e t h e r e sp on sib ilit y k eepi ng i n v iew t he ov er all o ut lo ok of t h e o rgan i sat i o n . BO A RD O F D IR EC TO RS P RE SI DE N T

V .P .(P r o d uct i on )

V .P .(F in anc e )

V .P .(S a le s )

Tr ea s ur er

C ont r oll er

Cr edit M gmt .

Ca sh M gmt .

B an ki n g rel at i on s

P ort f oli o M gmt .

C or po rat e G ene ral & C o st Ac c o u nt ing

Tax e s

I nt ernal Au dit

Bu dg et ing

Or ga nis a ti on c har t of fin an ce fun ct io n The Ch i ef fi n a n ce e x ec ut i ve w o rk s di re ct ly u nd er t h e Pr esi den t or M anagi n g Di re ct or o f t h e c omp an y . Be sid es r o ut ine w or k , he k eep s t he Boa rd i n f o rm ed ab o ut al l p h a se s o f b usin es s act ivit y , i ncl usi ve o f ec on omi c , s oci al an d p ol i t i cal de vel o pm ent s af fect ing t he b u sine s s beha vi o ur an d f ro m t i me t o t ime f u rni she s in f or mat io n ab o ut t he financi al st at u s o f t h e c omp a n y . Hi s f unct i on s a re : (i ) T rea s ur y f u nct ion s a nd (ii ) C ont r ol f un ct i on s . Re lat io ns hi p B et w ee n fin an cia l ma nag e me nt an d ot her ar ea s o f man ag em en t : Th er e i s cl o se r elat i ons hip bet w een t h e a rea s o f fi nanci al and ot h e r man a ge m en t l i ke pr o d uct io n , s ales , mar ket ing , p er s onn el , et c . Al l act i vi t i e s di r ect l y or i n di rect l y inv ol ve acq uisit i on and us e of f un d s . Det er mi n at i on o f p r o du ct i on , p r oc ur em en t and mar ket ing st r at egie s ar e t he imp o rt an t p r er og at i ve s of t he re sp ect i ve de part m ent h ead s , b ut fo r imple men t i n g , t h ei r deci si on s f und s a re r eq uir ed . Like , repl ac eme nt of fixe d a s set s f o r i mp r o vi n g p r od u ct ion cap acit y re q uir es f un ds . Simil arl y , t he p urc h a se a n d s al es p r o mot i on p olicie s a re laid d ow n b y t h e p ur cha se and mar ket i n g di vi si on s re sp e ct ivel y , b ut agai n p ro c ur em ent of raw mat eri al s , a dv ert i si n g an d ot he r sale s pr om ot i on req ui re f un d s . Sa me i s fo r , r ecr ui t m en t an d p ro m ot i o n of st a ff b y t he p er s onn el d epa r t ment w ou ld req ui re f un d s f or p a y ment o f sala ri es , w ag es an d ot he r bene fit s . I t ma y , ma n y t i m es , b e di f fi c ul t t o d em arc a t e w her e on e fu nct io n en ds an d ot he r st art s . Al t h o ug h , fi n an c e f unct i on h as a signi fica nt impa ct on t he ot he r f u n ct i o n s , i t n e ed n ot l i mit or obst r u ct t he g ene ral f unct i on s o f t he bu sin es s . A fi r m f aci n g fi n an cial di ffi c ult ie s , ma y gi ve w eight a ge t o financi al c on si der at i on s a n d de vi se it s o w n pr od uct i on and mark et ing st rat egi e s t o s ui t t h e si t u at i on . W hile a fir m ha ving s urpl u s fina nce , w o ul d have c o mp ar at i vel y l ow er ri gidit y a s re ga rd s t he fin ancial c on sid erat i on s vis- a - vi s ot h e r f un ct i on s o f t h e ma nag em ent . P er vas i v e Nat ur e of F inan c e Fun ct io n : Fin ance is t he li fe bl o o d of of an or gani sat i on , i t i s t h e c om mo n t hr ead bin ding all or g ani sat i on al f un ct ion s . Thi s int e rf ace can b e exp l ai ne d a s bel ow :

* Pr o du cti on - F ina nc e : P r od uct i on f unct i on re q uire s a l arg e i nve st me nt . Pr od u ct i ve us e o f r e s o ur ce s ens u re s a c o s t adva nt age f o r t he firm . Opt im u m i n ve st me n t i n i n vent ori es im pr o ve s p r of it mar gin s . M any para met e rs of p r od u ct i on h av e a n i mpac t on c ost and can p o ssi bl y b e cont r ol l ed t h r o ugh i n t ern al man age me nt , t hu s enhan cing pr o f it s . I mport an t p r od uct i o n de ci si o ns like ma k e or b u y c an b e t ak e n o nl y a ft er t he fin an ci al i mp l i ca t i on s ar e co ns i de re d . * Mar k eti ng - Fi nan c e : V ari o u s a sp ect s o f m ark et ing man age ment h av e financi al i mp l i cat i on s , de ci si on s t o h old i nvent ori es on l arg e s cale t o pro vid e o ff t h e sh el f se rvi c e t o c u st om er s incre as es in vent or y h oldi ng co st and at t h e sa me t i m e m a y i n cre as e sal es , s imila r w it h e xt en si o n o f cr edit facilit y t o c u st o me rs . M ark et ing st rat e gie s t o in cr ea se sal e i n mo st c as es , have a ddi t i o n al co st s t h at a re t o be w eig ht ed c are f ull y agai n st incre men t al r ev en ue b e fo re t aking d eci si on . * Per s on ne l - Fin an c e : I n t h e gl o bali sed co mpet it iv e sce nari o , b u sine s s or gani sat i on s a re m o vi n g t o a flat t er o rga nisat i onal st r uct ur e . I nve st me nt s in h um an r e s o urc e d ev el o p m ent s ar e al s o in cr ea sing . Re st r uc t urin g of rem u ner at i on st r u ct u re , v ol unt a r y r et ire m ent s che me s , sw eat eq uit y , et c . have b ec om e maj or fi n an ci al d eci si on s in t he h u man re s o ur ce mana ge men t .

Ques ti on : Dis cus s s o me of t he i ns ta nc es i ndi cat ing t he cha ngi ng s c enar io of fin an cia l ma nag e me nt in Ind ia ? Ans w er : M ode rn fi n a n ci al mana ge ment h as c om e a l ong w a y fr om t radit ion al c o rp orat e fi n a n ce , t he fin anc e man ag er i s w ork ing in a challen gi n g en vi r on men t t h at i s c hangi n g c ont in u o usl y . D ue t o t h e op enin g of t h e ec on omi e s , gl obal r es o u r ces a re bein g t app e d , t he opp o rt un i t i e s av ai l a b l e t o f i nanc e mana ger s virt uall y ha ve n o li mit s , h e m ust al s o u n d er st an d t h e ri sks ent aili ng all hi s d eci si on s . Fin a ncial mana ge men t i s p as si n g t h r o ug h an e ra o f exp eri me nt at ion an d excit e men t i s a p art o f fi n an ce act ivit ie s now a da y s . A f ew i nst anc es ar e as bel ow : i) I nt ere st rat e s h av e b e en fr eed f r om re g ulat i on , t rea s u r y op e rat ion s t h u s , have t o b e m o re s op h i st i cat ed d u e t o fl u ct uat ing int er est rat es . M ini m um co st of cap i t al n e ce ssi t at e s ant icipat ing int ere st rat e m o ve m ent s . ii) T he r up ee h ad b e co me f ull y c onv ert ibl e on c ur r ent a cc o un t . iii) O pt i m um de b t eq ui t y mi x i s po s sibl e . Fi rm s ha ve t o t ake ad vant ag e o f t he fin an ci al l e ve rag e t o i n c rea s e t he sh a reh old er ' s w e alt h , h o w eve r , u sing fi n an ci al l e ve r age n ec e ss aril y mak es b usi ne ss v ul ner abl e t o financi al ri sk . Fi n d i n g a c o rr ect t rad e o ff bet w een ri sk a nd i m pro v ed ret u rn t o sh a reh ol de r s i s a ch allen ging t as k f or a fina nce ma na ger .

iv ) Wit h fr ee p ri ci n g of i ss u es , t he opt im u m pr ice d et er minat i o n o f new iss u e s i s a da u n t i n g t ask as ov erp ricin g r e s ult s i n un der s ubs cri pt ion and lo ss of i n v est or c on f i den c e , w hile un de r pricing le ad s t o unw arrant ed incre as e i n n um b e r o f sh ar e s t he reb y r ed u cing t he E PS . v ) M ain t ai n i n g sh are p ri ce s i s cr uci al . I n t he lib erali s ed sc ena r io t h e capit al m ark et s i s t h e i m p ort ant a ven u e of f un d s f o r b u sin es s . Divi den d and b o n us p ol i ci e s fr ame d b y fin anc e m a nage rs ha ve a dir ect bea ring on t he sh ar e p ri ce s . vi ) E n s uri n g man a ge men t c ont r ol is vit al esp eciall y in li ght of fo rei gn part icip at i on i n eq u i t y , b a cke d b y h ug e r es o ur ce s makin g t he fir m an eas y t ake o ve r t ar get . E xi st i n g man ag em e nt s mi ght l o se c ont r o l in t he ev ent u al i t y o f b ei n g un a b l e t o t ak e u p sh are ent it lem ent s , fin ancial st rat egi e s , ar e vi t al t o p re ve nt t his . I n a re s o urc es c on st raint sit u at io n , t he imp o rt ance of fina ncial mana g e men t i s h i gh l i gh t ed as fi nancia l st rat egi es ar e req ui re d t o get t he co mpan y t h r o ugh t h e c on st raint s p o sit io n . The r ea s ons f o r it , ma y b e l ack of d em an d , sca rci t y of raw mat e rial s , lab o ur c on st raint s , et c . I f t he pro ble m i s n ot p r op e rl y d eal t w it h at init i al st a ge s , it c o uld le ad ult imat el y t o ban kr up t c y an d si ckn e ss . Th e financ ial man ag er 's r ol e in s u ch sit u at ion s , w o ul d b e fi r st t o as ce rt ain , w h et her und er t h e ci rc u mst anc e s , t he org an i s at i on i s vi ab l e o r n ot . I f t he vi abilit y o f t h e or gani s at ion , it s elf i s in d o ub t , t h en t h e al t ern at i v e of cl o sing dow n o per at ion s m u st be expl or ed . B ut , i n maj or ca se s t he p r oble m can be s ol ve d w it h pro pe r st rat egi e s .

Ques ti on : W hat is t h e r el e va nc e o f ti m e va lu e o f m on ey i n fi n anc ial de cis i on ma kin g ? Ans w er : A fi n an c e man a ge r i s r eq ui red t o m ake d eci si ons o n inv est ment , financi n g an d di vi d e n d i n vi ew of t h e c o mpan y ' s obj ect iv es . The d eci si on s as p urch as e o f a s set s or p r o c ure me nt o f f un ds i .e . t h e inve st me n t /fi n an ci n g de ci si on s af fect t h e cash fl ow in di ff er ent t i me peri od s . Ca sh o ut fl o w s w o ul d b e at on e point o f t im e an d in fl ow at s om e ot he r p oi n t o f t i m e , h en c e , t h e y a re n ot co mpa rable d u e t o t he ch ang e in r up ee val u e o f mo n e y . Th e y can be ma de co mpa rabl e b y in t rod u cing t he int er est fact or . I n t h e t h e o r y of fin an c e , t h e int e re st f act o r is o ne o f t he cr u ci al an d ex cl u si v e c on cept , kn ow n a s t he t ime val u e o f m on e y . Ti me val u e o f m on e y me an s t hat w ort h of a r up ee re c eiv ed t od a y is dif fer en t fr om t h e s ame r ecei ve d in f ut u re . The pr ef er ence f o r m on e y now a s c omp are d t o f ut u re i s kn ow n as t ime pre fe re nce of m on e y . Th e con cep t i s ap p l i c ab l e t o b ot h in divi d ual s and b u sin es s h o us e s . Re as o ns o f ti me pr e f er e nc e o f m on e y : 1) R is k : The re is un c ert ai n t y ab o ut t h e r ec eipt of mo ne y in f ut u re .

2) Pr e f er e nc e f or pr e s ent co ns u mpt io n : M o st o f t h e p er s on s an d co mpa nie s h av e a pr ef er ence f o r p r es ent con s u mp t i on m a y b e d ue t o urg enc y of n eed . 3) I n ves tm en t op por t unit ies : M o st o f t h e p er s on s an d co mpa nie s h av e pr ef er enc e f or pre sent m one y beca u se of av ai l ab i l i t i es o f opp o rt unit ie s of in ve st ment f or ea r ning addit i on al ca sh fl ow s . Im por tan c e o f ti me v alu e o f m on ey : The c on c ep t o f t i m e val ue of m on e y h elp s in ar rivin g at t he c om par able val ue of t h e di f fer en t ru p e e a m o unt ari si ng at dif fe rent p oint s o f t im e int o eq uival en t val ue s o f a p a rt i cul ar p oint of t ime , pre s ent or f ut ur e . Th e c as h flow s a ri si n g at di ff er en t p oi nt s o f t im e ca n be ma de c om par a ble b y usi ng any on e of t h e f ol l o w i n g : - b y c o mp o un di n g t h e p r e sent m one y t o a f ut ur e d at e i .e . b y findin g o ut t he va l u e o f p re se n t mo n e y . - b y di sc o un t i n g t h e fut ur e m one y t o pr e s ent dat e i .e . b y findi ng o ut t he pre sen t val u e (PV ) of fut ur e m one y . 1) T ec hni qu es o f c o mp oun din g : i) F utur e val ue ( F V) o f a s ing le cas h fl o w : The f ut ur e val u e of a si n gl e ca sh fl ow is d efin ed as :

FV = PV (1 + r)n
Wher e , FV = f ut ur e v al u e PV = Pr es en t val ue r = r at e o f i n t e re st p er an n um n = n um b e r of ye ar s fo r w h i ch c om p o und ing i s do ne . I f, an y va ri ab l e i .e . P V , r , n va rie s , t hen F V als o va rie s . I t is ver y t e di o u s t o calc ulat e t h e val ue of

(1 + r)n so di ff ere n t c om b i n at i ons ar e p ub lishe d in t he f or m o f t ables .

The s e ma y b e re fe rr e d f o r c o mp ut at ion , o t herw ise one s h o uld u se t he know le dg e of l oga ri t h ms .

ii) Fut ur e va lu e o f an an nui ty : An ann ui t y i s a se ri e s o f p eri o dic ca sh fl o w s , p a ym ent s o r r ec eipt s , of eq ual am o un t . T h e p remi u m pa ym ent s of a lif e in s ur anc e p olic y , f o r inst anc e a re an an n ui t y . I n gen eral t er ms t he f ut u re val u e o f an ann uit y i s give n a s :

FVAn = A * ([(1 + r)n - 1]/r)

Where,

FVAn =

Future value of an annuity wh ich has duration of n years.

A = Constant periodic flow r = Interest rate per period n = Duration of the annuity Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest and the time period, if any of these variable changes it will change the future value of the annuity . A published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2) T ec hni qu es o f dis c oun tin g : i) Pr es en t v alu e o f a s in gl e cas h fl o w : The pr e sen t val u e of a si n gl e ca sh fl ow i s give n a s :

PV = FVn ( 1 )n
1 + r

Where, FVn = F u t u r e

value n years hence

r = rate of interest per annum n = number of years for which discounting is done. From above, it is clear that present value of a future money depends upon 3 variables i.e. FV , the rate of interest and time period. The published tables for various combinations of

)n

1 + r are available.

ii) Pr es ent va lu e o f a n a nnu it y : S om et ime s i n st e ad o f a si n gl e ca sh fl ow , cash fl ow s of s am e a mo u nt is rec eiv ed f or a n umb er o f y ear s . The pr es ent val u e o f a n an n u it y ma y b e expr e ss ed a s b el ow :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n = A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 + r)n ] = A [ (1 + r)n - 1] r(1 + r)n Where, PVAn = Present value of annuity which has duration of n years
A = Constant periodic flow r = Discount rate.

CH A P TE R O N E

FI N A NC I AL M A N AG E ME NT : A N O V ER V IE W

Ques ti on : W hat d o y ou m ea n by fin an cia l man ag em en t ? Ans w er : Mea nin g o f Fin an cia l Ma nag e me nt : Th e p ri mar y t ask o f a Cha rt er ed Ac c o u nt ant is t o de al w it h fu nd s , 'M an ag em en t o f F un ds ' i s an i mp or t ant asp ect of fin an cial mana ge men t i n a b u si n e s s un de rt aking or an y ot he r in st it ut i on like ho spit al , art s oci et y , an d s o on . Th e t er m ' Finan cial M a nag em e nt ' ha s been d efi n ed di ff er e n t l y b y di ff er ent a ut h or s . Ac c or di n g t o S ol om o n " Finan cial M anag em ent i s c on cern ed w it h t he e ffi ci en t u se of a n i mp o rt ant ec on o mi c r es o u rce , n am el y c apit al fu nd s ." Ph i l l i p p at u s h as gi v en a m or e el a bor at e de finit io n of t he t e rm , a s , "Finan ci al M an ag em en t , i s c on ce rne d w it h t he mana ge rial de cisi on s t hat re s ult s i n t h e ac q ui si t i on an d finan cing of sh o rt an d l on g t e rm cr edit s f or t he fi rm ." Th u s , i t d e al s w i t h t he sit uat i on s t hat r eq ui re s elect i on o f spe cific p r ob l e m of s i ze an d g r ow t h o f a n ent e rpri se . Th e an al y sis of t he se deci si on s i s b as ed o n t h e exp ect ed in fl o w s an d o ut fl ow s o f f un ds an d t heir ef fect on m an a geri al obj ect iv es . Th e m o st ac cept abl e d efinit i on o f financi al man a ge me n t i s t h at giv en b y S .C .K uch hal as , " Fina n cial mana ge men t deal s w i t h p roc u re me nt o f fu nd s a nd t h eir ef fe c t ive ut ilis at i on i n t h e b u si n e s s ." Th u s , t h er e a re 2 basi c a sp ect s of fi nancial mana ge men t : 1) pr oc ur e m ent of fu nds : As f u n d s c an b e o b t aine d f r om di ffe re nt s o u rce s t h u s , t heir pro c ur em en t i s al w a y s c on si der ed a s a c om plex pr o ble m b y bu sin es s con cer n s . Th es e f un d s p r oc u r ed fr o m dif fe rent s o urc es ha ve di f fer ent chara ct eri st i cs i n t e r ms of ri sk , c ost and c ont r ol t hat a mana g er m ust con sid er w h i l e p r oc u ri n g f un d s . Th e f und s sh o ul d b e p r oc ur ed at minim u m co st , at a b al an c ed ri sk an d c ont r ol fa ct or s . F un d s rai se d b y i s s ue of eq uit y sh are s are t he be st f r o m ri sk p oint of vi ew f o r t h e c om p an y , as it ha s n o re p ay ment li abilit y e xc e pt on w inding up of t h e c o mp an y , b ut fr om c o s t point o f view , it is mo st exp ensi ve , a s di vi de n d e xp ect at ion s o f s hareh ol de rs ar e high er t h an pre vail i n g i n t e re st ra t es a n d divi den d s a r e ap pr opri at ion of pr ofit s a nd not all ow e d a s ex p e n se un d er t he in c om e t ax act . Th e i s s ue o f n ew eq uit y sha re s ma y di l ut e t h e c on t r ol o f t h e e xi st ing sha reh ol der s . D eb e n t u re s are c omp arat iv el y c heap e r sin ce t h e int ere st i s p aid o ut of p r o fi t s b e fo re t ax . B ut , t he y ent ail a high d eg re e of ri sk sin ce t h e y have t o b e r ep ai d a s p er t h e t er ms of agr eem ent ; al so , t he int ere st pay me n t h a s t o b e mad e w het h er o r n ot t he c o mpan y m ake s pr ofit s . F un d s can al s o b e p r oc ur ed fr o m banks an d financi al i nst it ut i ons , t hey pr o vi d e f un d s s ub j ect t o c ert ain r est rict ive c ov enant s . T h es e co ven an t s re st ri ct fr eed o m o f t he b or ro w er t o rai s e l oan s fr o m ot her s o urc es . Th e re fo rm p ro ce s s i s al s o m ovi n g in dir ect io n of a cl o ser mo nit ori n g o f ' en d us e' of re s o ur ce s m obil ise d t hr o ug h c apit al mark et s .

S uch r est ri ct i on s are es se n t i al f o r t he s af e t y of f un d s p ro vid ed by inst it ut i on s an d i n ve s t or s . Th er e a re ot her financi al in st r um ent s u se d fo r raisi ng fi n an ce e .g . co mm erci al pa pe r , d eep di sc o unt b on ds , et c . Th e financ e man a ge r h a s t o b al anc e t he av a ilabilit y o f f und s and t he re st rict i ve p r o vi si o n s t i ed w i t h s u ch f und s re s ult ing in lack of fl exibilit y . I n t h e gl ob al i se d c o mpet it iv e sce nari o , it is n ot en o u g h t o de p en d on av ai l ab l e w a ys of fi n a n ce b ut r es o u rc e m ob ilisat i on is t o b e un dert ak en t h r o ugh i n n o vat i v e w a y s or fi nancial pr od u ct s t ha t ma y me et t he ne ed s o f i n ve st o r s . M ul t i pl e opt i on co nve rt ible b o nd s c an be sight e d as an exa mp l e , f un d s c an b e rai se d in dig en o u sl y a s al s o fr o m abr oad . F or eign Di r ect I n ve st men t (F DI ) an d F or ei gn I nst it ut i onal I nve s t or s (FI I ) ar e t w o ma jo r s o urc e s of fi n a n ce f ro m abr oa d al on g w it h Am eric an Dep o si t o r y Re cei p t s ( AD R ' s ) and Gl obal D ep osit or y Rec eipt s (GD R ' s ). The mech an i sm o f p r oc ur i n g f u n d s i s t o b e m o difie d in t he light o f req uir em en t s of f or ei gn i n ve st o rs . Pr oc u re ment o f f u nd s int e r a lia incl u de s : - I dent i fi cat i on o f s o ur ce s o f financ e - Det e rmi n at i on of fi n an ce mi x - R aisin g o f f un d s - Divi si on o f p r ofi t s b et w een divi den ds an d r et ent io n of pr o fit s i .e . int e rnal fu nd ge n er at i on . 2) e f fe ct i ve us e o f s u ch f unds : The fi nan c e man a ge r i s al s o re sp on sible f or e ff ect iv e ut ilis at io n o f f und s . He m ust p oi n t o ut si t uat i on s w he re f un ds are kept i dle or ar e u se d impr op erl y . Al l f un d s are p r oc u re d at a c e rt ain c o st and a ft er ent ailing a cert ain am o un t o f ri s k . I f t h e f un ds a re n o t ut ilis ed in t he m ann er s o t hat t hey g en e rat e an i n c om e h i gh er t ha n c o s t of pr o c ure me nt , t h ere i s n o meani n g i n r u n n i n g t h e b u si n es s . I t is an i mp ort ant c on sid er at ion i n divid en d d eci si on s al s o , t h u s , it is cr u cial t o emp lo y f un d s p r op erl y and pro fit ab l y . Th e f un d s are t o be e mpl o ye d i n t he mann er s o t hat t he co mpan y can p r o d u ce at i t s opt im u m l ev el w it ho ut enda ng eri ng it s financi al s ol v en c y . T h u s , fi n ancial impli c at ion s of e ach de cisi on t o i nv est in fix ed a ss et s ar e t o b e p r op erl y anal y se d . F o r t hi s , t h e f inan ce mana ge r m ust p o s se ss so u n d k n ow l e dg e of t echni q ue s o f capit al b udg e t ing and m ust k ee p i n vi ew t h e n eed of ad eq uat e w orkin g c apit al an d ens u re t hat w hile fi rm s en j o y an op t i m u m l ev el of w o r king c apit al t he y d o not k eep t oo m u ch f un d s b l o c ked i n i n vent ori e s , b o ok debt s , ca sh , et c . Fix ed a ss et s ar e t o fi n an ce d f r om m edi um or lo ng t erm f un ds , a nd not sh ort t e rm f un ds , as fi xe d a s set s can n ot b e s ol d i n sh ort t e rm i .e . w it hin a yea r , al so a l arg e a m o unt of f un ds w o uld b e bl ock ed in st oc k in hand as t h e c omp an y can n ot i mm ediat el y s ell it s fini sh ed g o o ds .

Ques ti on : E xpl ain t h e s c op e o f fi nan ci al man ag em en t ? Ans w er : Sc op e o f f in anc ial man ag e m en t :

A s o un d fi n a n ci al mana ge ment i s es se nt ial in all t ype o f finan cial or gani sat i on s - w h et h er p r ofi t o rient ed o r not , w he re f und s ar e in v olv ed and als o i n a c en t ral l y p l an n ed ec on o m y as als o in a ca pit alist s et - up . Fir ms , a s p e r t h e c o mm er ci al hi st o r y , ha ve not l iq uidat e d b e ca us e t hei r t echn ol o g y w a s ob s ol et e or t heir pr o d uc t s ha d n o o r l ow d em and o r d u e t o an y ot h er fa ct o r , b ut d ue t o l ack o f fin ancial man age me nt . E ve n in bo om p eri od , w h e n a c om p an y mak es hi gh p ro fit s , t he re is d ange r o f l iqui dat i o n , d ue t o b ad fi n anci al mana ge ment . T he main ca u s e of liqui dat i o n of s u ch c om p an i es is ov er - t ra ding o r o ver - exp andi ng w it ho ut an a deq uat e fi n an ci al b a se . Fi n an ci al man age ment opt im is es t he o ut p ut f r om t h e g iven inp ut of fu nd s a n d at t emp t s t o u se t he f un ds in a mo st p r od uct iv e ma nner . I n a co unt r y l i ke I n di a , w h er e r e so u rc es ar e s carc e an d de man d on f un ds ar e man y , t h e n e ed f or p ro p e r fi nanci al man age ment i s en or m o u s . I f pr op er t echniq ue s ar e u se d mo st of t he ent e rpri s es can r ed uc e t hei r c apit al empl o y ed an d i mp r o ve ret urn on i nv est m ent . Th u s , as m en an d m achin e are pr op erl y ma n ag ed , fi n anc es ar e als o t o b e w el l m ana ged . I n n ew l y st a rt ed c omp anie s , it is im p ort ant t o h av e s o und fina ncial mana ge men t , a s i t e n s ur es t heir s urv ival , oft e n s uch c omp ani es ign or e s financi al man a ge me n t at t h eir ow n pe ril . E ven a sim ple act , lik e dep o si t i n g t h e ch eq ue s o n t he da y of t heir rec eipt i s n ot p er f or me d . S u ch or gani sat i on s p a y h e av y i n t e re st ch ar ge s on b orr ow e d f und s , but a re t ard y in r eal i si n g t h ei r ow n d ebt o r s . Thi s i s du e t o t he f act t he y lack reali sat i on o f t h e c o n cep t of t ime v al ue of m on e y , it is n ot a ppre ciat ed t hat each val u e o f r up ee h a s t o b e mad e u se o f and t hat it h as a di re ct co st of ut i l i sat i on . I t m ust b e reali s ed t hat ke eping r up ee id l e ev en fo r a da y , re s ul t s i n t o l os s e s . A n on - p r ofit or gani sat io n ma y n ot b e ke en t o make p r o fi t , t ra di t i o n al l y , b ut it d oe s ne e d t o c ut d ow n it s c o s t and u se t he f un ds at i t s di sp o sal t o t he ir opt i m um capacit y . A s o und s e nse of financi al man a ge me n t h as t o be c ult ivat ed am on g o ur b ur ea uc rat s , admini st rat or s , en gi n eer s , e d ucat i oni st s a nd p ubli c at l arg e . U nles s t hi s i s don e , c ol o ss al w ast a ge o f t he capit al r es o ur ce s c ann ot b e a rr est e d .

