PART 3 LESSON 6

COST OF CAPITAL
LESSON – 6
COST OF CAPITAL

A company raises funds in the form of capital and uses the same to finance in assets or
production or service. The funds providers expect suitable return for investing the funds into
the company. The cost of capital refers to the return, which is expected by the investors.

While studying the cost of capital, the term “capital “must be clearly understood. The total
capital of the firm is the value of its equity plus cost of debt. The “equity “in the debt to
equity ratio is the market value of all equity, not the share holder equity on the balance sheet.
Therefore cost of capital is the minimum rate of return that a firm must earn on its
investment. This is to maintain its market value and attract investors to invest funds. This cost
of capital refers to discount rate that is used in determining present value of future cash flows
and to decide whether the project is worth while to invest.

Weighted Average Cost of Capital

Capital structure refers to the way in which the finance arranged it self’s through some
combination of equity sales, equity options, bonds and loan. The optional capital structure
refers to a particular combination that minimizes the cost of capital while maximizing the
stock price. The management must identify the “optional mix” of financing capital structure
where the cost of capital minimized so that the firms value can be maximized. Thus the
capital structure of a firm comprises of many components. Out of which, three main
components are preferred - equity, common equity and debts (Bonds and notes). Each
component has its own cost and they are called specific cost of capital. When these specific
cost of capital are combined to arise at an over all cost of capital, it is known as the weighted
average cost of capital.

Cost of individual capital components

There are four main components in the capital structure namely, debt, preference shares,
equity capital, and retained earnings. The cost of each components or source is called specific
cost. The cost of capital is the over all cost which is the combined cost of the specific cost.

The computation of cost of capital involves two steps (a) compute specific cost for each
components. (b) Calculation of over all cost which is called cost of capital. The specific costs
have to be calculated for long term debt, preference shares, and equity capital and retain
earnings.

Cost of long term debts:

The cost of debt is easy to calculate. By applying the following formulae, we can find the
cost of funds raised through debt in the form of debenture or loan from financial institutions.

n
CIo = ∑ cot
t=i
(1 + c) t
Where
CIo = initial cash inflows (cash proceeds receives from the sale of security).

To find explicit cost of debt we require the following data.

Net cash process:

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The amount of loan minus all floatation cost. The floatation cost is the total cost of issuing
and selling securities.

Net cash out flows:

Periodic interest payment and repayment of principal either in installment during the period
or in lump sum on maturity.

Tax deduction:
The interest payments made by the firm, may quality for deduction of tax. Therefore the net
efficient cash out flows is less than the actual of tax shield on interest payments.

Cost of irredeemable / perpetual debt:

The debt carries certain rate of interest. The coupon interest rate or market yield on debt may
be the cost of debt. The coupon rate of interest is the before tax cost of debt. The cost of debt
should be adjusted for the tax effect. The effective cost of debt is tax adjusted rate of interest.
The coupon rate of interest will requires adjustment to find true cost of debt.

Ki = I.
SV
Ki = I . (1– t)
SV
Ki = before tax cost of debt.
Kd = tax – adjusted cost of debt.
I = annual interest payment.
SV = sales proceeds of the bond / debenture
t = tax rate.
Further these debts may be issued at par or at discount or at premium.

Cost of redeemable debt:

In the redeemable debt, we have to consider not only payment of interest but also the
repayment of capital in number of installments or in lump sum on maturity. The repayment of
capital in number of investments, the cost of debt can be calculated as follows:

n
CIo = ∑ CoI t + CoI t
t =1 (1 + Kd ) t

kd = cost of debt.
CIo = net cash proceeds from raising debts.
CoI t = cash out flows on interest payment o. (t) is time period.
CoP t = principle repayment.

The cost of capital can be find out from the following equation, in the case where the
repayment of principle is in one lump sum as the time of maintain.
n
CIo = ∑ CoI t + CoI
t
t=i (1 + Kd ) (1 + Kd ) n

Kd = I (1 – t + ( f + d + Pr – Pi ) / NM
RV + SV2

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Cost of preference shares:

The cost of preference capital may be defined as the dividend expected by the preference
share holders. Generally fixed dividend rate is stipulated on preference shares. The holders of
shares have preferential right as regards payment of dividend as well as return of capital as
compared to ordinary equity share holders. The preference shares are usually cumulative
which means that preference divided will get accumulated till it is paid.

The stipulated dividend rate on preference shares is the basis for calculation of the cost of
preference shares.

The payment of dividend is not a charge against earnings but is only an appropriation of
profit. They are paid out of after – tax earrings of the company. Therefore no adjustment is
required for taxes while computing cost of preference capital.

The calculation differs depend upon the type of preference shares. There are redeemable
preference shares and irredeemable preference shares. The principal will not be return to
share holders in irredeemable preference shares. This amount is available as Capital till the
end of life of the company.

In the case of redeemable preference shares, shares are issued with maturity date so that the
principal will be repaid at some future date.

Formula for calculating cost of capital for perpetual security that is irredeemable preference
capital.

Kp = Dp
Po (1 – f )

Kp = Dp ( 1 – D t )
Po (1 – f)

Where:
Kp = cost of preference capital.
Po = expected sales price of preference shares.
Dt = tax on preference dividend.
F = flotation cost as a percentage share price.
Dp = constant annual dividend pay.

