Study Material-1

Study Material-1
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Course: Financial Management
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Table of contents
 Unit-3
o COST OF CAPITAL-1
o COST OF CAPITAL – II
o CAPITAL STRUCTURAL MANAGEMENT OR PLANNING THE CAPITAL

STRUCTURE
o FINANCING DECISION: EBIT –EPS ANALYSIS
o FINANCING DECISION – LEVERAGE ANALYSIS
 Unit-4
o DIVIDEND DECISION AND VALUATION OF THE FIRM
o DIVIDEND POLICY : DETERMINANTS AND CONSTRAINS
o DIVIDEND POLICY IN PRACTICE
 Unit-5
o WORKING CAPITAL MANAGEMENT AND FINANCE
o WORKING CAPITAL: ESTIMATION AND CALCULATION
o MANAGEMENT OF CASH
o RECEIVABLES MANAGEMENT
o INVENTORY MANAGEMENT
Unit-3
Contains five parts...
1. COST OF CAPITAL-1
2. COST OF CAPITAL – II
3. CAPITAL STRUCTURAL MANAGEMENT OR PLANNING THE CAPITAL STRUCTURE
4. FINANCING DECISION: EBIT –EPS ANALYSIS
5. FINANCING DECISION – LEVERAGE ANALYSIS
COST OF CAPITAL-1
UNIT 3
COST OF CAPITAL- I
Smriti Chawla
Shri Ram College of Commerce
University of Delhi
CHAPTER OBJECTIVES
 Understand the Meaning, Concept and

Significance of Cost of Capital.
 Classification of Cost
 Problems in Determining the Cost of Capital
 Computation of Specific Source of Finance
Cost of Debt
Cost of Preference Capital

Cost of Equity Share Capital
Cost of Retained Earnings
 Illustrations
Meaning, Concept and Definition
The cost of capital of a firm is the minimum rate of return expected

by its investors. It is the weighted average cost of various sources of finance
used by a firm. The capital used by a firm may be in the form of debt,
preference capital, retained earnings and equity shares. The concept of cost
of capital is very important in the financial management. A decision to
invest in a particular project depends upon the cost of capital of the firm or
the cut off rate which is the minimum rate of return expected by the
investors. In case a firm is not able to achieve even the cut off rate, the
market value of its shares will fall. In fact cost of capital is the minimum
rate of return expected by its investors which will maintain the market
value of shares at its present level. Hence to achieve the objective of
wealth maximisation, a firm must earn a rate of return more than its cost of
capital. The cost of capital of a firm or the minimum rate of return
expected by its investors has a direct relation with the risk involved in the
firm. Generally, higher the risk involved in a firm, higher is the cost of
capital.
According to Solomon Ezra Cost of capital is the minimum required

rate of earnings or the cut-off rate of capital expenditures.
Thus, we can say that cost of capital is that minimum rate of return
which a firm, and, is expected to earn on its investments so as to maintain
the market value of its shares.
From the definitions given above we can conclude three basic aspects of the
concept of cost of capital:
(i) Cost of capital is not a cost as such. In fact, it is the rate of

return that a firm requires to earn from its projects.
(ii) It is the minimum rate of return. Cost of capital of a firm is

that minimum rate of return which will at least maintain the
market value of the shares.
(iii) It comprises of three components. As there is always some

business and financial risk in investing funds in a firm, cost of
capital comprises of three components:
(a) the expected normal rate of return at zero risk level, say
the rate of interest allowed by banks;
(b) the premium for business risk; and
(c) the premium for financial risk on account of pattern of

capital structure.
Symbolically cost of capital may be represented as:
where, K = ro+b+f
K=Cost of capital
ro=Normal rate of return at zero risk level
b=Premium for business risk.
f=Premium for financial risk.
Significance of the Cost of Capital

The concept of cost of capital is very important in the financial
management. It plays a crucial role in both capital budgeting as well as
decisions relating to planning of capital structure. Cost of capital concept
can also be used as a basis for evaluating the performance of a firm and it
further helps management in taking so many other financial decisions.
(1) As an Acceptance Criterion in Capital Budgeting: Capital budgeting

decisions can be made by considering the cost of capital. According to the
present value method of capital budgeting, if the present value of expected
returns from investment is greater than or equal to the cost of investment,
the project may be accepted; otherwise the project may be rejected. The
present value of expected return is calculated by discounting the expected
cash inflows at cut-off rate (which is the cost of capital). Hence, the
concept of cost of capital is very useful in capital budgeting decision.
(2) As a Determinant of Capital Mix in Capital Structure Decisions:

Financing the firm’s assets is a very crucial problem in every business and as
a general rule there should be a proper mix of debt and equity capital in
financing a firm’s assets. While designing an optimal capital structure, the
management has to keep in mind the objective or maximising the value of
the firm and minimising the cost of capital. Measurement of cost of capital
from various sources is very essential in planning the capital structure of any
firm.
(3) As a basis for evaluating the Financial Performance: The concept of

cost of capital can be used to ‘evaluate the financial performance of top
management’. The actual profitability of the project is compared to the
projected overall cost of capital and the actual cost of capital of funds
raised to finance the project. If the actual profitability of the project is
more than the projected and the actual cost of capital, the performance
may be said to be satisfactory.
(4) As a Basis for taking other Financial Decisions: The cost of capital is
also used in making other financial decisions such as dividend policy,
capitalisation of profits, making the rights issue and working capital.
Classification of Cost
(1) Historical cost and Future Cost: Historical costs are book costs which
are related to the past. Future costs are estimated costs for the future. In
financial decisions future costs are more relevant than the historical costs.
However, historical costs act as guide for the estimation of future costs.
(2) Specific Cost and Composite Cost: Specific cost refers to the cost of a
specific source of capital while composite cost is combined cost of various
sources of capital. It is the weighted average cost of capital. In case more
than one form of capital is used in the business, it is the composite cost
which should be considered for decision-making and not the specific cost.
But where only one type of capital is employed the specific cost of that type
of capital may be considered.
(3) Explicit Cost and Implicit Cost: An explicit cost is the discount rate
which equates the present value of cash inflows with the present of cash
outflows. In other words it is the internal rate of return.
where, Io, is the net cash inflow at zero point of time,
Ot is the outflow of cash in period 1, 2 and n.
k is the explicit cost of capital.
Implicit cost also known as the opportunity cost is the cost of the
opportunity foregone is order to take up a particular project.
(4) Average Cost and Marginal Cost: An average cost refers to the
combined cost of various sources of capital such as debentures, preference
shares and equity shares. It is the weighted average cost of the costs of
various sources of finance. Marginal cost of capital refers to the average
cost of capital which has to be incurred to obtain additional funds required
by a firm. In investment decisions, it is the marginal cost which should be
taken into consideration.
Determination of Cost of Capital
It has already been stated that the cost of capital plays a crucial role
in the decisions relating to financial management. However, the
determination of the cost of capital of a firm is not an easy task because of
both conceptual problems as well as uncertainties of proposed investments
and the pattern of financing. The major problems concerning the
determination of cost of capital are discussed as below:
Problems in determining Cost of Capital
1. Conceptual controversies regarding the relationship between

the cost of capital and the capital structure : Different theories have
been propounded by different authors explaining the relationship between
capital structure, cost of capital and the value of the firm. This has resulted
into various conceptual difficulties. According to the Net Income Approach
and the traditional theories both the cost of capital as well the value of the
firm have a direct relationship with the method and level of financing. In
their opinion, a firm can minimise the weighted average cost of capital and
increase the value of the firm by using debt financing. On the other hand,
Net Operating Income and Modigliani and Miller Approach prove that the
cost of capital is not affected by changes in the capital structure or say that
debt equity mix is irrelevant in determination of cost of capital structure
determination of cost of capital and the value of a firm. However, the M and
M approach is based upon certain unrealistic assumptions such as, there is a
perfect market or the expected earnings of all the firms have identical risk
characteristic, etc.
2. Problems in computation of cost of equity: The computation of

cost of equity capital depends upon the expected rate of return by its
investors. But the quantification of the expectations of equity shareholders
is a very difficult task because there are many factors which influence their
valuation about a firm.
3. Problems in computation of cost of retained earnings: It is

sometimes argued that retained earnings do not involve any cost but in
reality, it is the opportunity cost of dividends foregone by its shareholders.
Since different shareholders may have different opportunities for investing
their dividends, it becomes very difficult to compute the cost of retained
earnings.
4. Problems in assigning weights: For determining the weighted

average cost of capital, weights have to be assigned to the specific cost of
individual source of finance. The choice of using the book value of the
source or the market value of the source poses another problem in the
determination of capital.
COMPUTATION OF SPECIFIC SOURCE OF FINANCE
Computation of each specific source of finance, viz, debt, preference

share capital equity share capital and retained earnings is discussed as
below:
1. Cost of Debit
The cost of debt is the rate of interest payable on debt. For example,
a company issues Rs. 1,00,000 debentures at par; the before tax cost of this
debt issue will also be 10%. By way of formula, before-tax-cost of debt may
be calculated as:
(i) Kdb =
where, Kdb = Before tax cost of debt
I = Interest
and P = Principal
In case the debt is raised at premium or discount, we should consider

P as the amount of the net proceeds received from the issue and not the
face value of securities. The formula may be changed to
(ii) Kdb = (where, NP = Net Proceeds)
Further, when debt is used as a source of finance, the firm saves a

considerable amount in payment of tax as the interest is allowed as a
deductable expense in computation tax. Hence, the effective cost of debt is
reduced. The after tax cost of debt may be calculated with the help of
following formula;
(iii) Kda = Kdb (1-t) =

where, Kda = After tax cost of debt
t = Rate of tax.
Cost of Redeemable Debt
Usually, the debt is issued to be redeemed after a certain period during

lifetime of a firm. Such a debt issue is known as Redeemable debt. The cost
of redeemable debt capital be computed as:
(iv) Before-tax cost of debt
where, I = Interest
N = Number of years in which debt is to be redeemed
P = Proceeds at par
NP = Net Proceeds
(v) After tax cost of debt, Kda = Kdb (1-t)
where,
Illustration1: A Company issues shares of Rs.10,00,000, 10%

redeemable debentures at a discount of 5%. The cost of floatation amount
to Rs.30,000. The debentures are redeemable after 5 years. Calculate
before tax and after tax cost of debt assuming tax rate of 50%.
Solution:
Before-tax cost of debt,
(NP=Rs. 10,00,000-50,000 (discount) – 30,000 cost of floatation)
After tax cost of debt, Kda = Kdb (1-0.5)
= 12.09 (1-0.5) = 6.04%
Cost of Debt Redeemable at Premium
Sometimes debentures are to be redeemed at a premium; i.e at more

than the face value after the expiry of a certain period. The cost of such
debt redeemable at premium can be computed as below:
(i) Before tax cost of debt,
where, I = Interest
n = Number of years in which debt is to be redeemed
RV= Redeemable value of debt

NP = Net Proceeds
(ii) After-tax cost of debt,
Kda= Kdb (1-t)
Illustration2: A 5-year Rs.100 debenture of a firm can be sold for a

net price of Rs.96.50. The coupon rate of interest is 14 %per annum and
debenture will be redeemed at 5% premium on maturity. The firm tax rate is
40%. Compute the after tax cost of debentures.
Solution:
After-tax cost of debt,
Kda = Kdb (1-t)
= 15.58 (1-0.4) = 15.58 x 0.6 = 9.35%
Cost of Debt Redeemable in Instalments

Financial institutions generally require principal to be amortised in
instalments. A company may also issue a bond or debenture to be redeemed
periodically. In such a case, principal amount is repaid each period instead
of a lump sum at maturity and hence cash period include interest and
principal. The amount of interest goes on decreasing each period as it is
calculated on decreasing each period as it is calculated on the outstanding
amount of debt. The before-tax cost of such a debt can be calculated as
below:
or, Vd=
or, Vd =
where, Vd = Present value of bond or debt
I1, I2....In = Annual interest (Rs.) in period 1,2... and so on.
P1,P2...Pn=Periodic payment of principal in period 1, 2, and so on.
n = Number of years to maturity
Kd = Cost of debt or Required rate of return.
Cost of Existing Debt
If a firm wants to compute the current cost of its existing debt, the
current market yield of the debt should be taken into consideration.
Suppose a firm has 10% debentures of Rs. 100 each outstanding on January
1, 1994 to be redeemed on December 31, 2000 and the new debentures
could be issued at a net realisable price of Rs. 90 in the beginning of 1996,
the current cost of existing debt will be computed as:
Further, if the firm’s tax rate is 40% the after-tax cost of debt will be:
Kda = Kdb (1-t)
= 12.63 (1-0.4)
= 7.58%
Cost of Zero Coupon Bonds

Sometimes companies issue bonds or debentures at a discount from their
eventual maturity value and having zero interest rate. No interest is payable
on such debentures before their redemption and at the time of redemption
the maturity value of the bond is to be paid to the investors. The cost of
such debt can be calculated by finding the present values of cash flows as
below:
(i) Prepare the cash flow table using an arbitrary assumed discount
rate to discount the cash flows to the present value.
(ii) Find out the net present value by deducting the present value of
the outflows from the present value of the inflows.
(iii) If the net present value is positive apply higher rate of discount.
(iv) If the higher discount rate still gives a positive net present value
increase the discount rate further until the UPV becomes negative.
(v) If the NPV is negative at this higher rate the cost of debt must
be between these two rates.
Illustration 3: X Ltd. has issued redeemable zero coupon bonds of Rs. 100
each at a discount rate of Rs. 60 repayable at the end of fourth year.
Calculate the cost of debt.
Cash Flow Table At Various Assumed Discount Rates

Year Cash flow Discount P.V. at Discount P.V. at
(Rs.) Factor at 12% Rs. Factor at 14% Rs.
12% 14%
0 60 1.000 (60) 1.000 (60)
4 100 0.636 63.60 0.592 59.20
3.60 -0.80
Cost of Debt (Kd) = 12+
= 12+ = 13.64%
Floating or Variable Rate Debt
The interest on floating rate debt changes depending upon the market
rate of interest payable on gilt edged securities or the prime lending rate of
the bank. For example, suppose a company raises debt from external
sources on the terms of prime lending rate of the bank plus four percent. If
the prime lending rate of the bank is 8% p.a. the company will have to pay
interest at the rate of 12% p.a. Further, if the prime lending rate falls to 6%
p.a. the company shall pay interest at only 10% p.a.
Illustration 4: ABC Ltd. raised a debt of Rs. 50 lakhs on the terms that
interest shall be payable at prime lending rate of bank plus three percent.
The prime lending rate of the bank is 7 per cent. Calculate the cost of debt
assuming that the corporate rate of tax is 35%.
Solution:
Before-tax cost of debt,
Kdb = 7%+3% = 10%
After-tax cost of debt,
Kda = Kdb (1-t)
= 10% (1-0.35) = 10% (0.65) = 6.5%
Real or Inflation Adjusted Cost of Debt
In the days of inflation, the real cost of debt is much loss than the
nominal cost as the fixed amount is payable irrespective of the fall in the
value of money because of price level changes. The real cost of debt can be
calculated as below:
Real Cost of Debt =
2. Cost of Preference Capital
A fixed rate of divided is payable on preference shares. Though

dividend is payable at the discretion of the Board of directors and there is
no legal binding to pay dividend, yet it does not mean that preference
capital is cost free. The cost of preference capital is a function of dividend
expected by its investors i.e. its stated dividend. In case dividends are not
paid to preference shareholders, it will affect the fund raising capacity of
the firm. Hence, dividends are usually paid regularly on preference shares
except when there are no profits to pay dividends. The cost of preference
capital which is perpetual can be calculated as:
Kp =
where Kp = Cost of Preference Capital
D = Annual Preference Dividend
P = Preference Share Capital (Proceeds.)
Further, if preference shares are issued at Premium or Discount or

when costs of floatation are incurred to issue preference shares, the
nominal or par value of preference share capital has to be adjusted to find
out the net proceeds from the issue of preference shares. In such a case,
the cost of preference capital can be computed with the following formula:
Kp=
It may be noted that as dividend are not allowed to be deducted in

computation of tax, no adjustment is required for taxes.
Sometimes Redeemable Preference Shares are issued which can be

redeemed or cancelled on maturity date. The cost of redeemable
preference share capital can be calculated as:
where, Kpr = Cost of Redeemable Preference Shares
D = Annual Preference dividend
MV = Maturity Value of Preference Shares
NP = Net proceeds of Preference Shares
Illustration 5: A company issues 10,000 shares 10% Preference Shares of Rs.