Ques ti on : W hat ar e t he o bj e ct i ves of fin a nci al m ana ge m ent ? Ans w er : Obje ct i ves of fin an ci al ma nag e me nt : E f fi ci e n t fi n an ci al man age me nt req uir e s exi st enc e of s o me obj ect i v es or g oal s b eca u se j ud gm ent a s t o w het he r or n ot a f inancial deci si on i s ef fi ci en t i s t o b e mad e in light o f s om e ob ject iv e . T he t w o main obj ect i v es of fi n an ci al ma n ag em ent a re : 1) Pr o fi t Ma xi mis ati o n : I t is t radi t i o n al l y b ei n g ar g ue d , t hat t he o bject iv e o f a c om pa ny is t o ea rn pro fit , h en c e t h e ob j ect i ve of fin ancial m anag em ent is pr o fit maxi mi s at i on . Th u s , e ach al t e rnat iv e , is t o be s een b y t h e f ina nce mana ge r f r om t h e vi ew p oi n t of pr o fit ma ximi sat ion . B ut , it ca nnot b e t h e

onl y o b je ct i ve of a c om p an y , it i s at b e st a limit e d obj ect iv e e lse a nu mbe r o f p ro b l e ms w ou l d ari se . S om e o f t hem ar e : a ) T he t erm p r o fi t i s va g ue an d d o es n ot clari f y w hat exa ct ly it mean s . I t con ve y s di f fe ren t me an i n g t o dif fe rent p e opl e . b) Pr ofi t maxi mi sat i on h a s t o b e at t em p t ed w it h a rea lisat i on o f risk s inv olv ed . Th e re i s di r ect r el at io n b et w een ri sk a nd pr ofit ; high er t h e ri sk , highe r i s t h e p r o fi t . F or ma xi mi sin g p r ofit , risk is alt oget h er ign or ed , impl yin g t h at fi n an c e m an a ger ac cept s highl y risk y pr o po sal s als o . Pra ct ical l y , ri sk i s a v er y i mp ort ant fact or t o b e bal anc ed w it h pro fit obj ect i v e . c ) P r ofi t maxi mi s at i on i s an ob je ct ive n o t t aking int o a cc o unt t he t im e pat t ern of r et u rn s . E .g . P r op os al X gi v e s ret urn s high er t han t hat b y p ro p os al Y b u t , t h e t im e peri od i s sa y , 1 0 y ear s a n d 7 y ear s re sp ec t ivel y . Th u s , t he o ve r all pr o fit is onl y c on si de re d n ot t h e t i me pe ri od , n or t he fl ow o f pr o fit . d ) P r ofi t maxi mi sat i on as an obj ect ive is t o o n arr ow , it fa ils t o t ak e int o acc o un t t h e s oci al c on si d erat i on s a nd ob ligat ion s t o va rio u s in t ere st s o f w ork er s , c on s u me r s , s oci et y , a s w ell a s et hical t ra de pr act ice s . I gno ring t hese f act o rs , a c o m p an y c ann ot s u rvi ve fo r l on g . P ro fit m axi misat i on at t he c ost o f s oci al an d m o ral obli gat i ons i s a s h ort sight e d p oli cy . 2) W eal th m a xi mis a ti on : Th e c omp a n i es h a ving pr o fit ma ximi sat ion a s it s obj e ct ive , ma y ad opt p ol i ci es yi el di n g e x orbit ant p r ofit s in t he sh ort r un w hic h ar e unh eal t h y f or t h e gr o w t h , s ur viv al an d o v erall int er est s o f t he bu sin es s . A co mpan y ma y n ot u n dert ak e plann ed a nd p re scri be d sh ut - d ow ns of t he plant f or m ai n t en an ce , an d so on f or ma ximi sing pr o fit s in t he sh o r t r un . Th u s , t h e ob j ect i v e o f a fi r m sh o ul d b e t o maxi mis e it s v al ue or w ealt h . Acc or di n g t o V a n H o rne , "V al u e of a fir m i s re pre s ent ed b y t he mark et p ri ce o f t h e co mp an y ' s c o mm on st oc k .... ...t h e mark et pric e o f a firm ' s st o ck rep re se n t s t h e f oc al j u dg ment o f al l m ark et pa rt icipant s as t o w hat t h e val u e o f t h e p a rt i c ular fi rm is . I t t ake s int o a cc o unt pre sent as als o p r os p ect i v e f ut u re ear n ing s p er s har e , t he t i ming and ri sk of t he se earnin g , t h e di vi den d p ol i c y of t h e fir m a nd m an y ot he r fact o rs havi ng a beari ng on t h e ma rk et p ri c e o f st oc k . Th e ma rket p ric e se rv es as a per fo rm an c e i n dex o r r ep ort c ar d of t he f irm 's pr o gr es s . I t indi cat es h ow w ell man ag em en t i s doi n g on be half of st ockh ol de rs ." Sh are pr ices in t h e sha re ma rket , at a gi ven p oi n t of t ime , a r e t he re s ult o f a mixt ur e o f man y fact o r s , as g en e ral e con o mi c o ut l o ok , pa rt icul ar o ut l o ok o f t h e co mpan i es un d er c o n si d erat i on , t ech nic al fa ct o rs an d e ve n mas s ps ych ol o g y , b ut , t ak en on a l on g t e rm b asi s , t h e y re flect t he val ue , w hich vari o u s p art i e s , p ut o n t h e c o mpan y . N or mal l y t h i s val u e i s a f un ct io n , o f : - t he lik el y rat e o f ea rn i n g s p er s har e o f t h e c o mpan y ; an d - t he c ap i t al i s at i on r at e .

Th e l i kel y r at e of ea rnin gs pe r sha re (E P S ) de pen ds up on t h e as se s sm en t a s t o t h e p r ofi t abl y a c omp a ny is g oin g t o ope rat e in t h e fut ur e o r w h at i t i s l i k el y t o e arn aga inst e ach of it s o rdin ar y sh are s . Th e cap i t al i s at i on rat e re fle ct s t h e likin g o f t he inv est or s o f a co mpan y . I f a c o mp an y e arn s a hi gh r at e of ea rnin gs pe r sh a re t hr o u gh it s ri sk y op er at i on s o r ri sk y fi nanci ng pat t e rn , t h e in ve st o rs w ill not l o ok up on it s sh a re w i t h f av o ur . T o t hat ext ent , t he ma rket val u e of t he sha re s of s u ch a c o mp an y w i l l b e l ow . An eas y w ay t o det e rmin e t h e capit al i s at i on rat e i s t o st art w it h fix ed d e po sit int er e st rat e of banks , inve st o r w o ul d w an t a h i gh er r et u rn i f h e i nve st s in sha re s , a s t he ri sk incre as es . How m uch h i gh er ret urn i s exp e ct ed , de pen ds on t h e ri sk s inv olv ed i n t h e p a rt i cul ar sh a re w hich i n t urn de pen ds on co mpan y polici e s , p a st re c ord s , t yp e o f b u sin es s a nd c on fid enc e c o m mand ed b y t he ma n ag em en t . Th u s , cap i t ali sat i on rat e i s t he c um ul at ive r es ult o f t he as se s sm en t of t h e va ri o u s sh are ho lde r s r e gar ding t h e risk an d ot he r qualit at i v e fact or s o f a c o mpan y . I f a c o mpan y inv e st s it s f un ds in risk y vent ur es , t h e i n v e st o rs w i l l p ut in t h eir m o ne y i f t he y g et high e r r et u rn as co mpa red t o t h at f r om a l ow ri sk sha re . Th e m ark et v al u e o f a s har e i s t h u s , a f unct i on o f e arni ngs pe r sha re an d cap i t al i sa t i on r at e . Sinc e t h e pro fit m axi mis at ion c rit eria cann ot b e ap p l i ed i n re al w orld sit uat i on s b eca u se of it s t e ch nical limit at ion t h e fi n an c e m an a ger of a co m pan y ha s t o en s ur e t hat his deci si on s a re s u ch t h at t h e m ark et va l ue of t he sh are s o f t h e co mpan y is maxi m um i n t h e l o n g r un . Th i s im plie s t hat t he financi al p olic y has t o be s uch t h at i t o p t i mi s e s t h e E P S , ke eping in view t he ri sk and ot her fact or s . Th u s , w eal t h m axi mi s at i on i s a b et t er ob je ct ive f or a c o mm erci al un dert ak i n g as c om p are d t o r et urn and risk . Th e re i s a gr ow i n g em pha sis on s ocial an d ot he r obli g at ion s of an ent erp ri s e . I t can n ot b e den i ed t hat in t h e ca s e of und ert akin gs , esp ecial l y t h o s e i n t h e p ub l i c sect or , t he qu est i on o f w e alt h m aximi sat i on is t o b e se en i n c on t ext of s oci al a nd ot h er obli ga t i ons of t he ent erp ris e . I t m ust b e un der st o o d t hat finan ci al d eci sio n makin g i s rel at ed t o t he ob je ct i ve s o f t h e b usi n e ss . Th e financ e m ana ger ha s t o en s ur e t hat t here is a p o si t i v e i m p act of ea ch financi al d eci sio n on t he f u rt heran ce of t he b u si n e s s ob j ect i v es . On e of t he main obj ect iv e o f an und e rt aking ma y be t o " p r ogr e ssi vel y b ui l d up t he capabili t y t o und ert ak e t h e de sign and dev el op men t o f ai rcr aft en gine s , h elic opt er s , et c ." A financ e mana ge r in s uch ca se s w i l l al l oc at e f un d s in a w a y t h at t his obj ect iv e i s a chiev ed alt ho ugh s uch an a l l ocat i on ma y n ot ne c es sa ril y m axi mis e w e alt h.

Ques ti on : W hat ar e t he f un cti ons of a F in anc e Ma nag er ? Ans w er : Fun cti ons of a F ina nc e Man ag er : Th e t w i n as p ect s , p ro c ur em ent and ef fe ct ive ut ilisat ion o f f und s are cr uci al t a sk s f ac ed b y a fin ance m an age r . Th e finan cial mana ge r i s req uir ed t o l o ok i n t o t h e fi n ancial impli ca t ions of an y de cisi on in t he fi rm .

Th u s all d eci si on s i n v ol v e m an age me nt o f f und s und er t h e p u r view of t he financ e man a ge r . A l arg e n u mbe r o f d eci si ons in vol ve s ubst an t ial o r mat eri al ch an g es i n val ue of f un ds pr oc u red or em pl o yed . Th e fi nanc e mana ge r , h as t o ma n age f un d s in s uc h a w ay s o a s t o m ake t heir opt im u m ut i l i s at i on a n d t o e ns u re t heir pr oc u re ment in a w a y t hat t he risk , c o st an d c on t r ol ar e p ro pe rl y bal anc ed un de r a gi ven sit uat i on . He ma y n ot , b e c on c ern ed w i t h t he d eci si ons , t hat d o n ot af fe ct t he b asic financi al man a ge me n t an d st r uct ur e . Th e n at ure of j ob o f an a cc o unt ant and fin anc e m a nage r i s diff er en t , an a cc o un t an t 's j ob i s prim aril y t o r ec or d t he b u sine ss t ransa ct i on s , p r ep a r e fi n an ci al st at em en t s s how in g r e s ult s o f t he or gani sat i on f or a gi ven p e ri od and it s fi nancial c ondit i on at a gi v en point o f t i m e . He i s t o rec o rd va ri o us hap pening s in m onet ar y t erm s t o ens u re t h at a ss et s , l i ab i l i t i es , in co me s an d e xpe ns es ar e pr op erl y gr o upe d , cl a s si fi ed a n d di scl o se d in t he fi nancial st at e ment s . Ac c o u nt ant is n ot c on ce rn e d w i t h man ag em ent of f u nds t hat is a sp eciali se d t a sk a nd in m od ern t i me s a c o mp l e x on e . Th e finan ce mana ge r or c ont r olle r h as a t ask en t i rel y di ff er en t fr om t hat of an acc o unt ant , he is t o ma nage f un d s . S om e o f t h e i mp o rt an t deci si on s a s re ga r ds fina nce ar e as f oll ow s : 1) Es ti m at ing t he r eq uir e m ents of fun ds : A b u sin e ss r eq uir es f un ds f or l ong t erm p urp o se s i .e . i n ve st men t i n fixe d a s s et s a nd s o on . A ca r ef ul e st imat e of s u ch f un d s i s re q ui red t o be ma de . An as se s sm ent ha s t o b e ma de reg ardi n g req ui re me n t s of w o rking capit a l i nv ol ving , e st im at io n o f am o unt of f un d s b l oc ked i n c ur ren t as s et s and t ha t likel y t o b e gen erat ed f or sh ort p eri o ds t h r o ug h c ur ren t li abilit ie s . F or eca st ing t he req ui r eme nt s o f fu nd s i s d on e b y u se of t ech ni q ue s o f b u d get ar y c ont r ol a nd l ong r ang e p l a n n i n g . E st i mat e s of r eq ui r em ent s of f u nds can be m ad e on ly i f all t he phy sic al a ct i vi t i es of t h e org anis at ion ar e fo re ca st ed . The y ca n be t ranslat e d i n t o m on e t ary t er ms . 2) D e cis i on r egar din g cap ita l s tr u ctur e : Onc e t he r eq uir em e nt s of f un ds i s est im at ed , a de ci si o n re ga rdin g v ari o u s s o ur ce s fr om w he re t h e f u nd s w ou ld b e rai se d i s t o b e t ak en . A pr op er mix o f t he v ari o u s s o ur ce s i s t o be w ork ed o ut , e ach s o ur ce o f f und s inv o lve s dif fer ent i ss u e s f or con sid er at i on . Th e fi n an ce m anag er ha s t o ca re f ull y l o ok int o t he exi st ing capit al st r uct u re an d s ee h ow t he vari o u s pro p os als of rai sing f un ds w ill aff ect i t . He i s t o mai n t ai n a p r ope r b alan ce b et w een lo ng an d sh ort t er m fu nd s a n d t o en s ur e t h at s uf ficie nt l ong - t erm f un d s a re rai se d in o rd er t o financ e fi x ed a s s et s an d ot h e r l on g - t er m inve st me nt s and t o p ro vid e f or per man en t n e ed s o f w orki n g c apit al . I n t he ov er all v ol um e of lon g - t er m fu nd s , h e i s t o mai n t ai n a p r op er balan c e b et w een ow n and loan f un d s and t o se e t h at t h e ov er al l c apit alis at ion o f t he c o mpan y i s s uch , t hat t he co mpan y i s ab l e t o p ro c ur e f und s at min im um c ost and is abl e t o t ol erat e sh ock s o f l ean p er i o ds . Al l t h es e deci si on s a re kn ow n a s ' finan cing deci si on s' . 3) I n ves tm en t de cis i on : F un d s pr oc u red fr om di ff er ent s o u rce s h av e t o b e inve st ed i n va ri o u s ki n ds of as s et s . Lo ng t erm f un d s a re us ed i n a p r oje ct fo r fix ed an d al s o c u rren t as s et s . T he inv e st ment o f f und s i n a pro ject i s t o be mad e a ft er ca re f ul as s es sm ent of v ari o u s p ro ject s t hr o u gh capit al bu dg et i n g . A p a rt of l on g t e rm f un ds i s al s o t o b e k ept f o r fina ncing

w orkin g c ap i t al r eq u i rem en t s . As s et m an age ment p oli cie s ar e t o be lai d dow n re gar di n g v ari o u s i t e ms of c ur rent as set s , in ve nt or y p oli cy is t o be det er mi n ed b y t h e p ro d uct i o n an d finan ce mana ge r , w hil e k eepin g in mind t h e req ui re me n t of p r o d uct io n an d f ut ure pri ce e st imat e s o f raw mat eri al s an d a vai l a b i l i t y o f f und s . 4) D i vid en d de cis io n : Th e fi nan ce man ag er i s c once rn ed w it h t he deci si on t o p a y or d ecl ar e divi den d . He i s t o a s sist t h e t o p ma nage ment in d eci di n g a s t o w h at am o unt of di vid en d sh o uld be paid t o t he sha reh ol der s an d w h at am o unt b e ret ain ed b y t he c omp an y , it inv olv es a larg e n u mb e r o f c on si d erat i on s . E c on omi call y spe aking , t he a mo u nt t o be ret aine d o r b e p a i d t o t h e shar eh old er s s ho ul d d ep end o n w h et her t he co mpan y or sh are h ol der s can mak e a mo re p r ofit abl e u se of r es o ur ce s , als o co n si de rat i o n s l i ke t r en d o f ea rning s , t he t r end o f sha re m arket price s , r eq ui r em en t of f un d s f o r f ut u re gr ow t h , c ash fl ow sit ua t ion , t a x po sit ion of s h ar e h ol der s , an d s o on t o b e k ept in mi nd . Th e p ri n ci p al f un ct i on of a finan ce mana ge r r elat e s t o dec isi on s reg ardi n g p r oc u re m en t , i n ve st m ent and divid end s . 5) S upp ly of fun ds to all par ts o f th e or g an is ati on or cas h ma na ge me nt : The fi nan c e man a ge r h a s t o en s ure t hat all s ect i ons i .e . bra n che s , fact o ri e s , un i t s or de p art me nt s o f t he org anisat i on ar e s uppli e d w it h adeq u at e f un d s . Sec t i on s h a ving e xce s s f un ds c ont rib ut e t o t he c ent ral po ol f or us e i n ot h er sect i on s t hat n ee ds f un ds . An ad eq uat e s uppl y of cash at al l p oi n t s of t i m e i s a bs ol ut el y e s s ent ial f o r t he s m o ot h fl ow of bu sin es s op er at i on s . E ven i f o ne o f t h e m any br anch es i s sh ort o f f und s , t he w h ol e b us i n e s s ma y b e i n d ang er , t h u s , ca sh mana ge me nt and ca sh disb u rs em en t p ol i ci e s a re i mp o rt ant w it h a vi ew t o s up pl ying adeq u at e fu nd s at al l t i m es an d p oi n t s in an or gani sat io n . I t sh o ul d en s u re t hat t h ere is n o ex ce s si v e ca sh . 6) E v alu ati ng f ina nc i al per f or m an ce : M a nage ment c ont r ol s y st em s ar e u s uall y b a sed on fi n an ci al anal y sis , e .g . R OI (ret urn on in ve st ment ) s y st em of di visi o n al co n t rol . A f i n an ce ma nag er has t o c onst ant l y re v iew t he financi al p er f orm an c e of va ri o u s unit s of t he or gani sat i on . Ana ly sis of t he financi al p er f orm an c e h el p s t he man ag e ment f or as se s sing h ow t he f un ds are ut il i se d i n v ari o u s di vi si on s and w hat c an b e d on e t o i mpr o ve it . 7) Fi nan ci al n eg oti at ions : Fi na nce m ana ger ' s maj o r t im e i s ut i lise d in carr yi n g o ut n eg ot i a t i on s w i t h fina ncial in st it ut io ns , ba nks an d publi c dep o si t o rs . H e h as t o f urn i sh a l ot o f in f or mat ion t o t he se inst it ut io ns an d per s on s i n o rd er t o e n s ur e t h at rais ing o f f un ds is w it hin t he st a t ut es . Ne g ot iat i on s f or o ut s i de fi n an cing oft en r eq uir es s peci alis ed s kills . 8) Ke ep ing i n to uc h wi th s t oc k e x ch ang e qu ot ati ons a nd b eh av ior of s har e pr ic es : I t i n v ol ve s a n al y sis of maj o r t rend s in t he st ock mark et an d ju dgin g t h ei r i mp act on sh are pri ce s o f t h e c o mpan y ' s sha re s .

Ques ti on : W hat ar e t he var i ous me th ods and t oo ls us e d f or fi n anc ial man ag em en t ? Ans w er : Fi n an ce ma n age r u se s va ri o us t o ol s t o di sch ar ge his f unct i on s a s reg ard s fi n a n ci al ma n age ment . I n t he ar ea o f fi nanci ng t h er e a re va ri o us met h od s t o p r oc ur e f un ds f ro m l on g as al s o sh ort t erm so u rc es . Th e financ e man a ge r h a s t o d eci de an opt i m u m ca pit al st r uct u re t hat can cont rib ut e t o t h e ma xi mi sat i on of s har eh o lder ' s w e alt h . Fina nci al le ve rag e or t radi n g on e q ui t y i s a n i m p ort ant m et h od b y w hic h a fin an ce mana ge r ma y in cr eas e t h e r et ur n t o c o mm on sh ar eh old er s . F or e val uat i on o f capit al p r op o s als , t he fina nce ma n age r u se s capit al b u dget i n g t e ch n i q ue s as pa yb ac k , int e rnal rat e of ret ur n , net pre sen t val u e , p r o fi t ab i l i t y i nd ex , a ver ag e r at e of r et u rn . I n t he a rea of cu rr ent a ss et s man a gem en t , he us es m et hod s t o che ck ef fici ent ut ilisat i on of c ur re n t r es o u rc es at t h e ent er pri se ' s di sp os al . An ent erp ri se can incre as e i t s p r o fi t ab i l i t y w i t h o ut af fect ing it s liq uidit y b y an e ffi cient mana ge men t o f w or ki n g c apit al . F o r in st ance , in t he a re a of w orkin g capit al m an a ge men t , ca sh mana ge ment ma y be ce nt rali sed or d e cent ral i se d ; ce n t ral i s ed met h od i s c on sid ere d a b et t er t ool of man agin g t he ent e rp ri s e' s l i q ui d r es o u rce s . I n t he ar ea o f di vid end d eci si on s , a fir m is fac ed w i t h t h e p r o b l em of de clar at ion or p ost p onin g decl ar at ion o f divid en d , a p ro b l e m of i n t er nal finan cing . F or e val uat i on o f an ent er p ri se ' s per f or manc e , t her e are va ri o us met h od s , a s r at i o an al y si s . Thi s t echniq u e is us ed b y all c onc e rned per s on s . Di f fe ren t rat i o s se rvi n g dif fer ent obj ect iv es . An inv e st or us e s vari o u s rat i o s t o ev al uat e t h e pr ofit abilit y o f inv e st ment in a part ic ular co mpan y . Th e y e n ab l e t h e i nv est or , t o j u dge t he pr ofit abilit y , s ol venc y , liqui dit y an d g r ow t h asp ect s o f t h e f irm . A s h o rt - t erm cr edit or is m or e int ere st ed i n t h e l i q ui di t y as pect o f t he fi r m , and it is p os sibl e by a st ud y of liq ui di t y rat i os - c u rren t rat i o , q uick rat i o s , et c . T he main c o ncern of a financ e man a ge r i s t o p r ovi de ad eq uat e fu nd s fr om b est p o s si ble s o urc e , at t he ri gh t t i me an d at mi n i m um c o st an d t o en s ur e t hat t h e fu nd s s o acq uir ed ar e p ut t o b est p o s sibl e u se . F u nds fl ow a nd ca sh fl ow st at em en t s an d p r oj ect ed fi n ancial st at e ment s he lp a l ot in t his re gar d .

Ques ti on : Dis cus s th e r ol e o f a f ina nc e m anag er ? Ans w er : I n t h e mo d ern en t e rpri se , a fi na nce man age r oc c upi es a k e y po sit ion , h e b ei n g on e of t h e d yna mic me mbe r of c or po rat e m anag erial t eam . Hi s r ol e , i s b e c omi n g m or e a nd m or e p er vasi ve an d sign ificant in s olvin g c o mp l e x man age ri al p r oble m s . T ra dit ionall y , t he r ol e o f a financ e mana ge r w as c on fi n ed t o rai sing f un ds f r om a n umb er of s o ur ces , b ut d ue t o r ec en t d ev el op m en t s i n t he s oci o - ec o no mic and p olit ical s cena rio t hro ug h o ut t h e w orl d , h e i s pla ce d in a c ent ral po sit i on in t he or gani sat i on . He i s r e sp on si b le f o r shapin g t he fo rt u ne s o f t he e nt erpri se and i s i n v ol ved i n t h e m o st vit al d eci si on o f al lo cat io n of ca p it al like mer ge rs , a cq ui si t i on s , et c . A finan ce ma n age r , as ot her m emb er s of t he co rp orat e t ea m c an n ot b e a ve rs e t o t h e fast de vel op me nt s , a ro un d hi m

a n d h as t o t ake n ot e o f t h e ch ang es in o r der t o t ake rel ev ant st ep s in view of t h e d yn a mi c ch an g es in circ u m st ance s . E .g . int r o d uct ion o f E u r o as a sin gl e c u rr en c y of E ur op e i s an int e r nat ional le vel cha ng e , h avin g impact on t h e co rp o rat e fi n anc ial pl an s a nd p oli cie s w orl d - w ide . D om e st i c d ev el o p m ent s as e me rgen ce of fina ncial s ervi ce s sect or s an d SE B I as a w at ch d og f o r in ve s t or p r ot ect i on a nd re gul at ing bo d y of cap i t al ma rk et s i s co nt rib ut ing t o t he imp o rt ance of t he fi nanc e mana ge r' s j ob . B a n k s an d fi n ancial in st it ut ion s w e re t he maj o r s o ur ce s o f financ e , m on op ol y w as t h e st at e of a ffai r s of I ndian b usi ne ss , sha reh ol der s sat i sfa c t i on w a s n ot t he pr o mot e r 's c onc ern a s mo st of t he co mpan i es , w e re cl o sel y h el d . D ue t o t he op enin g o f e c on om y , co mpet i t i o n i n c re as ed , s el l e r 's m ark et is being c on vert e d int o b u yer ' s mark et . De vel op men t of i n t er net h as br o u ght new c halle nge s bef or e t h e mana ge rs . I n di an c o n cern s n o l on ger ha v e t o c om pet e onl y n at ionall y , it is facin g i n t e rn at i on al c om p et it ion . Th u s a ne w era i s u she re d d urin g t he rec ent ye ar s , i n fi n a n ci al mana ge ment , s peciall y , w it h t he de vel op ment of fin an ci al t o ol s , t e ch n i q ue s , in st r um ent s a nd pr od u ct s . Als o du e t o incre asi n g emp h a si s on p ub l ic s ect o r un d ert aking s t o be s elf - s upp o rt ing and t he i r dep en den ce on capit al ma rket f or f un d req ui re men t s an d t he incre asi n g si g n i fi c an ce o f l i b erali sat i on , glo balis at ion an d de reg ul at ion .

Ques ti on : Dr a w a t y pic al or gan is at io n c har t hi ghl igh tin g th e fin an ce fun ct io n o f a c om pa ny ? Ans w er : Th e fi n an ce f un ct i on i s t h e sa me in all ent e rpri s es , de t ails m a y diff er , b ut maj o r feat ur e s a re univ er sal in nat ur e . The fin ance f unct i on occ u pi e s a si gn i fi ca n t p o si t i o n in an o rg anisat i on and is n ot t he re sp on si b i l i t y of a s ol e e xec ut i ve . The imp ort ant asp ect s of fin ance mana ge r a re t o car ri ed on b y t op man ag eme nt i .e . man agin g dir ect o r , chair man , b oa rd o f di re ct or s . The b oa rd of di rect or s t ak e s d e cisi on s inv olvin g fi n an c i al c on si d erat i on s , t he fin ancial c ont r olle r i s b asica ll y meant f or a ssi st i n g t h e t op mana ge ment and ha s a n i mp ort a nt rol e o f cont rib ut i n g t o g o o d de ci si on m aking on iss u e s in v olvin g all f u nct ional area s o f b usi n e ss . H e i s t o b rin g o ut fi nan cial im plicat i on s of a ll de cisi on s and mak e t h e m un d er st o od . H e ma y be called a s t he fi nanci al c ont r olle r , vice- p re si d en t (f i n an ce ) , ch i ef acc o unt a nt , t rea s ur er , or b y a ny ot h er de signat i on , b ut h as t h e p ri mar y r es p onsi bilit y o f p er f ormi ng fi nance fu nct io n s . H e i s t o di s ch arg e t h e r e sp on sib ilit y k eepi ng i n v iew t he ov er all o ut lo ok of t h e o rgan i sat i o n . BO A RD O F D IR EC T O RS P RE SI DE N T

V .P .(P r o d uct i on )

V .P .(F in anc e )

V .P .(S a le s )

Tr ea s ur er

C ont r oll er

Cr edit M gmt .

Ca sh M gmt .

B an ki n g rel at i on s

P ort f oli o M gmt .

C or po rat e G ene ral & C o st Ac c o u nt ing

Tax e s

I nt ernal Au dit

Bu dg et ing

Or ga nis a ti on c har t of fin an ce fun ct io n The Ch i ef fi n a n ce e x ec ut i ve w o rk s di re ct ly u nd er t h e Pr esi den t or M anagi n g Di re ct or o f t h e c omp an y . Be sid es r o ut ine w or k , he k eep s t he Boa rd i n f o rm ed ab o ut al l p h a se s o f b usin es s act ivit y , i ncl usi ve o f ec on omi c , s oci al an d p ol i t i cal de vel o pm ent s af fect ing t he b u sine s s beha vi o ur an d f ro m t i me t o t ime f u rni she s in f or mat io n ab o ut t he financi al st at u s o f t h e c omp a n y . Hi s f unct i on s a re : (i ) T rea s ur y f u nct ion s a nd (ii ) C ont r ol f un ct i on s . Re lat io ns hi p B et w ee n fin an cia l ma nag e me nt an d ot her ar ea s o f man ag em en t : Th er e i s cl o se r elat i ons hip bet w een t h e a rea s o f fi nanci al and ot h e r man a ge m en t l i ke pr o d uct io n , s ales , mar ket ing , p er s onn el , et c . Al l act i vi t i e s di r ect l y or i n di rect l y inv ol ve acq uisit i on and us e of f un d s . Det er mi n at i on o f p r o du ct i on , p r oc ur em en t and mar ket ing st r at egie s ar e t he imp o rt an t p r er og at i ve s of t he re sp ect i ve de part m ent h ead s , b ut fo r imple men t i n g , t h ei r deci si on s f und s a re r eq uir ed . Like , repl ac eme nt of fixe d a s set s f o r i mp r o vi n g p r od u ct ion cap acit y re q uir es f un ds . Simil arl y , t he p urc h a se an d s al es p r o mot i on p olicie s a re laid d ow n b y t h e p ur cha se and mar ket i n g di vi si on s re sp e ct ivel y , b ut agai n p ro c ur em ent of raw mat eri al s , a dv ert i si n g an d ot he r sale s pr om ot i on req ui re f un d s . Sa me i s fo r , r ecr ui t m en t an d p ro m ot i o n of st a ff b y t he p er s onn el d epa r t ment w ou ld req ui re f un d s f or p a y ment o f sala ri es , w ag es an d ot he r bene fit s . I t ma y , ma n y t i m es , b e di f fi c ul t t o d em arc a t e w her e on e fu nct io n en ds an d ot he r st art s . Al t h o ug h , fi n an c e f unct i on h as a signi fica nt impa ct on t he ot he r f u n ct i o n s , i t n e ed n ot l i mit or obst r u ct t he g ene ral f unct i on s o f t he bu sin es s . A fi r m f aci n g fi n an cial di ffi c ult ie s , ma y gi ve w eight a ge t o financi al c on si der at i on s a n d de vi se it s o w n pr od uct i on and mark et ing st rat egi e s t o s ui t t h e si t u at i on . W hile a fir m ha ving s urpl u s fina nce , w o ul d have c o mp ar at i vel y l ow er ri gidit y a s re ga rd s t he fin ancial c on sid erat i on s vis- a - vi s ot h e r f un ct i on s o f t h e ma nag em ent . P er vas i v e Nat ur e of F inan c e Fun ct io n : Fin ance is t he li fe bl o o d of of an or gani sat i on , i t i s t h e c om mo n t hr ead bin ding all or gani sat i on al f un ct ion s . Thi s int e rf ace can b e exp l ai ne d a s bel ow : * Pr o du cti on - F ina nc e : P r od uct i on f unct i on re q uire s a l arg e i nve st me nt . Pr od u ct i ve us e o f r e s o ur ce s ens u re s a c o s t adva nt age f o r t he firm . Opt im u m i n ve st me n t i n i n vent ori es im pr o ve s p r ofit mar gin s . M any para met e rs of p r od u ct i on h av e a n i mpac t on c ost and can p o ssi bl y b e cont r ol l ed t h r o ugh i n t ern al man age me nt , t hu s enhan cing pr o f it s . I mport an t p r od uct i o n de ci si o ns like ma k e or b u y c an b e t ak e n o nl y a ft er t he fin an ci al i mp l i ca t i on s ar e co nsi de re d .