Formula for calculating cost of preference capital for redeemable preference capital:

Po (1 – f) = Dp 1 + Dp 2 …………………+ Pn
1
( 1 + Kp ) ( 1 + Kp) 2 ( 1 + Kp) n.
n
Po (1 + f) = ∑ Dp 1 + Pn
t=1
( 1 = Kp) t ( 1 + Kp) n .

where:
Po = expected sale price of preference shares.
Dp = dividend paid on preference shares

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Pn = repayment of preference capital amount.
F = flotation cost as percentage of Po.

Cost of equity capital:

The cost of equity is the highest among all the sources of funds generally. The investors
invested their money on equity shares in the expectation of certain rate of return is the firm of
dividends. The quantum of rate of return depends upon the business risk and financial risk of
a company. The equity shares involve the highest degree of financial risk. This is because
they are entitled to receive dividend and return of capital after all other obligations of the firm
are met. Since, the equity share holders are exposed to such higher risk, they expect a high
return, and high cost is associated with them. Therefore, the cost of equity capital is the
minimum rate of return that a firm must earn on the equity – financed portion of a investment
project in order to leave unchanged the market price of the shares.

The following two approaches can be employed to calculate the cost of equity capital.

 Dividend approaches.
 Capital asset pricing model approach.

Dividend approach – to calculate the cost of equity capital:

The cost of equity capital can be measured by the following formula:

n
Po ( I + f ) = ∑ D1 ( 1 + g ) t – 1 simplifying this equation.
t=1
( 1 + Ke ) t
Po = D1
Ke – g.

Ke = D1 + g.
Po

Where: D1 = dividend expect per share.

g = growth in expected dividend.
Po = net proceeds per share / current market price.

The calculation of cost of equity capital is based on certain assumption.

• The initial dividend is greater than zero. (Do > 0 ).
• The investors can accurately measure the risk ness of the firm.
• Dividend payment ratio is constant.
• The market value of shares depends upon the expected dividends.
• The investors can formulate subjective probability distribution of dividends for shares
expected to be paid in various future periods.

Capital Asset Pricing Model approach (CAPM approach):

The capital asset pricing model ( CAPM) approach is another technique used to estimate the
cost of equity. The CAPM explain the behavior of security prices and provides mechanism
where investors could assess the impact of proposed investment of security on their overall

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portfolio risk and return. The basic assumption of CAPM is related to the efficiency of
security market and investors preference.

The security investment is exposed to risks, which are unsystematic and systematic. The
unsystematic risk is other wise called divisible risk. These are the risks that can be eliminated
or minimized. The source of risk includes management capabilities and decisions, strikes,
government regulation, availability of raw material and competition.

Systematic risk is also known as non – divisible risk. The factors of such risk will affect all
firms. For example inflation, political changes and changes in investors expectations about
over all performance of the economy. This is the relevant risk, and the investor or firm should
be concerned. This can be measured, according to CAPM. The non – divisible risk of an
investment is assessed in terms of beta coefficient. The beta for market portfolio as measured
by the broad – based market Index equals one. The bet coefficient of 1 would display that the
risk of the specified security is equal to market. There is no market related risk at zero
coefficients to the investment.

CAPM approach describes the relationship between cost of equity capital and relevant / non –
divisible risk. The non divisible risk of the firm as reflected on its index of non – divisible
risk that is beta. The cost of capital (Ke ) can be calculated by the following formula:

Ke = R f + b ( Km - R f ).

Where:
R f = the rate of return on risk free assets, or investment.
Km = the required rate of return on market portfolio of assets that can be viewed
as the average rate of return on all assets.
b = the beta coefficient.

Cost of retained earnings:

Retained earnings are a source of finance for investment proposals. This is completely
different from other source of finance, like equity shares, preference shares are debt. There is
no obligation on a firm to make payment of its return. It appears that it carry no cost, because
they have not been raised from out side. On the contrary they also involve cost.

Marginal cost of capital:

The cost of financing for the next dollar of new capital rose. Some source, like low grade
debt would be more expensive to raise. This requires a higher interest rate.

The capital must be raised to finance a new project, and the marginal cost should be the
hurdle rate. The huddle rate will be used in discounted cash flows present valued analysis but
must average cost of capital.
The marginal cost of capital increases, because the lower cost of capital sources are used first.
If the return on additional investment decreases because the most profitable movements made
initially, this is called the marginal efficiency of investment. Combining both marginal cost
of capital and marginal efficiency investment produces the equilibrium investment level of
the firm at a particular interest rate and the capital budget.

Modigliani – miller theory of the cost of capital:

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The Theory states that overall capital remain constant as the financial gearing of a firm
increases. But critics have said that the theory is not considering the risk of bankruptcy as
affirms debt increases. Modigliani – miller theory forms the basis of modern thinking on
capital structure.

The basic theorem states “in the absence of taxes ,bankruptcy costs , and symmetric
information and in an efficient market, the value of the firm is unaffected by how that firm is
financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt”.

Working Capital

There are two components in working capital, one is current asset and the other is current
liabilities.

The current assets refer to those assets which will be converted into cash during the ordinary
course of business within one year. The major current assets are cash, marketable securities,
accounts receivables and Inventory. The current assets are also known as “gross working
capital”.

The current liabilities are the liabilities which are to be paid in the ordinary course of business
I.e. within one year, out of current assets or earnings from the business. They are accounts
payable, bills payable, out standing expenses and bank over draft.