100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference
capital if these shares are issued (a) at par, (b) at a premium of 10% and (c)
at a discount of 5%.
Solution:
Cost of Preference Capital, Kp =
(a)
(b) =
= 9.26%
(c) =
=10.75%
3. Cost of Equity Share Capital
The cost of equity is the maximum rate of return that the company
must earn on equity financed portion of its investments in order to leave
unchanged the market price of its stock.’ The cost of equity capital is
function of the expected return by its investors. The cost of equity is not
the out-of-pocket cost of using equity capital as the equity shareholders are
not paid dividend at a fixed rate every year. Moreover, payment of dividend
is not a legal binding. It may or may not be paid. But it does not mean that
equity share capital is a cost free capital. The cost of equity can be
computed in following ways:
(a) Dividend Yield Method or Dividend/Price Ratio Method :

According to this method, the cost of equity capital is the ‘discount rate
that equates the present value of expected future dividends per share with
the net proceeds (or current market price) or a share’. Symbolically.
Ke =
where, Ke = Cost of Equity Capital
D = Expected dividend per share
NP = net proceeds per share
and MP = Market Price per share.
Illustration 6: A company issues 1000 equity shares of Rs. 100 each at a

premium of 10%. The company has been paying 20% dividend to equity
shareholders for the past five years and expects to maintain the same in the
future also. Compute the cost of equity capital, Will it make any difference
if the market price of equity share is Rs. 160?
Solution:
Ke = D/NP
If the market price of a equity share is Rs. 160
Ke = D/MP
(b) Dividend yield plus growth in dividend method : When the

dividends of the firm are expected to grow at a constant rate and the
dividend pay out ratio is constant this method may be used to compute the
cost of equity capital. According to this method the cost of equity capital is
based on the dividends and the growth rate.
Ke =
where, Ke = Cost of equity capital
D1 = Expected Dividend per share at the end of the year
NP = Net proceeds per share
G = Rate of growth in dividends
Do = previous year’s dividend.
Further, in case cost of existing equity share capital is to be calculated,

the NP should be changed with MP (market price per share) in the above
equation.
Ke =
Illustration7: (a) A company plans to issue 1000 new shares of Rs. 100 each
at par. The floatation costs are expected to be 5% of the share price. The
company pays a dividend of Rs. 10 per share initially and the growth in
dividends is expected to be 5%. Compute the cost of new issue of equity
shares.
(b) If the current market price of an equity share is Rs. 150, calculate the
cost of existing equity share capital.
Solution:
(a) Ke =
=
(b) Ke =
(c) Earning Yield Method : According to this method, the cost of

equity capital is the discount rate that equates the present values of
expected future earnings per share with the net proceeds (or, current
market price) of a share. Symbolically:
Ke =
where, the cost of existing capital is to be calculated:
Ke =
(d) Realised Yield Method: One of the serious limitations of using

dividend yield method or earnings yield method is the problem of estimating
the expectations of the investors regarding future dividends and earnings. It
is not possible to estimate future dividends and earnings correctly; both of
these depend upon so many uncertain factors. To remove this drawback,
realised yield method which takes into account the actual average rate of
return realised in the past may be applied to compute the cost of equity
share capital. To calculate the average rate of return realised, dividend
received in the past along with the gain realised at the time of sale of
shares should be considered. The cost of equity capital is said to be the
realised rate of return by the shareholders. This method of computing cost
of equity share capital is based upon the following assumptions:
(a) The firm will remain in the same risk class over the period.
(b) The shareholders expectations are based upon the past realised yield.
(c) The investors get the same rate of return as the realised yield even if
they invest elsewhere;
(d) The market price of shares does not change significantly.
4. Cost of Retained Earning
It is sometimes argued that retained earnings do not involve any cost

because a firm is not required to pay dividends on retained earnings.
However, the shareholders expect a return on retained profits. Retained
earnings accrue to a firm only because of some sacrifice made by the
shareholders in not receiving the dividends out of the available profits.
The cost of retained earnings may be considered as the rate of return

which the existing shareholders can obtain by investing the after tax
dividends in alternative opportunity of equal qualities. It is, thus, the
opportunity cost of dividends foregone by the shareholders. Cost of retained
earnings can be computed with the help of following formula:
Kr =
where,
Kr = Cost of retained earnings
D = Expected dividend
NP = Not proceeds of share issue
G = Rate of growth.
COST OF CAPITAL – II
COST OF CAPITAL – II
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
 Computation of weighted average

cost of capital
 Marginal cost of capital
 Cost of Equity using Capital Asset
Pricing Model
 Illustrations
 Lets Sum Up
 Questions
Computation of Weighted Average Cost of Capital
Weighted average cost of capital is the average cost of the costs of

various source of financing. Weighted average cost of capital is also known
as composite cost of capital, overall cost of capital or average cost of
capital. Once the specific cost of individual sources of finance is
determined, we can compute the weighted average cost of capital by
putting weights to the specific costs of capital in proportion of various
sources of funds to total. The weights may be given either by using the book
value of source or market value of source. If there is a difference between
market value and book value weights, the weights, the weighted average
cost of capital would also differ. The market value weighted average cost
would be overstated if market value of the share is higher than book value
and vice versa. The market value weights are sometimes preferred to the
book value weights because the market value represents the true value of
investors. However, the market value weights suffer from the following
limitations:
(i) It is very difficult to determine the market values because of

frequent fluctuations.
(ii) With the use of market value weights, equity capital gets greater
importance.
For the above limitations, it is better to use book value which is readily
available. Weighted average cost of capital can be computed as follows:
Kw =
Kw = Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source of finance

Illustration1: A firm has the following capital structure and after-tax costs
for the different sources of funds used:
Source of Funds Amount Proportion After-tax cost

Rs. % %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100

You are required to compute the weighted average cost of capital.
Solution:
Computation of Weighted Average Cost of Capital

Source of Funds Proportion % Cost % Weighted Cost %
Proportion Cost
(W) (X) (XW) %
Debt 25 5 1.25
Preference shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75

Weighted Average 9.60%
Cost of Capital
Illustration2: Continuing illustration 1, the firm has 18,000 equity shares of

Rs. 100 each outstanding and the current market price is Rs. 300 per
calculate the market, value weighted average cost of capital assuming that
the market values and book values of the debt and preference capital are
same.
Solution:
Amount Proportion Cost Weighted
(Rs.) %W %X Cost
Sources of Funds Proportion
Cost XW
Debt 15,00,000 18.52 5 0.93
Preference Capital 12,00,000 14.81 10 1.48
Equity Share Capital
(18000 shares @ Rs. 54,00,000 66.67 12 8.00

300)
81,00,000 100
Weighted Average Cost of Capital 10.41%
Marginal Cost of Capital
The marginal cost of capital is the weighted average cost of new

capital calculated by using the marginal weights. The marginal weights
represent the proportion of various sources of funds to be employed in
raising additional funds. In case, a firm employs the existing proportion of
capital structure and the component costs remain the same the marginal
cost of capital shall be equal to the weighted average cost of capital. But in
practice, the proportion and /or the component costs may change for
additional funds to be raised. Under this situation the marginal cost of
capital shall not be equal to weighted average cost of capital. However, the
marginal cost of capital concept ignores the long-term implications of the
new financing plans, and thus, weighted average cost of capital should be
preferred for maximisation of shareholder’s wealth in the long-run.
Illustration3: A firm has the following capital structure and after-tax costs for the different
sources of funds used:
Source of Funds Amount Proportion (%) After-tax Cost

(Rs.) (%)
Debt 4,50,000 30 7
Preference Capital 3,75,000 25 10
Equity Capital 6,75,000 45 15
15,00,000 100
(a) Calculate the weighted average cost of capital using book-value
weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the
project as below.
Debt Rs. 3,00,000
Preference Capital Rs. 1,50,000
Equity Capital Rs. 1,50,000
Assuming that specific costs do not change, compute the weighted marginal
cost of capital.
Solution:
Computation of Weighted Average Cost of Capital (WACC)
Source of Proportion (%) After tax cost Weighted Cost %
Funds (W) (%) (X) (XW) %
Debt 30 7 2.10
Preference 25 10 2.50
Capital
45 15 6.75
Equity Capital
Weighted Average Cost of Capital (WACC) 11.35%
Computation of Weighted Marginal Cost of Capital (WMCC)
Source of Marginal After tax cost Weighted
Funds Weights (%) (X) Marginal Cost %
Proportion (%)
(W)
Debt 50 7 3.50
Preference 25 10 2.50
Capital
25 15 3.75
Equity Capital
Weighted Marginal Cost of Capital (WMCC) 9.75%
Cost of Equity Using Capital Asset Pricing Model (CAPM)
The value of an equity share is a function of cash inflows expected by

the investors and risk associated with cash inflows. It is calculated by
discounting the future stream of dividends at required rate of return called
capitalization rate. The required rate of return depends upon the element
of risk associated with investment in share. It will be equal to the risk free
arte of interest plus the premium for risk. Thus required rate of return K e for
the share is,
Ke = Risk – free rate of interest + Premium for risk
According to CAPM, the premium for risk is the difference between market
return from diversified portfolio and risk free rate of return. It is indicated
of beta coefficient (b):
Risk – premium= (Market return of a diversified portfolio – Risk free return) x

b I =b I (Rm - Rf )
Thus, cost of equity, according to CAPM can be calculated as below:
Ke = Rf + b I (Rm - Rf )
where, Ke = Cost of equity capital
Rf = Risk free rate of return

Rm = Market return of a diversified portfolio
b I = Beta coefficient of the firm’s portfolio
Illustration3: You are given the following facts about a firm:
1.Risk free rate of return is 11%.
2.Beta co-efficient bI of the firm is 1.25.
Compute the cost of equity capital using Capital Asset Pricing Model (CAPM)
assuming a market return of 15 percent next year. What would be the cost
of equity if bI rises to 1.75.
Solution:
when bI = 1.25
Ke =11% +1.25(15%-11%)
=11%+5% =16%
when bI =1.75 Ke= 11%+1.75(15%-11%)
=11%+7%
=18%
Illustration 4: The following is an extract from the financial statement of

KPN Ltd.
Rs.lakhs (Operating
Profit 105
Less :Interest on debentures

33
72
Less: Income –tax (50%)

36
Net Profit
36
Equity Share capital (shares of Rs.10 each) 200
Reserves and Surplus 100
15%Non-convertible debentures (of Rs.100 each) 220
520
The market price per equity share Rs.12 and per debenture Rs.93.75.
1.What is the earning per share?
2. What is the percentage cost of capital to the company for the debenture
funds and the equity?
Solution:
1.Calculation of Earnings per Share:
Earnings Per Share (EPS) = Profit After Tax/ No. Of Equity Shares
= 36,00,000/20,00,000=Rs.1.80
2.Computation of Percentage Cost of Capital.
a) Cost of Equity Capital:
Cost of Equity (Ke) = D/MP
or Ke (%)= 1.80/12 *100= 15%
where D = expected earnings per share
and MP= Market price per share.
b) Cost of Debenture Funds:
At Book Value At Market

Value
(Rs. Lakhs) (Rs.

Lakhs)
Value of 15% debenture 220.00 206.25
Interest cost for the year 33.00 33.00
Less: Tax at 50% 16.50 16.50
Interest cost after tax 16.50 16.50
Cost of Debenture Fund
(%) 16.50/220 x100 16.50/206.25x100

= 7.5% = 8%.
Illustration5: Given below is the summary of the balance sheet of a

company as at 31st December, 1999:
Liabilities Rs. Assets

Rs.
Equity share capital
20,000 shares of Rs.100 each 2,00,000 Fixed Assets 4,00,000
Reserves and surplus 1,30,000 Investments 50,000
8% debentures 1,70,000 Current assets 2,00,000
Current Liabilities
Short term loans 1,00,000
Trade creditors 50,000
6,50,000
6,50,000
You are required to calculate the company’s weighed average cost of

capital using balance sheet valuations: The following additional information
is also available:
(1) 8%Debentures were issued at par.
(2) All interests payments are up to date and equity dividends is

currently 12%.
(3) Short term loan carries interest at 18% p.a

(4) The shares and debentures of the company are all quoted on the
Stock Exchange and current Market prices are as follows:
Equity Shares Rs.14 each
8% Debentures Rs.98 each.
(5) The rate of tax for the company may be taken at 50%.
Solution:
Calculation of the Cost of Equity: Rs.
Equity Share 2,00,000
Reserves and Surplus

1,30,000
Equity (Shareholder’s )Fund 3,30,000
Book Value Per Share = 3,30,000/20,000

=Rs.16.50.
Equity Dividend Per Share = 12/100*10 =Rs.1.20
Therefore, Cost Of Equity (%)= 1.20/16.50*100= 7.273 %
Computation of Weighted Average Cost of Capital:

Capital Structure or
Type of Capital Amount (Rs) Before Tax After Tax Weighted

Average cost Cost% (Rs.) Cost%
Equity Funds 3,30,000 7.273% 7.273%

24,000
Debentures 1,70,000 8% 4%
6,800
Total 5,00,000
30,800
Weighted Average Cost of Capital = 30,800/5,00,000*100 =6.16 %.
Summary of Formulae
S.N Purpose Formula
o
1 Before tax cost of debt Kdb =
Kda = Kdb (1-t) =

2 After cost of debt
3 Before tax cost of redeemable debt
4 After tax cost of redeemable debt

Kda = Kdb (1-t)
5 Cost of debt redeemable at premium
6 Cost of debt redeemable in instalments

Vd =
7 Cost of irredeemable preference share

Kp =
capital
8
Cost of redeemable preference share
capital
9 Cost of equity –dividend yield approach

Ke =
10 Cost of equity – dividend yield plus

constant growth
Ke =
Cost of retained earnings
11
Weighted average cost of capital Kr =

12
Kw =
Cost of equity – CAPM approach

13
Lets Sum Up
 The cost of capital is the minimum required rate of return which firm
must earn on its funds in order to satisfy the expectation of its
supplier of funds. If the return from capital budgeting proposals is
more than cost of capital then difference will be added to wealth of
shareholders.
 The concept of cot of capital has a role to play in capital budgeting as
well as in finalizing the capital structure for the firm. The cost of
capital depends upon the risk free interest rate and risk premium,
which depends upon the risk of investment and risk of firm.
 The cost of capital may be defined in terms of (1) explicit cost, which
the firm pays to supplier, and (2) implicit cost. i.e. opportunity cost of
funds to firm. The cost of capital is calculated in after tax terms.
 Different sources of funds available to firm may be grouped into Debt,
Pref. share capital, Equity share capital and retained earning and
these sources have their specific cost of capital. However the overall
cost of capital of the firm may be ascertained as the weighted average
of these specific costs of capital.
 The cost of retained earnings is lower than cost of equity as former
does not have any floatation cost.
 The Weighted average cost of capital WACC may be ascertained by
applying book value weights or market value weights of different
sources of funds. The WACC is denoted as Kw.
QUESTIONS
1. What is the relevance and significance of cost of capital in capital
budgeting? How does the cost of capital enter the capital budgeting
process?
2. Define the concept of cost of capital? State how you would determine
the weighted average cost of capital of a firm?
3. How cost of equity capital is determined under CAPM?
4. Write short notes on (a) Marginal cost of capital (b) Cost of retained
earnings
5. The cost of preference capital is generally lower than cost of equity.
State the reasons?
6. What are the problems in determining the cost of capital?
7. How is the cost of zero coupon bonds determined?
CAPITAL STRUCTURAL MANAGEMENT OR PLANNING THE CAPITAL STRUCTURE
4
CAPITAL STRUCTURE: PLANNING AND DESIGNING
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
 Capital Structure Management or planning

the Capital Structure
 Essential features of sound capital mix
 Factors determining capital structure
 Profitability and Capital Structure: EBIT –
EPS Analysis
 Liquidity and Capital Structure: Cash Flow
Analysis
 Illustrations
 Lets Sum Up
 Questions
Capital Structure Management or Planning The Capital Structure

Estimation of capital requirements for current and future needs is
important for a firm. Equally important is the determining of capital mix.
Equity and debt are the two principle sources of finance of a business. But,
what should be the proportion between debt and equity in the capital
structure of a firm now much financial leverage should a firm employ? This
is a very difficult question. To answer this question, the relationship
between the financial leverage and the value of the firm or cost of capital
has to be studied. Capital structure planning, which aims at the
maximisation of profits and the wealth of the shareholders, ensures the
maximum value of a firm or the minimum cost of the shareholders. It is very
important for the financial manager to determine the proper mix of debt
and equity for his firm. In principle every firm aims at achieving the optimal
capital structure but in practice it is very difficult to design the optimal
capital structure. The management of a firm should try to reach as near as
possible of the optimum point of debt and equity mix.
Essential Features of a Sound Capital Mix
A sound or an appropriate capital structure should have the

following essential features:
(i) Maximum possible use of leverage.
(ii) The capital structure should be flexible.
(iii) To avoid undue financial/business risk with the increase of

debt.
(iv) The use of debt should be within the capacity of a firm. The
firm should be in a position to meet its obligation in paying the
loan and interest charges as and when due.
(v) It should involve minimum possible risk of loss of control.
(vi) It must avoid undue restrictions in agreement of debt.
(vii) The capital structure should be conservative. It should be

composed of high grade securities and debt capacity of the
company should never be exceeded.
(viii) The capital structure should be simple in the sense that can
be easily managed and also easily understood by the investors.
(ix) The debt should be used to the extent that it does not
threaten the solvency of the firm.
Factors Determining the Capital Structure
The capital structure of a concern depends upon a large number of

factors such as leverage or trading on equity, growth of the company,
nature and size of business, the idea of retaining control, flexibility of
capital structure, requirements of investors costs of floatation of new
securities, timing of issue, corporate tax rate and the legal requirements. It
is not possible to rank them because all such factors are of different
importance and the influence of individual factors of a firm changes over a
period of time. Every time the funds are needed. The financial manager has
to advantageous capital structure. The factors influencing the capital
structure are discussed as follows:
1. Financial leverage of Trading on Equity: The use of long term fixed

interest bearing debt and preference share capital along with equity
share capital is called financial leverage or trading on equity. The use
of long-term debt increases, magnifies the earnings per share if the
firm yields a return higher than the cost of debt. The earnings per
share also increase with the use of preference share capital but due to
the fact that interest is allowed to be deducted while computing tax,
the leverage impact of debt is much more. However, leverage can
operate adversely also if the rate of interest on long-term loan is more
than the expected rate of earnings of the firm. Therefore, it needs
caution to plan the capital structure of a firm.
2. Growth and stability of sales: The capital structure of a firm is highly
influenced by the growth and stability of its sale. If the sales of a firm
are expected to remain fairly stable, it can raise a higher level of
debt. Stability of sales ensures that the firm will not face any
difficulty in meeting its fixed commitments of interest repayments of
debt. Similarly, the rate of the growth in sales also affects the capital
structure decision. Usually greater the rate of growth of sales, greater
can be the use of debt in the financing of firm. On the other hand, if
the sales of a firm are highly fluctuating or declining, it should not
employ, as far as possible, debt financing in its capital structure.
3. Cost of Capital. Every rupee invested in a firm has a cost. Cost of
capital refers to the minimum return expected by its suppliers. The
capital structure should provide for the minimum cost of capital. The
main sources of finance for a firm are equity, preference share capital
and debt capital. The return expected by the suppliers of capital
depends upon the risk they have to undertake. Usually, debt is a
cheaper source of finance compared to preference and equity
capital due to (i) fixed rate of interest on debt: (ii) legal
obligation to pay interest: (iii) repayment of loan and priority in
payment at the time of winding up of the company. On the other
hand, the rate of dividend is not fixed on equity capital. It is not a
legal obligation to pay dividend and the equity shareholders undertake
the highest risk and they cannot be paid back except at the winding
up of the company and that too after paying all other obligations.
Preference capital is also cheaper than equity because of lesser risk
involved and a fixed rate of dividend payable to preference
shareholders. But debt is still a cheaper source of finance than even
preference capital because of tax advantage due to deductibility of
interest. While formulating a capital structure, an effort must be
made to minimize the overall cost of capital.
4. Minimisation of Risk: A firm’s capital structure must be developed
with an eye towards risk because it has a direct link with the value.
Risk may be factored for two considerations: (a) the capital
structure must be consistent with the business risk, and (b) the
capital structure results in certain level of financial risk. Business risk
may be defined as the relationship between the firm's sales and its
earnings before interest and taxes (EBIT). In general, the greater the
firm's operating leverage – the use of fixed operating cost – the higher
its business risk. Although operating leverage is an important factor
affecting business risk, two other factors also affect it – revenue
stability and cost stability. Revenue stability refers to the relative
variability of the firm's sales revenue. Firms with highly volatile
product demand and price have unstable revenues that result in high
levels of business risk. Cost stability is concerned with the relative
predictability of input price. The more predictable and stable these
inputs prices are, the lower is the business risk, and vice-versa. The
firm's capital structure directly affects its financial risk, which may be
described as the risk resulting from the use of financial leverage.
Financial leverage is concerned with the relationship between
earnings before interest and taxes (EBIT) and earnings per share
(EPS). The more fixed-cost financing i.e., debt (including financial
leases) and preferred stock, a firm has in capital structure, the
greater its financial risk.
5. Control: The determination of capital structure is also governed by
the management desire to retain controlling hands in the company.
The issue of equity share involve the risk of losing control. Thus in
case the company is interested in – retaining control, it should prefer
the use of debt and preference share capital to equity share capital.
However, excessive use of debt and preference capital may lead to
loss of control and other bad consequences.
6. Flexibility: The term flexibility refers to the firm’s ability to adjust its
capital structure to the requirements of changing conditions. A firm
having flexible capital structure would face no difficulty in changing
its capitalization or source of fund. The degree of flexibility in
capitals structure depends mainly on (i) firm’s unused debt
capacity, (ii) terms of redemption (iii) flexibility in fixed charges, and
(iv) restrictive stipulation in loan agreements.
If a company has some unused debt capacity, it can raise funds to meet
the sudden requirements of finances. Moreover, when the firm has a right to
redeem debt and preference capital at its discretion it will able to
substitute the source of finance for another, whenever justified. In essence,
a balanced mix of debt and equity needs to be obtained, keeping in view the
consideration of burden of fixed charges as well as the benefits of leverages
simultaneously.
7. Profitability: A capital structure should be the most profitable from