* Mar k eti ng - Fi nan c e : V ari o u s a sp ect s o f m ark et ing man age ment h av e financi al i mp l i cat i on s , de ci si on s t o h old i nvent ori es on l arg e s cale t o pro vid e o ff t h e sh el f se rvi c e t o c u st om er s incre as es in vent or y h oldi ng co st and at t h e sa me t i m e m a y i n cre as e sal es , s imila r w it h e xt en si o n o f cr edit facilit y t o c u st o me rs . M ark et ing st rat e gie s t o in cr ea se sal e i n mo st c as es , have a ddi t i o n al co st s t h at a re t o be w eig ht ed c are f ull y agai n st incre men t al r ev en ue b e fo re t aking d eci si on . * Per s on ne l - Fin an c e : I n t h e gl o bali sed co mpet it iv e sce nari o , b u sine s s or gani sat i on s a re m o vi n g t o a flat t er o rga nisat i onal st r uct ur e . I nve st me nt s in h um an r e s o urc e d ev el o p m ent s ar e al s o in cr ea sing . Re st r uc t urin g of rem u ner at i on st r u ct u re , v ol unt a r y r et ire m ent s che me s , sw eat eq uit y , et c . have b ec om e maj or fi n an ci al d eci si on s in t he h u man re s o ur ce mana ge men t .

Ques ti on : Dis cus s s o me of t he i ns ta nc es i ndi cat ing t he cha ngi ng s c enar io of fin an cia l ma nag e me nt in Ind ia ? Ans w er : M ode rn fi n a n ci al mana ge ment h as c om e a l ong w a y fr om t radit ion al c o rp orat e fi n a n ce , t he fin anc e man ag er i s w ork ing in a challen gi n g en vi r on men t t h at i s c hangi n g c ont in u o usl y . D ue t o t h e op enin g of t h e ec on omi e s , gl obal r es o u r ces a re bein g t app e d , t he opp o rt un i t i e s av ai l a b l e t o f i nanc e mana ger s virt uall y ha ve n o li mit s , h e m ust al s o u n d er st an d t h e ri sks ent aili ng all hi s d eci si on s . Fin a ncial mana ge men t i s p as si n g t h r o ug h an e ra o f exp eri me nt at ion an d excit e men t i s a p art o f fi n an ce act ivit ie s now a da y s . A f ew i nst anc es ar e as bel ow : i) I nt ere st rat e s h av e b e en fr eed f r om re g ulat i on , t rea s u r y op e rat ion s t h u s , have t o b e m o re s op h i st i cat ed d u e t o fl u ct uat ing int er est rat es . M ini m um co st of cap i t al n e ce ssi t at e s ant icipat ing int ere st rat e m o ve m ent s . ii) T he r up ee h ad b e co me f ull y c onv ert ibl e on c ur r ent a cc o un t . iii) O pt i m um de b t eq ui t y mi x i s po s sibl e . Fi rm s ha ve t o t ake ad vant ag e o f t he fin an ci al l e ve rag e t o i n c rea s e t he sh a reh old er ' s w e alt h , h o w eve r , u sing fi n an ci al l e ve r age n ec e ss aril y mak es b usi ne ss v ul ner abl e t o financi al ri sk . Fi n d i n g a c o rr ect t rad e o ff bet w een ri sk a nd i m pro v ed ret u rn t o sh a reh ol de r s i s a ch allen ging t as k f or a fina nce ma na ger . iv ) Wit h fr ee p ri ci n g of i ss u es , t he opt im u m pr ice d et er minat i o n o f new iss u e s i s a da u n t i n g t ask as ov erp ricin g r e s ult s i n un der s ubs cri pt ion and lo ss of i n v est or c on f i den c e , w hile un de r pricing le ad s t o unw arrant ed incre as e i n n um b e r o f sh ar e s t he reb y r ed u cing t he E PS .

v ) M ain t ai n i n g sh are p ri ce s i s cr uci al . I n t he lib erali s ed sc ena r io t h e capit al m ark et s i s t h e i m p ort ant a ven u e of f un d s f o r b u sin es s . Divi den d and b o n us p ol i ci e s fr ame d b y fin anc e m a nage rs ha ve a dir ect bea ring on t he sh ar e p ri ce s . vi ) E n s uri n g man a ge men t c ont r ol is vit al esp eciall y in li ght of fo rei gn part icip at i on i n eq u i t y , b a cke d b y h ug e r es o ur ce s makin g t he fir m an eas y t ake o ve r t ar get . E xi st i n g man ag em e nt s mi ght l o se c ont r o l in t he ev ent u al i t y o f b ei n g un a b l e t o t ak e u p sh are ent it lem ent s , fin ancial st rat egi e s , ar e vi t al t o p re ve nt t his . I n a re s o urc es c on st raint sit u at io n , t he imp o rt ance of fina ncial mana g e men t i s h i gh l i gh t ed as fi nancia l st rat egi es ar e req ui re d t o get t he co mpan y t h r o ugh t h e c on st raint s p o sit io n . The r ea s ons f o r it , ma y b e l ack of d em an d , sca rci t y of raw mat e rial s , lab o ur c on st raint s , et c . I f t he pro ble m i s n ot p r op e rl y d eal t w it h at init i al st a ge s , it c o uld le ad ult imat el y t o ban kr up t c y an d si ckn e ss . Th e financ ial man ag er 's r ol e in s u ch sit u at ion s , w o ul d b e fi r st t o as ce rt ain , w h et her und er t h e ci rc u mst anc e s , t he org an i s at i on i s vi ab l e o r n ot . I f t he vi abilit y o f t h e or gani s at ion , it s elf i s in d o ub t , t h en t h e al t ern at i v e of cl o sing dow n o per at ion s m u st be expl or ed . B ut , i n maj or ca se s t he p r oble m can be s ol ve d w it h pro pe r st rat egi e s .

Ques ti on : W hat is t h e r el e va nc e o f ti m e va lu e o f m on ey i n fi n anc ial de cis i on ma kin g ? Ans w er : A fi n an c e man a ge r i s r eq ui red t o m ake d eci si ons o n inv est ment , financi n g an d di vi d e n d i n vi ew of t h e c o mpan y ' s obj ect iv es . The d eci si on s as p urch as e o f a s set s or p r o c ure me nt o f f un ds i .e . t h e inve st me n t /fi n an ci n g de ci si on s af fect t h e cash fl ow in di ff er ent t i me peri od s . Ca sh o ut fl o w s w o ul d b e at on e point o f t im e an d in fl ow at s om e ot he r p oi n t o f t i m e , h en c e , t h e y a re n ot co mpa rable d u e t o t he ch ang e in r up ee val u e o f mo n e y . Th e y can be ma de co mpa rabl e b y in t rod u cing t he int er est fact or . I n t h e t h e o r y of fin an c e , t h e int e re st f act o r is o ne o f t he cr u ci al an d ex cl u si v e c on cept , kn ow n a s t he t ime val u e o f m on e y . Ti me val u e o f m on e y me an s t hat w ort h of a r up ee re c eiv ed t od a y is dif fer en t fr om t h e s ame r ecei ve d in f ut u re . The pr ef er ence f o r m on e y now a s c omp are d t o f ut u re i s kn ow n as t ime pre fe re nce of m on e y . Th e con cep t i s ap p l i c ab l e t o b ot h in divi d ual s and b u sin es s h o us e s . Re as o ns o f ti me pr e f er e nc e o f m on e y : 1) R is k : The re is un c ert ai n t y ab o ut t h e r ec eipt of mo ne y in f ut u re . 2) Pr e f er e nc e f or pr e s ent co ns u mpt io n : M o st o f t h e p er s on s an d co mpa nie s h av e a pr ef er ence f o r p r es ent con s u mp t i on m a y b e d ue t o urg enc y of n eed .

3) I n ves tm en t op por t unit ies : M o st o f t h e p er s on s an d co mpa nie s h av e pr ef er enc e f or pre sent m one y beca u se of av ai l ab i l i t i es o f opp o rt unit ie s of in ve st ment f or ea r ning addit i on al ca sh fl ow s . Im por tan c e o f ti me v alu e o f m on ey : The c on c ep t o f t i m e val ue of m on e y h elp s in ar rivin g at t he c om par able val ue of t h e di f fer en t ru p e e a m o unt ari si ng at dif fe rent p oint s o f t im e int o eq uival en t val ue s o f a p a rt i cul ar p oint of t ime , pre s ent or f ut ur e . Th e c as h flow s a ri si n g at di ff er en t p oi nt s o f t im e ca n be ma de c om par a ble b y usi ng any on e of t h e f ol l o w i n g : - b y c o mp o un di n g t h e p r e sent m one y t o a f ut ur e d at e i .e . b y findin g o ut t he val u e o f p re se n t mo n e y . - b y di sc o un t i n g t h e fut ur e m one y t o pr e s ent dat e i .e . b y findi ng o ut t he pre sen t val u e (PV ) of fut ur e m one y . 1) T ec hni qu es o f c o mp oun din g : i) F utur e val ue ( F V) o f a s ing le cas h fl o w : The f ut ur e val u e of a si n gl e ca sh fl ow is d efin ed as :

FV = PV (1 + r)n
Wher e , FV = f ut ur e v al u e PV = Pr es en t val ue r = r at e o f i n t e re st p er an n um n = n um b e r of ye ar s fo r w h i ch c om p o und ing i s do ne . I f, an y va ri ab l e i .e . P V , r , n va rie s , t hen F V als o va rie s . I t is ver y t e di o u s t o calc ulat e t h e val ue of

(1 + r)n so di ff ere n t c om b i n at i ons ar e p ub lishe d in t he f or m o f t ables .

The s e ma y b e re fe rr e d f o r c o mp ut at ion , o t herw ise one s h o uld u se t he know le dg e of l oga ri t h ms .

ii) Fut ur e va lu e o f an an nui ty : An ann ui t y i s a se ri e s o f p eri o dic ca sh fl o w s , p a ym ent s o r r ec eipt s , of eq ual am o un t . T h e p remi u m pa ym ent s of a lif e in s ur anc e p olic y , f o r inst anc e a re an an n ui t y . I n gen eral t er ms t he f ut u re val u e o f an ann uit y i s give n a s :

FVAn = A * ([(1 + r)n - 1]/r)

Where,

FVAn =

Future value of an annuity wh ich has duration of n years.

A = Constant periodic flow r = Interest rate per period n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest and the time period, if any of these variable changes it will change the future value of the annuity . A published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2) T ec hni qu es o f dis c oun tin g : i) Pr es en t v alu e o f a s in gl e cas h fl o w : The pr e sen t val u e of a si n gl e ca sh fl ow i s give n a s :

PV = FVn ( 1 )n
1 + r

Where, FVn = F u t u r e

value n years hence

r = rate of interest per annum n = number of years for which discounting is done. From above, it is clear that present value of a future money depends upon 3 variables i.e. FV , the rate of interest and time period. The published tables for various combinations of

)n

1 + r are available.

ii) Pr es ent va lu e o f a n a nnu it y : S om et ime s i n st e ad o f a si n gl e ca sh fl ow , cash fl ow s of s am e a mo u nt is rec eiv ed f or a n umb er o f y ear s . The pr es ent val u e o f a n an n u it y ma y b e expr e ss ed a s b el ow :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n = A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 + r)n ] = A [ (1 + r)n - 1] r(1 + r)n Where, PVAn = Present value of annuity which has duration of n years
A = Constant periodic flow r = Discount rate.

CH A P TE R T H RE E

TOOL S OF F I N A NC I AL A N AL YS I S A N D PL A N N I NG

Ques ti on : Wr it e a no te o n Fin an cia l St at e me nt Ana lys is ? Ans w er : Th e b a si s of fi n a n ci al anal y si s , pl anning and d eci si on makin g i s financi al i n f or mat i on . A fi r m p rep are s fina l acc o unt s vi z . Bal an ce Sh eet and Pr o fi t an d L os s Acco u n t pr o vidin g in f or mat i on f or de cisi o n ma king . Finan ci al i n f or mat i on i s n e ed ed t o p re dict , c om par e a nd e val u at e t he firm ' s ear n i n g ab i l i t y . Pr o fi t an d L o ss acc o unt sh ow s t he c o nce rn' s op erat i n g act i vi t i es an d t h e Bal anc e She et de pict s t he b alan ce val ue of t he acq ui re d a s set s an d o f l i a bilit ies at a part ic ula r p oint o f t i me . How e ve r , t h es e st at e men t s d o n ot di scl o s e all of t h e n ece s sa r y and rele van t i n f or mat i on . F or t h e p urp o se of o bt aining t he m at erial and rele van t i n f or mat i on n ece s sar y f o r a sc ert aining o f finan cial st r engt hs an d w eakne s se s o f an en t erp ri se , it i s es s ent ia l t o anal y se t he dat a de pic t ed in t he fi n an ci al st at e men t . T he fina ncial mana ge r ha ve c ert a in anal yt ical t ool s t h at h el p i n fi n an ci al anal y sis an d planning . I n a ddit i on t o st ud yin g t he pa st fl ow , t h e fi n an ci al man age r can eval u at e f ut u re fl ow s b y mean s of f un d s st at em en t b ase d on f o rec ast s . Fi n an c i al St a t emen t An al ysi s i s t he pr o ce s s of id ent if yi ng t he financi al st ren gt h an d w eak ne ss of a fir m fr om t he avail able a cco u nt ing dat a an d fi n an ci al st at emen t s . I t is d on e by pr op erl y e st abli sh ing relat i on sh i p b et w een t h e i t e ms of balan c e she et an d p ro fit an d l os s acc o un t a s , 1 ) Th e t a sk o f fi n an c i al an al y st s is t o d et e rmin e t he inf o rmat i o n rel e vant t o t he de ci si on un d e r c on si d erat i on fr o m t ot al inf o rmat i on c o nt ained in t he fin an ci al st at e m en t . 2 ) T o a rra n g e i n f orm at i on i n a w ay t o hig hlight si gni ficant rela t ions hips . 3 ) I nt erp r et at i on an d draw i n g of in fer enc es and c oncl u si on . T hu s , financi al an al ysi s i s t h e p r oce s s of sel ect ion , r elat i on a nd ev al uat i on o f t he acc o un t i n g d at a /i n f o rm at ion . Pur pos es o f Fi nan ci al S tat e me nt Ana lys is : Fi nanci al St at em ent An al y sis is t he m ean i n gf ul i n t er p ret at i o n of 'Fi nanci al St at eme nt s ' fo r ' P art ies Dem an di n g Fi n a n ci a l I n fo rmat i on ' , s u ch a s : 1 ) Th e G ov ern me n t ma y b e i nt ere st e d in kn ow ing t he c o mpa rat ive en er g y con s u mp t i on of s o m e p r i vat e an d p ubli c sect or ce me nt c omp anie s . 2 ) A nat i on al i s ed b a n k m a y m a y b e k ee n t o k n ow t he p o s sible de bt co ve rag e o ut of p r o f i t at t h e t ime of len d ing . 3 ) Pr o sp e ct i ve i n v e st or s ma y be d esi r o us t o k n ow t he a ct u al a nd fo re ca st ed yi el d dat a .

4 ) C u st o me rs w an t t o k n ow t he b u sin es s viabilit y p ri or t o ent e ring i nt o a long - t erm c on t ra ct . Th e re ar e o t h er p u rp os e s al s o , i n ge ne ral , t he p u rp o se o f financi al st at em en t an al ysi s aid s dec isi o n ma king b y u se rs of acc o unt s . St eps f or f ina nc ial s t ate m ent a nal ys is : I den t i fi cat i o n of t h e u se r' s p urp o se I den t i fi cat i o n of dat a s o u rce , w hich pa rt o f t he ann u al rep o rt o r ot h e r i n f orm at i on i s r eq uir ed t o b e anal y s ed t o s uit t he p urp o s e Sel ect i n g t h e t e ch n i q u es t o be us ed f o r s uch an al ysi s As s u ch an al y si s i s p u rp o siv e , it ma y b e re st rict e d t o any part ic ul ar p ort i on o f t h e av ailabl e financi al st at e ment , t aking care t o ens u re ob je ct i vi t y an d un b i a s edn es s . I t cov er s st ud y o f rel at io nship s w it h a s et of fi n an ci al st a t emen t s at a p oint of t ime an d w it h t ren d s , in t he m , ov er t ime . I t co ve r s a st ud y of s o me c om parabl e fir ms at a p art ic ular t ime or of a p art i c ul a r fi r m ov er a pe ri od o f t ime o r ma y co v er b o t h. Typ es o f Fi nan ci al s t ate m ent a nal ys is : Th e m ain ob ject iv e of financi al anal ysi s i s t o det e rmi n e t h e fin ancial he al t h o f a b us ine s s e nt e rpri se , w hich ma y b e of t h e f ol l ow i ng t yp es : 1) E x ter nal a nal ys is : I t i s p e rf o rm ed b y o ut si de part i es , s uch as t r ad e cre dit or s , i n ve st o rs , s up p l i er s o f l on g t e rm de bt , et c . 2) I nt er na l ana lys is : I t i s p er f or me d b y c o rpo rat e fin ance an d acc o unt ing depa rt me n t an d i s m or e det ail ed t han e x t ernal anal y sis . 3) Hor iz on tal a nal ys i s : Th i s ana l ysi s co mp are s finan cial st at em ent s vi z . pro fit an d l o s s ac c o u n t an d balan ce sh ee t of pr evi o u s y ea r w it h t hat o f cu rr ent yea r . 4) V er t ic al an al ys is : V ert i cal anal y sis c on vert s each el em ent of t he inf orm at i on i n t o a p e rcen t a ge o f t h e t ot al am o unt o f st at em en t s o a s t o est abli sh rel at i on sh i p w i t h ot he r c o mp on e nt s of t he sa me st at e ment . 5) Tr end a nal ys is : T r en d an al y si s c o mpa r es rat i os of di ff ere nt co mp one nt s of fin an ci al st at eme n t s r el at e d t o di ff er e nt peri o d w it h t hat o f t he ba se y ear . 6) R ati o Ana lys is : I t est ab l i sh es t he n u me rical o r q u ant it at ive relat i on ship bet w een 2 i t e m s/ va ri ab l e s of fi nanci al st at ement s o t hat t he st rengt h s and w e akn e s se s o f a fi r m as al so it s hist ori cal p er fo rm anc e an d c ur re nt financi al p o si t i o n m a y b e det ermi ne d . 7) Fu nds f lo w s t at em en t : Th i s st at em ent pro vid e s a c om pre h ensi ve id ea abo ut t h e m o ve me n t o f fi n an ce i n a b u sin es s unit d urin g a pa rt icul ar peri od of t i me .

8) Br ea k- e v en an al y s is : Th i s t yp e of an al y sis r ef er s t o t he int e rpret at i on o f financi al d at a t h at r ep r es en t ope rat ing act ivit ies .

Ques ti on : W hat ar e t he us u all y f ol lo w ed r ati o ca te gor ies for b us in es s dat a anal ys is ? M ent io n fi nan cia l r ati os us ed i n ea ch c at eg or y ? Ans w er : Rat i o An al y si s i s a w idel y us ed t o ol o f financi al a nal y sis . ' Rat i o ' i s relat i on sh i p exp re s se d i n mat he mat ical t e rm s b et w een 2 i ndivi du al or gr o up o f fi g ur e s c on n ect ed w it h ea ch ot her in s o me l o g ical mann er ; sel ect ed f r om fi n an c i al st at e ment s o f t he c once rn . Rat i o an al y sis i s ba s ed on t h e fact t h at a si n gl e acc o unt ing fi g u re b y it s elf mi ght n ot co mm un i cat e me an i n gf ul i n f or mat i on , b u t w hen e xpr es s ed i n r elat ion t o s om e f i g ur e , i t ma y d efi n i t el y pr o vid e c ert ain signi ficant in f or m at ion , t his relat i on sh i p b et w een acc o unt ing fi g ur es i s kn ow n as fi nancial rat io . Finan ci al rat i o h el p s t o e xp r es s t he relat i o nship bet w ee n 2 ac c o unt ing fig ur e s i n a man n er t h at u s er s c an draw c oncl u si on s a b o ut t he per fo rm an c e , st r en g t h s an d w ea kne s se s of a fir m . Clas s i fi ca ti on o f R ati os : I) A c cor din g to s our ce : Fi n an cial rat i os acc or ding t o s o ur ce fr om w hich t he fi g ure s ar e ob t ai n ed ma y be cla s sifi e d a s b el ow : 1) R e v enu e r at ios : W h en 2 va riabl es ar e t aken fr o m re ven u e st at ement t he rat i o s o c o mp ut e d i s kn ow n as , R ev en ue r at io . 2) B ala nc e s h ee t r ati o : Wh en 2 vari able s are t aken f ro m t h e b alance she et , t h e r at i o s o c om p ut ed is kn ow n a s , Bal ance she et rat i o . 3) Mi x ed r a ti o : Wh e n o n e va riabl e i s t ak en fr om t he R ev en u e st a t e ment and ot h e r fr o m t h e B al an ce she et , t he rat io s o co mp ut e d i s k n ow n a s , M ixed rat i o . II) A cc or d ing t o us a ge : Ge o rg e F ost er o f St anf o rd Uni ve r sit y gav e se ven cat eg ori e s of fi n an ci al rat i o s t hat e xha u st ivel y c ov er dif fe rent asp ect s o f a b u sin e s s or gan i sat i on , t h e y ar e : 1 ) Ca sh p osi t i on 2 ) Liq ui d i t y 3 ) W o rki n g Cap i t al / C ash Fl ow 4 ) Ca p i t al st r uct u re 5 ) Pr of i t ab i l i t y 6 ) D eb t Se rvi ce C o v era ge 7 ) T urn o ve r Wh i l e w orki n g on rat i o an al ysi s , it is i mp ort ant t o a v o id du plicat i on o f w ork , as sa me inf o rmat i on ma y b e p r ovi de d b y mo re t han on e r at i o , t h e an al y s t h as t o be s elect i ve in re sp ect of t he us e of fin ancial rat io s . T h e o p e rat i on s a n d fi nan cial po sit i on o f a fi rm can b e de scrib ed b y st u d yin g i t s sh o rt an d l on g t e rm liq uidit y p o sit ion , p r ofit ab ilit y and op erat i on al act i vi t i e s . Th u s , r at io s ma y b e cla s sifi ed a s foll ow s : 1 ) Liq ui d i t y rat i os

2 ) Ca p i t al st r uct u re /l ev era ge rat i os 3 ) Act ivi t y rat i os 4 ) Pr of i t ab i l i t y rat i os

Ques ti on : Dis cus s th e v ar i ous r at ios i n de tail ? Ans w er : 1) L iq uid it y r ati os : 'Li q ui di t y' a n d 's h ort - t er m s olv en cy ' ar e u se d a s s yn o ny ms , meani n g ab i l i t y of t h e b u si n e s s t o p a y it s sh ort - t er m li abilit ie s . I nabilit y t o p a y- o ff s h ort t er m l i a b i l i t i es af fect s t he c o ncern ' s cr edibilit y a n d cr edit rat ing ; c on t i n u o us d efa ul t i n pa y ment s l e ads t o c om me rcial b ankr upt c y t hat eve n t ua l l y l e ad s t o si ck ne ss an d dis s ol ut io n . Sh o rt - t erm le nder s and cre dit or s o f a b u si n e ss ar e i n t ere st e d in k now ing t he co nce rn ' s st at e of liqui dit y f or t h ei r fi n a n ci al st ake . Tr adit i on ally c ur rent and q uic k rat i os ar e u se d t o h i g h l i gh t t h e b usi n e ss 'liq uidit y ' , o t hers ma y b e c ash ra t io , int erv al mea s ur e rat i o an d n et w or ki ng capit al ra t io . i) C ur r e nt r at io : C ur re n t rat i o = C u rr ent As set s / C urr ent Li abilit ies Wher e , C ur re n t as s et s = I n ve n t ori es + S und r y debt or s + Ca sh and Bank balanc es + Re cei vab l es / Ac cr ual s + L oan s a n d ad vanc es + Disp os able I nve st me nt s . C ur re n t l i ab i l i t i e s = C redi t or s f or g o od s an d ser vic es + Sh ort - t er m L oan s + Bank Ov er dra ft + C a sh cr edi t + O ut st an ding e xpen se s + P r ovi si on f or t axat i on + Pr op o se d d i vi d en d + Un cl ai m ed divi den d . C u rre n t rat i o i n di cat es t he avail abilit y o f c urr ent a s s et s t o me et cu rr ent l i ab i l i t i e s , h i g h er t h e rat io , b et t er i s t he c ov er age . T rad it ionall y , it is c alle d 2 : 1 r at i o i .e . 2 i s t h e st anda rd c ur rent as s et s f or eac h unit of cu rr ent l i ab i l i t y . T h e l ev el of c ur rent rat i o var y f ro m i nd u st r y t o ind ust r y dep endi n g on t h e sp eci fi c i n d ust r y cha ra ct erist ic s and al so a firm di ff er s fr om t h e i n d u st r y r at i o d ue t o it s p oli c y . ii) Qui c k r ati o : Q uick rat i o o r a ci d t est rat i o = Q uick As set s / C u rr ent or Q ui ck liabilit ie s Wher e , Q uick a ss et s = S un d r y de b t or s + Ca sh a n d Ban k bal anc es + Re cei vab l es / Ac cr ual s + L oan s a n d ad vanc es + Disp os able I nve st me nt s i .e . = C u rr e n t as set s - I nv ent o rie s .

C ur re n t l i ab i l i t i e s = C redi t or s f or g o od s an d ser vic es + Sh ort - t er m L oan s + Bank Ov er dr a ft + C a sh cr edi t + O ut st an ding e xpen se s + P r ovi si on f or t axat i on + Pr op o se d d i vi d en d + Un cl ai m ed divi den d . Q uick l i ab i l i t i e s = Cr e di t or s f or g o od s and se rvic e s + Sh o rt - t erm L oa ns + O ut st an di n g e xp en s es + P ro vi si o n fo r t ax at ion + Prop o se d divi den d + Uncl aim ed di vi de n d i .e . = C ur ren t l i a bilit ies - B ank ov er dra ft - C as h c re dit . I n t h e a b o v e f o rm ul a , in st e ad o f t ot al c u rr ent liabilit i es o nl y t hos e c u rr en t l i ab i l i t i es ar e t ak en t hat a re pa yabl e w it hin 1 y e ar t hat a re know n as q ui ck l i ab i l i t i es . Q uick as s et s a r e al s o c alle d liq ui d a ss et s , t he y con si st s o f c as h an d on l y 'n ea r c ash a ss et s' . I nv ent o rie s are d e du ct ed fr om c ur ren t as s et s , as t h e y a re n ot c on si der ed a s 'ne ar ca sh as set s ' , b ut in a sel l er ' s mar ket t h e y a re n ot s o c on sid ere d . J u st like la g in coll ect io n of d ebt o rs , t h ere i s l ag i n c on ver si on o f i nvent ori es int o fi nish ed g o od s and s un dr y deb t or s , al s o sl ow - m ovi ng i nv ent o r ie s a re n ot ne ar ca sh as set s . Wh i l e cal c ul a t i n g t h e q ui ck rat io , t he c on s erv at is m c on vent i on , quic k li a b i l i t i es ar e t h at p o rt io n of c ur ren t liabilit ies t hat fall d ue imm edi at el y , h en c e b an k o ve rdr aft an d cash cr edit ar e e xcl ud ed . iii) Cas h r ati o : C as h r at i o = (C a sh + M arket able s ec urit i es )/ C u rre nt liabilit ie s The ca sh rat i o mea s ur e s ab s ol ut e liq uidit y o f t he b u sine s s a va ilable w it h t he c on c ern . iv) Int er va l m eas ur e : I nt erval mea s ur e = (C u r re nt a ss et s - I nve nt or y )/ Av er age d ail y op er at ing exp ens e s Wher e , Av er ag e d ai l y op era t i n g ex p en se s = (C o s t of g o od s + Sellin g , admini st rat i v e an d g en e ral exp en se s Dep re cia t ion an d ot he r n on - c ash exp endi t ur e )/ n o . o f da ys i n a y ear .