The net working capital is the difference between current assets and current liabilities. The
positive working capital means the company is able to pay off its short term liabilities, with
the current assets. If the company’s current assets do not exceeds its current liabilities, then it
may run into trouble paying back creditors in the short term. This is called working capital
deficit. The worst case is bankruptcy.

The working capital includes both short term and long term funds. Since the current –
liabilities represent short term sources of funds as long as current assets exceed current
liabilities, the excess must be financed with long term funds.

Operating cycle:
Sales do not convert in to cash instantly. There is a time lag between sales and recipt of cash.
Here the need for working capital arises, to meet problems due to lack of intermediate
realization of cash against goods sold. Sufficient working capital is necessary to sustain sales
activity. To complete the sales activity to receipt of cash, the following cycle of events to be
performed.

 Convert cash to inventory.

 Convert inventory to receivables.
 Convert receivables to cash.

This is not possible to complete the sequence instantaneously. There would be a need for
working capital in each phase of conversion.

Phase 1 Conversion of cash (capital) to inventory:

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• The chain starts with the firm buying raw materials on credit.
• In due course the raw materials will be used in production. Work will be carried out
on the stock. It will become part of firms work in progress ( WIP ).
• Work on the stock / WIP will continue until it eventually emerges as the finished
product.
• As production progresses, labor cost and over heads need to be paid.
• Trade credits will need to be paid as agreed.

Phase 2. Conversion of inventory to receivable:

• When finished goods are sold either debtors are increased ( or cash will be received. If
it is cash sale ).
• There will be a time lag between inventory and sale of stock in the market. The over
heads such as rent for stockyard, electricity, securities also incurred.

Phase 3. Conversion of receivables to cash.

• They will eventually pay, so that cash will be injected into the firm. That is realization
of debtors / receivable.

All cash transactions need not be a “working capital “transitions. There are non working
capital cash transactions in the business. Most of these “non working capital “. Cash
transactions are not every day events. Some of them are annual events ( e.g) tax payments,
dividends, interest and purchases of fixed assets or sale. Others are new equity and loan
finance and redemption of old equity and loan finance which would be rare event.

Different industries produce and sell different type of products. They adopt different strategy
to complete the business cycle. Therefore, each one will have a different optimum working
capital profile which reflects their methods of doing business. For example:

a) Larger companies may be able to use their bargaining strength as customers to obtain
more favorable, extended credit terms from supplies by contact. Smaller companies
or companies which are recently started may be required to pay the suppliers
immediately.
b) “Seasonality” of cash flow occurs in some industries, Like travel agents, who have
peak sale in the weeks immediately following Christmas
c) Some finished goods which are perishable, have to the sold with in a limited period.
d) Some business will have lot of cash sales and few credit sales. They should have
minimal trade debtors. E,g: super markets.
e) Trading is possible only for finished goods. This should be compared with
manufactures who will maintain stocks of raw materials and work in process.

Fixed / permanent and fluctuating / temporary working capital:

A business requires working capital to complete the operating cycle. Once the operating cycle
ends, we can’t say that we do not need working capital because the cycle starts once again.
Therefore requirement of working capital will continued to keep the cycle alive. However the

magnitude of working capital required is not constant, but fluctuating. A certain minimum
level of working capital is necessary on a continuous and uninterrupted basis to carry on the
business. This refers to a fixed part of the working capital. This is also known as permanent
working capital. It should be met permanently as with other fixed assets. The fixed element

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of working capital should be financed from fairly permanent sources ( e.g. Equity and loan
stocks). Any amount above the permanent level of working capital is fluctuating or temporary
working capital. Both fixed as well as fluctuating working capital are necessary to fecilitate
the process of sale through operating cycle. Temporary working capital is created to meet
liquidity requirement.

Due to the following reasons the change in the level of working capital may occur:
a) Change in policies.
b) Change in technologies.
c) Change in sales and operating expenses.
d) Operating Efficiency.
e) Depreciation policy.
f) Change in price level.
g) Dividend policy
h) Change in taxation.
i) Profit level changes.
j) Availability of raw material.
k) Growth and expansion.
l) Credit policy changes.
m) Change in production policy.
n) Change in business cycle.
o) Change in production cycle.

Cash Management
The corporate treasures are using financial management technique to speed up the collection
of receivables, regulate payments trade creditors and efficiently manage the cash. The
corporations which are large in size collect funds from different accounts and invest excess
funds in money market. The treasurers also controls the out flow of funds by timely payment
on due dates. Therefore cash is the common denominator to which all current assets have to
be converted finally.

The following are the main objectives of cash management:

1. Maintaining required balance of cash is one of the objectives of the cash management.
The cash is a non – earning asset. The high level of cash balance of corporate ensures prompt
disbursement or settlement of trade creditors on due dates. This attracts many advantages
likes cash discount. The high level cash balance implies that large funds remain idle. This
means that we loose profits. The failure to meet the payment schedule is possible in
maintaining low level cash balance. Therefore to avoid either idle funds on hand or failure to
meet prompt payment, the corporate should maintain as optimal amount of cash balance.

2. Maintaining payment schedule:

In the normal course of business the firm is collecting cash from account receivables and
make payments to trade creditors or employees etc. This is a continuous cycle. To meet such
payment schedule promptly, the firm have to maintain sufficient cash balance.