the point of view of equity shareholders. Therefore, within the given
constraints, maximum debt financing (which is generally cheaper)
should be opted to increase the returns available to the equity
shareholder.
8. Cash Flow Ability: The EBIT – EPS analysis, growth of earnings and
coverage ratio are very useful indicator of a firm’s ability to meet its
fixed obligations at various levels of EBIT. Therefore, an important
feature of a sound capital structure is the firm’s ability to generate
cash flow to service fixed charges.
At the time of planning the capital structure, the ratio of net cash
inflows to fixed charges should be examined. The ratio depicts the number
of times the fixed charges commitments are covered by net cash inflows.
Greater is this coverage, greater is this capacity of a firm to use debts an
other sources of funds carrying fixed rate of interest and dividend.
9. Characteristics of the company: The peculiar characteristics of a

company in regards to its size, nature, credit standing etc. play a
pivotal role in ascertaining its capital structure. A small size company
will not be able to raise long-term debts at reasonable rate of interest
on convenient terms. Therefore, such companies rely to a significant
extent on the equity share capital and reserves and surplus for their
long-term financial requirements.
In case of large companies the funds can be obtained on easy terms and
reasonable cost by selling equity shares and debentures as well. Moreover
the risk of loss of control is also less in case of large companies, because
their shares can be distributed in a wider range. When company is widely
held, the dissident shareholders will not be able to organize themselves
against the existing management, hence, no risk of loss of loss of control.
Thus, size of a company has a vital role to play in determining the capital
structure.
The various elements concerning variation in sales, competition with
other firms and life cycle of industry also affect the form and size of
capitals structure. If company’s sales are subject to wide fluctuations, it
should rely less on debt capital and opt for conservative capitals structure.
A company facing keen competition with other companies will run the
excessive risk of not being able to meet payments on borrowed funds. Such
companies should place much emphasis on the use of equity than debt,
similarly, if a company is in infancy stage of its life cycle, it will run a high
risk of mortality. Therefore, companies in their infancy should rely more on
equity than debt. As a company grows mature, it can make use of senior
securities (bonds and debentures).
Capital Structure of a New Firm : The capital structure a new firm is
designed in the initial stages of the firm and the financial manager has to
take care of many considerations. He is required to assess and evaluate not
only the present requirement of capital funds but also the future
requirements. The present capital structure should be designed in the light
of a future target capital structure. Future expansion plans, growth and
diversifications strategies should be considered and factored in the analysis.
Capital Structure of an Existing Firm: An existing firm may require
additional capital funds for meeting the requirements of growth, expansion,
diversification or even sometimes for working capital requirements. Every
time the additional funds are required, the firm has to evaluate various
available sources of funds vis-à-vis the existing capital structure. The
decision for a particular source of funds is to be taken in the totality of
capital structure i.e., in the light of the resultant capital structure after the
proposed issue of capital or debt.
Evaluation of Proposed Capital Structure : A financial manager has to
critically evaluate various costs and benefits, implications and the after-
effects of a capital structure before deciding the capital mix. Moreover, the
prevailing market conditions are also to be analyzed. For example, the
present capital structure may provide a scope for debt financing but either
the capital market conditions may not be conducive or the investors may not
be willing to take up the debt-instrument. Thus, a capital structure before
being finally decided must be considered in the light of the firm’s internal
factors as well as the investor's perceptions.
Profitability and Capital Structure: EBIT – EPS Analysis
The financial leverage affects the pattern of distribution of operating

profit among various types of investors and increases the variability of the
EPS of the firm. Therefore, in search for an appropriate capitals structure
for a firm, the financial manager must analysis the effects of various
alternative financial leverages on the EPS. Given a level of EBIT, EPS will be
different under different financing mix depending upon the extent of debt
financing. The effect of leverage on the EPS emerges because of the
existence of fixed financial charge i.e., interest on debt financial fixed
dividend on preference share capital. The effect of fixed financial charge
on the EPS depends upon the relationship between the rate of return on
assets and the rate of fixed charge. If the rate of return on assets is higher
than the cost of financing, then the increasing use of fixed charge financing
(i.e., debt and preference share capital) will result in increase in the EPS.
This situation is also known favourable financial leverage or Trading on
Equity. On the other hand, if the rate of return on assets is less than the
cost of financing, then the effect may be negative and therefore, the
increasing use of debt and preference share capital may reduce the EPS of
the firm.
The fixed financial charge financing may further be analyzed with
reference to the choice between the debt financing and the issue of
preference shares. Theoretically, the choice is tilted in favour of debt
financing because of two reasons: (i) the explicit cost of debt financing i.e.,
the rate of interest payable on debt instruments or loans is generally lower
than the rate of fixed dividend payable on preference shares, and (ii)
interest on debt financing is tax-deductible and therefore the real costs
(after-tax) is lower than the cost of preference share capital.
Thus, the analysis of the different capital structure and the effect of
leverage on the expected EPS will provide a useful guide to select a
particular level of debt financing. The EBIT-EPS analysis is of significant
importance and if undertaken properly, can be an effective tool in the
hands of a financial manager to get an insight into the planning and
designing the capital structure of the firm.
Limitations of EBIT-EPS Analysis: If maximization of the EPS is the only
criterion for selecting the particular debt-equity mix, then that capital
structure which is expected to result in the highest EPS will always be
selected by all the firms. However, achieving the highest EPS need not be
the only goal of the firm. The main shortcomings of the EBIT-EPS analysis
may be noted as follows:
(i) The EPS criterion ignore the risk dimension: The EBIT-EPS
analysis ignores as to what is the effect of leverage on the overall risk
of the firm. With every increase in financial leverage, the risk of the
firm and therefore that of investors also increase. The EBIGT-EPS
analysis fails to deal with the variability of EPS and the risk return
trade-off.
(ii) EPS is more of a performance measure: The EPS basically, depends
upon the operating profit which in turn, depends upon the operating
efficiency of the firm. It is a resultant figure and it is more a measure
of performance rather than a measure of decision-making.
These shortcomings of the EBIT-EPS analysis do not, in any way, affect its
value in capital structure decisions. Rather the following dimensions may be
added to the EBIT-EPS analysis to make it more meaningful.
The Risk Considerations: The risk attached with the leverage may be
incorporated in the EBIT-EPS analysis. The financial manager may start by
finding out the indifference level of EBIT (i.e., the level of EBIT at which the
EPS will be same for more than one capital structure). The expected value
of EBIT may then be compared with this indifference level of EBIT. If the
expected value of EBIT is more than the indifference level of EBIT, than the
debt financing is advantageous to the firm. The more is the difference
between the expected EBIT and the indifference level of EBIT, greater is the
benefit of debt financing, and so stronger is the case for debt financing.
In case, the expected EBIT is less than the indifference level of EBIT,
then the probability of such occurrence is to be assessed. If the probability
is high, i.e., there are more chances that the expected EBIT may fall below
the indifference level of EBIT, then the debt financing is considered to be
risky. If, however, the probability is negligible, then the debt financing may
be opted.
Debt Capacity: Whenever a firm goes for debt financing (howsoever big
or small), it inherently opts for taking two burdens, i.e., the burden of
interest payment and the burden of repayment of the principal amount.
Both these burdens are to be analyzed (i) from the point of view of liquidity
required to meet the obligations, and (ii) from the point of view of debt
capacity.
The profits of the firm’s vis-à-vis the burden of debt financing should also
be analyzed. The debt capacity or ability of the firm to service the debt
can be analyzed in terms of the coverage ratio, which shows the relationship
between the EBIT and the fixed financial charge. The higher the EBIT in
relation to fixed financial charge, the better it is. For this purpose, Interest
coverage ratio may be calculated as follows :
Interest Coverage Ratio = EBIT/Fixed Interest Charge
Liquidty and Capital Structure: Cash Flow Analysis
A finance manager, while evaluating different capital structure,
should also find out the liquidity required for (i) interest on debt (ii)
repayment of debt, (iii) dividend on preference share capital, and (iv)
redemption of preference share capital. The requirement of liquidity should
then be compared with the cash availability from operations of the firm as
follows:
1. Debt Service-Coverage Ratio: In the Debt Service Coverage Ratio
(DSCR), the cash profits generated by the operations are compared with the
total cash required for the service of the debt and the preference share
capital i.e.,
2. Projected Cash Flow Analysis: The firm may also undertake the
cash flow analysis for the period under consideration. This will enable the
financial manager to assess the liquidity capacity of the firm to meet the
obligations of interest payments and the repayment of principal obligations.
A projected-cash budget may be prepared to find out the expected cash
inflows and cash outflows (including interest and repayments). If the
inflows are comfortably higher than the outflow, then the firm can proceed
with the debt financing.
EBIT-EPS Analysis versus Cash flow Analysis (i.e., Profitability versus
Liquidity): In the EBIT-EPS analysis, it has been pointed out that a financial
manager should evaluate a capital structure from the point of view of the
profitability of equity shareholders. A capital structure which is expected to
result in maximisation of EPS should be selected. Financial leverages at
different levels are considered so as to find out their effect on the EPS.
On the other hand, in the cash flow analysis, the liquidity side of the
leverage is stressed. A capital structure should be evaluated in the light of
available liquidity. The firm need not face any liquidity problem in debt
servicing.
Under these two analyses, the different aspects of the capital
structure are evaluated. The EBIT-EPS analysis stresses the profitability of
the proposed financing mix and analyses it from the point of view of equity
shareholders. The cash flow analysis looks upon a financing mix and stresses
the need for liquidity requirement of debt financing and thus, it emphasizes
the debt investor.
Financial Distress
An increase in debt thus increases the probability of financial
distress. The financial distress is a situation when a firm finds it difficult to
honor its commitment to the creditors/debt investors. With reference to
capital structure, the financial distress refers to the situation when the firm
faces difficulties in paying interest and principal repayments to the debt
investors. Financial distress arises when the fixed financial obligations of
the firm affect the firm's normal operations. There are many degrees of
financial distress. One extreme degree of financial distress is the
bankruptcy, a condition in which the firm is unable to meet its financial
obligation and faces liquidation. The firm should try to achieve a trade-off
between the costs and benefits of debt financing. The cost being the
financial distress and the benefits being the interest tax-shield. The
financial manager must weigh the benefits of tax savings against the cost of
financial distress in the form of increasing risk. The cost of financial
distress is reflected in the market value of the firm and can be measured
therefore, through its effect on the value of the firm. Lower levels of
leverage will have little effects, but as the financial leverage increases, the
cost of financial distress increases and the market value of the debt as well
as the equity falls.
In view of the cost of financial distress, the market value of the firm
may not be as much as it could have been in absence of such costs. Thus,
the value of the firm is:
Value = Value (fall equity firm) + Present value of tax-shield – Present value
of cost of financial distress.
Illustration 1: Alpha company is contemplating conversion of 500 14%

convertible bonds of Rs.1,000 each. Market price of bond is Rs. 1,080. Bond
indenture provides that one bond will be exchanged for 10 share. Price
earning ratio before redemption is 20:1 and anticipated price earning ratio
after redemption is 25:1.Number of shares outstanding prior to redemption
are 10,000. EBIT amounts to Rs 2,00,000. The company is in the 35% tax
bracket. Should the company convert bonds into share? Give reasons.
Solutions:
Present Position After

Conversion
EBIT Rs.2,00,000
Rs.2,00,000
Less interest @ 14% 70,000 ---
1,30,000 2,00,000
less tax @15% 45,500 70,000
Number of share 10,000 15,000
EPS Rs. 8.45 Rs. 8.67
P E Ratio 20 25
Expected market Price Rs. 169.00 Rs. 216.75
The company may opt for conversion of bonds into equity shares as this will
result in increase in market price of share from Rs.169 of Rs.216.75.
Lets Sum Up
 The relationship between capital structure, cost of capital and value

of firm has been one of the most debated area of financial
management.
 Factors determine capital structure are control, flexibility,
characteristic of company, profitability, cash flow ability, cost of
capital, minimization of risk, trading leverage.
 Two basic techniques available to study the impact of a particular
capital structure are (i) EBIT –EPS Analysis which studies the impact
of financial leverage on the EPS of the firm and (ii) Cash Flow Analysis
which emphasizes the liquidity required in view of particular capital
structure.
 Different accounting ratios such as interest coverage ratio and debt
service coverage ratio may be ascertained to find out the debt
capacity of the firm and the cash profit generated by the firm which
may be used to service the debt.
 The financial manager should also take care of the financial distress
which refers to the situation when the firm is not able to met its
interest / repayment liabilities and may even face a closure.
QUESTIONS
1. Explain the factors relevant in determining the capital structure?

2. Explain the feature of EBIT-EPS analysis, cash flow analysis and
valuation models approach to determination of capital structure?
3. What is financial distress? Examine the effects of financial distress on
the value of firm?
4. Explain theories of capital structure?
5. What is optimal capital structure?
6. Give critical appraisal of the traditional approach and the Modigliani –
Miller Approach to the problem of capital structure?
FINANCING DECISION: EBIT –EPS ANALYSIS
FINANCING DECISION: EBIT –EPS ANALYSIS
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
 Introduction
 Constant EBIT with Different Financing Patterns
 Varying EBIT with Different Financing Patterns
 Financial break even level
 Indifference level of EBIT
 Shortfalls in EBIT-EPS Analysis
 Lets Sum Up
 Questions
Introduction
The
analysis of the
effect of different patterns of financing or the financial leverage on the
level of returns available to the shareholders, under different assumptions
of EBIT is known as EBIT-EPS analysis. A firm has various options regarding
the combinations of various sources to finance its investment activities. The
firms may opt to be an all-equity firm (and having no borrowed funds) or
equity-preference firm (having no borrowed funds) or any of the numerous
possibility of combinations of equity, preference shares and borrowed
funds. However, for all these possibilities, the sales level and the level of
EBIT is irrelevant as the pattern of financing does not have any bearing on
the sales or the EBIT level. In fact, the sales and the EBIT level are affected
by the investment decisions.
Given a level of EBIT, a particular combination of different sources of
finance will result in a particular EPS and therefore, for different financing
patterns, there would be different levels of EPS.
Constant EBIT and Changes in the Financing Patterns: Holding the
EBIT constant while varying the financial leverage or financing patterns, one
can imagine the firm increasing its leverage by issuing bonds and using the
proceeds to redeem the capital, or doing the opposite to reduce leverage.
Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per

annum on an investment Rs.5,00,000, is considering the finalization of the
capital structure or the financial plan. The company has access to raise
funds of varying amounts by issuing equity share capital, 12% preference
share and 10% debenture or any combination thereof. Suppose, it analyzes
the following four options to raise the required funds of Rs.5,00,000.
1. By issuing equity share capital at par.
2. 50% funds by equity share capital and 50% funds by preference
shares.
3. 5% funds by equity share capital, 25% by preference shares and 25%
by issue of 10% debentures.
4. 25% funds by equity share capital, 25% as preference share and 50%
by the issue of 10% debentures.
Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under the above four options can
be calculated as follows:
Option 1 Option 2 Option 3 Option 4
Equity share capital Rs.5,00,000 Rs.2,50,000 Rs.2,50,000 Rs.1,25,000
Preference share --- 2,50,000 1,25,00 1,25,000

capital
10% Debentures --- --- 1,25,000 2,50,000
Total Funds 5,00,000 5,00,000 5,00,000 5,00,000
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
- Interest --- --- 12,500 25,000
Profit before Tax 1,50,000 1,50,000 1,37,500 1,25,000

- Tax @ 50% 75,000 75,000 68,750 62,500
Profit after Tax 75,000 75,000 68,750 62,500
- Preference Dividend --- 30,000 15,000 15,000
Profit for Equity 75,000 45,000 53,750 47,500
shares
No. of Equity shares 5000 2500 2500 1250
(of Rs.100 each)
EPS (Rs.) 15 18 21.5 38
In this case, the financial plan under option 4 seems to be the best as
it is giving the highest EPS of S.38. In this plan, the firm has applied
maximum financial leverage. The firm is expecting to earn an EBIT of
Rs.1,50,000 on the total investment of Rs.5,00,000 resulting in 30% return.
On an after-tax basis, this return comes to 15% i.e., 30% x (1-.5). However,
the after tax cost of 10% debentures is 5% i.e., 10% (1- .5) and the after tax
cost of preference shares is 12% only. In the option 4, the firm has
employed 50% debt, 25% preference shares and 25% equity share capital,
and the benefits of employing 50% debt (which has after tax cost of 5% only)
and 25% preference shares (having cost of 12% only) are extended to the
equity shareholders. Therefore the firm is expecting an EPS of Rs.38.
In case, the company opts for all-equity financing only, the EPS is
Rs.15 which is just equal to the after tax return on investment. However, in
option 2, where 5% funds are obtained by the issue of 12% preference
shares, the 3% extra is available to the equity shareholders resulting in
increase in of EPS from Rs.15 to Rs.18. In plan 3, where 10% debt is also
introduced, the extra benefit accruing to the equity shareholders increases
further (from preference shares as well a from debt) and the EPS further
increases to Rs.21.50. The company is expecting this increase in EPS when
more and more preference share and debt financing is availed because the
after tax cost of preference shares and debentures are less than the after
tax return on total investment.
Hence, the financial leverage has a favourable impact on the EPS-only

if the ROI is more than the cost of debt. It will rather have an unfavourable
effect if the ROI is less than the cost of debt. That is why financial leverage
is also called the twin-edged sword.
Varying EBI with Different Patterns: Suppose, there are three firm X & Co., Y & Co.
and Z & Co. These firms are alike in all respect except the leverage. The financial position of
the three firms is presented as follows:
Capital Structure X & Co. Y & Co. Z & Co.
Share Capital (of Rs.100 each) Rs.2,00,000 Rs.1,00,000 Rs.50,000
6% Debenture --- 1,00,000 1,50,000
Total 2,00,000 2,00,000 2,00,000
These firms are expected to earn a ROI at different levels depending upon the economic
conditions. In normal conditions, the ROI is expected to be 8% which may fluctuate by 3% on
either side on the occurrence of bad economic conditions or good economic conditions. How is
return available to the shareholders of the three firms is going to be affected by the variations in
the level of EBIT due to differing economic conditions? The relevant presentations have been
shown as follows:
Poor Normal Good

Eco. Cond. Eco. Cond. Eco. Cond.
Total Assets Rs.2,00,000 Rs.2,00,000 Rs.2,00,000
ROI 5% 8% 11%
EBIT Rs.10,000 Rs.16,000 Rs.22,000
X & Co. (No Financial Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000

- Interest --- --- ---
Profit before Tax 10,000 16,000 22,000
- Tax @ 50% 5,000 8,000 11,000
Profit After Tax 5,000 8,000 11,000
Number of Shares 2,000 2,000 2,000
EPS (Rs.) 2.5 4 5.5
Y & Co. (50% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000

- Interest 6,000 6,000 6,000
- Tax @ 50% 2,000 5,000 8,000
Profit After Tax 2,000 5,000 8,000
Number of Shares 1,000 1,000 1,000
EPS (Rs.) 2 5 8
Z & Co. (75% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000

- Interest 9,000 9,000 9,000
- Tax @ 50% 500 3,500 6,500
Profit After Tax 500 3,500 6,500
Number of Shares 500 500 500
EPS (Rs.) 1 7 13
On the basis of the figures given above, it may be analyzed as to how the financial
leverage affects the returns available to the shareholders under varying EBIT level. For this
purpose, the normal rate of return i.e. 8% and EPS of different firms in normal economic
conditions, both may be taken at 100 and position of other figures of EBIT and EPS may be
shown on relative basis as follows:
Poor Eco. Cond. Normal Eco. cond.