2) Ca pit al s tr u ct ur e / L e ver ag e r ati os : Th e cap i t al st r uct u re or le ver ag e rat i os ar e de fine d a s , t h o se financi al r at i o s t h at mea s ur e l on g t e rm st abilit y and st r u ct u re of t he fir m and in di cat e mi x o f f un ds p r o vid ed b y ow ner s a nd l en der s , in or de r t o as s ur e l e n d er s of l on g t er m f und s as t o : Pe ri o di c p a y men t o f i nt ere st d u ring t he p eri od of t h e l oan , an d Re p a ym en t of t h e p ri n cipal am o unt on m at urit y . The y a re cl a ssi fi e d a s :

i) C api tal s tr uc tur e r ati os : Cap i t al st r u ct ur e rat io s pr ovi de an in sight int o t h e fi n ancing t echniq ue s u s ed b y a b u si n e s s an d c o ns eq uent l y f oc u s on t he l ong - t e rm s olv enc y p osi t i on . F r om t h e balan ce sh e et o ne can get ab sol ut e f un d empl o y ed an d i t s s o ur ce s , b ut ca pit al st r uct ur e rat io s sh ow re lat ive w eight of di f fe ren t s o ur ce s . F un d s on li ab ilit ies sid e o f b alanc e she et ar e clas sifi ed a s ' ow n er ' s eq ui t i e s ' a nd ' ext er n al eq uit ie s ' als o call e d 'eq uit y ' and 'd eb t ' . Ow n e r 's eq ui t i es or eq uit y me ans sh ar eh old er 's f un ds con si st i n g o f eq ui t y an d p re fe ren ce sh ar e ca pit al an d r e se rv es and s urpl u s . E xt e rn al eq ui t i es mea ns all o ut sid e liabilit i es incl u siv e of c ur re nt liabilit ies an d p ro vi si on s , w h i l e debt i s cla ssi fie d as l ong t erm b or r ow ed fu nd s t h u s , exc l udi n g sh o rt - t erm lo an s , c ur rent lia bilit ies an d p r ovi si on s . As per g ui d el i n es f or i ss ue of 'De bent ur es b y P ubli c Limit e d C o m pan y' d ebt mean s t erm l oan s , d eb en t ur es an d b on d s w it h an init ial mat u rit y per io d o f y ear s o r m o re i n cl usi ve o f i n t e re st a ccr u e d t her e on , all de fe rr ed pa ym ent liabilit ies , p r op os ed deb en t u re is s u e b ut excl u d ing sh o rt - t erm bank bor r ow i n g s an d ad v an ce s , un sec u re d l o ans o r dep o sit s f ro m t he p ublic , sha reh ol der s an d e m p l o y ee s a nd u ns ec ur ed l o ans an d d ep o sit s fr om ot he rs . Ca p i t al st r uct ur e rat i o s us ed ar e : a) O w ner 's E qui ty t o tot al E qui ty : Ow n er ' s E q ui t y t o t ot al eq uit y rat i o = Ow n er 's E q uit y/ T ot al E q ui t y I t i n di cat e s p ro p ort io n of ow ner s ' f und t o t ot al f und i nve st ed in bu sin es s . Tra di t i on al b el i e f sa y s , high er t he pr o po rt io n of ow ne r' s f und low er i s t h e de gr ee of ri sk . b) De bt E qui ty Rat io : Deb t - eq uit y rat io = D ebt /E q uit y I t i s t h e i n di cat or of le ve rag e , sh ow ing t h e p r op ort i on o f debt fu nd in r el at i on t o e q ui t y . I t i s r ef er red in capit al st r uct ur e de cisi on as al s o in t he l egi sl at i on s d e al i n g w i t h t he capit a l st r uct ur e dec i si on s i .e . is s u e of sha re s a n d deb en t ur es . Len de rs a re ke en t o k n ow t his rat i o a s it sh ow s relat iv e w ei gh t s o f d eb t an d e q uit y . As p er t r adit io nal sch o ol , c ost o f capit al fi r st l y d ecr ea se s d ue t o t h e hi ghe r d os e o f l ev era ge , r e ache s minim u m a n d t h er ea ft er i n cr ea se s , t hu s i nfinit e i ncr ea se in l e ver ag e i .e . debt - eq ui t y rat i o i s n ot p o ssi ble . H ow e ve r , ac co rdin g t o M odi gliani - M ille r t heo r y , c ost o f c ap i t al an d l e ve ra ge ar e i ndep end ent of e ach ot h er and bas ed o n c ert ai n re s t ri ct i ve as s um pt ion s , namel y , - per fe ct cap i t al ma r ket s - ho m og en e o u s exp e ct at i on s b y t h e p re se nt and pr o spe ct ive i nve st o rs - pre s en c e of h om o g en e o u s risk cla s s fir m s - 10 0 % di vi d en d p a y - o ut - no t ax si t uat i on an d so on .

M ost o f t h e ab o ve a ss u mpt i ons a re un re alist ic . I t is b e li ev ed t hat lev era ge an d c o st o f cap i t al ar e r elat e d . The re is n o no rm f o r maxi m um debt - eq ui t y rat i o , l e n di n g i n st it ut ion s u s u ally , set t h eir ow n no rm s con sid eri n g t h e ca p i t al i n t ensit y and ot her fact or s .

ii) Co v er a ge r a ti os : Th e c ov era ge rat i o m ea s ur es t h e fi rm ' s a bilit y t o s er v ice fix ed liabilit ies . Th es e rat i o s est ab l i sh t he relat i on ship bet w ee n fi xe d clai m s an d w hat is u s ual l y av ai l ab l e o ut o f w hich t hes e cl aim s are t o be paid . The fixe d cl ai m s co n si st of : I n t erest on l o an s Pr ef ere n ce di vi d en d Am o rt i sat i on o f p ri n c i pal or re pa ym ent o f t he in st alm ent of l o ans o r red em p t i on o f p re fe r ence ca pit al on mat urit y . The y ar e cla ssi f ied as f ol l ow s : a) De bt s er v ic e c o v e r age r a ti o : Len de rs ar e i n t er est e d in j ud gin g t he fir m 's abilit y t o pay of f cu rr ent i n t er e st an d i n st al m ent s and t h us t he d ebt s er vic e c o v era ge rat i o . Deb t se rvi c e co ve ra ge rat io = E a rnin gs a vailabl e f or de bt se rvi c e / (I nt e re st + I nst alm ent s ) Wher e , E arning a vai l ab l e f or de b t s er vice = Net p ro fit + N on - c ash ope rat ing exp ens e s l i k e d ep rec i at i on an d ot her am o rt isat i ons + N on op erat i n g a dj ust men t s a s l o ss on sale of fix ed a ss et s + I nt ere st on debt fu nd . b) Int er es t c o v er ag e r ati o : I t i s al s o k n ow n a s "t ime s i nt er est earn ed rat i o" an d indi cat e s t he fi rm ' s ab i l i t y t o m eet i n t e re st oblig at io ns and ot h er fix ed c harg es . I n t erest c o ve rag e ra t io = E BI T /I nt ere st Wher e , E BI T = E a rn i n g s B e fo r e I n t ere st an d Ta x E B I T i s u sed i n t h e n um erat or a s t he abilit y t o pa y int ere st i s n ot aff ect e d b y t ax b u rd en a s i n t er est on d e bt f und s i s a ded u ct ible exp ens e . Thi s r at i o i n di cat e s t h e ext en t t o w hich e arning s ma y fall w it ho ut ca u sin g any di ffi c ul t t o t h e fi r m r ega rdin g t h e pa y ment o f int e re st cha r ge s . A hig h int ere st c ov er ag e r at i o me ans t hat an ent erpri s e c an ea sil y m eet it s int ere st ob l i g at i on s e ven i f E BI T s uf fe r a c on sid era ble de cline , w hile a low er rat i o i n di c at es exc es si v e u s e of d eb t or ine ffi cient op er a t ions . c) Pr e fer en c e di vi de nd c o ver ag e r ati o :

I t mea s ure s t h e fi r m' s a b i l i t y t o pa y pre fe renc e divi den d at t h e st at ed rat e . Pr ef ere n ce di vi d en d co ve rag e rat io = E AT /P re fe ren ce div ide n d liabilit y Wher e , E AT = E arn i n g s a ft er t ax E AT i s c on si der ed a s unlik e debt on w hich i nt er est i s a cha rg e on t he fi rm ' s p ro fi t , p re f ere n ce di vid end is a n app r opriat i on o f p r ofit . The rat io in di c at es m argi n o f sa fet y avail able t o p re fe ren ce sh ar e hol der s . A highe r r at i o i s d esi ra b l e fr om pr ef er enc e sha reh ol der s p oint of view .

iii) Ca pit al G ear i ng r ati o : Ca pit al g eari n g rat i o = (P re fe ren ce S har e C apit al + Deb ent ur e s + L on g t erm l o an )/ (E q ui t y sh a re capit al + Re se r ve s & S urpl u s - L os se s ) I t i s u se d i n addi t i on t o debt eq u it y r at io t o sh ow t he pro p ort io n of fi xe d i n t e re st / di vi den d b earin g capit a l t o f und s bel on ging t o e q uit y sha reh ol der s . F o r t h e j ud g i n g of t he l o ng - t er m s olv enc y p osit i on , in addit i on t o debt - eq ui t y an d cap i t al gea ring r at io s , t he f oll ow ing a re u s ed : a) F i xe d As s ets / L on g t er m fu nd : Fix ed a ss et s and c or e w orki ng ca pit al are ex p ect e d t o b e f i n an ce d b y l ong t er m f u nd . I n va ri o us in du st ri es t he pro p ort i o n of fi xe d a n d c u rr ent a ss et s ar e dif fe re nt , t h us t her e can b e n o uni f orm st an da rd o f t h i s rat i o , b ut it sh o ul d b e le s s t han 1 . I f it is m ore t han 1 , it me an s sh ort - t er m f u n d h a s b een us e d t o fin anc e fi xe d a s set s , o ft en big c o mp an i es r es o rt t o s uch pr act ice d ur ing e xpan si on . Thi s m ay be a t emp ora r y a rra n g em en t b ut n ot a lo ng - t e rm re me d y . b) Pr opr i et ar y r a ti o : Pr op ri et ar y rat i o = P r opr iet ar y f un d /T ot al as set s Wher e , Pr op riet ar y f un d = E q ui t y sh a re capit al + P ref er enc e sha re capi t al + Re s er ve s & s urp l u s - F i ci t i t i ou s as s et s T ot al a s set s = Al l as s et s , b ut e xcl ud es fi ct it io us a ss et s and l os s es . I t i s p o ssi b l e t o re d uce eq uit y st a ke b y l ow erin g liq ui d it y r at io i .e cu rr ent rat i o , E xa mpl e : Wh en c ur r en t an d d ebt - eq uit y rat io s are b ot h 2 : 1 each , an d t he pr op o rt i on of fi x ed an d c ur rent as set s i s 5 : 1 E q ui t y /t ot al a s s et s = 31 .6 7 % b ut if t he c u rr ent rat i o i s re du ce d t o 1 .5 : 1 eq ui t y /t ot al as s et s = 31 .1 1 % .

3) Ac ti vi ty r a ti os : Th e act i vi t y rat i os al s o kn ow n as t ur no ve r o r p er fo rm ance rat i os are e mp l o ye d t o e va l uat e t he ef fici enc y w it h w hich t he f irm mana ge s and ut i l i se s i t s a ss et s . Th e se rat i os us u all y i ndicat e t he fr eq uen cy of sal e s w it h res p ect t o i t s a s set s , w h ich m a y b e c apit al a ss et s o r w orki ng ca pit al or av er ag e i n ven t or y . Th e se a re calc ul at e d w it h re fe re nce t o s ales /c o st of g o od s s ol d an d ar e e xp r e ss ed in t e rm s of rat e or t ime s . The y ar e a s foll ow s : i) C api tal t ur n o ver r a tio : Ca p i t al t u rn ov er rat i o = S ale s / Capit a l em plo y ed I t i n di cat e s t h e fi rm ' s a bilit y o f gen erat ing s ale s per ru pe e of long t er m i n ve st m en t , t h e h i gh er t he rat io , m o re e ffici ent i s t h e ut ilisat i on of t he ow n er ' s an d l o n g - t er m c re dit or s ' f u nds . ii) Fi x ed As s e ts tur n o v er r ati o : Fi xed As s et s t urn o ve r rat i o = S ale s / Capit al a ss et s A h i gh fi xe d a ss et s t u rn ov er rat i o in dicat es e ffici ent ut ilis at ion of fixe d a s set s i n ge n e r at i on o f sal es . A fir m w hos e pl ant an d ma chiner y a re old m a y sh ow a h i gh er fi x ed as s et s t urn o v e r rat io t han t h e fir m w ho pu rcha se d t h em re c en t l y . iii) W or k ing cap ita l t ur no v er r at io : Wo rki n g ca p i t al t u rn ov er = Sal es /W o rking C apit al I t is f urt h e r di vi de d a s b el ow : a) In v ent or y tur n o v er r at io : I n ven t or y t u rn ov er ra t io = Sal es / Av e rag e i nven t or y Wher e , Av er ag e i n ven t or y = (O p en i ng St ock + Cl o sing st ock )/ 2 I t may al s o b e cal cu l at ed w i t h r ef er enc e t o c o st of sal e s in st e ad o f sale s , as : I n ven t or y t u rn ov er ra t io = C o st of s ale s / Aver ag e in vent or y F or i nv en t o r y o f r aw mat eri al , I nvent or y t u rn ov er ra t i o = Raw mat e rial c on s um ed / Av er ag e r aw mat e rial st oc k .

Th i s rat i o i n di cat e s t h e spe ed of in vent or y u sa ge . A h igh rat i o i s go o d fr om l i q ui di t y p oi n t of vi ew an d vice ve r sa . A l ow r at io i n dicat e s t hat inven t or y i s n ot u se d/ s old or is l ost a nd st a ys in a shel f or in t he w areh o u se f or a l on g t i me . b) De bt or s tur n o v er r ati o : W h en a fi rm se l l s g o od s on cr e dit , t he re alis at ion of sal e s rev en u e i s del a y ed a n d r ec eiva ble ar e c r eat ed . Ca sh is r eali s ed fr o m t hese r ecei vab l e s l at er on , t he spe ed w it h w hich it i s reali s ed aff ect s t he firm ' s li q ui di t y p o si t i o n . D eb t o r s t urn o ver r at io t hr ow s light o n t he coll ect i o n an d cre di t p o l i ci e s o f t he fi rm . Deb t or s t urn o ver r at i o = S ale s o r Cr edit sa les / Av er ag e ac c o un t s rec eiva ble As acc o u n t rec eiv able pe rt ai ns t o c re dit s ale s onl y , it i s oft e n rec o mm en d ed t o c o mp ut e debt or ' s t urn o ver w it h re fe re nce t o cr edit sale s rat h e r t h an t ot al s al e s . Av er ag e c ol l ect i o n p eri od = Av er ag e a c co unt s r ec eiva ble s /a ver ag e d ai l y cre dit s ale s Wher e , ave rag e dai l y cr edi t sal e s = Cr edit sal es / 3 65 Th e ab ov e r at i os p r o vid e a uniq ue g ui de f or d et er mi ning t he firm ' s cre di t p ol i c y . c) Cr e dit or s tur no v er r at io : I t i s ca l c ul a t ed on sa me line a s debt or s t urn o ve r r at io and sh ow s t he v el oci t y of d eb t p ay me n t b y t he fi rm , Cr edi t or s t ur n o ve r ra t i o = C re dit p urc ha s es o r An n ual n et c re dit p u rch a se s / Av er age acc o unt s pa yabl e A l ow rat i o r efl ect s l i be ral c re dit t erm s g rant e d b y su pplier s , w hile a high rat i o re fl e ct s r ap i d set t le ment o f a cco u nt s . Av er ag e p a y me n t p eri od = Av er age ac c o unt s pa ya ble /a ve ra ge dail y cre dit p urc ha se s Wher e , ave rag e dai l y cr edi t p u rch a se s = cr edit p ur cha se s /3 65 Th e fi r m c an c omp are w hat cr edi t peri od it r ecei v es fr om t he s uppli er s an d w h at i t o ff er s t o t he c u st o m er s . I t can al s o c o mp are t he ave rag e cre di t p eri o d of fe re d t o t he c ust om er s i n t he ind u st r y t o w hich it bel ong s .

4) Pr o fi tab ili ty r a ti o :

Th e p r ofi t ab i l i t y r at i o s me as u re pr ofit abilit y o r t he ope rat ion al eff icien c y o f t h e fi r m re fl e ct i ng t he fin al r es ult s of b u sine s s op erat i on s . Th e re s ult s o f t h e fi rm ma y b e e val uat e d in t er ms of it s earni ng s w it h re fe re nce t o a gi ven l e vel o f as set s or s ale s or ow ne rs int er est , e t c . Th u s , t he pro fit ab i l i t y r at i o s ar e b r o adl y cla ssi fie d i n f oll ow ing cat eg o ri es : i) Pr of ita bil it y r ati os ar e r e quir ed for a nal ys is fr o m o wn er s p oi nt o f v ie w : a) Re tur n on e qui ty ( RO E) : I t mea s ur e s t h e pr o fit abilit y of eq ui t y f u nd s inve st ed i n t h e fi rm a n d r ev eal s h ow pr ofit ably t he ow n er ' s f u n ds ar e ut ilis ed b y t h e b u si n e ss . R OE = Pr o fit a ft er t a x es / Net w ort h b) Ear n ings p er s har e ( E P S) : T he pr of it ab ilit y of a fir m fr o m vie w point o f or dina r y sh a reh ol der s c an b e me as u re d i n t er ms of n umb er of eq uit y sha re s kn ow n as e ar n i n gs p er sha re . E P S = N et p r o fi t av ai l ab l e t o eq uit y h old er s/ n o . o f or dina r y sha re s o ut st an ding c) Di v id end p er s har e : E P S a s ab o ve r efl ect s t h e p r ofit abilit y of a fir m p er sha re , i t d o es n ot r ef l ect h ow m u ch p r ofit is paid a s divi den d and h ow m uch i s ret ai n ed b y t h e b u si n es s . Di vid en d p er sha re rat i o in di cat es t he am o un t of p r o fi t di st r i b ut e d t o shar eh ol de rs pe r shar e . Di vi d en d p er sh a re = T ot al pr ofit s d ist rib ut ed t o eq uit y shar e h ol der s / N um ber of e quit y sha re s d) Pr i c e Ear nin g r ati o ( P. E. Rat io) : Th e p ri ce earni ng rat i o in di cat es t he exp ect at i on of eq ui t y i n v est or s ab o ut t he ea rning s o f t he fi rm and relat es t o m ark et p ri ce an d i s gen erall y t aken a s a s u mm ar y me as u re of g r ow t h pot ent i al of an i n ve s t men t , risk cha ract e r i st ics , sha reh ol der s o rient at io n , co rp orat e i m age an d d eg re e of liq uidit y . P . E . Rat i o = M ark et price pe r sha re /E P S

ii) Pr o fit abi lit y r at ios bas e d on as s ets /i n ve s tm ents : a) Re tur n on c api tal em pl oy ed / Re tur n on In v es t me nt ( R OI) : R OI = Ret urn / Ca p it al em pl o yed * 1 00 Wher e , Ret ur n = N et p r o fi t + / - N on - t ra ding a dj u st ment s e xcl udi ng acc ru al adj u st men t s fo r am or t i sat i on of p rel i mi n a r y exp en s e s , g o odw ill , et c . + I nt erest on l on g t er m debt s + Pro visi o n f o r t ax I n t er est /Di vi den d f r om n on - t ra de inv est m ent s .

Ca pit al e mp l o ye d = E q ui t y sha re capit al + Res er ve s & S ur pl us + Pr ef ere n ce s h ar e c a p i t al + Debent ur e s a n d ot h e r l ong t er m l o an - M i sc ellan eo u s e xpen dit u re and l o s se s - No n - t rad e i n ve st me nt s . I t can b e f urt h e r b i f u rcat ed a s : R OI = (R et urn / sal e s ) * (S al e s / Capit al e m plo y ed ) * 1 00 Wher e , Ret ur n/ sal es * 10 0 = Pr ofi t ab i lit y rat i o Sal es / C ap i t al emp l o y ed = Capit al t ur no v er rat io Th u s , R OI = Pr ofi t ab ilit y ra t io * Ca pit al t u rn ov er rat i o R OI can b e i mp ro ve d b y i mp ro vin g op er at ing pr o fit or capit a l t ur no ve r o r bot h . c) R etur n on as s ets ( RO A) : The pr o fi t ab i l i t y r at i o i s m eas u re d in t er ms o f relat i on ship bet w een net pro fit s an d a s set s e m p l o y ed t o ear n t hat pro fit . I t m ea s ure s t h e fi rm ' s pro fit ab i l i t y i n t er ms of a ss et s e mpl o ye d i n t he fir m . R O A = N et p r o fi t a ft e r t axe s / Av er age t ot a l as s et s o r = N et p r o fi t aft e r t axe s / Av er age t an gible as s et s o r = N et p r o fi t aft e r t axe s / Av er age f i xe d a ss et s . The ca u s e of an y i n c rea se or de cr eas e i n R OI can be t rac ed o ut onl y aft er a co mp l et e a n al y si s t h r o u gh exp en se s and t u rn ov er rat i o s .

ROI = Return/Capital employed * 100 Profitability ratios (Return/Sales * 100) Capital Turnover ratio (Sales/Capital employed)

i) Material consumed/sales * 100 ii) Wages/Sales * 100

i) Fixed expenses/Sales * 100

Fixed assets turnover ratio (sales/fixed assets)

Working capital turnover ratio (sales/working capital)

iii) Manufacturing expenses/sales *100 iv) Administration expenses/sales * 100 v) Selling & Distribution expenses/Sales * 100 ii) Variable expenses/Sales * 100

Turnover of individual assets

Inventory Debtor's Creditor's turnover turnover turnover ratio ratio ratio

iii) Pr o fi tab ili ty r a ti os bas ed on s al es o f th e fir m : a) Gr os s pr of it r at io : Gr o s s p r ofi t r at io = G ro s s p r ofit / sal e s * 10 0 I t is u se d t o c o mp a re de p art m ent al or pr o du ct pr o fit abilit y . I f co st s ar e clas sifi ed s ui t ab l y i n t o fi x ed and v ariabl e ele ment s , t he n in st e ad o f g r os s pro fit r at i o o n e ma y fi n d P /V rat io . P/V rat i o = (S ale s - V ariabl e c o st )/ Sal e s * 10 0 Fix ed c ost re mai n i n g sa me , hi ghe r t he P/ V rat io l ow er is t he b reak e ven point (B .E .P .) Op e rat i n g p ro fit r at io is calc ulat e d t o eval u at e o perat in g per fo rm an c e of b u si n es s . b) O per ati ng pr of it r ati o : Op e rat i n g p r o fi t rat i o = O per at ing p r ofit / Sal es * 1 00 Wher e , Ope rat i n g p r o fi t = Sa l es - C o st of sal e s c) N et pr o fit r a ti o : I t me as u re s t h e ov er al l pr ofit abil it y o f t h e bu sin es s . Net p r ofi t rat i o = N et pr ofit /s ale s * 10 0 Ques ti on : Ar e fi nan c ial r a t ios r el e van t in fin an cia l de cis io n m aki ng ? Ans w er : A p o p ul ar t ech n i q u e o f an al ysi n g t he pe rf or man ce o f a b usi ne ss con cer n i s t h at o f fi n an ci al rat i o a nal y sis , it , a s a t o ol of fi nan cial mana ge men t i s o f c r uci al si gni fican ce . I t s i mp ort anc e li es in t he fact t hat it pre sen t s fact s on a c omp arat iv e b asi s a nd e nabl es d raw ing of infe ren c e s a s re gar d s a fi rm ' s p er f orm anc e . I t is rel e vant in as s es sing t he firm ' s p er f or man c e i n t h e b el ow m ent ion e d a spe ct s :

I) Fin an cia l r ati os f or e v alu ati on of p er for man c e : L iqui dit y p os it io n : R at io a nal y sis a ssi st s i n dr aw ing c o ncl u sio ns as reg ard s t h e fi r m' s l i q ui dit y p osit i on . I t w ould b e sat is fact or y i f t he fi rm i s ab l e t o me et i t s c ur rent obli gat i ons w hen t he y b ec om e du e . A f i r m c an b e sai d t o hav e t he abilit y t o meet it s sh ort - t er m l i ab i l i t i es i f i t h a s s uf f i cient liq ui dit y t o pa y i nt er est on it s sh o rt mat u ri n g d eb t , u s ual l y w it hin a y ear a s al s o t he prin cipal . Thi s ab i l i t y i s r efl ect ed i n t he liq uidit y rat io s o f t he firm an d liq ui dit y rat i o s are u se fu l i n cr edit an al ysi s b y ba nk s a nd ot he r s uppli er s o f sh ort - t er m l oan s . L ong -t er m s ol v en cy : R at io anal y si s i s eq u ally hel pf ul f or a ss e ss ing a fi rm ' s l on g - t er m fi n an cial vi abilit y . Thi s as p ect of t he finan cial p o si t i on of a b o rr ow er i s o f c o nce rn t o t h e l ong - t e rm cr edit or s , sec u ri t y an al yst s an d t he p re sent and p ot ent ial ow ner s o f a b u si n es s . Th e l on g - t e rm s olv enc y is m ea s u red b y t h e l ev era ge /ca p i t al st ru ct ur e a nd pr ofit abilit y rat i os f oc u sin g on earn i n g p ow e r an d o p erat in g e ffi cien c y a nd r at io anal y si s r ev eals t h e st r en gt h an d w e akne ss e s of a fir m i n re spe ct t her et o . The l ev era ge rat i os , f or e xampl e , indic at e s w het her a fir m h as a rea s on ab l e p r op ort i o n o f va rio u s s o u rce s of fin anc e or w het he r h eavi l y l oa ded w i t h debt in w hich cas e it s s olv enc y is ex p os e d t o se ri o us s t r ai n . I n t h e sam e mann er , vari o u s p r ofit abilit y rat io s r ev eal w h et h er o r n ot t h e fi r m i s abl e t o o ff er ad eq uat e ret urn t o it s ow n e rs c on si st e n t w i t h t he ri sk i nv ol ve d . Oper ati ng e f fi ci en cy : Rat i o an al ysi s t hr o w s light on t he de gr e e of eff i ci en c y i n t h e ma n age ment and ut ilis at ion o f it s a ss et s . V ari o us act i vi t y rat i os m ea s u re t hi s kin d o f op erat ional e ffi cienc y , a fi r m' s s ol v en c y i s , i n t h e ul t i mat e anal y sis , dep e ndent on t he sal es rev en u es g en e rat ed b y t he u se of it s as se t s - t ot al a s w ell a s it s co mp on e n t s . Ov er - all -pr of ita bil it y : Unlik e o ut si de pa rt ies , t hat a re int er est e d in on e a sp ect of t h e fi n ancial po sit i on o f a f irm , t he man age me n t is con st an t l y c on cer n e d ab o ut t he ov erall pro fit abilit y of t he en t erp ri s e i .e . t h e y a re co nce rne d ab o ut t he fi rm ' s abilit y t o m eet i t s s h o rt - t erm an d l on g - t erm oblig at ion s t o it s c re dit o rs , t o e ns u re rea s on ab l e ret urn t o i t s ow ner s and s ec ur e opt im u m ut ilis at ion o f t h e fi rm ' s a s set s . I t i s p o ssi ble if an i nt egr a t ed vi ew i s t ak en a n d all t h e rat i os a re c on si d ere d t og et her . Int er - fir m c o mpar is o n : Rat i o a nal y sis n ot onl y t hr ow s light on t he fi rm ' s fi n an ci al p o si t i on b ut al s o ser v es a s a st eppin g st o ne t o rem edi al mea s ur e s . I t is mad e p o s sible b y int er - firm co mp a ri s on /c o mp a ri s on w it h in d ust r y av e rag e . I t sh o uld be rea s on ab l y e xp e ct e d t hat t he fir m ' s pe rf or manc e i s in b r oad con f or mi t y w i t h t h at of t he i nd u st r y t o w hi ch it be lo ng s . An int er fi rm c om p ari s on de m on st rat e s t he r elat iv e p o sit ion vi s - - vis it s co mp et i t o rs . I f t h e r e s ult s ar e at vari anc e eit her w it h t he in d ust ry

ave rag e o r w i t h t h at o f t he c o mpet it o rs , t he fi rm can s eek t o i den t i f y t h e p r ob ab l e r ea s ons an d in it s li ght , t ake r em edial mea s ur e s . R at i o s n ot onl y p erf o rm p ost - m ort e m o f op erat i on s , but al s o se rv e s a s b ar o m et er f or f ut ur e , t h e y have pr edi ct o r y v al u e an d are h el p f ul i n f o rec a st i ng a nd plannin g f ut ure b u sine s s a ct ivit ies an d h el p s i n b ud get i n g .

II) F ina nc ial r a ti os f o r bu dg eti ng : I n t his f ield rat i os ar e a ble t o p r ovi de a gre at de al o f a s si st a n ce , b ud get i s onl y an e st imat e of f ut ur e act ivit y bas ed o n p a st exp eri en ce , i n t he mak i ng of w hich t h e r elat i on ship bet w een di f fe ren t sp h er es of act ivit ie s ar e in val uabl e . I t is u s u ally p os sibl e t o e st imat e b u dget e d fi g ur es usi ng fina n cial r at io s . Rat io s als o can be mad e u se of f or m ea s uri n g a ct ual p erf o r manc e w it h b ud get e d fi g ur es and in di cat e di rect i on s i n w hich adj u st m ent s sh o ul d b e mad e eit he r in t he bu dg et o r i n p e rf o rm an ce t o brin g t he m clo se r t o each ot her .