Following are some of the advantages to keep required cash balance:

a) It prevents bankruptcy by providing the ability of a firm to meet its obligation.

b) It maintains good relation with trade creditors and suppliers.

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c) If the payment is made within due date, the cash discount may be availed.
d) The relationship with bank will be good and not strained, if we meet repayments on
due dates.
e) The firm may purchase goods on favorable terms due to strong credit rating.
f) During emergencies such as strikes or new marketing campaign by competitors or
fire, the firm can meet unexpected cash expenditure if the firm maintains heavy cash
balance. But it implies high cost.

Factors determining required cash balance:

There are certain factors which determine the required cash balance or optimal cash balance.

 The cost of excess cash balance:

The cost of large cash balance, excessively held, is known as excess cash balance cost. This
implies, the firm missed opportunities to invest and there by lost interest or return.

 Uncertainty or management strategy:

The impact of uncertainty on cash management strategy is a relevant factor. The cash flows
will not be able to predict clearly, so that large amount are left as cash balance to meet
irregularities in cash flow, unexpected delay in collection from receivables and disbursements
to trade creditors on defaults.

 Non – synchronization of cash flows:

The cash inflows and out flows will not synchronize. Therefore the cash balance is to be
maintained to balance. We have to consider the fact of non – synchronization of cash receipts
and disbursement. For this purpose, planning of cash inflows or out flows for short term ( that
is less than one year ) to be prepared.

 Cost of short fall:

The cost forecast presented in the cash budget would reveal periods of cash shortages. The
shortage may be expected or unexpected. This involves the following costs:.
• Transaction cost.
• Loss of cash discount.
• Penalty rates.
• Borrowing cash - Borrowing cost to cover the shade’
• Cost associated with deterioration of the credit rating.

Cash management techniques:

We discuss few management techniques used in cash management.

Speedy cash collection:

In managing cash efficiently, cash flow process can be accelerated through systematic
planning and refried techniques. The two main approaches are,

• Customers should be encouraged to pay as quickly as possible.

• The payments received from customers should be converted into cash without any
delay.

Prompt billing:

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Inducing customers to make prompt payments by making them to understand what amount
they have to pay and the period of payment. The must know all bill details and payment terms
in advance. The uses of mechanical devices for billing along with enclosure of a self
addressed return envelope will speed up payment by customers.

Another way of inducing customers to make prompt payment is offering cash discounts; the
discount implies considerable saving to customers which will make the customer to pay early.

Conversion of payments into cash:

In settling the accounts receivable the customer issue checks. But the checks can not be used
instantly like cash, because it is to be cleared by the bank and credited to our accounts. The
time lag between the issues of check by customers and the amount credited by bank in their
account is called as deposit float.

“The deposit floats “is defined as ’” the sum of check written by customers that are not yet
usable by the firm.”
The deposit float is divided into three parts which are postal float, lethargy float and bank
float.

 Postal float:
The transit time or mailing time, that is the time taken by post office to transfer checks to the
firm from customer.

 Lethargy float:
Lethargy float is time taken for processing checks with the firm after received from mail or
before deposited in the bankers.

 Bank float:
“Bank float “is time taken for collection by the bank from customer’s bank.

The collection of accounts receivables can be speeded up considerably by reducing transit or

mailing, processing and collection time. Cash management technique is to reduce in deposit
float. The policy of decentralized collections will help to reduce deposit float.

The principle methods of establishing a decentralized collection network are:

o Concentration banking
o Lock box system.

Concentration banking:
Concentration banking is a method of establishing a decentralized collection network. This is
a system of decentralized billing and multiple collection points.

A Large firm will have large number of branches at different places. Some of the selected
branches will be made as collection centers. There is no need to send all the receivable
checks to head office of the firm. The customers are required to send their payment to local

collection centers. Funds beyond a predetermined minimum are transfer daily to a “central
account “. This arrangement is referred to as concentration banking.

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This concentration banking technique is to expedite the collection of accounts receivable. It
reduces time required for collection process by reducing mailing time.
It saved both mailing time

(1) In respect of sending bill to customers and

(2) The receipt of payments.

The customers and firm may be in close proximity in concentration banking of which will
help in reducing deposit float. Another advantage is that the concentration permits the firm to
store its cash efficiently. This is because the firm is pooling all collected funds in a single
account.

Lock box system:

Under this system, the firm hires a post office lock box at important collection centers. The
customers are requested to remit cheques to post office lock box. The local bank, which is
authorized for such purpose, opens the box and collect all cheques received from customers.
Usually the authorized banks pick up cheques several times a day and deposit them in the
firm accounts. After crediting the account of the firm the bank send deposit slips along with
list of payments and enclosures to the firm by way of proof and record of the collection.

Some of the advantages in implementing this system are mentioned below:

1. Like concentration banking the collection is decentralized, the cheques are directly
received by the bank by emptying the lock box.
2. The processing time with in the firm before deposing the investments into the bank
eliminated.
3. The bank performs the task of handling the remittances prior to deposits or some of
the services the bank may perform at lower cost.
4. The process of collection through banking system begins immediately upon the
receipt of instruments or emptying the lock box located at post office.

Slow down disbursements:

Under the cash management system speedy collection is very important and at the some time
the slowdown disbursement is also equally important. Slow disbursement represents a source
of fund requiring no interest payment.