Good Eco. cond.
EBIT 62.5
100 137.5
X & Co.
EPS 62.5
100 137.5
% change from normal - 37.5%
---- + 37.5%
Y & Co.
EPS 40
100 160
% change from normal -60%
----- +60%
Z & Co.
EPS 14.3
100 185.7
% change from normal -85.7% -----
+85.7%
It is evident from the above figures that when economic conditions
change from normal to good conditions, the EBIT level increases by 37.5%
(i.e. from 8% to 11%). The firm X & Co. having no leverage, is not able to
have the magnifying effect of its EBIT and therefore its EPS increases only
by 37.5%. On the other hand the firm Y& Co.(having 50% leverage) is able to
have an increase in EPS (from Rs. 5 to Rs. 8). Similarly, the firm Z & Co.
(having still higher leverage of 75%) is able to have an increase of 85.7% in
EPS (from Rs. 7 to Rs.13). Thus, higher the leverage, greater is the
magnifying effect on the EPS in case when economic condition improves
On the other hand just reverse is the situation in case when economic
conditions worsen and the EBIT level is reduced by 37.5% (i.e. from 8% ROI
to 5% ROI). In this case the EPS of X & Co. reduces only by 37.5%(from Rs 4
to Rs 2.5) whereas the EPS of Y & Co. (50% leverage) reduces by 60% (from
Rs. 5 to Rs.2). In case of Z & Co. the decrease is more pronounced and EPS
reduces by 85.7% (from Rs. 7 to Rs. 13). Thus, higher the leverage, greater
is the magnifying effect on the EPS in case when the economic conditions
improve.
On the other hand, just reverse is the situation in case when the
economic conditions worsen and the EBIT level reduced by 37.5% ) i.e. from
8% ROI to 5% ROI ). In this case, the EPS of X & Co. reduces only by 37.5%
(from Rs. 4 to Rs. 2.5 ), whereas the EPS of Y &Co. (50% leverage) reduces
by 60%(from Rs. 5 to Rs. 2). In case of Z & Co. the decrease is more
pronounced and EPS reduces by 85.7% (from Rs. 7 to Rs.1).
Financial Break-Even Level
In case the EBIT level of a firm is just sufficient to cover the fixed
financial charges then such level of EBIT is known as financial break-even
level. The financial break-even level of EBIT may be calculated as follows:
If the firm has employed debt only (and no preference shares), the
financial break-even EBIT level is :
Financial break-even EBIT = Interest Charge
If the firm has employed debt as well as preference share capital,
then its financial break-even EBIT will be determined not only by the
interest charge but also by the fixed preference dividend. It may be noted
that the preference divided is payable only out of profit after tax, whereas
the financial break-even level is before tax. The financial break-even level
in such a case may be determined as follows:
Financial break-even EBIT = Interest Charge + Pref. Div./(1-t)
Indifference Point/Level
The indifference level of EBIT is one at which the EPS remains same
irrespective of the debt equity mix. While designing a capital structure, a
firm may evaluate the effect of different financial plans on the level of EPS,
for a given level of EBIT. Out of several available financial plans, the firm
may have two or more financial plans which result in the same level of EPS
for a given EBIT. Such a level of EBI at which the firm has two or more
financial plans resulting in same level of EPS, is known as indifference level
of EBIT.
The use of financial break-even level an the return from alternative
capital structures is called the indifference point analysis. The EBIT is used
as a dependent variable and the EPS from two alternative financial plans is
used as independent variable and the exercise is known as indifference
point analysis. The indifference level of EBIT is a point at which the after
tax cost of debt is just equal to the ROI. At this point the firm would be
indifferent whether the funds are raised by the issue of debt securities or by
the issue of share capital. The following example will illustrate this point.
Suppose, PQR & Co. is expecting an EBIT of Rs.55,00,000 after implementing the
expansion plan for Rs.50,00,000. The funds requirements needed to implement the plan can be
raised either by the issue of further equity share capital at an issue price of Rs.5,000 each, or by
the issue of 10% debenture. Find out the EPS under these two alternative plans if the existing
capital structure of the firm stands at 10,000 shares. The above situation can be analyzed as
follows:
Financial Plan 1 Financial Plan 2

Number of existing shares 10,000 10,000
Number of new shares 1,000 ---
Total Number of shares 11,000 10,000
10% Debenture --- Rs.50,00,000
EBIT (Given) Rs.55,00,000 Rs.55,00,000
- Interest --- 5,00,000
Profit before Tax 55,00,000 50,00,00
Tax @ 50% 27,50,000 25,00,000
Profit after Tax 27,50,000 25,00,000
EPS (Rs.) 250 250
So, at the EBIT level of Rs.55,00,000, the EPS is expected to be Rs.250 irrespective of
the fact whether the additional funds are raised by the issue of equity share capital or by the issue
of 10% debt. This EBIT level of Rs.55,00,000 is known as the indifference level of EBIT.
However, in case the company is expecting EBIT of Rs.50,00,000 or Rs.60,00,000, the EPS for
both the financial plans has been calculated in the following table.
Financial Plan 1 Financial Plan 2

EBIT Rs.50,00,000 Rs.60,00,000 Rs.50,00,000 Rs.60,00,000
- Interest --- --- 5,00,000 5,00,000
Profit before Tax 50,00,000 60,00,000 45,00,000 55,00,000
Tax @ 50% 25,00,000 30,00,000 22,50,000 27,50,000
Profit after Tax 25,00,000 30,00,000 22,50,000 27,50,000
Number of Equity 11,000 11,00 10,000 10,000
shares
EPS (Rs.) 227 272 225 275
The above figures show that for an EBIT level below the indifference level of
Rs.55,00,000, the EPS is lower at Rs. 225 in case of leveraged option (i.e.,
debt financing) than the EPS of unleveraged option of Rs.227. However, if
the EBIT is higher than the indifference level, then the EPS is higher at
Rs.275 in case of levered option than the EPS of Rs.272 under unlevered
option.
If the firm expects to generate exactly the same amount of EBIT at
which the EBIT-EPS lines intersect, ten from the point of view of the equity
shareholders, the firm would be indifferent as to choice of capital structure
because the same EPS would result from either of the alternatives.
Figure shows that if the firm expects the EBIT at a level higher than
the indifference level, plan I is better and the PS will be higher than EPS
under plan II. However, if the expected level of EBIT is less than the
indifference level of EBIT, than plan II is better as the EPS under plan II will
be higher. It is only in such a situation when the expected EBIT is just equal
to the indifference level of EBIT that the EPS under both the plans would be
same.
The EBIT-EPS line or a particular financial plan also shows the financial
break even level of EBIT. The intercepts on the horizontal axis OA (in case
of plan II) and OB (in case of plan I) are the financial break even level of
EBIT under respective financial plans.
Shortfalls of EBIT-EPS Analysis
EBIT-EPS analysis helps in making a choice for a better financial plan.
However, it may have two complications namely:
1. If neither of the two mutually exclusive alternative financial plans
involves issue of new equity shares, then no EBIT indifference point will
exist. For example, a firm has a capital consisting of 1,00,000 equity
shares and wants to raise Rs. 10,00,000 additional funds for which the
following two plans are available: (i) to issue 10% bonds of Rs. 10,00,000,
or(ii) to issue 12% preference shares of Rs. 100 each. Assuming tax rate to
be 50% the indifference level of EBIT for the two plans would be as
follows:
(EBIT – 1,00,000) (1 - .5)/1,00,000 = EBIT (1 - .5) – 1,20,000
.5 EBIT – 50,000 = 5 EBIT – 1,20,000
0 = - 70,000
So, there is an inconsistent result and it indicates that there is no
indifference point of EBIT. If the EBIT-EPS lines of these two plans are
drawn graphically, these will be parallel and no intersection point will
emerge.
2. Sometimes, a given set of alternative financial plans may give negative
EPS to cause an indifference level of EBIT. For example, a firm having
1,00,000 equity shares already issued, requires additional funds of
Rs.10,00,000 for which the following two options are available : (i) to
issue 20,000 equity shares of Rs.25 each and to raise to Rs.5,00,000 by
the issue of 9% bonds, or (ii) to issue 30,000 equity shares at Rs.25 each
and to issue 2,500 12% preference shares of Rs. 100 each. Assuming the
tax rate to be 50%, the indifference level of EBIT for the two plans would
be as follows :
= EBIT = Rs. – 1,35000
So, the indifference point occurs at a negative value of EBIT, which is
imaginary.
Lets Sum Up
 EBIT-EPS Analysis is another way of looking at the effects of different
types of capital structures. EBIT –EPS Analysis considers the effect on
EPS under different types of capital mix.
 Given a level of EBIT particular combination of different sources will
result in a particular level of EPS, and therefore for different financing
patterns, there would be different levels of EPS.
 Financial break even level of EBIT is that level of EBIT at which EPS of
a firm is zero.
 Indifference level of EBIT is one at which the EPS remains same under
two different financial plans. At the difference level of EBIT, the firm
would be indifferent whether funds are raised by one capital mix or
another both will have same level of EPS.
QUESTIONS
1. What is EBIT –EPS Analysis? How is it different from leverage analysis?
2. Examine effects of change in EBIT of a firm on the EPS under (i) same
capital structure and (ii) different capital structure?
3. What are the shortcomings if any of the EBIT–EPS Analysis?
FINANCING DECISION – LEVERAGE ANALYSIS
FINANCING DECISION – LEVERAGE ANALYSIS
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
§ Meaning of Leverage
§ Operating Leverage
q Significance of Operating Leverage
§ Financial Leverage
Meaning of
§ Combined Leverage Leverage
§ Illustrations in Leverage Analysis The term

leverage, in
§ Lets Sum Up general, refers to
a relationship
§ Questions between two
interrelated
variables. With reference to a business firm, these variables may be costs,
output, sales revenue, EBIT, Earnings Per share (EPS) etc. In financial
analysis, the leverage reflects the responsiveness or influence of one
financial variable over some other financial variable.
The leverage may be defined as the % change in one variable divided

by the % change in some other variable or variables. Impliedly, the
numerator is the dependent variable, say X, and the denominator is the
independent variable, say Y. The leverage analysis thus, reflects as to how
responsiveness is the dependent variable to a change in the independent
variables. Algebraically, the leverage may be defined as:
For example, a firm increased its sales promotion expenses from

Rs.5,000 to Rs.6,000 i.e., an increase of 20%. This resulted in the increase
in number of unit sold from 200 to 300 i.e. an increase of 50%. The leverage
between the sales promotion expenses and the number of units sold may be
defined as:
This means that % increase in number of unit sold is 2.5 times that of
% increase in sales promotion expenses. The operating profit of a firm is a
direct consequence of the sales revenue of the firm and in turn the
operating profit determines of profit available to the equity shareholders.
The functional relationship between the sales revenue and the EPS can be
established through operating profits (EBIT) as follows:
The left hand side of the above presentation shows that the level of EBIT depends upon the level
of sales revenue and the right hand side of the above presentation shows that the level of profit
after tax or EPS depends upon the level of EBIT. The relationship between sales revenue and
EBIT is defined as operating leverage and the relationship between EBIT and EPS is defined as
financial leverage. The direct relationship between the sales revenue and the EPS can also be
established by the combining the operating leverage and financial leverage and is defined as
combined leverage.
Operating Leverage
The operating leverage measures the relationship between the sales

revenue and the EBIT. It measures the effect of change in sales revenue on
the level of EBIT. Hence, the operating leverage is calculated by dividing
the % change in EBIT by the % change in sales revenue.
For example, ABC Ltd. sells 1000 unit @ Rs.10 per unit. The cost of
production is Rs.7 per unit and the whole of the cost is variable in nature.
The profit of the firm is 1,000 x (Rs.10 – Rs.7) = Rs.3,000. Suppose, the firm
is able to increase its sales level by 40% resulting in total sales of 1400
units. The profit of the firm would now be 1400 x (Rs.10 – Rs.7) = Rs.
4200.The operating leverage of the firm is
= Increase in EBIT/EBIT/ Increase in Sales/

Sales
Rs. 1200 ¸ Rs.3000
Rs.4000 ¸ Rs.10,000
=1
The Operating Leverage of 1 denotes that the EBIT level increases or

decreases in direct proportion to the increase or decrease in sales level.
This is due to fact that there is no fixed costs and total cost is variable in
nature.
Whenever, the % change in EBIT resulting from given % change in sales

is greater than the % change in sales, the OL exists and the relationship is
known as the DOL (Degree of Operating Leverage). This means that as long
as the DOL is greater than 1, there is an OL. The OL emerges as result of
existence of fixed element in the cost structure of the firm. The OL,
therefore, may be defined as firm's position or ability to magnify the effect
of change in sales over the level of EBIT. The level of fixed costs, which is
instrumental in bringing this magnifying effect, also determines the extent
of this effect. Higher the level of fixed costs in relation to variable costs,
greater would be the DOL. The DOL may, at any particular sales volume,
also be calculated as a ratio of contribution to the EBIT.
Degree of Operating Leverage = Contribution/EBIT
Thus, on the basis of the above analysis, the OL may be interpreted as
follows:
1. The OL is the % change in EBIT as a result of 1% change in sales. OL
arises as a result of fixed cost in the cost structure. If there is no
fixed cost, there will be no OL and the % change in EBIT will be same
as % change in sales.
2. A positive DOL means that the firm is operating at a level higher
than the break-even level and both the EBIT and sales will vary in the
same direction.
3. A negative DOL means that the firm is operating at a level lower tan
the break-even level; and the EBIT will be negative.
Significance of Operating Leverage
Operating Leverage explains the effect of change in sales on EBIT.

When there is high operating leverage, a small rise in sales will result in a
larger rise in EBIT. But if there is small drop in sales, EBIT will fall
dramatically or may even be wiped off. Thus, existence of high operating
leverage reflects high-risk situation. As the operating leverage reaches its
maximum near break even point, the firm can protect itself from the
dangers of operating leverage and the consequent operating risk by
operating sufficiently above the break even point.
Financial Leverage
The Financial Leverage (FL) measures the relationship between the

EBIT and the EPS and it reflects the effect of change in EBIT on the level of
EPS. The FL measures the responsiveness of the EPS to a change in EBIT and
is defined as the % change in EPS divided by the % change in EBIT.
Symbolically,
= Increase in EPS ¸EPS/Increase in EBIT¸EBIT

Hence, the FL may be defined as a % increase in EPS that is associated
with a given % increase in the level of EBIT. The increase in EPS of the firm
may be more than proportionate for increase in the level of EBIT. In other
words, the effect of increase or decrease in EBIT is magnified on the level of
EPS. The existence of fixed financing charge is instrumental to bring this
magnifying effect and also determines the extent of this effect. Higher the
level of fixed financial charge, greater would be the FL. The FL may also be
defined as:
On the basis of above analysis, the Financial Leverage can be interpreted as:
(a) The Financial Leverage is a % change in EPS as result of 1% change
in EBIT. The FL emerges as a result of fixed financial cost (in the form
of interest and preference dividend). If there is no fixed financial
liability, there will be no FL. In such a case the % change in EPS will
be same as % change in EBIT.
(b) A positive FL means that the firm is operating at a level of EBIT
which is higher than the financial break-even level and both the EBIT
and EPS will vary in the same direction as the EBIT changes.
(c) A negative FL means that the firm is operating at a level lower than
the financial break-even level and the EPS will be negative.
Combined Leverage
The Combined Leverage (CL) is not a distinct type of leverage analysis,

rather it is a product of the OL and the FL. The CL may be defined as the %
change in EPS for a given % change in the sales level and may be calculated
as follows:
Combined Leverage = Operating Leverage x Financial Leverage

= % Change in EPS / % Change in sales
The Combined Leverage is interpreted as:
(a) The Combined Leverage is the % change in EPS resulting from a 1%
change in sales level.
(b) A positive CL means that the leverage is being computed for a sales
level higher than the break even level and both the EPS and sales will
vary in the same direction.
(c) A negative CL means that the leverage is being calculated for a
sales level lower than the financial break even level and EPS will be
negative.
Illustration 1: Calculate the Degree of

Operating Leverage (DOL), Degree of
Financial leverage (DFL) and the Degree of
Combined Leverage (DCL) for the following
firms and interpret the results.
Firm A Firm B
Firm C
Output (units) 60,000
15,000 1,00,000
Fixed Costs (Rs) 7,000
14,000 1,500
Variable cost per unit (Rs.) 0.20
1.50 0.02
Interest on borrowed funds 4,000

8,000 -----
Selling price per unit (Rs) 0.60

5.00 0.10
Solution:
Firm A Firm B
Firm C
Output (units) 60,000 15,000
1,00,000
Selling price per unit (Rs) 0.60
5.00 0.10
Variable cost per unit (Rs.) 0.20
1.50 0.02
Contribution per unit 0.40 3.50
0.08
Total Contribution Rs.24,000 Rs.52,500

RS.8,000
Less fixed costs 7,000

14,000 1,500
EBIT 17,000
38,500 6,500
Less Interest 4,000 8,000
---
Profit before Tax 13,000 30,500
6,500
Degree of Operating Leverage

Contribution/EBIT 24,000/17,000 52,500/38,000
8,000/6,500
= 1.41 =1.36 =
1.23
Degree of Financial Leverage
EBIT/PBT 17,000/13,000 38,500/30,500

6,500/6,500
= 1.31 = 1.26 =
1.00
Degree of Combined Leverage
Contribution/ EBIT 24,000/13,000 52,500/30,500

8,000/6,500
= 1.85 = 1.72 = 1.23
Illustration 2: A firm has sales of Rs. 10,00,000, variable cost of Rs.