Ques ti on : W hat ar e t he li mi tat io ns o f fi na nci al r at ios ? Ans w er : Li mi t at i on s of fi n an cial r at io s a r e a s f oll ow s : i) Di v er s i fi ed pr odu ct li nes : M a n y b u sin es se s op er at e a lar ge nu mbe r o f divi si on s i n q ui t e di f f ere n t i n d u st rie s . I n s u ch ca s es rat i os cal c ulat e d on t he ba si s of ag gr ega t e dat a cann ot b e u se d fo r int e r - fi rm c o mpari s on s . ii) Fin an cia l dat a ar e ba dl y dis t o r t ed b y i nfl ati on : Hist oric al c o st val u e s ma y b e s ub st an t i al l y di ff er ent f r om t r ue v alu es , s uch di st o rt ion s in financi al d at a a re al s o c arri ed in finan ci al rat i o s . iii) S eas on al f ac tor s ma y als o in flu en c e fi nan cia l dat a iv) T o gi v e g oo d s ha pe t o th e f i nan ci al r a tios us ed p op ular ly : The bu sin es s ma y mak e s om e y ear - en d a dj u st ment s , s uch w ind ow - dre s sing can ch an g e t h e ch a ract er of fin ancial ra t ios t hat w o ul d b e di ffe re nt had t here b e en n o ch a n ge . v ) Di ff er en c es i n acc o un t i n g p olici es and acc o unt ing peri o d m ake t h e acc o un t i n g dat a o f 2 fi rm s n on - c om para ble a s als o t he acc o unt ing rat i o s . vi ) Th ere i s n o st an d ard s et of rat i os ag ai nst w hich a fir m' s rat i o s ma y b e co mpa red , s om et i m es , i f a fi rm de ci d es t o b e ab ov e a ve ra ge t hen , ind ust r y av er ag e b e co me s a l ow st anda r d . On t he ot he r h an d , f or a bel ow av er age fi rm , i n d ust r y av er ag es be co me t o o high as st andar ds t o achie ve . vii ) I t is di f fi c ul t t o g en e ral i se w h et her a part ic ular rat i o i s g o od or bad , fo r in st an c e , a l ow c ur ren t rat i o ma y b e ' bad ' fr om t he view p oint of l ow

liqui dit y , w h i l e a h i g h c ur ren t rat io m a y be 'ba d ' a s it ma y re s ult f ro m inef fici e n t w o rki n g c ap i t al ma nag em ent . viii ) Fin an ci al rat i os are i n t er - relat e d and not i nd epen dent , w hen v iew e d in is olat i on o n e rat i o ma y h i ghlig ht e ffici e ncy b ut , as a s et o f r at ios it m a y spe ak di f fe ren t l y . S u ch i n t er de pen den ce am on g t he rat i o s ca n be t aken care of t h r o ugh m ul t i vari at e an al ysi s . Fina ncial rat io s pr ovi de clu es b ut not c on cl usi on s . Th e s e a re t o ol s in t he h a nds of ex pert s a s t h e re i s no st anda rd r ead y - mad e i n t e rp r et at ion o f fi nancial rat i os .

Ques ti on : w hat ar e t he var i ous r a ti os bas ed o n ca pit al m ar k et inf or mat io n ? Ans w er : fr eq u en t l y s h are p ri ce s dat a a re p unch ed w it h acc o unt ing dat a t o g ene rat e n ew set of i n f o rm at ion , t he se ar e : i) Pr i c e ear nin g r ati o : Pric e ear n i n g rat i o ( PE r at io ) = a ve rag e or cl o sing sh ar e p ric es /E PS I t indicat es t h e p a yb ack p eri o d t o in ve st or s o r p r osp ect iv e in ve st o rs .

ii) Y ie ld : Y i el d = di vi den d /av e ra g e or cl o sing sh ar e pric e * 10 0 I t i n di cat e s ret u rn o n in ve st me nt , w hich ma y be on a ver ag e or clo sing i n ve st men t . Di vi d en d % in dicat e s ret urn on p aid - up v alu e o f sha re s , b ut , yi el d % i s t h e i n dicat or o f t r u e ret urn in w hic h sha r e ca pit al i s t aken at i t s mark et v al u e . iii) Mar k et val ue /b o o k v alu e f or s har e : M arket val u e f o r sh a r e/b o ok v al ue pe r sh are = a ver ag e sha re price / (n et w ort h / n umb er o f eq uit y sha re s ) or = c lo sin g sha re pric e / (n et w ort h/ n umb er o f eq ui t y sh a re s ) I t i n di cat e s mark et r es po ns e o f s hareh ol de rs ' inv e st m ent . Hi ghe r t he rat i o b et t er i s t h e sh ar eh old er s po sit i on i n t e rm s o f r et u rn and capit al gain s .

Ques ti on : w hat ar e t he r at ios co mp ut ed f or in v es t me nt an al ys ts ? Ans w er : I n ve st men t an al ysi s ar e p ubli sh e d w ee kl y in ec on o mi c new spa p er s , s om e r a t i os ar e u se d b y anal y sis t o r ep ort p er f or manc e of sel ect ed c o mp an i es . L et us di sc u s s t he is s ue s highli ght ed b y E con o mic Tim e s un der t h e cap t i on ' p er f or manc e in d icat or s ' : i) B o ok v al ue p e r sh a re = (e q uit y capit al + re ser ve s and s urpl u s excl u ding rev al uat i o n r e se rv es ) /n um b er of eq ui t y sh are s ii) E P S = (n et p r ofi t - p re fer enc e divi den d )/n u mbe r of eq u it y s hare s iii) di vide n d % iv ) yi eld % = e q ui t y d i vi de n d /m ark et pric e * 1 00 v ) pa y o ut rat i o % = d i vi de n d i ncl udi ng pr efe re nce di vid end /p ro fit a ft er t ax * 1 00 vi ) g r os s ma rgi n / sal e s (% ) w here , gr os s ma rgi n = p r o fi t b ef or e dep re ciat io n but a ft er int er e st an d b ef or e t ax vii ) g r os s ma rgi n /c ap i t al empl o y ed (% ) w here , gr os s ma rgi n = p r o fi t b ef or e dep re ciat io n but a ft er int er e st an d b ef or e t ax capit al e mp l o y ed = f i xed a ss et s + capit al w ork - i n - p r og re ss + inve st me nt s + cu rr ent a ss et s i.e . ag gr egat e of fi x ed as set s , capit al w ork - i n - pr o gre s s , inv e s t ment an d cu rr ent a ss et s b ut ex cl u di n g acc u m ulat e d d efi cit . viii ) PE rat i o = p ri ce / earn i n g s ix) c u rre n t rat i o = c ur ren t a s set s /c u rr ent li abilit ies

Ques ti on : h o w d oes the cas h fl o w ana lys i s h elp a b us in es s e nt ity ? Ans w er : ca sh fl ow a n al y si s i s an i mp ort a nt t o ol w it h t he finan ce mana ge r fo r a sc ert ai n i n g t h e ch an g es in ca sh in h and and bank bala n ces a s fr o m on e d at e t o an ot h er , d uri n g t he ac c o unt ing ye ar and al s o b et w een t w o acc o un t i n g p eri o d s . I t sh ow s infl ow s an d o ut fl ow s o f ca sh i .e . s o urc es an d applicat i on s of ca sh du ri n g a part ic ula r p eri od . Th e p ro ce d ur e f or prep arat i on o f c ash fl ow st at e ment , it s o bject iv es an d req ui r eme nt s are co ve red i n AS - 3 . I t i s a n i m p o rt ant t o ol f or sh o rt - t erm anal y si s , l ike ot he r

financi al st at em en t s , i t i s an al y se d t o re v eal signi fic ant r elat io nship s . Tw o maj or ar ea s , t h at an al y st s ex amin e w hil e st u d ying a ca sh fl ow st at em ent are di sc u ss ed a s b el ow : 1) c as h g en er at ing e ff ic ie n c y : i t i s t h e ab i l i t y of a c omp an y t o gen erat e ca sh fr o m i t s c ur rent o r cont in ui n g op erat i on s . F ol l ow ing rat i o s a r e u se d f o r t he p ur po se . i) cas h fl o w yi el d : cash fl ow yi el d = n et ca sh fl ow fr o m op er at ing act ivit i es /n et i nco me ii) cas h fl o w t o s al es : cash fl ow t o sal es = n et ca sh fl ow f r om o perat in g act i vit ies /n et sal e s iii) c as h f lo ws t o as s ets : cash fl ow t o a s set s = n et c ash fl ow fr o m o perat in g act i vit ies /a ver ag e t ot al a ss et s

2) Fr ee cas h fl o w : st ri ct l y ca sh fl ow i s t he am o unt o f ca sh t hat r emai ns a ft er ded u ct i n g f un d s t h at t h e c o mpan y ha s t o c om mit t o c ont in ue op erat ing at it s p l a n n e d l ev el . S uch c om mit me nt ha s t o c o ve r c u rr ent or cont in uin g op erat i on s , i n t er est , i n co me t ax , di vid end , net capit al exp en di t ure s and s o on . I f t h e ca sh fl o w i s p o si t iv e , it me an s t he c om pan y ha s met all it s planne d c o mmi t m en t an d h as ca sh av ail able t o re d uce d ebt or e xpan d . A n eg at i ve f re e c ash fl ow m ean s t h e c o m pan y w ill h av e t o sell inve st me n t s , b or row mo n e y o r i s s ue st ock in sh ort - t er m t o c ont inu e at it s planne d l ev el .

3) o th er s : b e si de s me as uri n g ca sh ef ficie n cy an d f re e c as h flo w , w it h t he help o f c ash fl ow st a t emen t , t he finan cial anal y st s als o cal c ul at es a nu mbe r o f r at i o s b as ed on ca sh fig u re s ra t her t han on e arni ng fig u re s . S om e o f w h i ch ar e a s b el ow : i) pric e p er s h ar e /fr e e ca sh fl ow p er sh ar e ii) o pe rat i n g ca sh fl o w /op er at ing p r ofit it sh ow s t h at acc r ual adj u st m ent s ar e n ot havin g se ve re ef fe ct on rep ort e d p r ofi t s . iii) s elf - fi n an ci n g i n v est m en t r at io = int er nal f u ndin g/n et in ve st ment act ivit i es it indicat e s h ow m uc h o f t h e f und s gen er at ed b y t he b usin e ss ar e r e inve st ed i n as s et s .

Ques ti on : wh at d o y ou m ea n by fun ds fl o w an al ys is ? Ans w er : F un ds fl ow an al ysi s is an i mp ort ant lon g - t er m anal y s is t oo l in t he hand s o f fi n an c e ma n age r f or as cert aini n g cha ng es in finan ci al p osit i on of fi rm b et w ee n t w o acc o un t ing peri o d s . I t analy se s rea s on s f or cha nge s in fin an ci al p osi t i on b et w een t w o bal anc e she et s and s how s t he in fl ow and o ut fl ow o f f u n d s i .e . s o urc e s an d a pp licat ion of f un ds d uri ng a part ic ul ar p e ri od . I t pro vi d es i n f o rmat i on t h at balan ce sh e et and pr o fit an d l o s s a cc o unt fail t o p r ovi de i .e . c h an ge s i n financi al p o sit ion of an ent e rpri s e , w hich i s of g reat h el p t o t h e u se rs of fina ncial inf or mat i on . I t is o f g re at help t o mana ge men t , sh ar e h ol der s , c red it or s , br ok er s , et c . a s it h elp s in answ e ri n g t h e f ol l ow i n g q u est i on s : - w her e h a ve t h e p r o fi t s go n e ? - w hy t h er e i s a n i mb al an ce e xist in g b et w een liq uidit y and pr o fit abilit y po sit ion of t h e en t er p ri s e ? - w hy is t h e co n ce rn fi n an ci all y s olid ins pi t e o f l o s se s ? Th e p r o ject e d f un d s fl ow st at e ment c an be p rep ar ed f or b ud get ar y con t r ol an d ca p i t al exp endit ur e c ont r ol i n t he o rgani sat i on . A p ro ject ed f un d s fl ow st at e ment ma y be p repa re d an d re s o urc es p ro p e rl y al l oc at ed a ft er an a nal y sis of pr es ent st at e of af fai rs . Th e op t i m u m ut i l i s at i on o f avail able f un d s i s es s ent ial fo r o ve r all gr ow t h o f t h e e n t erp ri s e . Th e f und s fl ow st at ement pr e par ed in adva n ce gi ve s a cl e ar - c ut di rect i on t o t h e m ana ge ment in t his reg ard . I t i s al s o us ef ul t o ma n age ment f or j ud gin g t he fina ncial o pe r at ing p er fo rm an c e of t h e co mpan y an d i ndic at es w ork ing capit al p o si t i on t h at h e l p s t h e m ana ge ment in t a king p oli c y d eci si on s reg ardi n g di vi den d , et c . I t help s t he m an age ment t o t e st w he t her t h e w o rki n g cap i t al i s ef fect iv el y u s ed o r not an d t hat w orki ng cap i t al l e v el i s a deq uat e or i nad eq uat e f or t he req ui re me nt s of b u si n es s . I t h el p s i n ve st o r s t o d ecid e w het h er c omp a ny ha s f und s man a ged p ro p e rl y , i n di c at es c redit w o rt hine s s of a co mpan y t hat hel ps l en d er s t o d eci de w h et her t o l en d m o ne y t o t he c omp an y o r n ot . I t h el p s m an a ge men t t o mak e deci si on s a n d d ecid e ab o ut t he fi n an ci n g p ol i ci e s an d ca pit al e xpen dit ur e pr o gra mm e f or f ut ur e .

CHAPTER FOUR CAPITAL BUDGETING

Question : Explain the meaning of capital budgeting ?

Answer : The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to cho ose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the management in taking a proper capital budgeting decision. Capital budgeting decision is thus, evaluation of expenditure dec isions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an important, crucial and critical business decision due to : 1) substantial expenditure : capital budgeting decision involves the investment of substantial amount of funds and is thus it is ne cessary for a firm to make such decision after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions would not only result in huge losses but would also account for failure of the firm. 2) long time period : capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence the rate and direction of growth of the firm. 3) irreversibility : most of such decisions are irrevers ible, once taken, the firm may not been in a position to reverse its impact. This may be due to the reason, that it is difficult to find a buyer for second -hand capital items. 4) complex decision : capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to estimate in quantitative terms all benefits or costs relating to a particular investment decision.

Question: discuss the various types of capital investment decisions?

Answer : there are various ways to classify capital budgeting decisions, generally they are classified as : 1) on the basis of the firm's existence : capital budgeting decisio ns are taken by both newly incorporated and existing firms. New firms may require to take decision in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of new environment or to face c hallenges of competition. These decisions may be classified into: i) replacement and modernisation decisions : replacement and modernisation decisions aims to improve operating efficiency and reduce costs. Usually, plants require replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically outdated. The former decision is of replacement and latter one of modernisation , however, both these decisions are cost reduction decisions. ii) Expansion decision : existing successful firms may experience growth in demand of the product and may experience shortage or delay in delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product lines. iii) Diversification decisions : these decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure by dealing in different products or operating in several markets. expansion and diversification dec isions are revenue expansion decisions. 2) on the basis of decision situation : i) mutually exclusive decisions : decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would exclude the a cceptance of the other. ii) Accept-Reject decisions : the accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investme nt. All those proposals which have a higher return than certain desired rate of return are accepted and rest rejected. iii) Contigent decisions : contigent decisions are dependable proposals, investment in one requires investment in another.

Question: what are the various projects evaluation techniques explain them in detail ?'

Answer : At each point of time, business manager, has to evaluate a number of proposals as regards various projects where he can invest money. He compares and evaluates projects and decides which one to take up and which to reject. Apart from financial considerations, there are many other factors considered while taking a capital budgeting decision. At times a project may be undertaken only to establish foothold in the ma rket or for better welfare of the society as a whole or of the business or for increasing the safety and security of workers, or due to requirements of law or because of emotional reasons for instance, many industrial sector projects are taken up at home t owns even if better locations are available. The major consideration in taking a capital budgeting decision is to evaluate its returns as compared to its investments. Evaluation of capital budgeting proposals have two dimensions i.e. profitability and risk , which are directly related. Higher the profitability, higher would be the risk and vice versa. Thus, the finance manager has to strike a balance between profitability and risk. Following are some of the techniques used to evaluate financial aspects of a project : 1) payback period : it is one of the simplest method to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cas h outflow of project, cash inflow means profit after tax but before depreciation. merits: a) this method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. When funds are limited, they may be made to do more by selecting projects having shorter payback periods. This method is particularly suitable in the case of industries where risk of technological services is very high. In such industries, only those projects having a shorter payback period should be financed since changing technology would make the projects totally obsolete, before all costs are recovered. b) in case of routine projects also use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futuri ty.

c) by stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital. d) payback period can be compared to break -even point, the point a t which costs are fully recovered but profits are yet to commence. e) the risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster. Limitations : Technique of payback period is not a scientific one due to the following reasons: a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period. For example : project A may have payback period of 3 years and project B of 8 years, according to this method project A would be selected, however, it is possible that after 3 years project B earns returns @ 20 % for another 3 years while project A stops yielding returns after 2 years. Thus, payback period is not a good measure to evaluate where the comparison is between 2 projects, one involving long gestation period and the other yielding quick results but for a short period. b) this method becomes an inadequate meas ure of evaluating 2 projects where the cash inflows are uneven. c) this method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added. This treatment is in contravention of the basic principle of financial analysis that stipulates compounding or discounting of cash flows and when they arise at different points of time. Some accountants calculate payback period after discounting cash flows by a pre-determined rate and the payback period so calculated is called "discounted payback period". 2) payback reciprocal : it is reciprocal of the payback period. A major drawback of the payback period method of capital budgeting is that it does not indicate any cut off period for the purpose of investment decision. It is, argued that reciprocal of payback would be a close approximation of the internal rate of return if the life of the project is at least twice the payback period and project generates equal a mount of final cash inflows. In practice, payback reciprocal is a helpful tool for quickly estimating rate of return of a project provided its life is at least twice the payback period.

payback reciprocal = average annual cash inflows/initial investmen t 3) accounting or average rate of return method (ARR) : accounting or average rate of return means average annual yield on the project. Under this method profit after tax and depreciation as percentage of total investment is considered. rate of return = (total profit * 100)/(net investments in the project * number of years of profits) this rate is compared with the rate expected on the projects, had the same funds been invested alternatively in those projects. Sometimes , the management compares this rate with minimum rate known as cut -off rate. Merits : It is a simple and popular method as it is easy to understand and includes income from the project throughout its life. Limitations : it is based upon crude average profits of the future years. It ignores the effect of fluctuations in profits from year to year. And thus ignores time value of money which is very important in capital budgeting decisions. 4) net present value method : the best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inf lows can be calculated by adding depreciation to profit after tax arising out of that particular project. NPV = CF 0 /(1+K) 0 + CF 1 /(1+K) 1 .............................+ CF n /(1+K) n = (t=0 to n) CF t /(1+K) t Where, NPV = Net present value of a project CF 0 = Cash outflows at the time 0(zero). CF t = Cash flows at the end of year t(t = 0 to n) i.e. the difference between cash inflow and outflow). K = Discount rate n = Life of the project

Discounting cash inflows : Once cash inflows and outflows are determined, next step is to discount each cash inflow and work out its present value. For the purpose, discounting rates must be known. Normally, the discounting rate equals the opportunity cost of capital as a project must earn at least that much as is paid out on the funds locked in the project. The concept of present value is easy to understand .To calculate present value of various cash inflows reference shall be had to the present value tabl e. Discounting cash outflows : The cash outflows also requires discounting as the whole of investment is not made at the initial stage itself and will be spread over a period of time. This may be due to interest -free deferred credit facilities from supp liers of plant or some other reasons. Another change in cash flows to be considered in the capital budgeting decision is the change due to requirement of working capital. Apart from investment in fixed assets, each project involves commitment of funds in w orking capital. The commitment on this account may arise as soon as the plant starts production. The working capital commitment ends after the fixed assets of the project are sold out. Thus, while considering the total outflows, working capital requirement must also be considered in the year the plant starts production. At the end of the project, the working capital will be recovered and can be treated as cash inflow of last year. Acceptance rule : A project can be accepted if NPV is positive i.e. NPV > 0 and rejected; if it is negative i.e. NPV < 0. If NPV = 0, project may be accepted as it implies a project generates cash flows at the rate just equal to the opportunity cost of capital.

Merits : 1) NPV method takes into account the time value of money . 2) The whole stream of cash flows is considered. 3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives. 4) NPV uses discounted cash flows i.e. expresses cash flow s in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits. Limitations : 1) It involves different calculations. 2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.

3) The ranking of projects depends on the discount rate. 5) Desirability factor/Profitability Index : In cases of, a number of capital expenditure proposals, each involving different amounts of cash inflows, the method of working out desi rability factor or profitability index is followed. In general terms, a project is acceptable if its profitability index value is greater than 1. Merits : 1) This method also uses the concept of time value of money. 2) It is a better project evalu ation technique than NPV. Limitations of Profitability index : 1) Profitability index fails as a guide in resolving 'capital rationing' where projects are indivisible. Once a single large project with high NPV is selected, possibility of accepting several small projects that together may have higher NPV, then a single project is excluded. 2) Situations may arise where a project selected with lower profitability index may generate cash flows in such a manner that another project can be taken up one or two years later, the total NPV in such case being more than the one with a project having highest Profitability Index. The profitability index approach thus, cannot be used indiscriminately but all other type of alternatives of projec ts would have to be worked out. 6) Internal Rate of Return(IRR) : IRR is that rate of return at which the sum total of discounted cash inflows equals to discounted cash outflows. The IRR of a project is the discount rate that makes the ne t present value of the project equal to zero. CO 0 = CF 0 /(1+r) 0 + CF 1 /(1+r) 1 .............................+ CF n /(1+r) n + (SV + WC)/(1+r) n = (t=0 to n) CF t /(1+r) t + (SV + WC)/(1+r) n ........................................... Where, CO 0 = Cash outflows at the time 0(zero). CF t = Cash flows at the end of year t. r = Discount rate n = Life of the project SV & WC = Salvage value and Working capital at the end of 'n' years.

The discount rate i.e. cost of capital is assumed to be known in th e determination of NPV, while in the IRR, the NPV is set at 0(zero) and discount rate satisfying this condition is determined. IRR can be interpreted in 2 ways : 1) IRR represents the rate of return on the unrecovered investment balance in the project. 2) IRR is the rate of return earned on the intial investment made in the project. It may not be possible for all firms to reinvest intermediate cash flows at a rate of return equal to the project's IRR, hence the first interpretation seem s to be more realistic. Thus, IRR should be viewed as the rate of return on unrecovered balance of project rather than compounded rate of return on initial investment over the life of the project. The exact rate of interpolation as follows : IRR = r + [(PV C F A T - PV C 0 )/ PV * r

Where, PV C F A T = Present value of cash inflows (DF r * annuity) PV C 0 = Present value of cash outlay r = Either of 2 interest rates used in theformula r = Difference ininterest rates PV = Difference in present values ofinflows Acceptance Rule: The use of IRR, as a criterion to accept capital investmentdecision involves a comparison of IRR with required rate of return called as Cutoff rate. The project should the accepted if IRR is greater than cut off rate.If IRR is equal to cut off rate the firm is indifferent. If IRR less than cutoff rate, the project is rejected. Merits: 1) This method makes use of the concept of time value ofmoney. 2) All the cash flows in the project areconsidered. 3) IRR is easier to use as instant aneous understanding ofdesirability is determined by comparing it with the cost of capital. 4) IRR technique helps in achieving the objective ofminimisation of shareholders wealth. Demerits:

1) The calculation process is tedious if there are more tha none cash outflow interspersed between the cash inflows then there would bemultiple IRR's, the interpretation of which is difficult. 2) The IRR approach creates a peculiar situation if wecompare the 2 projects with different inflow/outflow patterns. 3) It is assumed that under this method all future cashinflows of a proposal are reinvested at a rate equal to IRR which is aridiculous assumption. 4) In case of mutually exclusive projects, investmentoptions have considerably different cash outlays. A pro ject with large fundcommitments but lower IRR contribute more in terms of absolute NPV and increasesthe shareholders' wealth then decisions based only on IRR may not becorrect.

Question : What is the significance of cut off rate? Answer : Cut off rateis the minimum that the management wishes to have from any project, usually itis based on cost of capital. The technical calculation of cost of capitalinvolves a complicated procedure, as a concern procures funds from any sourcesi.e. equity shares, ca pital generated from its own operations and retained ingeneral reserves i.e. retained earnings, debentures, preference share capital,long/short term loans, etc. Thus, the firm's cost of capital can be known onlyby working out weighted average of the variou s costs of raising various types ofcapital. A firm should not and would not invest in projects yielding returns ata rate below the cut off rate.

Question : Distinguish between desirability factor, NPV andIRR method of ranking projects? Answer : In case of anundertaking having 2 or more competing projects and a limited amount of fundsat its disposal, the question of ranking the projects arises. For every project,desirability factor and NPV method would give the same signal i.e. accept orreject. Bu t, in case of mutually exclusive projects, NPV method is preferred dueto the fact that NPV indicates economic contribution of the project in absoluteterms. The project giving higher economic contribution ispreferred.

As regards NPV vs.IRR met hod, one has to consider the basic presumption under each. In case ofIRR, the presumption is that intermediate cash inflows will be reinvested at therate i.e. IRR, while that under NPV is that intermediate cash inflows arepresumed to be reinvested at the c ut off rate. It is obvious that reinvestmentof funds at cut off rate is possible than at the internal rate of return, whichat times may be very high. Hence the NPV obtained after discounting at a fixedcut off rate are more reliable for ranking 2 or more pr ojects than theIRR.

Question : Write a note on capital rationing? Answer : Usually, firmsdecide maximum amount that can be invested in capital projects, during a givenperiod of time, say a year. The firm, then attempts to select a combination ofinvestment proposals, that will be within specific limits providing maximumprofitability and rank them in descending order as per their rate of return,this is a capital rationing situation. A firm should accept all investmentprojects with positive NPV, w ith an objective to maximise the wealth ofshareholders. However, there may be resource constraints due to which a firm mayhave to select from amongst various projects. Thus, there may arise a situationof capital rationing where, there may be internal or ex ternal constraints onprocurement of funds needed to invest in all investment proposals with positiveNPV's. Capital rationing can be experienced due to external factors, mainlyimperfections in capital markets attributable to non -availability of marketinformation, investor attitude, and so on. Internal capital rationing is due toself-imposed restrictions imposed by management as, not to raise additional debtor lay down a specified minimum rate of return on each project. There arevarious ways of resorting to c apital rationing. It may put up a ceiling when ithas been financing investment proposals only by way of retained earnings i.e.ploughing back of profits. Capital rationing can also be introduced by followingthe concept of 'Responsibility Accounting', whereb y management may introducecapital rationing by authorising a particular department to invest upto aspecified limit, beyond which decisions would be taken by the higher ups.Selection of a project under capital rationing involves : 1) Identification of the projects that can be accepted byusing evaluation technique as discussed. 2) Selection of the combination ofprojects. In capital rationing, it would be desirable to acceptseveral small investment proposals than a few large ones, for a fullerutilisatio n of the budgeted amount. This would result in accepting relativelyless profitable investment proposals if

full utilisation of budget is a primaryconsideration. It may also mean that the firm forgoes the next profitableinvestment following after the budget ceiling, even if it is estimated to yielda rate of return higher than the required rate. Thus capital rationing does notalways lead to optimum results.