Several techniques followed to delay payments:

1. Centralized disbursement.
2. Floats.
3. Accruals.
4. Avoidance of early payments.

1) Centralized disbursement:
All payment should be made by head office and from a single centralized account. This
system delays the payments and conserves cash. The disbursement should be made exactly
the day it is due.

2) Float:

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As we have already discussed, the float refers to the money tied up in cheques that have been
written but yet to be enchased. This represents the difference between bank balance and bank
balance of cash of a firm.
The time lag between issue of cheque and the presentation into the bank for payment
are called as float.. This time lag may be extended by issuing cheque from a distant bank or
scientific check enchasing analysis.

3) Accruals:
Accruals represent a service or goods received in advance by a firm but not paid for. For
expenses accruals are rent to lessors and taxes to government. They can be manipulated to
slow down disbursements.

4) Avoidance of early Payment:

According to terms and conditions the firm has to settle their creditors. If the payment is
made within the stipulated time, the firm is entitled for cash discount. The delay in making
the payment beyond due date will adversely affects the credit standing of the firm. Therefore
you can delay the disbursement only up to due date.

Marketable Securities Management:

The firm is required to maintain a level of cash balance to run the business smoothly as
determined by the management. The residual balance of cash will be invested in marketable
securities. Whenever cash is required, these securities will be converted into cash quickly.
Therefore the managing of marketable securities is also important.

Following are some of the characters of the marketable securities.

1. Securities are short – term investment.
2. They must obtain return on such temporary funds.
3. Marketability minimizes the time required to convert a security into cash.
4. There should be little or no less in value while converting the security into cash over a
period.
5. The securities can be easily converted into cash without any reduction in principal
amount.

We discuss some of the following Marketable Securities.

Treasury securities:

There are four types of treasury securities.

1. Treasury bills.
2. Treasury notes.
3. Treasury bonds and.
4. Savings bonds.

These securities are government bonds issued by the united states department of the treasury
through the Bureau of the Public Debt. These securities are the debt financing investments for
the U.S federal government. They are also referred to as treasuries.

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All the treasury securities ( besides savings bonds ) are very liquid and are heavily traded on
the secondary market.

Treasury bill:
The treasury bills are also called as T- bills. They mature in one year or less. They are sold at
a discount of the par value to create a positive yield to maturity. They are like zero bonds, in
that the interest will not be paid prior to maturity.

Treasury bills are considered to be the most risk – free investment. These bills are commonly
issued maturity dates of 28 days ( 1 month ), 91 days ( 3 months ) and 182 days ( 6 months ).
Treasury bills are issued each Thursday after weekly auctions which are held on Monday.
Matured T- bills are also redeemed on each Thursday. Banks and financial institutions are the
largest purchases of T - bills. They are quoted for purchase or sale in the secondary market on
an annualized percentage yield to maturity. Individuals can now purchase T- bills on line and
earn higher interest rates on their savings.

Treasury notes:
Treasury notes are also called as T- notes. They mature in two to ten years. The have coupon
payment every six months. They are commonly issued with maturity dates 2, 3, 5 and 10
years. T – notes and T – bonds are quoted on the secondary market. This is very important to
U.S mortgage market, which uses the yield on the 10 year treasury notes as a bench mark for
setting mortgage interest rates.

Treasury bonds:
Treasury bonds mature in ten years or more. This also like T- notes, they give coupon
payment every six months. They are highly liquid in secondary market. the frequency of long
term bond issues declining significantly in 1990 and 2000s.

The U.S government stopped issuing long bonds ( 30 years bonds ) on oct 31 st 2001. The
same class bonds are reintroduced in February 2006. and is issued quarterly. Some countries
including U.S, France,UK has began offering a 50 – years bond known as a Methuselah.

Treasury inflation – protected securities. (TIPS):

The TIPS are the inflation – indexed bonds issued by U.S treasury. The principal is adjusted
to the consumer price index. The coupon rate is constant but the different amount of interest
will be calculated by the inflation adjusted principal. Thus the securities held are protected
against inflation. TIPS can be a useful information source for policy makers.

Strips:
First separate the interest and principal portion of the security. They may be sold separately.
In the secondary market. such securities are known as strips. T – notes, T – bonds, or TIPS
may be stripped. But the government does not directly issued strips. They are formed by
investment bank or brokerage firms, but the government dose register Strip in its books and is
called as entry system. They can be brought only through brokers, not directly.

Negotiable certificate of deposits ( C D )

The negotiable certificate of deposits ( CDO )are negotiable instruments. There are
marketable deposit receipts for funds. They have seen deposited in a bank for fixed period of
time with fixed rate of interest. The denomination and maturities are made according to the

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investors need. These CDS are offered by bank. A secondary market exists for CDS. The
CDS may be issued in either registered or bearer form. The bearer form facilitates
transaction in the secondary market.

Banker’s acceptance (BA):

The banker’s acceptance is a negotiable instrument. It is a time draft drawn on and accepted
by the bank. An importer might write a draft promising payment to an exporter for delivery
of goods where the payment will be made on or before 60 days after the goods delivered.
Such draft is known as a” time draft “. This is said to be matured on the due date of payment.
Here drawer and drawee are different parties. The importer submits draft to its bankers for
confirmation that the draft is in order and importer will make the payments on the specified
date. Such confirmation is called acceptance. Since the drawer is the bank, the acceptance is
called bankers acceptance.