7,00,000 and fixed costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate
of interest. What are the operating, financial and combined leverages. If the
firm wants to double its earnings before interest and tax (EBIT), how much
of a rise in sales would be needed on a percentage basis?
Solution:
Statement of Existing Profit
Sales
Rs.10,00,000
Less Variable cost
7,00,000
Contribution
3,00,000
Less fixed cost
2,00,000
EBIT
1,00,000
Less Interest @ 10% on 5,00,000
50,000
Profit after Tax
50,000
Operating leverage Contribution/ EBIT = 3,00,000/1,00,000 = 3
Financial Leverage EBIT/PBT = 1,00,000/50,000 = 2
Combined Leverage = 3x 2= 6
Statement of sales needed to double EBIT

Operating Leverage is 3 times i.e. 33 – 1/3% increase in sales volume
causes a 100% increase in operating profit or EBIT. Thus, at the sales of Rs.
13,33,333, operating profit or EBIT will become Rs. 2,00,000 i.e. double
existing one.
Verification:
Sales
Rs.13,33,333
Variable cost (70%)
9,33,333
Contribution
4,00,000
Fixed Costs
2,00,000
EBIT
2,00,000
Illustration 3: The balance sheet of Well
Established Company is as follows:
Liabilities Amount Assets
Amount
Equity share capital 60,000 Fixed Assets
1,50,000
Retained Earnings 20,000 Current Assets
50,000
10% long term debt 80,000
Current Liabilities 40,000
------------
2,00,000
2,00,000
The company’s total assets turnover ratio is 3, its fixed operating costs
are Rs.1,00,000 and its variable operating cost ratio is 40%. The income tax
rate is 50%. Calculate the different types of leverages given that the face
value of share is Rs.10.
Solution: Total Assets Turnover Ratio = Sales / Total Assets
3 = Sales/2,00,000
Sales
6,00,000
Variable Operating Cost (40%)
2,40,000
Contribution
3,60,000
Less Fixed Operating Cost
1,00,000
EBIT
2,60,000
Less interest (10% of 80,000)
8,000
PBT
2,52,000
Tax at 50%
1,26,000
PAT
1,26,000
Number of shares
6,000
EPS
Rs.21
Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT / PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage =1.38 x 1.03 = 1.42
Illustration 4: The following information is available for ABC & Co.
EBIT Rs. 11,20,000

Profit before Tax 3,20,000
Fixed Costs 7,00,000
Calculate % change in EPS if the sales are expected to increase by 5%.
Solution: In order to find out the % change in EPS as a result of %
change in sales, the combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs.11,20,000 + Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT / Profit before Tax
= Rs. 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/ Profit before Tax = OL x FL
= 1.625 x 3.5 = 5.69
The combined leverage of 5.69 implies that for 1% change in sales
level, the % change in EPS would be 5.69% So, if the sales are expected to
increase by 5%, then the % increase in EPS would be 5 x 5.69 = 28.45%.
Illustration 5: The data relating to two

companies are as given below:
Company A Company
B
Capital Rs.6,00,000
Rs.3,50,000
Debentures Rs. 4,00,000
6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Fixed costs per annum 7,00,000
14,00,000
Variable cost per unit 10 75
You are required to calculate the Operating leverage, Financial leverage and
Combined Leverage of two companies.
Solution: Computation of Operating leverage, Financial Leverage and Combined leverage
Company A
Company B
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Sales Revenue 18,00,000
37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000
26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
on debentures 48,000 78,000
PBT 4,52,000 11,47,000
DOL = Contribution/EBIT 12,00,000/5,00,000
26,25,000/12,25,000
= 2.4 =
2.14
DFL = EBIT/ PBT 5,00,000/4,52,000 12,25,000/11,47,000
1.11 =1.07
DCL = DOL x DFL 2.14 x 1.11 = 2.66 2.14 x 1.07 = 2.2
Illustration 6: X Corporation has estimated that for a new product its

break-even point is 2,000 units if the item is sold for Rs. 14 per unit, the
cost accounting department has currently identified variable cost of Rs. 9
per unit. Calculate the degree of operating leverage for sales volume of
2,500 units and 3,000 units. What do you infer from the degree of operating
leverage at the sales volume of 2,500 units and 3,000 units and their
difference if any?
Solution:
Statement of Operating Leverage
Particulars 2500 units

3000 units
Sales @ Rs.14 per unit
35,000 42,000
Variable cost 22,500
27,000
Contribution
12,500 15,000
Fixed Cost (2,000 x (Rs.14 – 9) 10,000
10,000
EBIT
2,500 5,000
Operating Leverage
= Contribution/ EBIT 12,500/2,500
15,000/5,000
= 5
=3
Illustration 7: The following data is available for XYZ Ltd.

Sales Rs. 2,00,000
Less: Variable cost 60,000
Fixed Cost 1,00,000
EBIT 40,000
Less Interest 5,000
Profit before tax 35,000
Find out:
(a) Using concept of financial leverage, by what percentage will the taxable
income increase, if EBIT increases by 6 %.
(b) Using the concept of operating leverage, by what percentage will EBIT
increase if there is 10% increase in sales and,
(c) Using the concept of leverage, by what percentage will the taxable
income increase if the sales increase by 6%. Also verify the results in view of
the above figures.
Solution:
(i) Degree of Financial Leverage:
FL = EBIT/Profit before Tax = 40,000/35,000 = 1.15
If EBIT increases by 6%, the taxable income will increase by 1.15 x 6 = 6.9%
and it may be verified as follows:
EBIT (after 6% increase) Rs. 42,400
Less Interest 5,000

Profit before Tax 37,400
Increase in taxable income is Rs. 2,400 i.e 6.9% of Rs. 35,000
(ii) Degree of Operating Leverage:
OL = Contribution / EBIT = 1,40,000/40,000 = 3.50
If sale increases by 10%, the EBIT will increase by 3.50 x 10 = 35% and it
may be verified as follows:
Sales (after 10% increase) Rs. 2,20,000
Less variable expenses @ 30% 66,000
Less Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e 35% of Rs. 40,000
(iii) Degree of Combined leverage
CL = Contribution/ Profit before tax = 1,40,000/35,000 = 4
If sales increases by 6%, the profit before tax will increase by 4x6= 24% and
it maybe verified as follows:
Sales (after 6% increase) Rs. 2,12,000
Less Variable expenses@ 30% 63,600
Less Fixed cost 1,00,000
EBIT 48,400
Less Interest 5,000
Profit before tax 43,400

Increase in Profit before tax is Rs. 8,400 i.e 24% of Rs. 35,000
Lets Sum Up
§ In Leverage analysis the relationship between two interrelated

variables is established. In financial management Operating leverage,
financial leverage and Combined Leverage is calculated.
§ The Operating relationship establishes the relationship between sales

and EBIT. It measures the effect of change in sales revenue on the
level of EBIT.
§ Operating leverage appears as a result of fixed cost.
§ The financial leverage measures the responsiveness of the EPS for

given change in EBIT.
§ The financial leverage appears as a result of fixed financial charge i.e.

interest and preference dividend.
§ Combined leverage may also be ascertained to measures the % change

in EPS for a % change in the sales.
QUESTIONS
1 Distinguish between operating leverage and financial leverage. How

the two leverages can be measured?
2 Explain the concept of financial leverage. Examine the impact of

financial leverage on the EPS. Does the financial Leverage always
increases the EPS?
Unit-4
Contains three chapters...
1. DIVIDEND DECISION AND VALUATION OF THE FIRM
2. DIVIDEND POLICY : DETERMINANTS AND CONSTRAINS
3. DIVIDEND POLICY IN PRACTICE

DIVIDEND DECISION AND VALUATION OF THE FIRM
UNIT 4
DIVIDEND DECISION AND VALUATION OF THE FIRM
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
 Introduction
 Concept and Significance
 Dividend Decision and Valuation of Firms
q Relevance Concept of Dividend
Walter’s Approach
Gordon’s Approach
q Irrelevance Concept of Dividend
Residual Approach
Modigliani & Miller Approach

§ Lets Sum Up
§ Questions
Introduction
The term dividend refers to that profits of a company which is

distributed by company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. A
company may have preference share capital as well as equity share capital
and dividends may be paid on both types of capital. The investors are
interested in earning the maximum return on their investments and to
maximize their wealth on the other hand, a company needs to provide funds
to finance its long-term growth. If a company pays out as dividend most of
what it earns, then for Business requirements and further expansion it will
have to depend upon outside resources such as issue of debt or a new
shares. Dividend policy of a firm, thus affects both long-term financing and
wealth of shareholders.
Concept and Significance
The dividend decision is one of the three basic decisions which a

financial manager may be required to take, the other two being the
investment decisions and the financing decisions. In each period any earning
that remains after satisfying obligations to the creditors, the government
and the preference shareholders can either be retained or paid out as
dividends or bifurcated between retained earnings and dividends. The
retained earnings can then be invested in assets which will help the firm to
increase or at least maintain its present rate of growth.
In dividend decision, a financial manager is concerned to decide one or

more of the following:
- Should the profits be ploughed back to finance the investment

decisions?
- Whether any dividend be paid? If yes, how much dividend be

paid?
- When these dividend be paid? Interim or final.
- In what form the dividend be paid? Cash dividend or Bonus

shares.
All these decisions are inter-related and have bearing on the future
growth plans of firm. If a firm pays dividend it affects the cash flow position
of the firm but earns the goodwill among investors who therefore may be
willing to provide additional funds for financing of investment plans of firm.
On the other hand, the profits which are not distributed as dividends
become an easily available source of funds at no explicit costs.
However, in case of ploughing back of profits ,the firm may loose the
goodwill and confidence of the investors and may also defy the standards set
by other firms. Therefore, in taking dividend decision, the financial manager
has to consider and analyse various factors. Every aspects of dividend
decision is to be critically evaluated. The most important of these
considerations is to decide as to what portion of profit should be distributed
which is also known as dividend payout ratio.
Dividend Decision and Valuation of Firms
The value of the firm can be maximized if the shareholders wealth is

maximized. There are conflicting views regarding the impact of dividend
decision on valuation of the firm. According to one school of thought,
dividend decision does not affect shareholders wealth and hence the
valuation of firm. On other hand, according to other school of thought
dividend decision materially affects the shareholders wealth and also
valuation of the firm. We have discussed below the views of two schools of
thought under two groups:
1. The Relevance Concept of Dividend a Theory of Relevance.
2. The Irrelevance Concept of Dividend or Theory of Irrelevance.
The Relevance Concept of Dividend
The advocates of this school of thought include Myron Gordon, James

Walter and Richardson. According to them dividends communicate
information to the investors about the firm’s profitability and hence
dividend decision becomes relevant. Those firms which pay higher dividends
will have greater value as compared to those which do not pay dividends or
have a lower dividend pay out ratio. It holds that dividend decisions affect
value of the firm.
We have examined below two theories representing this notion: (i)

Walter’s Approach and (ii) Gordon’s Approach.
(i) Walter’s Approach: Prof. Walter’s model is based on the

relationship between the firms (a) return on investment i.e. r and (b) the
cost of capital or required rate of return i.e. k.
According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of
return on its investment than the required rate of return, the firm should
retain the earnings. Such firms are termed as growth firm’s and the
optimum pay-out would be zero which would maximize value of shares.
In case of declining firms which do not have profitable investments

i.e. where r<k, the shareholder would stand to gain if the firm distributes it
earnings. For such firms, the optimum payout would be 100% and the firms
should distribute the entire earnings as dividend.
In case of normal firms where r =k the dividend policy will not affect
the market value of shares as the shareholders will get the same return from
the firm as expected by them. For such firms, there is no optimum dividend
payout and value of firm would not change with the change in dividend rate.
Assumptions of Walter’s model
(i) The firm has a very long life.
(ii) Earnings and dividends do not change while determining the value.
(iii) The Internal rate of return ( r ) and the cost of capital (k) of the
firm are constant.
(iv) The investments of the firm are financed through retained earnings
only and the firm does not use external sources of funds.
Walter’s formula for determining the value of share
Where P = Market price per share
D = Dividend per share
r = internal rate of return
E = earnings per share
ke = Cost of equity capital.
Criticism of Walter’s Model
Walter’s model has been crticised on account of various assumptions

made by Prof Walter in formulating his hypothesis.
(i) The basic assumption that investments are financed through

retained earnings only is seldom true in real world. Firms do raise
fund by external financing.
(ii) The internal rate of return i.e. r also does not remain
constant. As a matter of fact, with increased investment the rate
of return also changes.
(iii) The assumption that cost of capital (k) will remain constant
also does not hold good. As a firm’s risk pattern does not remain
constant, it is not proper to assume that (k) will always remain
constant.
(ii) Gordon’s Approach : Another theory which contends that dividends

are relevant is Gordon’s model. This model which opinions that dividend
policy of a firm affects its value is based on following assumptions:-
1. The firm is an all equity firm. No external financing is used

and investment programmes are financed exclusively by retained
earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus,

the growth rate, (g=br) is also constant.
5. ke >br
Gordon argues that the investors do have a preference for current

dividends and there is a direct relationship between the dividend policy and
the market value of share. He has built the model on basic premise that
investors are basically risk averse and they evaluate the future
dividend/capital gains as a risky and uncertain proposition. Investors are
certain of receiving incomes from dividend than from future capital gains.
The incremental risk associated with capital gains implies a higher required
rate of return for discounting the capital gains than for discounting the
current dividends. In other words, an investor values current dividends more
highly than an expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that

dividend policy is relevant, as investors prefer current dividends as against
the future uncertain capital gains. When investors are certain about their
returns they discount the firm’s earnings at lower rate and therefore placing
a higher value for share and that of firm. So, the investors require a higher
rate of return as retention rate increases and this would adversely affect
share price.
Symbolically: -
where P = Market price of equity share
E = Earnings per share of firm.
b = Retention Ratio (1 – payout ratio)
r = Rate of Return on Investment of the firm.
Ke = Cost of equity share capital.
br = g i.e. growth rate of firm.
The Irrelevance Concept of Dividend
The other school of thought on dividend policy and valuation of the

firm argues that what a firm pays as dividends to share holders is irrelevant
and the shareholders are indifferent about receiving current dividend in
future. The advocates of this school of thought argue that dividend policy
has no effect on market price of share. Two theories have been discussed
here to focus on irrelevance of dividend policy for valuation of the firm
which are as follows:
1. Residual’s Theory of Dividend
According to this theory, dividend decision has no effect on the wealth

of shareholders or the prices of the shares and hence it is irrelevant so far as
valuation of firm is concerned. This theory regards dividend decision merely
as a part of financing decision because earnings available may be retained in
the business for re-investment. But if the funds are not required in the
business they may be distributed as dividends. Thus, the decision to pay
dividend or retain the earnings may be taken as residual decision. This
theory assumes that investors do not differentiate between dividends and
retentions by firm. Their basic desire is to earn higher return on their
investment. In case the firm has profitable opportunities giving higher rate
of return than cost of retained earnings, the investors would be content
with the firm retaining the earnings to finance the same. However, if the
firm is not in a position to find profitable investment opportunities, the
investors would prefer to receive the earnings in the form of dividends.
Thus, a firm should retain earnings if it has profitable investment
opportunities otherwise it should pay them as dividends.
Under the Residuals theory, the firm would treat the dividend decision in
three steps:
o Determining the level of capital expenditures which is determined by

the investment opportunities.
o Using the optimal financing mix, find out the amount of equity
financing need to support the capital expenditure in step (i) above
o As the cost of retained earnings kr is less than the cost of new equity
capital, the retained earnings would be used to meet the equity
portions financing in step (ii) above. If available profits are more than
this need, then the surplus may be distributed as dividends of
shareholder. As far as the required equity financing is in excess of the
amount of profits available, no dividends would be paid to the
shareholders.
Hence, in residual theory the dividend policy is influenced by (i) the

company’s investment opportunities and (ii) the availability of internally
generated funds, where dividends are paid only after all acceptable
investment proposals have been financed. The dividend policy is totally
passive in nature and has no direct influence on the market price of the
share.
2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive

manner in support of theory of irrelevance. They maintain that dividend
policy has no effect on market prices of shares and the value of firm is
determined by earning capacity of the firm or its investment policy. As
observed by M.M, “Under conditions of perfect capital markets, rational
investors, absence of tax discrimination between dividend income and
capital appreciation, given the firm’s investment policy, its dividend policy
may have no influence on the market price of shares”. Even, the splitting of
earnings between retentions and dividends does not affect value of firm.
Assumptions of MM Hypothesis
(1) There are perfect capital markets.

(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to effect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates
applicable to dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever

increase in value of the firm results from payment of dividend, will be
exactly off set by achieve in market price of shares because of external
financing and there will be no change in total wealth of the shareholders.
For example, if a company, having investment opportunities distributes all
its earnings among the shareholders, it will have to raise additional funds
from external sources. This will result in increase in number of shares or
payment of interest charges, resulting in fall in earnings per share in future.
Thus whatever a shareholder gains on account of dividend payment is
neutralized completely by the fall in the market price of shares due to
decline in expected future earnings per share. To be more specific, the
market price of share in beginning of period is equal to present value of
dividends paid at end of period plus the market price of shares at end of
period plus the market price of shares at end of the period. This can be put
in form of following formula:-
P0 = D 1 + P1
1 + Ke
where
PO = Market price per share at beginning of period.
D1 = Dividend to be received at end of period.
P1 = Market price per share at end of period.