Question : Discuss the estimation of future cash flows? Answer : In order touse any technique o f financial evaluation, data as regards cash flows from theproject is necessary, implying that costs of operations and returns from theproject for a considerable period in future should be estimated. Future, isalways uncertain and predictions can be made a bout it only with reference tocertain probability levels, but, still would not be exact, thus, cash flows areat best only a probability. Following are the various stages or steps used indeveloping relevant information for cash flow analysis : 1)Estimation of costs : To estimate cash outflows, information as regards followingare needed which may be obtained from vendors or contractors or by internalestimates : i) Cost of new equipment; ii) Cost of removal and disposal of old equipment less scrapvalue; iii) Cost of preparing the site and mounting of newequipment; and iv) Cost of ancillary services required for new equipmentsuch as new conveyors or new power supplies and so on. The vendor may haverelated data on costs of si milar equipment or the company may have to estimatecosts from its own experience. But, cost of a new project specially the oneinvolving long gestation period, must be estimated in view of the changes inprice levels in the economy. For instance high rates o f inflation has causedvery high increases in the cost of various capital projects. The impact ofpossible inflation on the value of capital goods must thus, be assessed andestimated in working out estimated cash outflow. Many firms work out a specificindex showing changes in price levels of capital goods such as buildings,machinery, plant and machinery, etc. The index is used to estimate the likelyincrease in costs for future years and as per it, estimated cash outflows areadjusted. Another adjustment requir ed in cash outflows estimates is thepossibility of delay in the execution of a project depending on a number offactors, many of which are beyond the management's control. It is imperativethat an estimate may be made regarding the increase in project cost

due to delaybeyond expected time. The increase would be due to many factors as inflation,increase in overhead expenditure, etc. 2)Estimation of additional working capitalrequirements : The next step is toascertain additional working capital required for fin ancing increased activityon account of new capital expenditure project. Project planners often do nottake into account the amount required to finance the increase in additionalworking capital that may exceed amount of capital expenditure required. Unlessan d until this factor is taken into account, the cash outflow will remainincomplete. The increase in working capital requirement arises due to the needfor maintaining higher sundry debtors, stock -in-hand and prepaid expenses, etc.The finance manager should make a careful estimate of the requirements ofadditional working capital. As the new capital project commences operation, cashoutflows requirement should be shown in terms of cash outflows. At the expiry ofthe useful life of the project, the working capital would be released and can bethus, treated as cash inflow. The impact of inflation is also to be brought intoaccount, while working out cash outflows on account of working capital. In aninflationary economy, working capital requirements may riseprogressive ly eventhough there is increase in activity of a new project. This is because the valueof stock, etc. may rise due to inflation, hence, additional working capitalrequirements on this account should be shown as cash outflows. 3)Estimation of production an d sales: Planning for a new project requires anestimate of the production that it would generate and the sale that it wouldentail. Cash inflows are highly dependent on the estimation of production andsales levels. This dependence is due to peculiar nature o f fixed cost. Cashinflows tend to increase considerably after the sales are above the break evenpoint. If in a year, sales are below the break -even point, which is quitepossible in a large capital intensive project in the initial year of itscommercial prod uction, the company may even have cash outflows in terms oflosses. On the basis of additional production units that can be sold and priceat which they may be sold, the gross revenues from a project can be worked out.In doing so however, possibility of a re duction in sale price, introduction ofcheaper or more efficient product by competitors, recession in the marketconditions and such other factors are to be considered. 4)Estimation of cash expenses : In thisstep, the amount of cash expenses to be incurred in running the project after itgoes into commercial production are to be estimated. It is obvious thatwhichever level of capacity utilisation is attained by the project, fixed costsremains the same. However, variable costs vary with changes in the level o fcapacity utilisation. 5)Working out cash inflows : The difference between gross revenues and cash expenses hasto be adjusted for taxation before cash inflows can be worked out. In view ofdepreciation and other taxable expenses, etc. the tax liability of t he

companymay be worked out. The cash inflow would be revenues less cash expenses andliability for taxation. One problem is oftreatment of dividends and interest. Some accountants suggest that interestbeing a cash expense is to be deducted and dividends to be deducted from cashinflows. However, this seems to be incorrect. Both dividends and interestinvolve a cash outflow, the fact remains that these constitute cost of capital, hence, ifdiscounting rate, is itself based on the cost of capital , interest on long termfunds and dividends to equity or preference shareholders should not be deductedwhile working out cash inflows. The rate of return yielded by a project at acertain rate of return is compared with cost of capital for determining whethe ra particular project can be taken up or not. If the cost of capital becomespart of cash outflows, the comparison becomes vitiated. Thus, capital cost likeinterest on long term funds and dividends should not be deducted from grossrevenues in order to work out cash inflows. Cash inflows can also be worked outbackwards, on adding interest on long term funds and depreciation to net profitsand deducting liability for taxation for the year.

Question : Write a note on social benefit analysis? Answer : It is beingincreasingly recognised that commercial evaluation of industrial projects is notenough to justify commitment of funds to a project specially, if it belongs tothe public sector and irrespective of its financial viability, it is to beimplemented i n the long term interest of the nation. In the context of thenational policy of making huge public investments in various sectors of theeconomy, the need for a practical method of making social cost benefit analysishas acquired great urgency. Hundreds of c rores of rupees are committed everyyear to various public projects of all types - industrial, commercial and thoseproviding basic infrastructure facilities, etc. Analysis of such projects has tobe done with reference to social costs and benefits as they cannot be expectedto yield an adequate commercial return on the funds employed, at least duringthe short run. Social cost benefit analysis is important for privatecorporations having a moral responsibility to undertake socially desirableprojects. In analysin g various alternatives of capital expenditure, a privatecorporation should keep in view the social contribution aspect. It can thus beseen that the purpose of social cost benefit analysis technique is not toreplace the existing techniques of financial anal ysis but to supplement andstrengthen them. The concept of social cost benefit analysis has progressedbeyond the stage of intellectual speculation. The planning commission hasalready decided that in future, the feasibility studies for public sectorprojects will have to include an analysis of the social rate of return. In caseof private sector also, a socially beneficial project may be more easilyacceptable to the government and thus, this analysis would be relevant

whilegranting various licenses and approval s, etc. Also, if the private sectorincludes social cost benefit analysis in its project evaluation techniques, itwill ensure that it is not ignoring its own long -term interest, as in the longrun only those projects will survive that are socially beneficial and acceptableto society. Need for Social Cost Benefit Analysis (SCBA) : 1) Market prices used to measurecosts and benefits inproject analysis do not represent social values due to marketimperfections. 2) Monetary cost benefit analysis fails to consi der theexternalities or external effects of a project. The external effects can bepositive like development of infrastructure or negative like pollution andimbalance in environment. 3) Taxes and subsidies are monetary costs and gains, butthese are only t ransfer payments from social viewpoint and thusirrelevant. 4) SCBA is essential for measuring the redistribution effectof benefits of a project as benefits going to poorer section are more importantthan one going to sections which are economically better off. 5) Projects manufacturing liqueur and cigarettes are notdistinguished from those generating electricity or producing necessities oflife. Thus, merit wants are important appraisal criterion forSCBA. The importantpublication on the te chnique of social cost benefit analysis are those by theUnited Nations Industrial Development Organisation(UNIDO) and the Centre forOrganisation of Economic Cooperation and Development(OECD). Both publicationdeal with the problem of measuring social costs and benefits. In this context,it is essential to understand that actual cost or revenues do not essentiallyreflect cost or benefit to the society. It is so, because the market price ofgoods and services are often grossly distorted due to various artificial restrictions and controls from authorities. Thus, a different yardstick is to beadopted in evaluating a particular proposal and its cost benefit analysis areusually valued at "opportunity cost" or shadow prices to judge the real impactof their burden as co sts to society. The social cost valuation sometimescompletely changes the estimates of working results of aproject.

Question : Is there any relationship between risk andreturn, if yes, of what sort?

Answer : Risk: The term risk with reference to investment decision isdefined as the variability in actual return emanating from a project in futureover its working life in relation to the estimated return as forecasted at thetime of initial capital budgeting decisions. Risk is differentiated withuncert ainty and is defined as a situation where the facts and figures are notavailable or probabilities cannot be assigned. Return: It cannot be denied that return is themotivating force and the principal reward to the investment process. The returnmay be defi ned in terms of : 1) realised return i.e. the return which was earned or couldhave been earned, measuring the realised return allows a firm to assess how thefuture expected returns may be. 2) expected return i.e. the return that the firm anticipatesto earn over some future period. The expected return is a predicted return andmay or may not occur. For, a firm thereturn from an investment is the expected cash inflows. The return may bemeasured as the total gain or loss to the firm over a given period of time andmay be defined as percentage on the initial amount invested. Relationship between risk and return : The main objectiveof financial management is to maximise wealth of shareholders' as reflected inthe market price of shares, that depends on risk -return characteristics of thefinancial decisions taken by the firm. It also emphasizes that risk and returnare 2 important determinants of value of a share. So, a finance manager as alsoinvestor, in general has to consider the risk and retu rn of each and everyfinancial decision. Acceptance of any proposal does not alter the business riskof firm as perceived by the supplier of capital, but, different investmentprojects would have different degree of risk. Thus, the importance of riskdimension in capital budgeting can hardly be over -stressed. In fact, risk andreturn are closely related, investment project that is expected to yield highreturn may be too risky that it causes a significant increase in the perceivedrisk of the firm. This trade off between risk and return would have a bearing onthe investor' perception of the firm before and after acceptance of a specificproposal. The return from an investment during a given period is equal to thechange in value of investment plus any income received from investment. It isthus, important that any capital or revenue income from investments to investormust be included, otherwise the measure of return will be deficient. The returnfrom investment cannot be forecasted with certainty as there is risk that thecash inflows from project may not be as expected. Greater the variabilitybetween the estimated and actual return, more risky is theproject.

CHAPTER FIVE LEVERAGE

Question : Discuss the concept of leverage and its types ? Answer : the term leverage generally, refers to a relationship between 2 interrelated variables. In financial analysis, it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output , sales revenue, EBIT (Earnings Before Interest and Tax), EPS (Earnings Per Share), etc. Types of leverages : Commonly used leverages are of the following type : 1) Operating Leverage : It is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its EBIT ". When there is an increase or decrease in sales level the EBIT also changes. The effect of changes in sales on the level EBIT is measured by operating leverage. Operating leverage = % Change in EBIT / % Change in sales = [Increase in EBIT/EBIT] / [Increase in sales/sales] Significance of operating leverage : Analysis of operating leverage of a firm is useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on EBIT for even a small change in sales level. Higher D.O.L. can dramatically increase operating profits. But, in case of decline in sales level, EBIT may be wiped out and a loss may be operated. As operating leverage, depends on fixed costs, if they are high, the firm's operating risk and leverage would be high. If operating leverage is high, it automatically means that the break -even point would also be reached at a high level of sales. Also, in case of high operating leverage, the margin of safety would be low. Thus, it is preferred to operate sufficiently above the break -even point to avoid the danger of fluctuations in sales and profits. 2) Financial Leverage : It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm's capital structure con tains obligation of fixed charges e.g. interest on debentures, dividend on preference shares, etc.

along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with the operating profits or EBIT. They are fi xed and are to be repaid irrespective of level of operating profits or EBIT. The ordinary shareholders of a firm are entitled to residual income i.e. earnings after fixed financial charges. Thus, the effect of changes in operating profit or EBIT on the level of EPS is measured by financial leverage. Financial leverage = % change in EPS/% change in EBIT or = (Increase in EPS/EPS)/{Increase in EBIT/EBIT} The financial leverage is favourable when the firm earns more on the investment/assets financed by sources having fixed charges. It is obvious that shareholders gain a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds, in such cases it is called 'trading on eq uity'. The financial leverage at the levels of EBIT is called degree of financial leverage and is calculated as ratio of EBIT to profit before tax. Degree of financial leverage = EBIT/Profit before tax Shareholders gain in a situation where a company has a high rate of return and pays a lower rate of interest to the suppliers of long term funds. The difference accrues to the shareholders. However, where rate of return on investment falls below the rate of interest, the shareholders suffer, as their earnin gs fall more sharply than the fall in the return on investment. Financial leverage helps the finance manager in designing the appropriate capital structure. One of the objective of planning an appropriate capital structure is to maximise return on equity shareholders' funds or maximise EPS. Financial leverage is double edged sword i.e. it increases EPS on one hand, and financial risk on the other. A high financial leverage means high fixed costs and high financial risk i.e. as the debt component in capita l structure increases, the financial risk also increases i.e. risk of insolvency increases. The finance manager thus, is required to trade off i.e. to bring a balance between risk and return for determining the appropriate amount of debt in the capital str ucture of a firm. Thus, analysis of financial leverage is an important tool in the hands of the finance manager who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm. 3) Combined leverage : Operating leverage explains operating risk and financial leverage explains the financial risk of a firm. However, a firm has to look into overall risk or total risk of the firm i.e. operating risk as also financial risk. Hence, the combined leverage is the re sult of a combination of operating and financial leverage. The combined leverage measures the effect of a % change in sales on % change in EPS.

Combined Leverage = Operating leverage * Financial leverage = (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT) = % change in EPS/% change in sales The ratio of contribution to earnings before tax, is given by a combined effect of financial and operating leverage. A high operating and high financial leverage is very risky, even a small fall in sales would affect tremendous fall in EPS. A company must thus, maintain a proper balance between these 2 leverage. A high operating and low financial leverage indicates that the management i s careful as higher amount of risk involved in high operating leverage is balanced by low financial leverage. But, a more preferable situation is to have a low operating and a high financial leverage. A low operating leverage automatically implies that the company reaches its break -even point at a low level of sales, thus, risk is diminished. A highly cautious and conservative manager would keep both its operating and financial leverage at very low levels. The approach may, mean that the company is losing p rofitable opportunities. The study of leverages is essential to define the risk undertaken by the shareholders. Earnings available to shareholders fluctuate on account of 2 risks, viz. operating risk i.e. variability of EBIT may arise due to variability of sales or/and expenses. In a given environment, operating risk cannot be avoided. The variability of EPS or return on equity depends on the use of financial leverage and is termed as financial risk. A firm financed totally by equity finance has no financial risk, hence it cannot be avoided by eliminating use of borrowed funds. Thus, a company has to consider its likely profitability position set before deciding upon the capital mix of the company, as it has far reaching implications on the financial posit ion of the company.

Question : What is the effect of leverage on capital turnover and working capital ratio ? Answer : An increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I) to a higher level. This however, is n ot possible in all situations, a rise in capital turnover is to be supported by adequate capital base. Thus, as capital turnover ratio increases, working capital ratio deteriorates, thus, management cannot increase its capital turnover ratio beyond a certa in limit. The main reasons for a fall in ratios showing the working capital position due to increase in turnover ratios is that as the activity increases without a corresponding rise in working capital, the working capital position becomes tight. As the sa les increases, both current assets and current liabilities also increases but not in proportion to current ratio. If current ratio and acid test ratio are high,

it is apparent that the capital turnover ratio can be increased without any problem. However, it may be very risky to increase capital turnover ratio when, the working capital position is not satisfactory. CHAPTER SIX CAPITAL STRUCTURE AND COST OF CAPITAL

Question : Explain the concept of capital structure ? Answer : A finance manager for procurement of funds, is required to select such a finance mix or capital structure that maximises shareholders wealth. For designing optimum capital structure he is required to select such a mix of sources of finance, so that the ov erall cost of capital is minimum. Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentu res and other sources of funds in total amount of capital which an undertaking may raise for establishing its business. In planning the capital structure, following must be referred to : 1) There is no definite model that can be suggested/used as an idea l for all business undertakings. This is due to varying circumstances of various business undertakings. Capital structure depends primarily on a number of factors like, nature of industry, gestation period, certainty with which the profits will accrue after the undertaking commences commercial production and the likely quantum of return on investment. It is thus, important to understand that different types of capital structure would be required for different types of undertakings. 2) Government policy is a major factor in planning capital structure. For instance, a change in the lending policy of financial institutions may mean a complete change in the financial pattern. Similarly, rules and regulations for capital market formulated by SEBI affect the cap ital structure decisions. The finance managers of business concerns are required to plan capital structure within these constraints. Optimum capital structure : The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the company's wealth is maximum. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But , it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In reality, however, instead of

optimum, an appropriate capital structure is more realistic. Featur es of an appropriate capital structure are as below : 1) Profitability : The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share. 2) Flexibility : The capitals structure should be suc h that the company is able to raise funds whenever needed. 3) Conservation : Debt content in capital structure should not exceed the limit which the company can bear. 4) Solvency : Capital structure should be such that the business does not run the risk of insolvency. 5) Control : Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.

Question : Explain the major considerations in the planning of capital structure ? Answer : The 3 major considerations evident in capital structure planning are risk, cost and control, they assist the management in determining the proportion of funds to be raised from various sources. The finance manager attempts to design the capital structure i n a manner, that his risk and cost are least and there is least dilution of control from the existing management. There are also subsidiary factors as, marketability of the issue, maneuverability and flexibility of capital structure and timing of raising f unds. Structuring capital, is a shrewd financial management decision and is something that makes or mars the fortunes of the company. The factors involved in it are as follows : 1) Risk : Risks are of 2 kinds viz. financial and business r isk. Financial risk is of 2 kinds as below : i) Risk of cash insolvency : As a business raises more debt, its risk of cash insolvency increases, as : a) the higher proportion of debt in capital structure increases the commitments of the company with re gard to fixed charges. i.e. a company stands committed to

pay a higher amount of interest irrespective of the fact whether or not it has cash. and b) the possibility that the supplier of funds may withdraw funds at any point of time. Thus, long term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. Such risk is absent in case of equity shares. ii) Risk of variation in the expected earnings available to equity share holders : In case a firm has a hig her debt content in capital structure, the risk of variations in expected earnings available to equity shareholders would be higher; due to trading on equity. There is a lower probability that equity shareholders get a stable dividend if, the debt content is high in capital structure as the financial leverage works both ways i.e. it enhances shareholders' returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest rate. In other words, there i s relative dispersion of expected earnings available to equity shareholders, that would be greater if capital structure of a firm has a higher debt content. The financial risk involved in various sources of funds may be understood with the help of debentures. A company has to pay interest charges on debentures even in case of absence of profits. Even the principal sum has to be repaid under the stipulated agreement. The debenture holders have a charge against the company's assets and th us, they can enforce a sale of assets in case of company's failure to meet its contractual obligations. Debentures also increase the risk of variation in expected earnings available to equity shareholders through leverage effect i.e. if return on investmen t remains higher than interest rate, shareholders get a high return and vice versa. As compared to debentures, preference shares entail a slightly lower risk for the company, as the payment of dividends on such shares is contingent upon the earning of profits by the company. Even in case of cumulative preference shares, dividends are to be paid only in the year in which company earns profits. Even, their repayment is made only if they are redeemable and after a stipulated period. However, preference shares increase the variations in expected earnings available to equity shareholders. From the company's view point, equity shares are least risky, as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. Thus, as seen here, financial risk encompasses the volatility of earnings available to equity shareholders as also, the probability of cash insolvency. 2) Cost of capital : Cost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of earning enough revenue to meet its cost of capital and also finance its growth. Thus, along with risk, the

finance manager has to consider the cost of capital factor for determination of the capital structure. 3) Control : Along with cost and risk factors, the control aspect is also an important factor for capital structure planning. When a company issues equity shares, it automatically dilutes the controlling interest of prese nt owners. In the same manner, preference shareholders can have voting rights and thereby affect the composition of Board of directors, if dividends are not paid on such shares for 2 consecutive years. Financial institutions normally stipulate that they sh all have one or more directors on the board. Thus, when management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is thus, obvious that decisions concerning capital structure are taken after keeping the control factor in view. 4) Trading on equity : A company may raise funds by issue of shares or by borrowings, carrying a fixed rate of interest that is payable irrespective of the fact whether or not there is a profit. Preference shareholders are also entitled to a fixed rate of dividend, but dividend payment is subject to the company's profitability. In case of ROI the total capital employed i.e. shareholders' funds plus long term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, the company is said to trade on equity. It is the finance manager's main objective to see that the return and overall wealth of the company both are maximised, and it is to be ke pt in view while deciding on the sources of finance. Thus, the effect of each proposed method of new finance on EPS is to be carefully analysed. This, thus, helps in deciding whether funds should be raised by internal equity or by borrowings. 5) Corporate taxation : Under the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. Cost of raising finance through borrowings is deductible in the year in which it is incurred. If it is incurred during the pre -commencement period, it is to be capitalised. Cost of share issue is allowed as deduction. Owing to such provisions, corporate taxation , plays an important role in determination of the choice between different sources of financing. 6) Government Policies : Government policies is a major factor in determining capital structure. For instance, a change in the lending policies of financial institutions would mean a complete change in the financial pattern follo wed by companies. Also, rules and regulations framed by SEBI considerably affect the capital issue policy of various companies. Monetary and fiscal policies of government also affect the capital structure decisions.

7) Legal requirements : The finance manager has to keep in view the legal requirements at the time of deciding as regards the capital structure of the company. 8) Marketability : To obtain a balanced capital structure, it is necessary to consider the company's ability to market corporate securities. 9) Maneuverability : Maneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with the prospective suppliers of funds. 10) Flexibility : It refers to the capacity of the business and its management to adjust to expected and unexpected chang es in circumstances. In other words, the management would like to have a capital structure providing maximum freedom to changes at all times. 11) Timing : Closely related to flexibility is the timing for issue of securities. Proper timing of a security issue often brings substantial savings due to the dynamic nature of the capital market. Intelligent management tries to anticipate the climate in capital market with a view to minimise cost of raising funds and the dilution resulting from an is sue of new ordinary shares. 12) Size of the company : Small companies rely heavily on owner's funds while large companies are usually considered, to be less risky by investors and thus, they can issue different types of securities. 13) Purpose of financing : The purpose of financing also, to some extent affects the capital structure of the company. In case funds are required for productive purposes like manufacturing, etc. the company may raise funds through long term source s. On the other hand, if the funds are required for non -productive purposes, like welfare facilities to employees such as schools, hospitals, etc. the company may rely only on internal resources. 14) Period of Finance : The period for whic h finance is required also affects the determination of capital structure. In case funds are required for long term requirements say 8 to 10 years, it would be appropriate to raise borrowed funds. However, if the funds are required more or less permanently , it would be appropriate to raise

borrowed funds. However, if the funds are required more or less permanently, it would be appropriate to raise them by issue of equity shares. 15) Nature of enterprise : The nature of enterprise to a great extent affects the company's capital structure. Business enterprises having stability in earnings or enjoying monopoly as regards their products may go for borrowings or preference shares, as they have adequate profits to pay interest/fixed charges. On th e contrary, companies not having assured income should preferably rely on internal resources to a large extent. 16) Requirement of investors : Different types of securities are issued to different classes of investors according to their req uirement. 17) Provision for future : While planning capital structure the provision for future requirement of capital is also required to be considered.

Question : Give in detail the various capital structure theories ? Answer : A firm's objective should be directed towards the maximisation of the firm's value; the capital structure or leverage decision are to examined from the view point of their impact on the value of the firm. If the value of the firm can be affected by capital s tructure or financing decision, a firm would like to have a capital structure that maximises the market value of the firm. There are broadly 4 approaches in the regard, which analyses relationship between leverage, cost of capital and the value of the firm in different ways, under the following assumptions : 1) There are only 2 sources of funds viz. debt and equity. 2) The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling shares to retire debt. 3) There are no retained earnings implying that entire profits are distributed among shareholders. 4) The operating profit of firm is given and expected to grow. 5) The business risk is assumed to be constant and is not affected by the financing mix decision.

6) There are no corporate or personal taxes. 7) The investors have the same subjective probability distribution of expected earnings. The approaches are as below : 1) Net Income Approach (NI Approach) : The approach is suggested by Durand. According to it, a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increa ses, the weighted average cost of capital would decline with every increase in the debt content in total funds employed, while the value of the firm will increase. Reverse would happen in a converse situation. It is based on the following assumptions : i) There are no corporate taxes. ii) The cost of debt is less than cost of equity or equity capitalisation rate. iii) The use of debt content does not change the risk perception of investors as a result of both the K d (Debt capitalisation rate) and K e (equity capitalisation rate) remains constant. The value of the firm on the basis of Net Income Approach may be ascertained as follows : V=S+D Where, V = Value of the firm S = Market value of equity D = Market value of debt S = NI/K e Where, S = Market value of equity NI = Earnings available for equity shareholders K e = Equity Capitalisation rate Under, NI approach, the value of a firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising cost of capital.

Overall cost of capital = EBIT/Value of the firm 2) Net Operating Income Approach (NOI) : This approach is also suggested by Durand, according to it, the market value of the firm is not affected by the capital structure changes. The market value of the firm is ascertained b y capitalising the net operating income at the overall cost of capital, which is constant. The market value of the firm is determined as : V = EBIT/Overall cost of capital Where, V = Market value of the firm EBIT = Earnings before interest and tax S=V-D Where, S = Value of equity D = Market value of debt V = Market value of firm Cost of equity = EBIT/(V - D) Where, V = Market value of the firm EBIT = Earnings before interest and tax D = Market value of debt It is based on the following assumptions : i) The overall cost of capital remains constant for all degree of debt equity mix. ii) The market capitalises value of the firm as a whole. Thus, the split between debt and equity is not important. iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity capialisation rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalisation rate. iv) There are no corporate taxes. v) The cost of debt is constant. Under, NOI approach since overall cost of capital is constant, thus, there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal.

3) Traditional Approach : The traditional approach, also called an intermediate approach as it takes a midway between NI approach, that the value of the firm can be increased by increasing financial leverage and NOI approach, that the value of the fi rm is constant irrespective of the degree of financial leverage. According to this approach the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of debt and equity in capital structure. At the optima l capital structure, the overall cost of capital will be minimum and the value of the firm is maximum. It further states, that the value of the firm increases with financial leverage upto a certain point. Beyond this, the increase in financial leverage wil l increase cost of equity, the overall cost of capital may still reduce. However, if financial leverage increases beyond an acceptable limit, the risk of debt investor may also increase, consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase. Thus, as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by t he judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point favourably affect the value of the firm. At this point, the capital structure is optimal & the overall cost of capital will be the least. 4) Modigliani and Miller Approach(MM Approach) : According to this approach, the total cost of capital of particular firm is independent of its method and level of financing. Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They argued, in support of their approach, that as per the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, is determined from the level of shareholder's expectations. That is if, shareholders expect a particular rate of return, say 15 % from a particular company, they do not take into account the debt equity ratio and they expect 15 % as they find that it covers the particular risk which this company entails. Suppose, the debt content in the capital structure of the company increases, this means, that in the eyes of shareholders, the risk of t he company increases, since debt is a more risky mode of finance. Thus, the shareholders would now, expect a higher rate of return from the shares of the company. Thus, each change in the debt equity mix is automatically set -off by a change in the expectat ions of the shareholders from the equity share capital. This is because, a change in the debt -equity ratio changes the risk element of the company, which in turn changes the expectations of the shareholders from the particular shares of the company. Modigliani and Miller, thus, argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the capitalisation rate of pure equity stream of its class of risk. Thus, financial

leverage has no impact o n share market prices nor on the cost of capital. They make the following propositions : i) The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its risk class. ii) The cost of equity (Ke) is equal to the capitalisation rate of pure equity stream plus a premium for financial risk. The financial risk increases wit h more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive sources of funds. iii) The cut off rate for investment purposes is completely independent of the way in which the investment i s financed. Assumptions : i) - The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities. - They are well-informed about the risk -return on all type of securities. - There are no transaction costs. - They behave rationally. - They can borrow without restrictions on the same terms as the firms do. ii) The firms can be classified into 'homogenous risk class'. They belong to this class, if their expected earnings have identical risk characteristics. iii) All investors have the same expectations from a firms' EBIT that is necessary to evaluate the value of a firm. iv) The dividend payment ratio is 100 %. i.e. there are no retained earnings. v) There are no co rporate taxes, but, this assumption has been removed. Modigliani and Miller agree that while companies in different industries face different risks resulting in their earnings being capitalised at different rates, it is not possible for thes e companies to affect their market values, and thus, their overall capitalisation rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company's capital struct ure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage. For instance : There are 2 companies X and Y in the same risk class. Compan y X is financed by only equity and no debt, while Company Y is financed by a

combination of debt and equity. The market price of shares of Company Y would be higher than that of Company X, market participants would take advantage of difference by selling e quity shares of Company Y, borrowing money to equate their personal leverage to the degree of corporate leverage in Company Y and use them for investing in Company X. The sale of shares of Company Y reduces its price until the market value of the company Y , financed by debt and equity, equals that of Company X, financed by only equity. Criticism : These propositions have been criticised by numerous authorities. Mostly criticism is as regards, perfect market and arbitrage assumption. MM hypoth esis argue that through personnel arbitrage investors would quickly eliminate any inequalities between the value of leveraged firms and that of unleveraged firms in the same risk class. The basic argument here, is that individual arbitrageurs, through the use of personal leverage can alter corporate leverage, which is not a valid argument in the practical world, as it is extremely doubtful that personal investors would substitute personal leverage for corporate leverage, as they do not have the same risk ch aracteristics. The MM approach assumes availability of free and upto date information, this also is not normally valid. To conclude, one may say that controversy between the traditionalists and the supporters of MM approach cannot be resolv ed due to lack of empirical research. Traditionalists argue that the cost of capital of a firm can be lowered and the market value of shares increased by use of financial leverage. But, after a certain stage, as the company becomes highly geared i.e. debt content increases, it becomes too risky for investors and lenders. Thus, beyond a point, the overall cost of capital begins to rise, this point indicates the optimal capital structure. Modigliani and Miller argues, that in the absence of corporate income taxes, overall cost of capital begins to rise.

Question : What kind of relationship exists between taxation and capital structure ? Answer : The leverage irrelevance theory of MM is valid only in perfect market conditions, but, in face of imperfections characterising the real world capital markets, the capital structure of a firm may affect its valuation. Presence of taxes is a major imperfect ion in the real world. When taxes are applicable to corporate income, debt financing is advantageous. This is because dividends and retained earnings are not deductible for tax purposes, interest on debt is a deductible expense for tax purposes. As a resul t, the total available income for both stock-holders and debt-holders is greater when debt capital is used. If the debt employed by a leveraged firm is permanent in nature, the present value of

the tax shield associated with interest payment can be obtaine d by applying the formula for perpetuity. Present value of tax shield (TD) = (T * k d * D)/k d Where, T = Corporate tax rate D = Market value of debt k d = Interest rate on debt The present value of interest tax shields is independent of the cost of debt, it being a deductible expense. It is simply the corporate tax rate times the amount of permanent debt. Value of an unleveraged firm : V u = [EBIT ( 1 - t )]/K 0 Value of leveraged firm : V l = V u + Debt (t) Greater the leverage, greater would be the value of the firm, other things being equal. This implies that the optimal strategy of a firm should be to maximise the degree of leverage in its capital structure.

Question : Enumerate the methods to calculate the cos t of capital from various sources ? Answer : The cost of capital is a significant factor in designing the capital structure of an undertaking, as basic reason of running of a business undertaking is to earn return at least equal to the cost of capital. Commercial undertaking has no relevance if, it does not expect to earn its cost of capital. Thus cost of capital constitutes an important factor in various business decisions. For example, in analysing financial implications of capital structure proposals, cost of capital may be taken as the discounting rate. Obviously, if a particular project gives an internal rate of return higher than its cost of capital, it should be an attractive opportunity. Following are the cost of capital acquired from various sour ces : 1) Cost of debt : The explicit cost of debt is the interest rate as per contract adjusted for tax and the cost of raising debt.