Before acceptance, the draft is merely an order to effect the payment to a specified date to a
named person, by the drawer to the bank. Once accepted by the bank the draft becomes a
primary and unconditional liability of the bank.

During the course of international trade, this is used as a money market instrument and used
as short term discount instrument. This can also be used in domestic trade. The draft
guarantees payment by the accepting bank at a specified point of time. The seller who holds
the acceptance may sell it at a discount to get immediate funds.

Commercial paper:
It is a short term promising note sold by large business firms to raise funds. This is a
unsecured promissory note. CPS can be sold directly or through dealers. The denominations
in which they can be bought vary over wide range.

Bills discounting:
Bill of Exchange are drawn by seller on the buyer for the value of goods delivered to him.
The seller may be in need of funds during the pendency of the bill. At that time, the seller
may discount bill and use the funds. On due date, the bill should be presented to the drawee
for payment.

Money market mutual funs / liquid funds:

Money market mutual funds are professionally managed port folios of marketable security.
The trade in short – term, low risk securities, such as certificate of deposit and U.S. treasury
notes. They provide instant liquidity. These funds have achieved significant growth now a
days.

Inter corporate deposits:

This is short term deposit with other companies. This is as alternative short term investment
with the expected rate of return currently ranges form 12 and 15%. These investments suffer
from higher degree of risk. They require one month time to convert them into cash.

Accounts Receivable Management

The accounts receivable management is also called as “trade credit management“. This
represents an extension of credit to customers. The firm allows customers a reasonable period
of time to pay for the goods received. The time is usually due with in a relatively short time

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ranging from a few days to one year. The objective of the accounts receivable management is
to promote sales and there by profit. The extension of credit involves risk and cost.

The main categories of costs are as follows:

 Cost of collection of debts:
The administrative cost incurred in collecting the receivables from customer and expenses
involved in acquiring credit information by the staff of the firm or outside agencies.

 Cost on the use of additional capital:

The accounts receivables are assets. Where there is increase in sales, automatically, there will
be an increase in accounts receivables. That means the firm is waiting for payment from
customers. In the mean time the firm has to make the payments to raw material, employees,
etc. An additional capital is to be arranged to support credit sales. Therefore the cost on the
use of additional capital is a part of the cost of extending credit to customers.

 Delinquency cost:
The main component of the costs are (1) blocking up of funds (2) cost of collection for the
over dues such as legal charges, reminders etc.

 Default cost:
The default cost are the over dues from customers which can not be recovered, such debts are
called as bad debts and have to written off as expense.

Credit Policies
The credit policy of a firm is a guidelines under which the management determine the
extension of credit to customers and how much credit to extend.

The following are main dimension of firm’s credit policy.

1. Credit standard.
2. Credit period.
3. Cash discount.
4. Collection effort.

 Credit standard:
The credit standard is a term which represents the guidelines of a company to determine
whether the credit applicant is credit worthy such guidelines; the company decides whether
the credit applicant is creditworthy. On the basis of such guidelines, the company decides
whether to accept or reject an account for credit granting. The factors like (a) collection cost,
(b) average collection period, (c) bad debts and (d) sale volume should be considered whether
to relax credit standard or not.

 Credit period:
The credit period is length of time the firm’s customer is allowed to pay their dues on the
credit sales. The number of days varies, industry to industry and firm to firm.

Lengthening of credit period pushes up sales. This induces present customers to purchases
more and attract new customer also. This leads to larger investment on debtors and higher

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incidence of bad debts. If the firm reduces the length of credit period, then it tends to lower
the sales, decrease in investment on debtors and reduce the incidence of bad debts.

 Cash discount:
In view of inducing customers to make payments promptly, the percentage of discount and
the period during which it is available are mentioned in credit terms. Increasing the discount
percentage or lengthening the discount period is liberalizing cash discount policy.

 Collection effort:
The collection program is to collect all accounts receivable in time. The collection program
may consist of the following activities:

a) Electronic and telephonic advice to buyers around due date.

b) Dispatch reminder letters to customers.
c) Monitoring the state of receivables.
d) Threat of legal action to overdue accounts.
e) Legal action taken against to overdue accounts.

If we put more collection effort, there will be a tendency to decrease sales, short term average
collection period, reduce bad debt percentage and increase in collection expenses.

Credit Analysis

The procedure for evaluating credit applicant is also a part of credit polices of the firm. The
elevating the credit applicant is a typical measurement of repayment ability and calculate
credit worthiness of a business or firm.

The credit analysis involves obtaining credit information and evaluating of the credit
applicants. On the basis of credit analysis, the decision would be taken of grant credit to a
customers and the quantum of credit.

Source of information:
There are two sources to collect information about customers,one is internal and the other is
external.

All information and references including trade references provided by the applicants in the
form of various documents and filled in application from are internal sources of credit
information. Another type of internal source is that the customer is the past customer. All
information relating to his behavior of the applicant in terms of historical payment pattern
and quantum credit facility availed, will be derived from firm’s record.

The information’s collected to assess the credit worthiness of customers from external source
are very important and depends upon the development of institutional facilities and industry
practices. Financial reports are published profit and loss account and balance sheet. They give
detailed account about applicant’s finance viability. It is very helpful to assess the overall
financial position of a firm.

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The following external resources are used to collect the information about customers:
• Financial reports
• Bank reference
• Trade reference
• Credit business reference.