Ke = Cost of equity capital.
The value of P1 can be derived by above equation as under.
The MM Hypothesis can be explained in another form also presuming

that investment required by the firm on account of payment of dividends is
financed out of the new issue of equity shares.
In such a case, the number of shares to be issued can be computed

with the help of the following equation:
Further, the value of the firm can be ascertained with the help of the
following formula:
where,
m = number of shares to be issued.
I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital.
n = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nPO = Value of the firm.

This equation shows that dividends have no effect on the value of the
firm when external financing is used. Given the firm’s investment decision,
the firm has two alternatives, it can retain its earnings to finance the
investments or it can distribute the earnings to the shareholders as
dividends and can arise an equal amount externally. If the second
alternative is preferred, it would involve arbitrage process. Arbitrage refers
to entering simultaneously into two transactions which exactly balance or
completely offset each other. Payment of dividends is associated with
raising funds through other means of financing. The effect of dividend
payment on shareholder’s wealth will be exactly offset by the effect of
raising additional share capital. When dividends are paid to the shareholder,
the market price of the shares will increase. But the issue of additional
block of shares will cause a decline in the terminal value of shares. The
market price before and after the payment of the dividend would be
identical. This theory thus signifies that investors are indifferent about
dividends and capital gains. Their principal aim is to earn higher on
investment. If a firm has investment opportunities at hand promising higher
rate of return than cost of capital, investor will be inclined more towards
retention. However, if the expected return is likely to be less than what it
would cost, they would be least interested in reinvestment of income.
Modigiliani and Miller are of the opinion that value of a firm is determined
by earning potentiality and investment policy and never by dividend
decision.
Criticism of MM Approach
MM Hypothesis has been criticized on account of various unrealistic

assumptions as given below.
1. Perfect capital markets does not exist in reality.
2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for

dividends and capital gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any
transaction.
7. Shareholders may prefer current income as compared to further
gains.
Lets Sum Up
· Dividend decision is an important decision, which a financial
manager has to take. It refers to that profits of a company which is
distributed by company among its shareholders.
· There has been a difference of opinion on the effect of
dividend policy on value of firm. Two schools of thought have
emerged on relationship between dividend policy and value of firm.
· On one hand Walter model and Gordon model consider dividend
as relevant for value of firm as investors prefer current dividend
over future dividend.
· On other hand Residuals Approach and MM Model consider
dividend is irrelevant for value of firm. The detention of profit for
re-investment is important. MM Model have introduced arbitrage
process to prove that value of firm remain same whether firm pays
dividend or not.
· Different models market price can be ascertained as :
Walter’s Model =
Gordon Model =
MM Model =
QUESTIONS
1 Explain the Modigliani-Miller hypothesis of dividend irrelevance. Does

this dividend irrelevance. Does this hypothesis suffer from deficiencies?
2 How far do you agree that dividends are irrelevant?
3 In Walter’s Approach, the dividend policy of firm depends on availability
of investment opportunity and relationship between firm’s internal rate
of return and its cost of capital. Discuss what are shortcomings of this
view?
DIVIDEND POLICY : DETERMINANTS AND CONSTRAINS
DIVIDEND POLICY: DETERMINANTS AND CONSTRAINTS
Smriti Chawla
University of Delhi
CHAPTER OBJECTIVES
 Determinants of Dividend Policy

 Types of Dividend Policy
 Forms of Dividend Policy
q Cash Dividend
q Scrip or Bond Dividend
q Property Dividend
q Stock Dividend
 Lintner Model
 Bonus Shares
 Shares Repurchase
 Clientele Effect
 Lets Sum Up
 Questions
Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial

considerations. It is difficult to determine a general dividend policy which
can be followed by different firms at different times because dividend
decision has to be taken considering the special circumstances of an
individual case. The following are important factors which determine
dividend policy of a firm:
1. Legal Restrictions: Legal Provisions relating to dividends as laid down in section,

205, 205A, 206 and 207 of companies Act, 1956 are significant because they lay down a
framework within which dividend policy is formulated. These provisions require that dividend
can be paid only out of current profit or past profits after providing for depreciation. The
companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than
10% dividend to transfer certain percentage of current year’s profit to Reserves.
When Dividend Proposed Amount to be transferred to

Reserves most not be less than
Exceeds 10% but not 12.5% of 2.5% of current year profit
paid up capital
Exceeds 12.5% but not 15% of 5% of current year profit
paid up capital
Exceeds 15% but not 20% of paid 7.5% of current year profits
up capital
Exceeds 20% of paid up capital 10% of current year profits.
Companies Act, further provides that dividend cannot be paid out of

capital, because it will amount to reduction of capital adversely affecting
the security of creditors.
2. Desire and Type of Shareholders: Although, legally, the direction

as to whether to declare dividend or not has been left with BOD, the
directors should give importance to desires of shareholders in declaration of
dividends as they are representatives of shareholders. Investors such as
retired persons, widows, and other economically weaker persons view
dividends as source of funds to meet their day-to-day living expenses. To
benefit such investors, the companies should pay regular dividends. On
other hand, a wealthy investor in a high income tax bracket may not benefit
by high current dividend incomes. Such an investor may be interested in
lower current dividend and high capital gains.
3. Nature of Industry: Nature of Industry to which company is

engaged also considerably affects dividend policy. Certain industries have
comparatively steady and stable demand irrespective of prevailing economic
conditions. For example, people used to drink liquor both in boom as well as
in recession. Such firms expect regular earnings and hence follow consistent
dividend policy. On the other hand, if earnings are uncertain, as in the case
of luxury goods conservative policy should be followed. Such firms should
retain a substantial part of their current earnings during boom period in
order to provide funds to pay adequate dividends in the recession periods.
Thus, industries with steady demand of their products can follow a higher
dividend payout ratio while cyclical industries should follow a lower payout
ratio.
4. Age of Company: It also influences dividend decision of company. A
nearly established concern has to limit payment of dividend and retain
substantial part of earnings for financing its future growth while older
companies which have established sufficient reserves can afford to pay
liberal dividends.
5. Future Financial Requirements: If a company has highly profitable

investment opportunities it can convince the shareholders of need for
limitation of dividend to increase future earnings and stabilise its financial
position. But when profitable investment appointments do not exist then
company may not be justified in retaining substantial part of its current
earnings. Thus, a concern having few internal investment opportunities
should follow high payout ratio as compared to one having more profitable
investment opportunities.
6. Liquid Resources: The dividend policy of a firm is also influenced

by availability of liquid resources. Although, a firm may have sufficient
available profit to declare dividends, yet it may not be desirable to pay
dividend if it does not have sufficient liquid resources. Hence liquidity
position of company is an important consideration in paying dividends. If
company does not have liquid resources, it is better to declare stock
dividend i.e. issue of bonus shares to existing shareholders.
7. Requirements of Institutional Investors: Dividend policy of a

company can be affected by requirements of institutional investors such as
financial institutions, banks, insurance corporations etc. These investors
usually favour a policy of regular payment of cash dividends and stipulate
there own terms with regard to payment of dividend on equity shares.
8. Stability of Dividends: Stability of dividend refers to payment of

dividend regularly and shareholders generally, prefer payment of such
regular dividends. Some companies follow a policy of constant dividend per
share while others follow a policy of constant payout ratio and while there
are some other who follow a policy of constant low dividend per share plus
an extra dividend in years of high profits. A policy of constant dividend per
share is most suitable to concerns whose earnings are expected to remain
stable over a number of years or those who have built up sufficient reserves
to pay dividends in years of low profits. The policy of constant payout ratio
i.e. paying a fixed percentage of net earnings every year may be supported
by firm because it is related to firms ability to pay dividends. The policy of
constant low dividend per share plus some extra dividend in years of high
profits is suitable to firms having fluctuating earnings from year to year.
9. Magnitude and Trend of Earnings: The amount and trend of

earnings is an important aspect of dividend policy. It is rather the starting
point of the dividend policy. As dividends can be paid only out of present or
past’s years profits, earnings of a company fix the upper limits on dividends.
The dividends should nearly be paid out of current years earnings only as
retained earnings of the previous years become more or less a part of
permanent investment in the business to earn current profits. The past
trend of the company’s earnings should also be kept in consideration while
making dividend decision.
10. Control objectives: When a company pays high dividends out of

its earnings, it may result in dilution of both control and earnings for
existing shareholders. As in case of high dividend pay out ratio the retained
earnings are insignificant and company will have to issue new shares to raise
funds to finance its future requirements. The control of the existing
shareholders will be diluted if they cannot buy additional shares issued by
the company. Similarly issue of new shares shall cause increase in number of
equity shares and ultimately cause a lower earnings per share and their
price in the market. Thus under these circumstances to maintain control of
the existing shareholders, it may be desirable to declare lower dividends
and retain earnings to finance the firm’s future requirements.
Types of Dividend Policy
The various types of dividend policies are discussed as follows:
(a) Regular Dividend Policy: Payment of dividend at usual rate is termed

as regular Dividend. The investors such as retired persons, widows, and
other economically weaker persons prefer to get regular dividends. A
regular dividend offer following Advantages.
 It establishes profitable record of company.
 It creates confidence among shareholder.
 It stabilises market value of shares
 It aids in long term financing and renders financing easier.
 The ordinary shareholders view dividends as a source of founds to
meet their day-to-day living expenses.
Regular dividend can be maintained only by companies of long standing
and stable earnings.
(b) Stable Dividend Policy: The term ‘Stability of Dividend’ means

consistency or lack of variability in stream of dividend payments. A stable
dividend policy may be established in any of following three forms.
(i) Constant Dividend Per Share: Some companies follow a policy of

paying fixed dividend per share irrespective of level of earnings year after
year. Such firms usually create a ‘Reserve for Dividend Equalisation’ to
enable them pay fixed dividend even in year when earnings are not
sufficient or when there are losses. A policy of constant dividend per share
is most suitable to concerns whose earnings are expected to remain stable
over number of years.
(ii) Constant Pay out ratio: It means payment of fixed percentage
of net earnings as dividends every year. The amount of dividend in such a
policy fluctuates in direct proportion to earnings of company. The policy of
constant pay out is preferred by the firms because it is related to their
ability to pay dividends.
(iii) Stable rupee Dividend plus extra dividend: Some companies
follow a policy of paying constant low dividend per share plus an extra
dividend in the years of high profit. Such a policy is most suitable to the
firm having fluctuating earnings from year to year.
Advantages of Stable Dividend Policy: A Stable dividend policy is
advantageous to both investors and company on account of the following:
(a) It is sign of continued normal operations of company.
(b) It stabilises market value of shares.
(c) It creates confidence among investors.
(d) It improves credit standing and making financing easier.
(e) It meets requirements of institutional investors who prefer

companies with stable dividends.
Dangers of Stable dividend policy
Inspite of many advantages, the stable dividend policy suffers from

certain limitations. Once a stable dividend policy is followed by a company,
it is not easier to change it. If stable dividends are not paid to shareholders
on any account including insufficient profits, the financial standing of
company in minds of investors is damaged and they may like to dispose of
their holdings. It adversely affects the market price of shares of the
company. And if companies pays stable dividends inspite of its incapacity it
will be suicidal in long run.
( c) Irregular Dividend Policy: Some companies follow irregular dividend

payments on account of following:
(a) Uncertainty of Business.
(b) Unsuccessful Business operations
(c) Lack of liquid resources.
(d) Fear of adverse effects of regular dividend on financial standing of

company.
(d) No Dividend Policy: A company may follow a policy of paying no

dividends presently because of its unfavourable working capital position or
on account of requirements of funds for future expansion and growth.
Forms of Dividend
Dividends can be classified in various forms. Dividend paid in ordinary

course of business are known as Profit Dividends, while dividends paid out
of capital are known as Liquidation dividends. Dividend may also be
classified on the basis of medium in which they are paid:
(a) Cash Dividend: A cash dividend is a usual method of paying

dividends. Payment of dividend in cash results in outflow of funds and
reduces the company’s net worth, though the shareholder get an
opportunity to invest the cash in any manner they desire. This is why
ordinary shareholders prefer to receive dividends in cash. But the
firm must have adequate liquid resources at its disposal or provide for
such resources so that its liquidity position is not adversely affected
on account of cash dividends.
(b) Scrip or Bond Dividend: A scrip dividend promises to pay
shareholders at future specific date. In case a company does not have
sufficient funds to pay dividends in cash, it may issue notes or bonds
for amounts due to shareholders. The objective of scrip dividend is to
postpone the immediate payment of cash. A scrip dividend bears
interest and is accepted as a collateral security.
(c) Property Dividend: Property dividends are paid in the form of
some assets other than cash. They are distributed under exceptional
circumstances and are not popular in India.
(d) Stock Dividend: Stock Dividend means the issue of bonus shares to
the existing shareholders. If a company does not have liquid resources
it is better to declare stock dividend. Stock dividend amounts to
capitalisation of earnings and distribution of profits among existing
shareholders without affecting the cash position of the firm.
Linter Model: Lintner Model supports the view on stability of dividend.

Some of proposition of Lintner model are:
(i) Firms follow a long – term target payout ratio.
(ii) Firms are more particular and careful for dividend changes than
absolute dividend amount.
(iii) Change in dividend follows change in earnings.
According to Linter Model, firms have a target payout ratio and change in
dividend would occur in such a way so as to move towards this ratio. The
dividend change depends upon adjustment factor. The more conservative
the firm is, the more slowly it would move towards its target and lower
would be adjustment rate. The model says that the dividends for a year
depends partly on earnings for that year and partly on dividend for previous
year which in turn depends on dividends for year before. In case of increase
in earnings per share the companies increase the dividends per share
gradually which helps in avoiding reduction in dividends if there is a
decrease in earnings. The Lintner model can be presented as follows:
Dt = EPSt x SA x DP Ratio + (1-SA) Dt-1
Dt – Dividend for current year
EPSt – EDS for current year.

SA – Speed of Adjustment
DP Ratio – Target pay out ratio
Dt-1 = Dividend for previous year.
Bonus Shares
Bonus shares are the shares issued by a company free of costs by

capitalisation of its profits and reserves. The issue of bonus shares results in
increase in number of shares and hence increases the paid up capital of
company without involving any monetary transaction. Such shares are issued
to all existing equity shareholders in proportion of their holding of share
capital of company. Since, the number of shares increases as a result of
bonus shares, the book value and earnings per share of company will
decrease.
The mechanism of bonus share is simple. The firm first issues

additional shares by passing a resolution and then distribute these shares
among existing shareholder in proportion to their holding. The bonus shares
do not alter the proportional ownership of firm as far as existing
shareholders are concerned. As the bonus issue does not effect the cash
flows or the operational efficiencies of the firm, there should not be any
change in total value of firm. The market price per share would decrease
but shareholder are no worse off after the bonus, notwithstanding such
decrease because they receive compensatory increase in number of shares
held.
Reasons for issue of Bonus Shares
Companies have a common tendency to issue bonus shares to their

shareholders. Many companies have issued bonus shares once a while,
whereas some other companies have issued bonus shares on regular basis.
Companies such as Bajaj Auto Ltd., Hindustan Level Ltd. have issued bonus
shares on regular basis. Companies prefer issue of bonus shares as against
payment of cash dividend for several reasons as follows:
1. When a company issues bonus shares, it utilises a part of profit

of company and also rewards the shareholders but without affecting
liquidity of company.
2. Since, bonus shares is capital receipt, it is not taxable in hands
of issuing company as well as shareholders.
3. Issue of bonus shares increases the goodwill of company in
capital market and build confidence among investors and helps raising
additional funds in future.
4. Bonus issue helps a company to streamline its capital structure
and bring its paid-up capital in line with capital employed in business.
5. It makes available capital to carry on a larger and more
profitable business.
6. It enables a company to make use of its profits on a permanent
basis and increases creditworthiness of the company.
7. The balance sheet of the company will reveal a more realistic
picture of the capital structure and capacity of the company.
8. The investors can easily sell these shares and get immediate
cash, if they so desire.
9. The bonus shares are a permanent source of income to the
investors.
Disadvantages of Issue of Bonus Shares
1. The issue of bonus shares leads to drastic fall in the future rate of
dividend as it is only the capital that increases and not the actual
resources of the company. The earnings do not usually increase with the
issue of bonus shares.
2. The fall in the future rate of dividend results in the fall of the market
price of shares considerably, this may cause unhappiness among the
shareholders.
3. The reserves of the company after the bonus issue decline and leave
lesser security to investors.
The Securities and Exchange Board of India has issued the guidelines for
issue of bonus shares in year 2000. The guidelines for issue of bonus shares
can be summarized as follows:
1. These guidelines are applicable to existing listed companies who shall

forward a certificate duly signed by the issuer and duly counter signed
by its statutory auditor or by company secretary in practice to the
effect that the terms and conditions for issue of bonus shares as laid
down in these guidelines have been complied with.
2. The bonus shares is made out of free reserves built out of genuine
profits or share premium collected in cash.
3. Reserves created by revaluation of fixed asset are not capitalized.
4. The declaration of bonus issue in lieu of dividend is not made.
5. The bonus issue is not made unless the partly paid shares if any
existing are made fully paid up.
6. A company which announces its bonus issue after the approval of the
board of directors must implement the proposals within the period of
six months from the date of such approval and shall not have the
option of changing the decision.
7. There should be provision in the Articles of Association of the company
for capitalisation of reserves etc., and if not the company shall pass
resolution at its general body meeting making provisions in the Articles
of Association for capitalization.
8. Consequent to issue of bonus shares if the subscribed and paid up
capital exceed the Authorised share capital a resolution shall be
passed by the company at its general body meeting for increasing
authorized capital.
Shares Repurchase
The shares repurchase or buy back of shares is a situation when company

uses its accumulated profits to cancel or retire a part of its outstanding
shares by purchasing from the market or directly from the shareholders. This
is particularly relevant when the shares are available in the market at price
below the book value. When shares are repurchased for cancellation the
underlying motive is to distribute excess cash among the shareholders. The
cancellation of shares means that the present shareholders will receive cash
for their shares. The rationale for repurchase is that as long as the earnings
remain constant, the repurchase of shares reduces the number of shares
outstanding and thus raising the earning per share and market price of
share. The company may have different methods of shares repurchase.
There are three widely used approaches to shares repurchase as follows:
1. Repurchase Tender Offer: In a repurchase tender offer, a firm

specifies a price at which it will buy back the shares the number of shares it
intends to repurchase and period of time for which it will keep the offer
open and invites the shareholders to submit their shares for the repurchase.
The firm may also retain the flexibility to withdraw the offer if insufficient
number of share re submitted for repurchase.
2. Open Market Repurchase: In case of open market repurchase the firm

buys the shares in the market at the prevailing market price. The open
market repurchase can be spread out over longer time periods than tender
offers. In terms of flexibility the open market repurchase provide the firm
more freedom in deciding when to repurchase and how many shares to be
repurchased.
3. Negotiated Repurchase: In this case, the firm may buy shares from
large shareholder at a negotiated price. This form of repurchase can be
adopted only when large shareholder generally one of the promoter groups
is willing to sell the shares.
Clientele Effect
The shareholders do have preference for cash dividends. However

there are companies like Microsoft which did not pay dividends for number
of years and still the shareholders seemed perfectly content with the policy.
There are some investors who prefer high pay out and there are some
shareholders which prefer low payout. Given the diversity of investors and
that of dividend policies match their preferences. This is known as clientele
effect.
The clientele effect refers to tendency of investors to buy shares in

companies that have dividend policies that meet their preferences for
dividend payout. The clientele effect states that different groups of
investors desire different levels of dividend.
Lets Sum Up
§ A firm should consider all the determinants in deciding the dividend policy
for the firm. It is probably difficult for financial manager to reach definite
conclusion, nevertheless, he is left with no choice. A firm must develop a
dividend policy which is based on the best available information.
§ Firms have variety of options available to them when it comes to distribution
of profits to the shareholders. They can pay out the profits as dividends,
either regular or special, repurchase the share or issue the bonus shares.
§ There are two basic dimensions of a dividend policy. These are Dividend
payout ratio and Stability of dividends.
§ DP Ratio refers to the portion of profit to be distributed among the

shareholders. The DP Ratio of the firm should be decided in view of the
liquidity of the firm, funds required for reinvestment etc. A higher DP Ratio
or lower DP Ratio may have different consequences.
§ Stability of dividends refers to consistency in dividend payment. There may

be different types of dividend policies such as constant DP Ratio, Steady
dividend per share, steady dividend plus extra etc.
§ In case the investment opportunities of the firm increase, the dividend

payout ratio should decrease.
§ Issue of bonus shares is another way of distribution of profit among the

shareholders. SEBI has announced guidelines for the issue of bonus shares by
companies in India.
QUESTIONS
1. Explain the various factors which influence the dividend. decision of

firm?
2. What do you understand by a stable dividend policy? Why should it be
followed?
3. Write short notes on (a) Dividend payout ratio (b) Lintner Model?
4. Difference between Stock dividend and Cash dividend?