- Cost of irredeemable debentures : Cost of debentures not redeemable during the life time of the company, K d = (I/NP) * (I - T) Where, K d = Cost of debt after tax I = Annual interest rate NP = Net proceeds of debentures T = Tax rate However, debt has an implicit cost also, that arises due to the fact that if the debt content rises above the optimal level, investors would start considering the company to be too risky and, thus, their expectations from equity shares will rise. This rise, in the cost of equity shares is actually the implicit cost of debt. - Cost of redeemable debentures : If the debentures are redeemable after the expiry of a fixed period the cost of debentures would be : K d = I(1 - t) + [(RV - NP)]/N [(RV + NP)/2] Where, I = Annual interest payment NP = Net proceeds of debentures RV = Redemption value of debentures t = tax rate N = Life of debentures 2) Cost of preference shares : In case of preference shares, the dividend rate can be taken as its cost, as it is this amount that the company intends to pay against the preference shares. As, in case of debt, the issue expenses or discount/premium on issue/redemption is also to be taken into account. - Cost of irredeemable preference shares : Cost of irredeemable preference shares = PD/PO Where, PD = Annual preference dividend PO = Net proceeds of an issue of preference shares - Cost of redeemable preference shares :

If the preference shares are redeemable after the expiry of a fixed period, the cost of preference shares would be. K p = PD + [(RV - NP)]/N [(RV + NP)/2] Where, PD = Annual preference dividend NP = Net proceeds of debentures RV = Redemption value of debentures N = Life of debentures However, since dividend of preference shares is not allowed as deduction from income for income tax purposes, there is no question of tax advantage in the case of cost of preference shares. It would, thus, be seen that both in case of debt and preference shares, cost of capital is calculated by reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account in working cost of capital. 3) Cost of ordinary or equity shares : Calculation of the cost of ordinary shares involves a complex procedure, because unlike debt and preference shares there is no fixed rate of interest or dividend against ordinary shares. Hence, to assign a certain cost to equity share capital is not a question of mere calculation, it requires an understanding of many factors basically concerning the behaviour of investors and their expectations. As, there can be different interpretations of investor's behaviour, there are many approaches regarding calculation of cost of equity shares. The 4 main approaches are : i) D/P ratio (Dividend/Price) approac h : This emphasises that dividend expected by an investor from a particular share determines its cost. An investor who invests in the ordinary shares of a particular company, does so in the expectation of a certain return. In other words, when an investor buys ordinary shares of a certain risk, he expects a certain return, The expected rate of return is the cost of ordinary share capital. Under this approach, thus, the cost of ordinary share capital is calculated on the basis of the present value of the expected future stream of dividends. For example, the market price of the equity shares (face value Rs. 10) of a particular company is Rs. 15. If it has been paying a dividend of 20 % and is expected to maintain the same, its cost of equity sh ares at face value is 0.2 * 10/15 = 13.3%, since it is the maximum rate of dividend, at which the investor will buy share at the present value. However, it can also be argued that the cost of equity capital is 20 % for the company, as it is on this expecta tion that the market price of shares is maintained at Rs. 15. Cost of equity shares of a company is that rate of dividend that maintains the present market price of shares. As the objective of financial management is to maximise the wealth of shareholders, it is rational to assume that the company must maintain the

present market value of its share by paying 20 % dividend, which then is its cost of equity capital. Thus, the relationship between dividends and market price shows the expectation of the investo rs and thereby cost of equity capital. This approach co -relates the basic factors of return and investment from view point of investor. However, it is too simple as it pre -supposes that an investor looks forward only to dividends as a return on his investment. The expected stream of dividends is of importance to an investor but, he looks forward to capital appreciation also in the value of shares. It may lead us to ignore the growth in capital value of the share. Under, this approach, a compan y which declares a higher amount of dividend out of a given quantum of earnings will be placed at a premium as compared to a company which earns the same amount of profits but utilises a major part of the same in financing its expansion programmes. Thus, D/P approach may not be adequate to deal with the problem of determining the cost of ordinary share capital. ii) E/P (Earnings/Price) ratio approach : The advocates of this approach co relates the earnings of the company with the market price of its sha res. As per it, the cost of ordinary share capital would be based on the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests, thus, an investor expects that the company in which he is going to subscribe for share should have at least 20 % of earning, the cost of ordinary share capital can be construed on this basis. Suppose, a company is expected to earn 30 % the investor will be prepared to pay Rs 150 (30/20 * 100) for each of Rs. 100 share. This approach is similar to the dividend price approach, only it seeks to nullify the effect of changes in dividend policy. This approach also does not seem to be a complete answer to the p roblem of determining the cost of ordinary share as it ignores the factor of capital appreciation or depreciation in the market value of shares. iii) D/P + growth approach : The dividend/price + growth approach emphasises what an investor actually expects to receive from his investment in a particular company's ordinary share in terms of dividend plus the rate of growth in dividend/earnings. This growth rate in dividend (g) is taken to be good to the compound growth rate in earnings per share. K e = [D 1 /P 0 ] + g Where, K e = Cost of capital D 1 = Dividend for the period 1 P 0 = Price for the period 0 g = Growth rate D/P + g approach seems to answer the problem of expectations of investor satisfactorily, however, it poses one problem that is how to qu antify expectation of investor relating to dividend and growth in dividend.

iv) Realised yield approach : It is suggested that many authors that the yield actually realised for a period of time by investors in a particular company may be used as an indicator of cost of capital. In other words, this approach takes into consideration the basic factor of the D/P + g approach but, instead of using the expected values of the dividends and capital appreciation, past yields are used to denote the cost of ca pital. This approach is based upon the assumption that the past behaviour would be repeated in future and thus, they may be used to measure the cost of ordinary capital. Which approach to use ? In case of companies with stable income and stable dividend po licies the D/P approach may be a good way of measuring the cost of ordinary share capital. In case of companies whose earnings accrue in cycles, it would be better if the E/P approach is used, but representative figures should be taken into account to incl ude complete cycle. In case of growth companies, where expectations of growth are more important, cost of ordinary share capital may be determined as the basis of the D/P + g approach. In the case of companies enjoying a steady growth rate and a steady rat e of dividend, the realised value approach may be useful. The basic factor behind determination of cost of ordinary share capital is to measure expectation of investors from ordinary shares of that particular company. Thus, the whole question of determining the cost of ordinary shares hinges upon the factors which go into the expectations of a particular group of investors in the company of a particular risk class. 4) cost of reserves : The profits retained by a company and used in the expansion of business also entail cost. Many people tend to feel that reserves have no cost. However, it is not easy to realised that by depriving the shareholders of a part of the earnings, a cost is automatically incurred on reserves. This may be termed as the opportunity co st of retained earnings. Suppose, these earnings are not retained and are passed on to shareholders, suppose further that shareholders invest the same in new ordinary shares. This expectation of the investors from new ordinary shares should be the opportun ity cost of reserves. In other words, if earnings were paid out as dividends and simultaneously an offer for right shares was made shareholders would have subscribed to the right share on the expectation of a certain return. This return may be taken as the indicator of the cost of reserves. People do not calculate the cost of capital of retained earnings as above. They take cost of retained earnings as the same as that of equity shares. However, if the cost of equity shares is determined on the basis of rea lised value approach or D/P + g approach, the question of working out a separate cost of reserves is not relevant since cost of reserves is automatically included in the cost of equity share capital. 5) Cost of depreciation funds : Depreciation funds, can not be construed as not having any cost. Logically speaking, they should be treated on the same footing as reserves when it comes to their use, though while calculating the cost of capital these funds may not be considered.

Question : Enumerate the pro cedure of calculating the weighted average cost of capital ? Answer : The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken to be proportion of each source of funds in the capital structure. While, making financial decisions this overall or weighted cost is used. Each investment is financed from a pool of funds which represents the various sources from which funds have been raised. Any decision of investment thus, has to be made with reference to the overall cost of capital and not with reference to cost of a specific source of fund used in that investment decisions. The weighted average cost of capital (WACC) is calculated by : 1) Calculating cost of specific sources of funds, e.g. cost of debt, etc. 2) Multiplying the cost of each source by its proportion in capital structure. 3) Adding the weighted component costs to get the firm's WACC. Thus, WACC is , K 0 = K 1 W 1 + K 2 W 2 +............. Where, K 1 , K 2 are component costs and W 1 , W 2 are weights. The weights to be used can be either book value weights or market value weights. Book value weights are easier to calculate and can be applied consistently. Market value weights are supposed to be superior to book valu e weights as component costs are opportunity costs and market values reflect economic values. However, these weights fluctuate frequently and fluctuations are wide in nature.

Question : What do you mean by marginal cost of capital ? Answer : The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds. Marginal cost of capita l is derived, when we calculate the average cost of capital using the marginal weights. The marginal weights represent the proportion of funds the firm intends to employ. Thus, the problem of choosing between the book value weights and the market value wei ghts does not arise in the case of marginal cost of capital computation. To calculate the marginal cost of capital, the intended financing proportion should be applied as weights to marginal component costs. The marginal cost of capital should, thus, be ca lculated in the

composite sense. When a firm raises funds in proportional manner and the component's cost remain unchanged, there will be no difference between average cost of capital of total funds and the marginal cost of capital. The component's cost ma y remain unchanged, upto a certain level of funds raised and then start increasing with amount of funds raised, e.g. The cost of debt remains 7 % after tax till Rs. 10 lakhs and between Rs. 10 - 15 lakhs, the cost may be 8 % and so on. Similarly, if the fi rm has to use the external equity when the retained profits are not sufficient, the cost of equity will be higher because of flotation costs. When the components cost starts rising, the average cost of capital would rise and marginal cost of capital would however, rise at a faster rate.

Question : What is the effect of a financing decision on EPS ? Answer : One of the prime objective of a finance manager is to maximise both the return on ordinary shares and the total wealth of the comp any. This objective has to be kept in view while, taking a decision on a new source of finance. Thus, the effect of each proposed method of new finance on the EPS is to be carefully analysed. EPS denotes what has been earned by the company during a particular accounting period, on each of its ordinary shares. This can be worked out by dividing net profit after interest, taxes and preference dividends by the number of equity shares. If a company has a number of alternatives for new financing, it can compute the impact of the various alternatives on earnings per share. It is obvious that, EPS would be the highest in case of financing that has the least cost to the company. 1) Explicit cost of new capital : It is a method that can compare the alternatives available for raising capital can be through the calculation of the explicit cost of new capital. Explicit cost of new capital is the rate of return at which the new funds must be employed so that the existing EPS is not affected. In other words, the rate of return of new funds must earn to maintain EPS at the existing levels. It is obvious that, if EPS were Rs. 2 earlier, the rate of return required to be earned by the source of new capital to maintain it at the old level is to be found. Long term debt would again be preferred as even if a lower rate of return is earned on the funds so raised, the old EPS will be maintained. 2) Range of earnings chart/Indifference point : Another method of considering the impact of various financing alternatives on EPS is to prepare the EBIT chart or the range of earnings chart. It shows the likely EPS at various probable EBIT levels. Thus, under one particular alternative, EPS may be Rs. 1 at a given EBIT level. However, the EPS may reduce if another alternative of financing is chosen even though the EBIT under the alternative may be drawn. Wherever this line intersects, it is known as break - even point. This point is a useful guide in

formulating the capital structure. This is known as EPS equivalency point or indifference point as, it shows that, between the 2 given alternatives of financing i.e. regardless of leverage in financial plans, EPS would be the same at the given EBIT level. The equivalency or indifference point can also be calculated algebraically as below : [X - B]/S 1 = X/S 2 Where, X = Indifference point (EBIT) S 1 = Number of equity shares outstanding S 2 = Number of equity shares outstanding when only equity capital is used. B = Interest on debt capital in rupees. 3) EPS Volatility : EPS Volatility refers to the magnitude or extent of fluctuations in EPS of a company in various years as compared to the mean or average EPS. In other words, EPS volatility shows whether a company enjoys a stable income or not. It is obvious that higher th e EPS Volatility, greater would be the risk attached to the company. A major cause of EPS Volatility would be the fluctuations in the sales volume and the operating leverage. It is obvious that the net profits of a company would greatly fluctuate with smal l fluctuations in the sales figures specially if the fixed cost content is very high. Thus, EPS will fluctuate in such a situation. This effect may be heightened by the financial leverage. CHAPTER SEVEN SOURCES OF FINANCE Question : List down the f inancial needs and the sources available with a business entity to satisfy such needs ? Answer : One of the most important consideration for an entrepreneur -company in implementing a new project or undertaking expansion, diversification, modernisation and rehabilitation scheme is ascertaining the cost of project and the means of finance. There are several sources of finance/funds available to any company. An effective appraisal mechanism of various sources of funds available to a company must be institut ed in the company to achieve its main objectives. Such a mechanism is required to evaluate risk, tenure and cost of each and every source of fund. This selection of fund source is dependent on the financial strategy pursued by the company, the leverage pla nned by the company, the financial conditions prevalent in the economy & the risk profile of both i.e. the company and the industry in which the company operates. Each and every source of fund has some advantages and disadvantages.

I) Financial needs of a business are grouped as follows : 1) Long term financial needs : Such needs generally refer to those requirements of funds which are for a period exceeding 5 - 10 years. All investments in plant and machinery, land, buildings, etc. are considered as l ong term financial needs. Funds required to finance permanent or hard core working capital should also be procured from long term sources. 2) Medium term financial needs : Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. Funds required for deferred revenue expenditure (i.e benefit of expense expires after a period of 3 to 5 years), are classified as medium term financial needs. Sometimes long term requirements, for which long term funds cannot be arranged immediately may be met from medium term sources and thus the demand of medium term financial needs are generated, as and when the desired long-term funds are available medium term loan may be paid off. 3) Short term financial needs : Such type of financial needs arise for financing current assets as, stock, debtors, cash, etc. Investment in these assets is known as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully. Th e requirement of working capital depends on a number of factors that may differ from industry to industry and from company to company in the same industry. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period i.e. one year. The basic principle for categorising the financial needs into short term, medium term and long term is that they are met from the corresponding viz. short term, medium term and long term s ources respectively. Accordingly the source of financing is decided with reference to the period for which funds are required. Basically, there are 2 sources of raising funds for any business enterprise viz. owners capital and borrowed capital. The owners capital is used for meeting long term financial needs and it primarily comes from share capital and retained earnings. Borrowed capital for all other types of requirement can be raised from different sources as debentures, public deposits, financial institutions, commercial banks, etc. II) Sources of finance of a business are : 1) Long term : i) Share capital or Equity share capital ii) Preference shares iii) Retained earnings iv) Debentures/Bonds of different types v) Loans from financial institutions vi) Loans from State Financial Corporation

vii) Loans from commercial banks viii) Venture capital funding ix) Asset securitisation x) International financing like Euro -issues, Foreign currency loans. 2) Medium term : i) Preference shares ii) Debentures/Bonds iii) Public deposits /fixed deposits for a duration of 3 years iv) Commercial banks v) Financial institutions vi) State financial corporations vii) Lease financing/Hire -purchase financing viii) External commercial borrowings ix) Euro-issues x) Foreign currency bonds. 3) Short-term : i) Trade credit ii) Commercial banks iii) Fixed deposits for a period of 1 year or less iv) Advances received from customers v) Various short-term provisions III) Financial sources of a business c an also be classified as follows on using different basis : 1) According to period : i) Long term sources ii) Medium term sources iii) Short term sources 2) According to ownership : i) Owners capital or equity capital, retained earnings, etc. ii) Borrowed capital such as, debentures, public deposits, loans, etc. 3) According to source of generation : i) Internal sources e.g. retained earnings and depreciation funds, etc. ii) External sources e.g. debentures, loans, etc. However, for convenience, the different sources of funds can also be classified into the following : a) Security financing - financing through shares and debentures b) Internal financing - financing through retained earning, depreciation

c) Loans financing - this includes both short term and long term loans d) International financing e) Other sources.

Question : Write a note on long term sources of finance. Answer : There are different sources of funds available to meet long term financial needs of the business . These sources may be broadly classified into share capital (both equity and preference) and debt (including debentures, long term borrowings or other debt instruments). In India, many companies have raised long term finance by offering various instrument s to public like deep discount bonds, fully convertible debentures, etc. These new instruments have characteristics of both equity and debt and it is difficult to categorise them into equity and debt. Different sources of long term finance are : 1) Owners' capital or equity capital : A public limited company may raise funds from promoters or from the investing public by way of owners capital or equity capital by issuing ordinary equity shares. Ordinary shareholders are owners of the compan y and they undertake risks of business. They elect the directors to run the company and have the optimum control over the management of the company. Since equity shares can be paid off only in the event in liquidation, this source has the least risk involved, and more due to the fact that the equity shareholders can be paid dividends only when there are distributable profits. However, the cost of ordinary shares is usually the highest. This is due to the fact that such shareholders expect a higher rate of r eturn on their investments compared to other suppliers of long term funds. The dividend payable on shares is an appropriation of profits and not a charge against profits, meaning that it has to be paid only out of profits after tax. Ordinary share capital also provides a security to other suppliers of funds. Thus, a company having substantial ordinary share capital may find it easier to raise funds, in view of the fact that the share capital provides a security to other suppliers of funds. The Companies Act , 1956 and SEBI Guidelines for disclosure and investors' protections and the clarifications thereto lays down a number of provisions regarding the issue and management of equity share capital. Advantages of raising funds by issue of equity shares are : i) It is a permanent source of finance. ii) The issue of new equity shares increases the company's flexibility. iii) The company can make further issue of share capital by making a right issue.

iv) There is no mandatory payments to shareholders of e quity shares. 2) Preference share capital : These are special kind of shares, the holders of which enjoy priority in both, repayment of capital at the time of winding up of the company and payment of fixed dividend. Long -term funds from preference shares can be raised through a public issue of shares. Such shares are normally cumulative, i.e. the dividend payable in a year of loss gets carried over to the next till, there are adequate profits to pay cumulative dividends. Rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans, etc. Most of preference shares now a days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period. Preference share capital is a hybrid form of financing that partakes some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax deductible payment. It resembles debt capital as the rate of preference dividend is fixed. When preference dividend is skipped, it is payable in future due to the cumulative feature associated with most of preference shares. Cumulative Convertible Preference Shares (CCPs) may also be offered, under which the shares would carry a cumulative dividend of specified limit for a period of say 3 years, after which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period. For normal preference shares, the maxi mum permissible rate of dividend is 14 %. Preference share capital may be redeemed at a predecided future date or at an earlier stage inter alia out of the company's profits. This enables the promoters to withdraw their capital from the company which is no w selfsufficient, and the withdrawn capital may be reinvested in other profitable ventures. Irredeemable preference shares cannot be issued by any company. Preference shares gained importance after the Finance Bill 1997 as dividends became tax exempted in the hands of the individual investor and are taxable in the hands of the company as tax is imposed on distributable profits at a flat rate. The Budget, for 2000 - 01 has doubled the dividend tax from 10 % to 20 % besides a surcharge of 10 %. The budget fo r 2001 - 2002 has reduced the dividend tax from 20 to 10 %. Many companies followed this route during 1997 especially through private placement or preference shares as the capital markets were not vibrant. The advantages of taking the preference share c apital are as follows : 1) No dilution in EPS on enlarged capital base : If equity is issued it reduces EPS, thus affecting the market perception about the company. 2) There is leveraging advantage as it bears a fixed charge. 3) There is no risk of t akeover.

4) There is no dilution of managerial control. 5) Preference capital can be redeemed after a specified period. 3) Retained Earnings : Long term funds may also be provided by accumulation of company's profits and on ploughing them back into business. Such funds belong to the ordinary shareholders and increases the company's net worth. A public limited company must plough back a reasonable amount of profit every year, keeping in view the legal requirements in this regard, and it s own expansion plans. Such funds entail almost no risk and the present owner's control is maintained as there is no dilution of control. 4) Debentures or bonds : Loans can be raised from public on issue of debentures or bonds by public limited companies. Debentures are normally issued in different denominations ranging from Rs. 100 to 1000 and carry different rates of interest. On issue of debentures, a company can raise long term loans from public. Usually, debentures are issued on the b asis of a debenture trust deed which lists terms and conditions on which debentures are floated. They are normally secured against the company's assets. As compared with preference shares, debentures provide a more convenient mode of long term funds. Cost of capital raised through debentures is low as the interest can be charged as an expense before tax. From the investors' view point, debentures offer a more attractive prospect than preference shares as interest on debentures is payable whether or not the company makes profits. Debentures are thus, instruments for raising long term debt capital. Secured debentures are protected by a charge on the company's assets. While the secured debentures of a well -established company may be attractive to investors, sec ured debentures of a new company do not normally evoke same interest in the investing public. Advantages : 1) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax -deductible. Also, investors consider debenture investment safer than equity or preferred investment and thus, may require a lower return on debenture investment. 2) Debenture financing does not result in dilution of control. 3) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases.

Disadvantages of debenture financing are as below : 1) Debenture interest and capital repayment are obligatory payments. 2) The protective covenants associat ed with a debenture issue may be restrictive. 3) Debentures financing enhances the financial risk associated with the firm. These days many companies are issuing convertible debentures or bonds with a number of schemes/incentives like wa rrants/options, etc. These bonds or debentures are exchangeable at the ordinary share holder's option under specified terms and conditions. Thus, for the first few years these securities remain as debentures and later they can be converted into equity shares at a pre -determined conversion price. The issue of convertible debentures has distinct advantages from the view point of the issuing company. - such as issue enables the management to raise equity capital indirectly without diluting the equity holding, until the capital raised starts earning an added return to support additional shares. - such securities can be issued even when the equity market is not very good. - convertible bonds are normally unsecured and, thus, their issuance may ordinarily not impair the borrowing capacity. These debentures/bonds are issued subject to the SEBI guidelines notified from time to time. Public issue of debentures a nd private placement to mutual funds, require that the issue be rated by a credit rating agency as CRISIL (Credit Rating and Information Services of India Ltd.). The credit rating is given after evaluating factors as track record of the company, profitabil ity, debt service capacity, credit worthiness and the perceived risk of lending. 5) Loans from financial institutions : In India specialised institutions provide long -term financial assistance to industries. Some of them are, Industrial Fina nce Corporations, Life Insurance Corporation of India, National Small Industries Corporation Limited, Industrial Credit and Investment Corporation, Industrial Development Bank of India and Industrial Reconstruction Corporation of India. Before sanctioning of a term loan, a company has to satisfy the concerned financial institution regarding the technical, commercial, economic, financial and managerial viability of the project for which the loan is required. Such loans are available at different rates of interest under different schemes of financial institutions and are to be repaid as per a stipulated repayment schedule. The loans in many cases stipulate a number of conditions as regards the management and certain other financial

policies of the company. Te rm loans represent secured borrowings and are an important source of funds for new projects. They generally, carry a rate of interest inclusive of interest tax, depending on the credit rating of the borrower, the perceived risk of lending and cost of funds and generally repayable over a period of 6 to 10 years in annual, semi -annual or quarterly installments. Term loans are also provided by banks, State Financial/Development institutions and all India term lending financial institutions. Banks and State Fin ancial Corporations provide term loans to projects in the small scale sector while, for medium and large industries term loans are provided by State developmental institutions alone or in consortium with banks and State financial corporations. For large scale projects All India financial institutions provide bulk of term finance singly or in consortium with other such institutions, State level institutions and/or banks. After independence, the institutional set up in India for the provision of medium and lo ng term credit for industry has been broadened. The assistance sanctioned and disbursed by these specialised institutions has increased impressively over the years. A number of specialised institutions are established over the country. 6) Loans from commercial banks : The primary role of the commercial banks is to cater to the short term requirement of industry. However, of late, banks have started taking an interest in term financing of industries in several ways, though the formal term len ding is, still, small and confined to major banks. Terms lendings by bank is a controversial issue these days. It is argued that term loans do not satisfy the canon of liquidity that is a major consideration in all bank operations. According to traditional values, banks should provide loans only for short periods and operations resulting in automatic liquidation of such credits over short periods. On the other hand, it is contended that the traditional concept needs modification. The proceeds of term loan a re used for what are broadly known as fixed assets or expansion in plant capacity. Their repayment is usually scheduled over a long period of time. The liquidity of such loans is said to depend on the anticipated income of borrowers. Working capital loan is more permanent and long term as compared to a term loan. The reason being that a term loan is always repayable on a fixed date and ultimately, the account will be totally adjusted. However, in case of working capital finance, though payab le on demand, in actual practice it is noticed that the account is never adjusted as such and if at all the payment is asked back, it is with a clear purpose and intention of refinance being provided at the beginning of next year or half year. This technique of providing long term finance is known as, "rolled over for periods exceeding more than one year". Instead of indulging in term financing by the rolled over method, banks can and should extend credit term after a proper appraisal of applications for t erm loans. The degree of liquidity in the provision for regular amortisation of term loans is more than in some of these so called demand loans which are renewed from year to year. Actually, term financing, disciplines both the banker and borrower

as long term planning is required to ensure that cash inflows would be adequate to meet the instruments of repayments and allow an active turnover of bank loans. The adoption of the formal term loan lending by commercial banks will not hamper the criteria of liqui dity, and will introduce flexibility in the operations of the banking system. The real limitation to the scope of bank activities is that all banks are not well equipped to appraise such loan proposals. Term loan proposals involve an element of risk because of changes in conditions affecting the borrower. The bank making such a loan, thus, has to assess the situation to make a proper appraisal. The decision in such cases depends on various factors affecting the concerned industry's conditions and borrower's earning potential. 7) Bridge finance : It refers to loans taken by a company from commercial banks for a short period, pending disbursement of loans sanctioned by financial institutions. Normally, it takes time for financia l institutions to disburse loans to companies. However, loans once approved by the term lending institutions pending the signing of regular term loan agreement, that may be delayed due to non compliance of conditions stipulated by the institutions while sa nctioning the loan. The bridge loans are repaid/adjusted out of term loans as and when disbursed by the concerned institutions. They are secured by hypothecating movable assets, personal guarantees and demand promissory notes. Generally, the interest rate on them is higher than on term loans.

Question : What do you mean by Venture Capital Financing ? Answer : Venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs lacking experience and funds to give shape to their ideas. Under it venture capitalist make investment to purchase equity or debt securities from in experienced entrepreneurs undertaking highly risky ventures with a potential of success. The venture capital industry in India is just a decade old. The venture capitalist finance ventures that are in national priority areas such as energy conservation, qu ality upgradation, etc. The Government of India in November 1988 issued the first set of guidelines for venture capital companies, funds and made them eligible for capital gain concessions. In 1995, certain new clauses and amendments were made in the guide lines that require the venture capitalists to meet the requirements of different statutory bodies and this makes it difficult for them to operate as they do not have much flexibility in structuring investments. In 1999, the existing guidelines were relaxed for increasing the attractiveness of the venture schemes and to induce high net

worth investors to commit their funds to 'sunrise' sectors, particularly the information technology sector. Initially the contribution to the funds available for venture capital investment in the country was from the All India development financial institutions, State development financial institutions, commercial banks and companies in private sector. Lately many offshore funds have been started in the country and maximum cont ribution is from foreign institutional investors. A few venture capital companies operate as both investment and fund management companies, other set up funds and function as asset management company. It is hoped that changes in the guidelines for implemen tation of venture capital schemes in the country would encourage more funds to be set up to give the required momentum for venture capital investment in India. Some common methods of venture capital financing are : 1) Equity financing : The venture capital undertakings usually require funds for a longer period but, may not be able to provide returns to investors during the initial stages. Thus, the venture capital finance is generally provided by way of equity share capital. The equity contribution of ven ture capital firm does not exceed 49 % of the total equity capital of venture capital undertakings so that the effective control and ownership remains with the entrepreneur. 2) Conditional loan : It is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India venture capital financers charge royalty ranging between 2 and 15 %, actual rate depends on other factors of the venture as gestation period, cash flow patterns, riskiness and other fa ctors of the enterprise. Some venture capital financers give a choice to the enterprise of paying a high rate of interest, which can be well below 20 %, instead of royalty on sales once it becomes commercially sounds. 3) Income note : It is a hybrid security combining features of both conventional and conditional loan. The entrepreneur has to pay interest and royalty on sales but, at substantially low rates. IDBI's Venture Capital Fund (VCF) provides funding equal to 80 - 87.5 % of the project cost for c ommercial application of indigenous technology. 4) Participating debentures : Such security carries charges in 3 phases - in the start up phase no interest is charged, next stage - a low rate of interest is charged upto a particular level of operation an d after that, a high rate of interest is required to be paid.

Question : Write a note on Debt Securitisation ?