Inventory management
The third major current asset is inventory. The term inventory is often used by accountants as
goods for sales. Manufacture’s, distributors, and whole seller’s inventory tends to cluster in
warehouse or in a shop or store available to customers.

Manufacturing organization usually divides their inventory into:

o Raw material: Material and components scheduled for use in making a product.
o Work in process: This is also called as WIP that has begun the manufacturing process
but yet to be finished.
o Finished goods: manufacturing process on materials is finished and ready for sale.

The current asset is very important because all functional areas like finance, marketing,
production and purchasing are involved. Each functional area’s view is different from other
with regard to inventory management. The views concerning the appropriate level of
inventory would differ from each other functional areas. The financial manger is to reconcile
different view points of various functional areas regarding appropriate level of inventory.
This is to achieve the overall objective of maximizing the owner’s wealth. The inventory
management should also be related to the overall objective of the firm like the management
of other current assets. Effective management of inventory should ultimately result in
maximization of the owners’ wealth.

The objective of inventory management consists of two parts, (1) to minimize investment in
inventory and (2) to meet demand for the product by efficiently organizing the operation of
production and sales. This can also be expressed in term of cost and benefits associated with
inventory.

The firm should minimize the total inventory costs. They include ordering costs, carrying
cost, the firm must also minimize the cost of stock outs and safety stock.

 Ordering cost. It is the cost of placing orders for purchase of material this includes.
• Cost of stationery, postage, and telephone charges.
• Cost of staff passed in the purchasing department, inspection section and payment
department.
• Cost of floating tenders, cost of comparative evaluation of quotations cost of paper
work, and postage for placing orders and cost of accounting and mailing payment.
This means, the cost varies with number of orders.

Ordering quantity is another important term. The quantity to be ordered should be such which
minimize the carrying and ordering cost. The ordering quantity of the material should be
large enough to earn more trade discount and to reduce transport expenses by bulk transports.
At the same time it should not be too large to incur heavy payment on account of interest,

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storage and insurance expenses. If the price is to be paid in stable quantity to be ordered each
time can be ascertain by the following formula.

Q = 2Co
I
Where Q = quantity to be ordered.
C = consumption of material in units during the year.
O = cost of placing order including the cost of receiving goods.
I = interest payment including variable cost of storing per unit per year.

 Stock out costs

The costs incurred when the entity does not have products demanded by customer. In other
words this cost refers to cost associated with the shortage of inventory.

Loss of profit which the firm could have earned from increased sale if there was no shortage
of inventory.

Expediting costs (additional ordering and transportation costs) may be incurred to avoid loss
of order.

 Safety stock:
Safety stock is quantity held for sale during the lead time. This is also called as buffer stock.
Safety stock exists to counter uncertainties in supply and demand. A company can meet a
sales demand which exceeds their sales forecast without altering production plan by having
an adequate amount of safety stock on hand. The safety stock may be defined as “the
minimum additional inventory to serve as a safety margin or buffer or cushions to meet an
unanticipated increase in usage resulting from an unusually both demand or an uncontrollable
late receipt of incoming inventory”.

The safety stock involves two types of cost

(1) Structure cost and
(2) Carrying cost.

Benefits of holding inventory:

The inventories acts as a buffer which enable the various interrelated activities of a firm work
independently so that all do not have to be pursed at exactly the same rate. The main
activities are purchasing, production and selling, for example,
Several advantages are available if firm purchase raw materials and other goods
independently, without tied to production / sales. This will enable it to avail of discounts that
are available on bulk purchase and the firm can purchase goods before anticipated price
increase.

The ABC system – a clarification technique:

Under inventory control process, the classifying different types of inventories are the first
step to inventory control process. This determines the type and degree of control required for
each.

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In a medium sized manufacturing or in a large scale manufacturing company, there are large
numbers of items in inventories. It is too difficult to monitor each item. ABC system is a
widely used classification technique to identify and monitor various items of inventory for
purpose of inventory control system.

The various inventory items are classified on the basis of cost involved, into three classes A,
B, and C. Group ‘A’ items involved largest investment, therefore control and maintaining
inventory will be rigorous. The sophisticated control technique should be applied.
‘C’category items deserve only minimum attention, since the cost involved is very low. ‘B’
group deserve less attention than A but more than C.

Economic Ordering Quality:

In inventory control the ordering quality is a major problem which should be considered
carefully by the management. The management should determine the appropriate quantity to
be purchased in each lot to replenish stock. This is called lot size.
If the firm place orders in large quantities per lot, it ensure, maintains high average inventory
level and., smooth operation of sale / production. If the lot size is small, then this reduces the
average inventory level and carrying cost inventory. Then order cost will increase and the
interruption of sale or production is possible for want of material / stock. Therefore a firm
should place economically viable lots. They are neither small nor large in size. They are
called as economic ordering quantity. The economic order of quality approach may be
explained by mathematical approach or trail and error approach. In mathematic approach, the
economic ordering quality can be calculated by the following formula:

E OQ = √ 2AB
C
Where A = annual usage of inventory (units).
B = buying cost per order.
C = carrying cost per order.

The Trail and Error Method:

This is an analytical approach. All formation of ordering and usage of stock and clearing
stock should be recorded and analyzed. The carrying and acquisition cost for different sizes
of orders should be analyzed. Finally compute the economic ordering quality on the basis of
analysis made.