DIVIDEND POLICY IN PRACTICE
DIVIDEND POLICY IN PRACTICE
The main consideration in determining the dividend policy is the

objective of maximization of wealth of shareholders. Thus, a firm should
retain earnings if it has profitable opportunities, giving a higher rate of
return than cost of retained earnings, otherwise it should pay them as
dividends. It implies that a firm should treat retained earnings as the active
decision variable, and dividends as the passive residual.
In actual practice, however, we find that most firms determine the

amount of dividends first, as an active decision variable, and the residue
constitutes the retained earnings. In fact, there is no choice with the
companies between paying dividends and not paying dividends. Most of the
companies believe that by following a stable dividend policy with a high pay
out ratio, they can maximize the market value of shares. Moreover, the
image of such companies also improved on the market and the investors also
favour such companies. The firms following this policy, can thus successfully
approach the market for raising additional funds for future expansion and
growth, as and when required. It has therefore, been rightly said that
theoretically retained earnings should be treated as the active decision
variable and dividends as passive residual but practice does not conform to
this in most cases.
Illustration 1: ABC Ltd. belongs to a risk class for which the
appropriate capitalization rate is 10%. It currently has outstanding 5,000
shares selling at Rs.100 each. The firm is contemplating the declaration of
dividend of Rs.6 per share at the end of the current financial year. The
company expects to have net income of Rs.50,000 and has a proposal for
making new investments of Rs.1,00,000. Show that under the MM
hypothesis, the payment of dividend does not affect the value of the firm.
Solution:
A. Value of the firm when dividends are paid:
(i) Price of the share at the end of the current financial year.
P1 = P0 (1 + Ke) – D1
= 100 (1 + 10) – 6
= 100 x 1.10 – 6
= 110 – 6 = Rs.104
B. Value of the firm when dividends are not paid:
(i) Price per share at the end of the current financial year
P1 = P0 (1 + ke) – D1
= 100 (1+.10)-0
= 100´1.10
= Rs. 110
Hence, whether dividends are paid or not, the value of the firm remains the
same Rs. 5,00,000.
Illustration 2: Expandent Ltd. had 50,000 equity shares of Rs. 10 each
outstanding on January 1. The shares are currently being quoted at par the
market. In the wake of the removal of dividend restraint, the company now
intends to pay a dividend of Rs. 2 per share for the current calendar year. It
belongs to a risk-class whose appropriate capitalization rate is 15%. Using
MM model and assuming no taxes, ascertain the price of the company's share
as it is likely to prevail at the end of the year (i) when dividend is declared,
and (ii) when no dividend is declared. Also find out the number of new
equity shares that the company must issue to meet its investment needs of
Rs. 2 lakhs, assuming a net income of Rs. 1.1 lakhs and also assuming that
the dividend is paid
Solution:
(i) Price as per share when dividends are paid
P1 = P0 (1+ke) – D1
= 10 (1+.15)-2
= 11.5-2
= Rs. 9.5.
(ii) Price per share when dividends are not paid:
P1 = P0 (1+ke)-D1
= 10 (1+. 15)-0
= Rs. 11.5
Illustration 3: The following information is available in respect of a firm:

Capitalisation rate = 10%
Earnings per share = Rs. 50
Assumed rate of return on investments:
(i) 12%
(ii) 8%
(iii) 10%
Show the effect of dividend policy on market price of shares applying
Walter's formula when dividend pay out ratio is (a) 0% (b) 20%, (c) 40%, (d)
80%, and (e) 100%
Solution :
Conclusion: From the above analysis we can draw the conclusion that when,
(i) r >k, the company should retain the profits, i.e., when
r=12%. ke=10%;
(ii) r is 8%, i.e., r<k, the pay-out should be high; and
(iii) r is 10%; i.e., r=k; the dividend pay-out does not affect the
price of the share.
Illustration 4: The earnings per share of company are Rs. 8 and the
rate of capitalisation applicable to the company is 10%. The company has
before it an option of adopting a payout ratio of 25% or 50% or 75%. Using
Walter's formula of dividend payout, compute the market value of the
company's share if the productivity of retained earnings is (i) 15% (ii) 10%
and (iii) 5%
Solution:
Illustration 5: The earnings per share of a share of the face value of
Rs.100 to PQR Ltd. is Rs.20. It has a rate of return of 25%. Capitalisation
rate of its risk class is 12.5%. If Walter's model is used:
a) What should be the optimum payout ratio?

b) What should be the market price per share if the payout ratio is zero?
c) Suppose, the company has a payout of 25% of EPS, what would be the
price per share?
Illustration 6: Determine the market value of equity shares of the
company from the following information:
Earnings of the company Rs.5,00,000
Dividend paid 3,00,000
Number of shares outstanding 1,00,000
Price-earning ratio 8
Rate of return on investment 15%
Illustration 7: The earnings per share (EPS) of a company is Rs.10. It
has an internal rate of return of 15% and the capitalization rate of its risk
class is 12.5%. If Walter's Model is used –
(i) What should be the optimum payout ratio of the company?
(ii) What would be the price of the share at this payout?
(iii) How shall the price of the share be affected, if a different payout
were employed?
Illustration 8 : From the following information supplied to you,
ascertain whether the firm is following an optimal dividend policy as per
Walter's model?
Total Earnings Rs.2,00,000

Number of equity shares (of Rs.100 each) 20,000
Dividend paid 1,50,000
Price/Earning ratio 12.5
The firm is expected to maintain its rate of return on fresh
investment. Also find out what should be the P/E ratio at which the
dividend policy will have no effect on the value of the share?
Illustration 9: A company has total investment of Rs.5,00,000 assets
and 50,000 outstanding equity shares of Rs.10 each. It earns a rate of 15%
on its investments, and has a policy of retaining 50% of the earnings. If the
appropriate discount rate for the firm is 10%, determine the price of its
share using Gordon Model. What shall happen to the price, if the company
has a payout of 80% or 20%.
Illustration 10: Assuming that rate of return expected by investor is
11%; internal rate of return is 12%; and earnings per share is Rs.15, calculate
price per share by 'Gordon Approach' method if dividend payout ratio is 10%
and 30%.
Illustration 11: Textrol Ltd. has 80,000 shares outstanding. The
current market price of these shares is Rs.15 each. The company expect a
net profit of Rs.2,40,000 during the year and it belongs to a risk-class for
which the appropriate capitalisation rate has been estimated to be 20%.
The Company is considering dividend of Rs.2 per share for the current year.
a) What will be the price of the share at the end of the year (i) if the
dividend is paid and (ii) if the dividend is not paid?
(b) How many new shares must the Co. issue if the dividend is paid and
the Co. needs Rs.5,60,000 for an approved investment expenditure
during the year? Use MM model for the calculation.
Unit-5
Contains five chapters...
1. WORKING CAPITAL MANAGEMENT AND FINANCE
2. WORKING CAPITAL: ESTIMATION AND CALCULATION
3. MANAGEMENT OF CASH
4. RECEIVABLES MANAGEMENT
5. INVENTORY MANAGEMENT
WORKING CAPITAL MANAGEMENT AND FINANCE
UNIT 5
WORKING CAPITAL: MANAGEMENT AND FINANCE
Smriti Chawla
University of Delhi
Delhi
CHAPTER OBJECTIVES
 Meaning and Concept of Working Capital

 Classification or Kinds of Working Capital
 Importance or Advantages of Adequate Working Capital
 Excess or Inadequate Working Capital
 Need or Objects of Working Capital
 Factors determining Working Capital Requirements
 Management of Working Capital Principles
 Determining Working Capital Financing Mix
 Lets Sum Up
 Questions
Meaning of Working Capital
Capital required for a business can be classified under two main categories
viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and to
carry out its day-to-day operations. Long-term funds are required to create
production facilities through purchase of fixed assets such as plant and
machinery, land, Building etc. Investments in these assets represent that
part of firm’s capital which is blocked on permanent basis and is called fixed
capital. Funds are also needed for short-term purposes for purchase of raw
materials, payment of wages and other day-to-day expenses etc. These
funds are known as working capital which is also known as Revolving or
circulating capital or short term capital. According to Shubin, “Working
capital is amount of funds necessary to cover the cost of operating the
enterprise”.
Concept of Working Capital

There are two concepts of working capital:
(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current assets of

the enterprise. Examples of current assets are : cash in hand and bank
balances, Bills Receivable, Short term loans and advances, prepaid
expenses, Accrued Incomes etc. The gross working capital is financial or
going concern concept. Net working capital is excess of Current Assets over
Current liabilities.
Net Working Capital = Current Assets – Current Liabilities
When current assets exceed the current liabilities the working capital is
positive and negative working capital results when current liabilities are
more than current assets. Examples of current liabilities are Bills Payable,
Sunday debtors, accrued expenses, Bank Overdraft, Provision for taxation
etc. Net working capital is an accounting concept of working capital.
Classification or Kinds of Working Capital
Working capital may be classified in two ways:
(a) On the basis of concept
(b) On the basis of time
On the basis of concept working capital is classified as gross working capital

and net working capital. On the basis of time working capital may be
classifies as Permanent or fixed working capital and Temporary or variable
working capital.
Permanent or Fixed working capital
It is the minimum amount which is required to ensure effective

utilisation of fixed facilities and for maintaining the circulation of current
assets. There is always a minimum level of current assets which its
continuously required by enterprise to carry out its normal business
operations. As the business grows, the requirements of permanent working
capital also increase due to increase in current assets. The permanent
working capital can further be classified as regular working capital and
reserve working capital required to ensure circulation of current assets from
cash to inventories, from inventories to receivables and from receivables to
cash and so on. Reserve working capital is the excess mount over the
requirement for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, rise in
prices, depression etc.
Temporary or Variable working capital
It is the amount of working capital which is required to meet the

seasonal demands and some special exigencies. Variable working capital is
further classified as seasonal working capital and special working capital.
The capital required to meet seasonal needs of the enterprise is called
seasonal working capital. Special working capital is that part of working
capital which is required to meet special exigencies such as launching of
extensive marketing campaigns for conducting research etc.
Importance or Advantages of Adequate Working Capital : Working

capital is the life blood and nerve centre of a business. Hence, it is very
essential to maintain smooth running of a business. No business can run
successfully without an adequate amount of working capital. The main
advantages of maintaining adequate amount of working capital are as
follows:
1. Solvency of the Business: Adequate working capital helps in

maintaining solvency of business by providing uninterrupted flow of
production.
2. Goodwill: Sufficient working capital enables a business concern to
make prompt payments and hence helps in creating and maintaining
goodwill.
3. Easy Loans: A concern having adequate working capital, high
solvency and good credit standing can arrange loans from banks and
others on easy and favourable terms.
4. Cash Discounts: Adequate working capital also enables a concern
to avail cash discounts on purchases and hence it reduces cost.
5. Regular Supply of Raw Material: Sufficient working capital
ensure regular supply of raw materials and continuous production.
6. Regular payment of salaries, wages and other day to day
commitments: A company which has ample working capital can make
regular payment of salaries, wages and other day to day commitments
which raises morale of its employees, increases their efficiency,
reduces costs and wastages.
7. Ability to face crisis: Adequate working capital enables a
concern to face business crisis in emergencies such as depression.
8. Quick and regular return on investments: Every investor wants a
quick and regular return on his investments. Sufficiency of working
capital enables a concern to pay quick and regular dividends to is
investor as there may not be much pressure to plough back profits
which gains the confidence of investors and creates a favourable market
to raise additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns
with adequate working capital can exploit favourable market conditions
such as purchasing its requirements in bulk when the prices are lower
and by holding its inventories for higher prices.
10. High Morale: Adequacy of working capital creates an environment
of security, confidence, high morale and creates overall efficiency in a
business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its
business operations. It should have neither excess working capital nor
inadequate working capital. Both excess as well as short working capital
positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for
business and hence business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary
purchasing and accumulation of inventories causing more chances of
theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may also
fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and
other financial institutions may not be maintained.
Disadvantages of Inadequate working capital

1. A concern which has inadequate working capital cannot pay its short-
term liabilities in time. Thus, it will lose its reputation and shall not
be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions
and undertake profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working
capital.
5. The firm cannot pay day-to-day expenses of its operations and it
created inefficiencies, increases costs and reduces the profits of
business.
The Need or Objects or Working Capital
The need for working capital arises due to time gap between production
and realisation of cash from sales. There is an operating cycle involved in
sales and realisation of cash. There are time gaps in purchase of raw
materials and production, production and sales, and sales and realisation of
cash. Thus, working capital is needed for following purposes.
1. For purchase of raw materials, components and spares.

2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel, power
etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores and
spares and finished stock.
Greater size of business unit large will be requirements of working

capital. The amount of working capital needed goes on increasing with
growth and expansion of business till it attains maturity. At maturity the
amount of working capital needed is called normal working capital.
Factors Determing the Working Capital Requirements
The following are important factors which influence working capital

requirements:
1. Nature or Character of Business: The working capital
requirements of firm depend upon nature of its business. Public
utility undertakings like electricity, water supply need very limited
working capital because they offer cash sales only and supply
services, not products, and such no funds are tied up in inventories
and receivables whereas trading and financial firms require less
investment in fixed assets but have to invest large amounts in
current assets and as such they need large amount of working
capital. Manufacturing undertaking require sizeable working capital
between these two.
2. Size of Business/Scale of Operations: Greater the size of a
business unit, larger will be requirement of working capital and
vice-versa.
3. Production Policy: The requirements of working capital
depend upon production policy. If the policy is to keep production
steady by accumulating inventories it will require higher working
capital. The production could be kept either steady by accumulating
inventories during slack periods with view to meet high demand
during peak season or production could be curtailed during slack
season and increased during peak season.
4. Manufacturing process / Length of Production cycle:
Longer the process period of manufacture, larger is the amount of
working capital required. The longer the manufacturing time, the
raw materials and other supplies have to be carried for longer
period in the process with progressive increment of labour and
service costs before finished product is finally obtained. Therefore,
if there are alternative processes of production, the process with
the shortest production period should be chosen.
5. Credit Policy: A concern that purchases its requirements on
credit and sell its products/services on cash requires lesser amount
of working capital. On other hand a concern buying its requirements
for cash and allowing credit to its customers, shall need larger
amount of working capital as very huge amount of funds are bound
to be tied up in debtors or bills receivables.
6. Business Cycles: In period of boom i.e. when business is
prosperous, there is need for larger amount of working capital due
to increase in sales, rise in prices etc. On contrary in times of
depression the business contracts, sales decline, difficulties are
faced in collections from debtors and firms may have large amount
of working capital lying idle.
7. Rate of Growth of Business: The working capital
requirements of a concern increase with growth and expansion of its
business activities. In fast growing concerns large amount of working
capital is required whereas in normal rate of expansion in the
volume of business the firm may have retained profits to provide for
more working capital.
8. Earning Capacity and Dividend Policy. The firms with high
earning capacity generate cash profits from operations and
contribute to working capital. The dividend policy of concern also
influences the requirements of its working capital. A firm that
maintains a steady high rate of cash dividend irrespective of its
generation of profits need more working capital than firm that
retains larger part of its profits and does not pay so high rate of
cash dividend.
9. Price Level Changes: Changes in price level affect the
working capital requirements. Generally, the rising prices will
require the firm to maintain large amount of working capital as
more funds will be required to maintain the same current assets.
The effect of rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the
working capital cycle starts with the purchase of raw material and
ends with realisation of cash from the sale of finished products. This
cycle involves purchase of raw materials and stores, its conversion
into stocks of finished goods through work in progress with
progressive increment of labour and service costs, conversion of
finished stock into sales, debtors and receivables and ultimately
realisation of cash and this cycle again from cash to purchase of raw
material and so on. The speed with which the working capital
completes one cycle determines the requirements of working capital
longer the period of cycle larger is requirement of working capital.
Managemant of Working Capital
Working capital refers to excess of current assets over current liabilities.