Answer : Debt securitisation is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the len ding volumes. Assets generating steady cash flows are packaged together and against this asset pool market securities can be issued. The basic debt securitisation process can be classified in the following 3 functions : 1) The origination function : A borrower seeks a loan from a finance company, bank, housing company or a lease from a leasing company. The creditworthiness of the borrower is evaluated and a contract is entered into with repayment schedule structured over the life of the loan. 2) The pooling function : Similar loans or receivables are clubbed together to create an underlying pool of assets. This pool is transferred in favour of a SPV (Special Purpose Vehicle), which acts as a trustee for the investor. Once the assets are transferred, they are held in the originators' portfolio. 3) The securitisation function : It is the SPV's job now to structure and issue the securities on the basis of the asset pool. The securities carry a coupon and an expected maturity which can be asset based or mortgage based. These are generally sold to investors through merchant bankers. The investors interested in this type of securities are generally institutional investors like mutual funds, insurance companies, etc. The originator usually keeps the spread available i.e. difference between yield from secured assets and interest paid to investors. The process of securitisation is generally without recourse i.e. the investor bears the credit risk or risk of default and the issuer is under an obligation to pay to investors only if the cash flows are received by him from the collateral. The risk run by the investor can be further reduced through credit enhancement facilities as insurance, letters of credit and guarantees. In a simple pass through structure, the investor owns a proportionate share of the asset pool and cash flows when generated are passed on directly to the investor. This is done by issuing pass through certificates. In mortgage or asset backed bonds, the investor has a lien on the underlying asse t pool. The SPV accumulates payments from borrowers from time to time and make payments to investors at regular predetermined intervals. The SPV can invest the funds received in short term instruments and improve yield when there is a time lag between rece ipt and payment. Benefits to the originator : 1) The assets are shifted off the balance sheet, thus, giving the originator recourse to off balance sheet funding. 2) It converts illiquid assets to liquid portfolio. 3) It facilitates better balance s heet management as assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms.

4) The originator's credit rating enhances. For the investor, securitisation opens up new investment avenues. Though the investor bears the credit risk. The securities are tied up to definite assets. As compared to factoring or bill discounting which largely solve the problems of short term trade financing. Securitisation helps to convert a stream of cash receivables into a source of long ter m finance. For a developed securitisation market, high quality assets with low default rate are essential with standardised loan documentation and stable interest rate structure and sufficient data on asset performance, developed secondary debt markets ar e essential for this. In Indian context debt securitisation has began to take off. The ideal candidates for this are hire purchase and leasing companies, asset finance and real estate finance companies. ICICI, HDFC, Citibank, Bank of America, etc. have or are planning to raise funds by securitisation.

Question : Explain briefly the term Lease Financing ? Answer : Leasing is a general contract between the owner and user of the asset over a specified period of time. The asset is purchased initially by the lessor (leasing company) and thereafter leased to the user (lessee company) that pays a specified rent at period ical intervals. Thus, leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease financing can be arranged much faster as compared to term loans from financial institutions. In recent years, leasing has become a pop ular source of financing in India. From the lessee's view point, leasing has the attraction of eliminating immediate cash outflow and the lease rentals can be deducted for computing the total income under the Income tax act. As against this, buying has the advantages of depreciation allowance inclusive of additional depreciation and interest on borrowed capital being tax deductible. Thus, an evaluation of the 2 alternatives is to be made in order to take a decision.

Question : Explain the various so urces of short term finance ? Answer : Following are the various sources of short term finance :

1) Trade credit : It represents credit granted by suppliers of goods, etc. as an incident of sale. The usual duration of such credit is 15 to 90 days. I t generates automatically, in the course of business and is common to almost all business operations. It can be in the form of an 'open account' or 'bills payable'. Trade credit is preferred as a source of finance as it is without any explicit cost and til l a business is a going concern, it keeps on rotating. It also, enhances automatically with the increase in the volume of business. 2) Advances from customers : Manufacturers and contractors engaged in producing or constructing costly goods involving c onsiderable length of manufacturing or construction time usually, demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful. 3) Bank advances : Banks receive deposits from public for different periods at varying rates of interest there are funds invested and lent in such a manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc. are met and a reasonable profit is made. A bank's lending policy is not merely profit motivated but has to keep in mind the socio -economic development of the country. As a prudent policy, banks normally spread out their funds as under : i) About 9 - 10 % in cash. ii) About 32 % in approved government and semi -government securities. iii) About 58 % in advances to their credits. Banks advances are in the form of loan, overdraft, cash credit and bills purchased/discounted, etc. Banks do not sanction advances on long term basis beyond a small proportion of their demand and time liabilities. Advances are granted against tangible securities such as goods, shares, go vernment promissory notes, bills, etc. In rare cases, clean advances may also be allowed. a) Loans : In a loan account, the entire advance is disbursed at one time in cash or by transfer to the current account of the borrower. It is a single advance, except by way of interest and other charges, no further adjustments are made in this account. Loan accounts are not running accounts like overdraft and cash credit accounts, repayment under the loan account, may be full amounts or by way of schedule of repaym ents agreed upon as in case of terms loans. The securities may be shares, government securities, life insurance policies and fixed deposit receipts and so on.

b) Overdrafts : Under this facility, customers are allowed to withdraw in excess of credit balance standing in their current deposit account. A fixed limit is thus, granted to the borrower within which the borrower is allowed to overdraw his account. Opening of an overdraft account requires that a current account is formally opened. Although overdr afts are repayable on demand, they usually continue for long periods by annual renewals of limits. This is a convenient arrangement for the borrower, as he is in a position to avail the sanctioned limit as per his requirements. Interest is charged on daily balances, cheque books are provided, these accounts being operative as cash credit and current accounts. Security, as in case of loan accounts, may be shares, debentures and government securities, life insurance policies and fixed deposit receipts are als o accepted in special cases. c) Clean overdrafts : Request for such facility is entertained only from financially sound parties that are reputed for their integrity. Bank is to rely on personal security of the borrowers, thus, it has to exercise a good deal of restraint in entertaining such proposals, as they have no backing of any tangible security. In case parties are already enjoying secured advance facilities, this may be a point in favour and may be taken into account while screening such proposals. The turnover in the account, satisfactory dealings for considerable period and reputation in the market are also considered by the bank. As a safeguard, banks take guarantees from other persons who are credit worthy before granting this facility. A clean advance is generally granted for a short period and must not be continued for long. d) Cash credits : Cash credit is an arrangement under which, a customer is allowed an advance upto certain limit against credit granted by bank. Under it, a customer need not borrow, the entire amount of advance at one time. He can only draw to the extent of his requirements and deposit his surplus funds in his account. Interest is not charged on the full amount of advance but, on the amount actually availed by him. Usuall y, credit limits are sanctioned against the security of goods by way of pledge or hypothecation, though they are repayable on demand, banks usually do not recall them, unless they are compelled to do so by adverse factors. Hypothecation is an equitable cha rge on movable goods for an amount of debt where neither possession nor ownership is passed on to the creditor. For pledge, the borrower delivers the goods to the creditor as security for repayment of debt. Since the banker, as creditor, is in possession of the goods, he is fully secured and in case of emergency he may fall back on the goods for realisation of his advance under proper notice to the borrower. e) Advances against goods : Advances against goods occupy an important place in total bank credit , goods as security have certain distinct advantages : - they provide a reliable source of repayment - advances against goods are safe and liquid

Generally, goods are charged to the bank by way of pledge or hypothecation. The term 'goods' includes all forms of movables that are offered to the bank as security. They may be agricultural commodities, industrial raw materials, partly finished goods and so on. RBI issues directives from time to time imposing restrictions on advances against cer tain commodities. It is obligatory on banks to follow these directives in letter and spirit, they may sometimes, also stipulate changes in margin. f) Bills purchased/discounted : These advances are allowed against the security of bills that may be clean or documentary. Bills are sometimes, purchased from approved customer, in whose favour limits are sanctioned. Before granting a limit, the banker satisfies himself as to the creditworthiness of the drawer. Although the term 'bills purchased' gives the imp ression that the bank becomes the owner or purchaser of such bills, in reality, the bank holds the bills as security only, for the advance. In addition to the rights against the parties liable on the bills, the banks can also exercise a pledgee's rights ov er the goods covered by the documents. Usuance bills maturing at a future date or sight are discounted by the banks for approved parties. When a bill is discounted, the borrower is paid the present worth. The bankers, however, collect the full amounts on m aturity, the difference between the 2 i.e. the amount of the bill and the discounted amount represents earnings of bankers for the period; it is termed as 'discount'. Sometimes, overdraft or cash credit limits are allowed against the security of bills. A s uitable margin is usually maintained. Here the bill is not a primary security but, only a collateral one. In such case, the banker does not become a party to the bill, but merely collects it as an agent for its customer. When a banker purchases or discount s a bill, he advances against the bill, he thus, has to be very cautious and grant such facilities only to creditworthy customers, having an established steady relationship with the bank. Credit reports are also complied on the drawees. g) Advance against documents of title to goods : A document becomes of document of title to goods when its possession is recognised by law or business custom as possession of the goods. These documents include a bill of lading, dock warehouse keeper's certificate, ra ilway receipt, etc. A person in possession of a document to goods can by endorsement or delivery or both of document, enables another person to take delivery of the goods in his right. An advance against pledge of such documents is equivalent to an advance against the pledge of goods themselves. h) Advance against supply of bills : Advances against bills for supply of goods to government or semi -government departments against firm orders after acceptance of tender fall under this category. Other type of b ills under this category are bills from contractors for work executed wholly or partially under firm contracts entered into with the herein mentioned government agencies. These are clean bills, without being accompanied by any document of title of goods. But, they evidence supply of goods directly to Governmental agencies.

They may, sometimes, be accompanied by inspection notes from representatives of government agencies for inspecting the goods before despatch. If bills are without inspection report, banks like to examine them with the accepted tender or contract for verifying that the goods supplied under the bills strictly conform to the terms and conditions in the acceptance tender. These supply bills represent debt in favour of suppliers/contractors, fo r goods supplied to government bodies or work executed under contract from the Government bodies. This debt is assigned to the bank by endorsement of supply bills and executing irrevocable power of attorney in favour of banks for receiving the amount of supply bills from the Government departments. The power of attorney has got to be registered with the department concerned. The banks also take separate letter from the suppliers/contractors instructing the Government body to pay the amount of bills direct to the bank. Supply bills do not enjoy the legal status of negotiable instruments as they are not bills of exchange. The security available to a banker is by way of assignment of debts represented by the supply bills. i) Term loans by banks : It is an instalment credit repayable over a period of time in monthly/quarterly/half -yearly or yearly instalments. Banks grant term loans for small projects falling under the priority sector, small scale sector and big units. Banks have now been permitted to sanctio n term loan for projects as well without association of financial institutions. The banks grant loans for periods normally ranging from 3 to 7 years and at times even more. These loans are granted on the security of fixed assets. j) Financing of exports by banks : Advances by commercial banks for export financing are in the form of : a) Pre-shipment finance i.e. before shipment of goods : This usually, takes the form of packing credit facility, which is an advance extended by banks to an exporter for the purpose of buying, manufacturing, processing, packing, shipping goods to overseas buyers. Any exporter, having at hand a firm export order placed with him by his foreign buyer or an irrevocable letter of credit opened in his favour, can approach a bank f or availing packing credit. An advance so taken requires to be liquidated within 180 days from the date of its commencement by negotiation of export proceeds in an approved manner. Thus, packing credit is essentially a short term advance. Usually, banks in sist on their customers to lodge with them irrevocable letters of credit opened in favour of the customers by overseas buyers. The letter of credit and firm sale contracts not only serve as evidence of a definite arrangement for realisation of the export proceeds but also indicate the amount of finance required by the exporter. Packing credit in case of customers of long standing, may also be granted against firm contracts entered into by them with overseas buyers. Following are the types of packing credit available :

i) Clean packing credit : This is an advance available to an exporter only on production of a firm export order or a letter of credit without exercising any charge or control over raw material or finished goods. Each proposal is weighted according to particular requirements of trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (E.C.G.C.) cover should be obtained by the bank. ii) Packing credit against hypothecatio n of goods : Export finance is made available on certain terms and conditions where the exporter has pledgeable interest and the goods are hypothecated to the bank as security with stipulated margin. At the time of utilising the advance, the exporter is re quired to submit, along with the firm export order or letter of credit, relative stock statements and thereafter continue submitting them every fortnight and/or whenever there is any movement in stocks. iii) Packing credit against pledge of goods : Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the banks with approved clearing agents who would ship the same from time to time as required by the exporter. Possession of goods so pledged lie s with the bank and are kept under its lock and key. iv) E.C.G.C. guarantee : Any loan given to an exporter for the manufacture, processing, purchasing or packing of goods meant for export against a firm order qualifies for packing. Credit guarantee is i ssued by the Export Credit Guarantee Corporation (E.C.G.C.). v) Forward exchange contract : Another requirement of packing credit facility is that if the export bill is to be drawn in a foreign currency, the exporter should enter into a forward exchange contract with the bank, thereby avoiding risk involved in a possible change in the exchange rate. Documents required : - In case of partnership firms, banks usually require the following documents : Joint and several demand pronote signed on behalf of the firm as also by partners individually; Letter of continuity, signed on behalf of the firm and partners individually; Letter of pledge to secure demand cash credit against stock, in case of pledge or agreement of hypothecation to secure demand cash credit, in case of hypothecation. Letter of authority to operate the account; Declaration of Partnership, in case of sole traders, sole proprietorship declaration; Agreement to utilise the monies drawn in terms of contract; Letter of hypothecation for bills. - Following documents are required by banks, in case of limited companies :

Demand pro-note; Letter of continuity; Agreement of hypothecation of letter of pledge, signed on behalf of the company; General guarantee of the di rectors' resolution; Agreement to utilise the monies drawn in terms of contract should bear the company's seal; Letter of hypothecation for bills b) Post shipment finance : It takes the below mentioned forms :

i) Purchase/Discounting of documentary export bills : Finance is provided to exporters by purchasing export bills drawn payable at sight or by discounting usuance export bills covering confirmed sales and backed by documents inclusive of documents of title to goods such as bill of lading, post parcel receipts or air consignment notes. Documents to be obtained are : Letter of hypothecation covering the goods; and General guarantee of directors or partners of the firm, as the case may be. E.C.G.C. Guarantee : Post-shipment finance, given to an e xporter by bank through purchase, negotiation or discount of an export bill against an order, qualifies for post -shipment export credit guarantee. It is necessary, that exporters obtain a shipment or contracts risk policy of E.C.G.C. Banks insist on the exporters to take a contracts shipments (comprehensive risks) policy covering both political and commercial risks. The Corporation, on acceptance of the policy, would fix credit limits for individual exporters and the Corporation's liability will be limited to the extent of the limit so fixed for the exporter concerned irrespective of the policy amount. ii) Advance against export bills sent for collection : Finance is provided by banks to exporters by way of advance against export bills forwarded through them for collection, taking into account the party's creditworthiness, nature of goods exported, usuance, standing of drawee, etc. appropriate margin is kept. Documents to be obtained : Demand promissory note; Letter of continuity; Letter of hypothecation c overing bills; General guarantee of directors or partners of the firm, as the case may be. iii) Advance against duty draw backs, cash subsidy, etc. : To finance export losses sustained by exporters, bank advance against duty draw -back, cash subsidy, etc. receivable by them against export performance. Such advances are of clean nature, hence, necessary precaution is to be exercised. Conditions : Bank providing finance in this manner should see that the relative export bills are either negotiated or forwarded for collection through it so that, it

is in a position to verify the exporter's claims for duty draw -backs, cash subsidy, etc. An advance so availed by an exporter is required to be liquidated within 180 days from the date of shipment of relative goods. Documents to be obtained are : Demand promissory note; Letter of continuity; General guarantee of directors or partners of the firm, as the case may be. Undertaking from the borrowers that they will deposit the cheques/payments received from the appropriate authorities immediately with the bank and will not utilise such amounts in any other way. c) Other facilities extended to exporte rs : i) On behalf of approved exporters, banks establish letters of credit on their overseas or up -country suppliers. ii) Guarantees for waiver of excise duty, etc. due performance of contracts, bond in lieu of cash security deposit, guarantees for adv ance payments, etc. are also issued by banks to approved clients. iii) To approved clients undertaking exports on deferred payment terms, banks also provide finance. iv) Banks also endeavour to secure for their exporter -customers status reports of their buyers and trade information on various commodities through their correspondents. v) Economic intelligence on various countries is also provided by banks to their exporter clients. 5) Inter corporate deposits : The companies can borrow funds for a s hort period say 6 months from other companies having surplus liquidity. The rate of interest on it varies depending on the amount involved and time period. 6) Certificate of deposit (CD) : It is a document of title similar to a time deposit receipt issued by a bank except, that there is no prescribed interest rate on such funds. Its main advantage is that banker is not required to encash the deposit before maturity period and the investor is assured of liquidity as he can sell it in the secondary market. 7) Public deposits : They are important source of short and medium term finances particularly due to credit squeeze by the RBI. A company can accept such deposits subject to the stipulations of the RBI from time to time maximum

upto 35 % of its paid up capital and reserves, from the public and the shareholders. These may be accepted for a period of 6 months to 3 years. Public deposits are unsecured loans, and not meant to be used for acquisition of fixed assets, since, they are to be repaid within a peri od of 3 years. These are mainly used to finance working capital requirements.

Question : Enumerate and explain the other sources of financing ? Answer : The other sources of financing are as discussed below : 1) Seed capital assistance : The seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons possessing relevant experience, skills and entrepreneurial traits. All the projects eligible for financial assistance from IDBI, dir ectly or indirectly through refinance are eligible under the scheme. The project cost should not exceed Rs. 2 crores and the maximum assistance under the project will be restricted to 50 % of the required promoter's contribution or Rs. 15 lakhs, whichever is lower. Seed capital assistance is interest free, but carries a service charge of 1 % per annum for the first 5 years and at increasing rate thereafter. However, IDBI will have the option to charge interest at such rate as determined by it on the loan if the financial position and profitability of the company so permits during the currency of the loan. The repayment schedule is fixed depending on the repaying capacity of the unit with an initial moratorium upto 5 years. For projects with cost exceeding Rs. 200 lakhs, seed capital may be obtained from the Risk Capital and Technology Corporation Ltd. (RCTC). For small projects costing upto Rs. 5 lakhs, assistance under the National Equity Fund of the SIDBI may be availed. 2) Internal cash accruals : Existing profit making companies undertaking an expansion/diversification programme may be permitted to invest a part of their accumulated reserves or cash profits for creation of capital assets. In such cases, the company's past performance permits capital ex penditure from within the company by way of disinvestment of working/invested funds. In other words, the surplus generated from operations, after meeting all the contractual, statutory and working requirement of funds, is available for further capital expenditure. 3) Unsecured loans : They are provided by promoters to meet the promoters' contribution norm. These loans are subordinate to institutional loans and interest can be paid only after payment of institutional dues. These loans cannot be repaid without the prior approval of financial institutions. Unsecured loans are considered as part of the equity for the purpose of calculating debt equity ratio.

4) Deferred payment guarantee : Many a time suppliers of machinery provide a deferred credit facility under which payment for the purchase of machinery may be made over a period of time. The entire cost of machinery is financed and the company is not required to contribute any amount initially towards acquisition of machinery. Normally, the supplier of ma chinery would insist that the bank guarantee be furnished by the buyer. Such a facility does not have a moratorium period for repayment. Hence, it is advisable only for an existing profit making company. 5) Capital Incentives : Backward area development incentives available often determine the location of a new industrial unit. They usually consist of a lumpsum subsidy and exemption from or deferment of sales tax and octroi duty. The quantum of incentives is determined by the degree of backwardness of th e location. Special capital incentive in the form of a lumpsum subsidy is a quantum sanctioned by the implementing agency as a percentage of the fixed capital investment subject, to an overall ceiling. This amount forms a part of the long term means of finance for the project. However, the viability of the project must not be dependent on the quantum and availability of incentives. Institutions, while appraising the project, assess its viability per se, without considering the impact of incentives on the ca sh flows and the project's profitability. Special capital incentives are sanctioned and released to the units only after they have complied with the requirements of the relevant scheme. The requirements may be classified into initial effective steps, that include formation of the firm/company, acquisition of land in the backward area and registration for manufacture of the products. The final effective steps include obtaining clearances under FEMA, capital goods clearance/import license, conversion of Letter of Intent to Industrial License, tie up of the means of finance, all clearances required for the setting up of the unit, aggregate expenditure incurred for the project should exceed 25 % of the project cost and atleast 10 %, if the fixed assets should ha ve been created/acquired at site. The release of special capital incentives by the concerned State Government generally takes 1 to 2 years. Promoters thus, find it convenient to avail the bridge finance against the capital incentives. Provision for the sam e should be made in the pre operative expenses considered in the project cost. As the bridge finance may be available to the extent of 85 %, the balance i.e. 15 % may have to be brought in by the promoters from their own resources. 6) Various short term provisions/accruals account : Accruals accounts are a spontaneous source of financing as they are self -generating. The most common accrual accounts are wages and taxes. In both cases, the amount becomes due but is not paid immediately.

Question : Wri te short notes on :

1) Deep Discount Bonds Notes 3) Zero interest fully convertible debentures 5) Double Option Bonds 7) Inflation Bonds

2) Secured Premium 4) Zero Coupon Bonds 6) Option Bonds 8) Floating Rate Bonds

Answer : 1) Deep Discount Bonds : It is a form of a zero interest bond, sold at a discounted value and on maturity face value is paid t o the investors. In such bonds, there is no interest paid during lock in period. IDBI was the first to issue a deep discount bond in India in January, 1992. It had a face value of Rs. 1lakh and was sold for Rs. 2700 with a maturity period of 25 years. The investor could hold the bond for 25 years or seek redemption at the end of every 5 years with maturity value as below : Holding period (years) Maturity value (Rs.) Annual rate of interest (%) 5 5700 16.12 10 12000 16.09 15 25000 15.99 20 50000 15.71 25 100000 15.54

The investor can sell the bonds in stock market and realise the difference between face value (Rs. 2700) and the market price as capital gain. 2) Secured Premium Notes : It is issued along with a detachable warrant and is redeemable after a notified period of say 4 to 7 years. The conversion of detachable warrant into equity shares will have to be done within the time period notified by the company. 3) Zero interest fully convertible debentures : These are fully convertible debentures which do not carry any interest. They are compulsorily and automatically converted after a specified period of time and holders thereof are entitled to new equity shares of the company at predetermined price. Fro m the company's view point, this kind of instrument is beneficial in the sense, that no interest is to be paid on it, if the share price of the company in the market is very high, then the investor tends to get equity shares of the company at a lower rate. 4) Zero Coupon Bonds : A zero coupon bond does not carry any interest, but it is sold by the issuing company at a discount. The difference between the discounted and

maturing or face value represents the interest to be earned by the invest or on them. 5) Double Option Bonds : Double Option Bonds are recently issued by the IDBI. The face value of each bond is Rs. 5000, it carries interest at 15 % per annum compounded half yearly from the date of allotment. The bond has a maturity period of 10 years. Each having 2 parts, in the form of 2 separate certificates, one for the principal of Rs. 5000 and other for interest, including redemption premium of Rs. 16500. Both these certificates are listed on all major stock exchanges. The investor has the facility of selling either one or both parts anytime he likes. 6) Option bonds : These are cumulative and non -cumulative bonds where interest is payable on maturity or periodically. Redemption premium is also offered to attract investors. These were recently issued by IDBI, ICICI, etc. 7) Inflation bonds : They are bonds in which interest rate is adjusted for inflation. The investor, thus, gets an interest free from the effects of inflation. For instance, i f interest rate is 12 % and inflation rate is 5 %, the investor will earn 17 %, meaning that the investor is protected against inflation. 8) Floating Rate Bonds : As the name suggests, Floating Rate Bonds are ones, where the rate of interest is not fixed and is allowed to float depending upon the market conditions. This is an ideal instrument that can be resorted to by the issuer to hedge themselves against the volatility in interest rates. This has become more popular as a money market inst rument and has been successfully issued by financial institutions like IDBI, ICICI, etc.

Question : Give a detailed account of International Financing ? Answer : The essence of financial management is to raise & utilise the funds raised effectively. There are various avenues for organisations to raise funds either through internal or external sources. External sources include : Commercial banks : Like domestic loans, commercial banks all over the world extend Foreign Currency (FC) loans, for international operations. These banks also provide to overdraw over and above the loan amount. Development banks : offer long and medium term loans includin g FC loans. Many agencies at the national level offer a number of concessions

to foreign companies to invest within their country and to finance exports from their countries e.g. EXIM Bank of USA. Discounting of trade bills : This is used as a short term financing method widely, in Europe and Asian countries to finance both domestic and international business. International agencies : A number of international agencies have emerged over the years to finance international trade and business. The more notable among them includes : International Finance Corporation (IFC), International Bank for Reconstruction & Development (IBRD), Asian Development Bank (ADB), International Monetary Fund (IMF), etc.

International capital markets : Modern organisations including MNC's depend upon sizeable borrowings in Rupees as also Foreign Currency. In order to cater to the needs of such organisation , international capital markets have sprung all over the globe such as in London. In International capital ma rket, the availability of FC is assured under the 4 main systems, as : Euro-currency market Export credit facilities Bonds issues Financial Institutions The origin of the Euro -currency market was with the dollar denominated bank deposits & loans in Europe particularly, London. Euro -dollar deposits are dollar denominated time deposits available at foreign branches of US banks and at some foreign banks. Banks based in Europe accept & make dollar denominated deposits to the clients. This form s the backbone of the Euro currency market all over the globe. In this market, funds are made available as loans through syndicated Euro -credit of instruments as FRN's, FR certificates of deposits. Below mentioned are some of the financial instruments : 1) Euro Bonds : Euro Bonds are debt instruments denominated in a currency issued outside the country of that currency, for instance : a yen note floated in Germany. 2) Foreign Bonds : These are debt instruments denominated in a currency which is foreign to the borrower and is sold in the country of that currency. 3) Fully Hedged Bonds : In foreign bonds, the risk of currency fluctuations exists. They eliminate the risk by selling in forward markets the entire stream of principal and interest payments. 4) Floating Rate Notes : They are issued upto 7 years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans.

5) Euro Commercial Papers (ECP) : ECP's are short term money market instruments, with maturity of less than 1 year and designated in US dollars. 6) Foreign Currency Option : A FC Option is the right to buy or sell, spot or future or forward, a specified foreign currency. It provides a hedge against financial and economic ris ks. 7) Foreign Currency Futures : FC Futures are obligations to buy or sell a specified currency in the present for settlement at a future date. 8) Euro Issues : In the Indian context, Euro Issue denotes that the issue is listed on a European Stock Exchange. However, subscription can come from any part of the world except India. Finance can be raised by Global Depository Receipts (GDR), Foreign Currency Convertible Bonds (FCCB) and pure debt bonds. However, GDR's and FCCB's are more popular. 9) Global Depository Receipts : A depository receipt is basically a negotiable certificate, denominated in US Dollars representing a non US company's publicly traded local currency (Indian Rupee) equity shares,. Theoretically, though a depository receipt can als o signify debt instrument, practically it rarely does so. DR's are created when the local currency shares of an Indian company are delivered to the depository's local custodian bank, against which the depository bank issues DR's in US Dollars. These DR's m ay be freely traded in the overseas- markets like any other dollar denominated security via either a foreign stock exchange or through a over the counter market or among a restricted group as Qualified Institutional Buyers (QIB). Rule 144 A of the Securiti es and Exchange Commission (SEC) of USA permits companies from outside USA to offer their GDR's to certain institutional buyers, known as QIBs. 10) GDR with Warrant : These receipts are more attractive than plain GDR's in view of additional value of att ached warrants. 11) American Depository Receipts (ADR's) : Depository Receipts issued by a company in USA is known as ADR's. Such receipts have to be issued in accordance with the provisions stipulated by the SEC, USA that are stringent. In a bid to bypass such stringent disclosure norms mandated by the SEC for equity shares, the Indian companies have, however, chosen the indirect route to tap the vast American financial market through private debt placement of GDR's listed in London and Luxembourg stock exchanges. Indian companies have preferred the GDR's and ADR's as the US market exposes them to a higher level or responsibility than a European listing in the areas of disclosure, costs, liabilities and timing. The SECs regulations set up to protect the retail investor base are some what more stringent and onerous, even for companies already listed and held by retail investors in their home

country. Most onerous aspect of a US listing for companies is to provide full, half yearly and quarte rly accounts in accordance with or atleast reconciled with US GAAPs. However, Indian companies are shedding their reluctance to tap the US markets as evidenced by Infosys Technologies Ltd. recent listing in NASDAQ. Most of India's top notch companies in th e pharmaceutical, info -tech and other sunrise industries are planning forays into the US markets. Another prohibitive aspect of the ADR's vis --vis GDR's is the cost involved of preparing and filling US GAAP accounts. Additionally, the initial SEC registra tion fees based on a percentage of issue size anmd 'Blue Sky' registration costs, permitting the securities to be offered in all States of US, will have to be met. The US market is widely recognised as the most litigious market in the world. Accordingly, the broader the target investor base in US, higher is the potential legal liability. An important aspect of GDR is that they are non voting and hence spells no dilution of equity. GDRs are settled through CEDEL and Euro -clear International Book Entry Syste ms. Other types of International issues : Foreign Euro Bonds : In domestic capital markets of various countries the Bond issues referred to above are known by different names as Yankee Bonds in US, Swiss Frances in Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK. Euro Convertible Bonds : A convertible bond is a debt instrument giving the holders of the bond an option to convert the bonds into a pre determined number of equity shares of the company. Usually, the price of equity shares at the time of conversion will have a premium element. They carry a fixed rate of interest and if the issuer company so desires may also include a Call Option, where the issuer company has the option of calling/buying the bonds for redemption prior to the maturity da te, or a Put Option, which gives the holder the option to put/sell his bonds to the issuer company at a pre -determined date and price. Euro Bonds : Plain Euro Bonds are nothing but debt instruments. These are not very attractive for an investor who desires to have valuable additions to his investments. Euro Convertible Zero Bonds : These are structured as a convertible bond. No interest is payable on the bonds. But conversion of bonds take place on maturity at a pre -determined price. Usually, there is a 5 y ears maturity period and they are treated as a deferred equity issue. Euro Bonds with Equity Warrants : These carry a coupon rate determined by market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed Income Funds Management may like to invest for the purposes of regular income.