Determinations of economic ordering quality in EOQ model are based on the following
assumptions:
• Rate of inventory is steady over a period of time.
• The orders placed only when the inventories reaches zero i.e. the lead time for
processing material is zero.
• The firm certainly knows annual consumption of particular item of inventory.
• Ordering and carrying cost are constant over certain range of inventory level.

Reorder point:

The “Reorder point” is a term used for level of inventory at which an order should be placed
for replenishing stock. We can calculate the reorder point by using the formula.

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• The reorder point = lead time in days usage of inventory. Or

• Reorder point = lead time in days * average daily consumption of inventory + safety
stock.

Lead time:
The lead time refers to time that covers the time – span from the point when placing an order
for procurement of inventory, to the actual receipt of inventory by the firm.

Financing Current Assets

The investment in current asset fluctuates during the year of operation. The current assets are
raw material, work in progress, and receivables. The current assets require financing for
creation and fluctuation during the year. The long term funds partly finance current assets
which provide margin money for current assets.. But all current assets are fully financed by
short term sources. The main short-term resources are Trade creditors, bank credit,
commercial papers, certificate of deposit and factoring.

 Trade creditors:
Trade creditors refer to the suppliers of goods who extend credit during the normal
course of the business. According to trade practices, cash is not paid immediately for credit
purchase. The payment will be made after a certain period of time as agreed. The differed
payments (trade credit) represent a source of finance for credit purchase. Such credits appear
in the records of the buyer’s book as sundry creditors or accounts payable. One specified date
or maturity date the payments is to be completed as agreed and the buyers need not
necessarily wait to make payments till maturity date. If the buyer has not met his obligations
of making payment on a specified date, legal action for recovery will be taken.

The advantages of trade credit short term finance:

• It is easily available.
• It is flexible source and the size of the trade credit is related to size of the operation.
• If the purchase reduce the use of trade credit will corresponding by decline.
• It does not require negotiation and formal agreement.

Credit just like any other source of finance has interest element hidden which most are not
able to recognize.
The discount may be offered to encourage early payment. The terms of trade credit vary
considerably from industry to industry.

The following main factors determine the length of credit allowed:

o Cash discount: the cost of capital can be high if the cash discount is taken into
account. When the high cost discount is offered, the period of trade discount will be
smaller.
o If the buyers are weak in liquidity position they may take long time for repayment.
The seller may not be willing to trade with such customer.
o If the seller’s liquidity position is weak, he will prefer early cash settlement and find it
difficult to allow more credit days.
o Production with high sales turnover is sold on short credit terms.
o If the credit term is used as a part of sales promotion, he may allow more credit days.

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 Factoring:
Accounts receivable / trade debt is one of the main current assets of a company which
fluctuate every day on the savings credit sales and collection. The companies have to wait for
the realization of debtors. In such circumstances, the certain companies come forward to raise
short term funds by using the current asset (AR / trade debt ) as a security are called
factoring.

These factoring companies offer the following services:

o Credit management, including guaranties against bad debt.
o Sales ledger accounting ,dispatching invoices.
o The provision of finance, advancing clients up to 80% of value of the debts that they
are collecting.
o Providing advisory services.

There are two types factoring.

 Non – recourse factoring: if the debtors do not pay, the factor will not ask for his
money back.
 Recourses factoring: 80 % of value of receivable is paid up front, the remaining 20 %
is paid over when either the debtor pay the factor are when the debts become due.

The factors provide various services at a charge. The charges for their service are (a)
administration fees and (b) finance changes.

Invoice discounting:
Invoice discounting is the transferring of invoice to finance house in exchange with
immediate cash. This is a purely financial arrangement which benefits the liquidity position
of the enterprise.

The company makes an offer to the finance house by sending the respective invoices and the
company also agrees to grantee payment of any debts that are purchased. If the finance house
accepts the offer, It make immediate cash payment above 75% and this should be repaid with
in the specified dates says 60 days.
The company is responsible for collecting the debt and for returning the amount advanced.

 Bank credit:
The bank credit represents the most important source for financing of current assets some of
the short term finance provided by bank are:
• Over drafts.
• Loans.
• Letter of credit.
• Working capital term loan.

• Bank Over Draft:

the most common used source of short term of finance because of its cost and flexibility.
The bank issue over drafts with right to call them in at short notice. Bank advances
are payable on demand. Normally the bank assures the borrower that he can rely on the over
draft not being recalled for a certain period of time. Under the overdraft arrangement of bank
finance, the bank specifies a predetermined credit limit.

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• Loans:
Under this bank finance arrangements the loan amount will be credited to the current account
of the borrower. The borrower has to repay principles in installments or on demand. Then can
be renewed from time to time.

• Letter of credit:
This is an indirect from of working capital financing and bank assures risk, the credit being
provided by supplier.
A letter of credit is a document, stating that bank guarantees payment of invoiced amount if
all the under lying agreements are met.

Bank provide credit on the basis of following modes of security:

a) Hypothecation: Banks provide credit to borrowers against security of movable

properties, or inventory of goods.
b) Pledge: goods used as collateral to obtain short term finance are called pledge. Goods
which are offered as security will be transferred to the physical possession of the
lender.
c) Lien: lien is a term used for the right of a party to retain goods belonging to another
party until a debt due is paid.
d) Mortgage: transfer a legal / eligible interest in specific immovable property for
security of the payment of debt.

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