Management of working capital therefore is concerned with the problems
that arise in attempting to manage current assets, current liabilities and
inter relationship that exists between them. The basic goal of working
capital management is to manage the current assets and current of a firm in
such a way that satisfactory level of working capital is maintained i.e. it is
neither inadequate nor excessive. This is so because both inadequate as well
as excessive working capital positions are bad for any business. Inadequacy
of working capital may lead the firm to insolvency and excessive working
capital implies idle funds which earns no profits for the business. Working
capital Management policies of a firm have a great effect on its
profitability, liquidity and structural health of organization. In this context,
evolving capital management is three dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard to

profitability, risk and liquidity.
2. Dimension II is concerned with decisions about composition and level
of current assets.
3. Dimension III is concerned with decisions about composition and level
of current liabilities.
Principles of Working Capital Management
Principles of Working Capital Management

Principle of Risk Principle of Principle of
Principle of
Variation Cost of Capital Equity position

Maturity of
Payment
1. Principle of Risk Variation: Risk refers to inability of firm to meet

its obligation as and when they become due for payment. Larger investment
in current assets with less dependence on short-term borrowings increases
liquidity, reduces risk and thereby decreases opportunity for gain or loss. On
other hand less investment in current assets with greater dependence on
short-term borrowings increases risk, reduces liquidity and increases
profitability.
There is definite direct relationship between degree of risk and profitability.

A conservative management prefers to minimize risk by maintaining higher
level of current assets while liberal management assumes greater risk by
reducing working capital. However, the goal of management should be to
establish suitable trade off between profitability and risk. The various
working capital policies indicating relationship between current assets and
sales are depicted below:-
2. Principle of Cost of Capital: The various sources of raising working

capital finance have different cost of capital and degree of risk involved.
Generally, higher the risk lower is cost and lower the risk higher is the cost.
A sound working capital management should always try to achieve proper
balance between these two.
3. Principle of Equity Position: This principle is concerned with

planning the total investment in current assets. According to this principle,
the amount of working capital invested in each component should be
adequately justified by firm’s equity position. Every rupee invested in
current assets should contribute to the net worth of firm. The level of
current assets may be measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.

4. Principle of Maturity of Payment: This principle is concerned with
planning the sources of finance for working capital. According to this
principle, a firm should make every effort to relate maturities of payment to
its flow of internally generated funds. Generally, shorter the maturity
schedule of current liabilities in relation to expected cash inflows, the
greater inability to meet its obligations in time.
(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two
off-selling transactions of a simultaneous but opposite nature which
counterbalance effect of each other. With reference to financing mix, the
term hedging refers to ‘process of matching of maturities of debt with
maturities of financial needs’. According to this approach the maturity of
sources of funds should match the nature of assets to be financed. This
approach is also known as ‘matching approach’ which classifies the
requirements of total working capital into permanent and temporary
working capital.
The hedging approach suggests that permanent working capital

requirements should be financed with funds from long-term sources while
temporary working capital requirements should be financed with short-term
funds.
(2) The Conservative Approach: This approach suggests that the entire
estimated investments in current assets should be financed from long-term
sources and short-term sources should be used only for emergency
requirements. The distinct features of this approach are:
(ii) Liquidity is greater
(iii) Risk is minimised
(iv) The cost of financing is relatively more as interest has

to be paid even on seasonal requirements for entire period.
Trade off Between the Hedging and Conservative Approaches
The hedging approach implies low cost, high profit and high risk while the
conservative approach leads to high cost, low profits and low risk. Both the
approaches are the two extremes and neither of them serves the purpose of
efficient working capital management. A trade off between the two will
then be an acceptable approach. The level of trade off may differ from case
to case depending upon the perception of risk by the persons involved in
financial decision making. However, one way of determining the trade off is
by finding the average of maximum and the minimum requirements of
current assets. The average requirements so calculated may be financed out
of long-term funds and excess over the average from short-term funds.
(3). Aggressive Approach: The aggressive approach suggests that entire

estimated requirements of current asset should be financed from short-term
sources even a part of fixed assets investments be financed from short-term
sources. This approach makes the finance – mix more risky, less costly and
more profitable.
Hedging Vs Conservative Approach

Hedging Approach Conservative Approach
1. The cost of financing is 1. The cost of financing is
reduced. higher
2. The investment in net 2. Large Investment is blocked
working capital is nil. in temporary working
capital.
3. Frequent efforts are 3. The firm does not face
required to arrange funds. frequent financing problems.
4. The risk is increased as firm 4. It is less risky and firm is

is vulnerable to sudden able to absorb shocks.
shocks.
Lets Sum Up
 The term working capital may be used to denote either the gross
working capital which refers to total current assets or net working
capital which refers to excess of current asset over current liabilities.
 The working capital requirement for a firm depends upon several
factors such as Nature or Character of Business, Credit Policy, Price
level changes, business cycles, manufacturing process, production
policy.
 The working capital need of the firm may be bifurcated into
permanent and temporary working capital.
 The Hedging Approach says that permanent requirement should be
financed by long term sources while the temporary requirement
should be financed by short-term sources of finance. The Conservative
approach on the other hand says that the working capital requirement
be financed from long-term sources. The Aggressive approach says
that even a part of permanent requirement may be financed out of
short-term funds.
 Every firm must monitor the working capital position and for this
purpose certain accounting ratios may be calculated.
QUESTIONS
1. Explain various factors influencing working capital?

2. What are the advantages of adequate working capital?
3. Discuss various approaches to determine an appropriate financing mix
of working capital?
WORKING CAPITAL: ESTIMATION AND CALCULATION
WORKING CAPITAL: ESTIMATION AND CALCULATION
Smriti Chawla
Shri Ram College of

Commerce
University of Delhi
Delhi
CHAPTER OBJECTIVES
q Estimate of Working Capital Requirements
(a) Working Capital as % of net sales
(b) Working Capital as % of total assets

or fixed assets
(c) Working capital based on operating
Cycle
q Illustrations
Estimate of Working Capital Requirements
“ Working Capital is the life blood and controlling nerve centre of a

business.” No business can be successfully run without an adequate
amount of working capital. To avoid the shortage of working capital at
once, an estimate of working capital requirements should be made in
advance so that arrangements can be made to procure adequate working
capital. But estimation of working capital requirements is not an easy
task and large numbers of factors have to be considered before starting
this exercise. There are different approaches available to estimate the
working capital requirements of a firm which are as follows:
(1) Working Capital as a Percentage of Net Sales: This approach
to estimate the working capital requirement is based on the fact that the
working capital for any firm is directly related to the sales volume of that
firm. So, the working capital requirement is expressed as a percentage of
expected sales for a particular period. This approach is based on the
assumption that higher the sales level, the greater would be the need for
working capital. There are three steps involved in the estimation of working
capital.
a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a
% of net sales.
(2) Working Capital as a Percentage of Total Assets or Fixed
Asset: This approach of estimation of working capital requirement is based
on the fact that the total assets of the firm are consisting of fixed assets
and current assets. On the basis of past experience, a relationship between
(i) total current assets i.e., gross working capital; or net working capital i.e.
Current assets – Current liabilities; and (ii) total fixed assets or total assets
of the firm is established. The estimation of working capital therefore,
depends upon the estimation of fixed capital which depends upon the
capital budgeting decisions.
Both the above approaches to the estimation of working capital
requirement are simple in approach but difficult in calculation.
(3) Working Capital based on Operating Cycle: In this approach,
the working capital estimate depends upon the operating cycle of the firm.
A detailed analysis is made for each component of working capital and
estimation is made for each of these components. The different components
of working capital may be enumerable as follows:
Current Assets Current
Liabilities
Cash and Bank Balance Creditors for
Purchases
Inventory of Raw Material Creditors for
Expenses
Inventory of Work-in-Progress
Inventory of Finished Goods
For manufacturing organisation, the following factors have to be taken into consideration while
making an estimate of working capital requirements.
Factors Requiring Consideration While Estimating Working

Capital
1. Total costs incurred on material, wages and overheads
2. The length of time for which raw material are to remain in stores
before they are issued for production.
3. The length of production cycle or work in process i.e. the time taken
for conversion of raw material into finished goods.
4. The length of sales cycle during which finished goods are to be kept
waiting for sales.
5. The average period of credit allowed to customers.
6. The amount of cash required to pay day to day expenses of the
business.
7. The average amount of cash required to make advance payments, if
any.
8. The average credit period expected to be allowed by suppliers.
9. Time lag in the payment of wages and other expenses.
From the total amount blocked in current assets estimated on the

basis of the first seven items given above, the total of the current liabilities
i.e. the last two item, is deducted to find out the requirements of working
capital. In case of purely trading concern, points 1,2,3 would not arise but
all other factors from points 4 to 9 are to be taken into consideration. In
order to provide for contingencies, some extras amount generally calculated
as a fixed percentage of the working capital may be added as margin of
safety.
Suggested Proforma for estimation of working capital requirements
under operating cycle is given below:
Estimation of Working Capital Requirements

I. Current Assets: Amount Amount Amount
Minimum Cash Balance ****
Inventories:
Raw Materials ****
Work-in-Progress ****
Finished Goods **** ****
Receivables
Debtors ****
Bills **** ****
Gross Working Capital (CA) **** ****
II. Current Liabilities : Amount Amount

Creditors for purchases ****
Creditors for Wages ****
Creditors for Overheads ****
Total Current Liabilities (CL) **** ****
Excess of CA over CL ****
+ Safety Margin ****
Net Working Capital ****
Illustration 1: XYZ Ltd. has obtained the following data concerning

the average working capital cycle for other companies in the same industry :
Raw material stock turnover 20 Days
Credit received 40 Days
Work-in-Progress Turnover 15 Days
Finished goods stock turnover 40 Days
Debtors' collection period 60 Days
95 Days
Using the following data, calculate the current working capital cycle for XYZ
Ltd. And briefly comment on it.
(Rs. in '000)
Sales 3,000
Cost of Production 2,100
Purchase 600
Average raw material stock 80
Average work-in-progress 85
Average finished goods stock 180
Average creditors 90
Average debtors 350
Solution: Operating cycle of XYZ Ltd.

1. Raw material
= 49 Days
2. Work-in-progress
= 15 Days
3. Finished Goods
= 31 Days
4. Debtors
= 43 Days
5. Creditors
= 55 Days
Net Operating Cycle = 49 days + 15 days + 31 days + 43 days – 55
days
= 138 Days – 55 Days = 83 Days
Comment : For XYZ Ltd., the working capital cycle is below the
industry average, including a lower investment in net current assets.
However, the following points should be noted about the individual
elements of working capital.
a) The stock of raw materials is considerably higher than average. So
there is a need for stock control procedure to be reviewed.
b) The value of creditors is also above average; this indicates that XYZ
Ltd. is delaying the payment of creditors beyond the credit period.
Although this is an additional source of finance, it may result in a higher
cost of raw materials or loss of goodwill among the suppliers.
c) The finished goods stock is below average. This may be due to a high
demand for the firm's goods or to efficient stock control. A low finished
goods stock can, however, reduce sales since it can cause delivery
delays.
d) Debts are collected more quickly than average. The company might
have employed good credit control procedure or offer cash discounts for
early payments.
Illustration 2: From the following data, compute the duration of operating cycle for each of
the two years and comment on the increase/decrease:
Year 1 Year 2
Stock:
Raw materials 20,000 27,000
Work-in-progress 14,000 18,000
Finished goods 21,000 24,000
Purchases 96,000 1,35,000
Cost of goods sold 1,40,000 1,80,000
Sales 1,60,000 2,00,000
Debtors 32,000 50,000
Creditors 16,000 18,000
Assume 350 Days per year for computational purposes
Solution:
a) Calculation of Operating Cycle
Year 1 Year 2
1. Raw Material Stock 20/96 x 360 = 75 Days27/135 x 360 = 72 Days
(Average Raw Material/Total Purchase x 360)
2. Creditors period 16/96 x 360 = 60 days 18/135 x 360 = 48 days
(Average Creditor/Total Purchase) x 360
3. Work-in-progress 14/140 x 360 = 36 18/180 x 360 = 36 days
days
(Average Work-in-progress/Total cost of goods sold) x 360
4. Finished goods 21/140 x 360 = 54 24/180 x 360 = 48 days
days
(Average Finished goods/Total cost of goods sold) x 360
5. Debtors 32/160 x 360 = 72 50/200 x 360 = 90 days
days
(Average Debtors/Total Sales) x 360
Net operating cycle 177 days 198 days
This is an increase in length of operating cycle by 21 days i.e., 12% increase

approximately. Reasons for increase are as follows:
Debtors taking longer time to pay (90-72)
18 days
Creditors receiving payment earlier (60-48)
12 days
30 days
-- Finished goods turnover lowered (54-48)
6 days
--Raw material stock turnover lowered (75-
72) 3 days
Increase in Operating Cycle
21 days
Illustration 3: A proforma cost sheet of a company provides the
following particulars:
Elements of Cost
Material
40%
Direct
Labour 20%
Overheads
20%
The following further particulars are available:
(a) It is proposed to maintain a level of activity of 2,00,000 units.
(b) Selling price is Rs.12/- per unit.
(c) Raw materials are expected to remain in stores for an average period
of one month.
(d) Materials will be in process, on averages half a month.
(e) Finished goods are required to be in stock for an average period of one
month.
(f) Credit allowed to debtors is two months.
(g) Creditor allowed by suppliers is one month.
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital
requirements, a forecast Profit and Loss Account and Balance Sheet of the
company assuming that:
Rs.
Share Capital
15,00,000
8% Debentures
2,00,000
Fixed Assets
13,00,000
Solution:
Statement of Working Capital
Current Assets: Rs. Rs.
Stock of Raw Materials (1 month)
80,000
Work in progress (1/2 month):

40,000
Materials
20,000
Labour
20,000 80,000
Overheads
Stock of Finished Goods (1 month)
80,000
Materials
40,000
Labour
40,000
Overheads
1,60,000
Debtors (2 months)
at cost
Material 1,60,000
Labour 80,000
Overheads 80,000 3,20,000
6,40,000
Less: Current Liabilities:
Creditors (1 month) for raw materials
80,000
Net Working Capital Required: 5,60,000
(Note: Sales = 2,00,000 X 12 = Rs.24,00,000)
Forecast Profit and Loss Account

For the year ended….
Rs. Rs.
To Materials 9,60,000By Cost of good old 19,20,000
To Wages 4,80,000
To Overheads 4,80,000
19,20,000 19,20,000
To Cost of goods sold 19,20,000By Sales 24,00,000
To Gross profit c/d 4,80,000
24,00,000 24,00,000
To Interest on Debentures 16,000By Gross Profit b/d 4,80,000
To Net Profit 4,64,000
4,80,000 4,80,000
Forecast Balance Sheet

as at……
Liabilities Rs.Assets Rs.
Share Capital 15,00,000Fixed Assets 13,00,000
8% Debentures 2,00,000Stocks:
Net Profit 4,64,000Raw Materials 80,000
Creditors 80,000Work-in-Progress 80,000
Finished Goods 1,60,000
Debtors 4,00,000
Cash & Bank Balance
(Balancing figure) 2,24,000
22,44,000 22,44,000
Working Notes:
(a) Profits have been ignored while preparing working capital
requirements for the following reasons:
(i) Profits may or may not be used for working capital.
(ii) Even if profits have to be used for working capital, they have to
be reduced by the amount of income tax, dividends, etc.
(b) Interest on debentures has been assumed to have been paid.

Illustration 4: A proforma cost sheet of a company provides the following
particulars:
Elements of Cost Amount per

unit
Rs.
Raw Material 80
Direct Labour 30
Overheads 60
Total Cost 170
Profit 30
Selling Price 200
The following further particulars are available:
Raw materials are in stock on an average for one month. Materials
are in process on an average for half a month. Finished goods are in stock on
an average for one month. Credit allowed by suppliers is one month. Credit
allowed to customers is two months. Lag in payment of wages is 1½ weeks.
Lag in payment of overhead expenses is one month. One-fourth of the
output is sold against cash. Cash in hand and at bank is expected to be
Rs.25,000.
You are required to prepare a statement showing the working

capital needed to finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the

year, wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
Solution:
Statement Showing the Working Capital Needed

Current Assets Rs.
Minimum cash balance 25,000
(i) Stock of raw materials (4 weeks)
1,60,000 x 4 6,40,000
Rs.
(ii) Work-in-Process (2 weeks):
Raw materials 1,60,000 x 2 3,20,000
Direct Labour 60,000 x 2 1,20,000
Overheads 1,20,000 x 2 2,40,000 6,80,000
(iii) Stock of Finished goods (4 weeks):
Raw Materials 1,60,000 x 4 6,40,000
Direct Labour 60,000 x 4 2,40,000
Overheads 1,20,000 x 4 4,80,000 13,60,000
(iv) Sundry Debtors (8 weeks):
Raw materials 1,60,000 x 3/4 x 8 9,60,000
Direct Labour 60,000 x 3/4 x 8 3,60,000
Overheads 1,20,000 x 3/4 x 8 7,20,000 20,40,000
47,45,000
Less Current Liabilities:
(i) Sundry Creditors (4 weeks)
1,60,000 x 4 6,40,000
(ii) Wages outstanding (1-1/2 weeks): 60,000 90,000
x
(iii) Lag in payment of overheads (4 weeks)
1,20,000 x 4 4,80,000 12,10,000
Net Working Capital Needed 35,35,000
Working Notes:
(i) It has been assumed that a time period of 4 weeks is equivalent to
one month.
(ii) It has been assumed that direct labour and overheads are in
process, on average, half a month.
(iii) Profit has been ignored and debtors have been taken at cost.
(iv) Weekly calculations have been made as follows:
(a) Weekly average of raw materials = 1,04,000 x 80/52 = 1,60,000
(b) Weekly labour cost = 1,04,000 x 30/52 = 60,000
(c) Weekly Overheads = 1,04,000 x 60/52 = 1,20,000
Illustration 5: From the following information you are required to estimate
the net working capital:
Cost per unit

Rs.
Raw Materials 400
Direct labour 150
Overheads (excluding depreciation) 300
Total Cost 850
Additional Information: 30
Selling-Price Rs.1,000 per unit
Output 52,000 units per
annum
Raw Material in stock average 4 weeks
Work-in-process:
(assume 50% completion stage with
full material consumption) average 2 weeks
Finished goods in stock average 4 weeks
Credit allowed by suppliers average 4 weeks
Credit allowed to debtors average 8 weeks
Cash at bank is expected to be Rs.50,000
Assume that production is sustained at an even pace during the 52 weeks of

the year. All sales are on credit basis. State any other assumption that you
might have made while computing.
Solution :
Statement Showing Net Working Capital Requirements

Current Assets : Rs.
Minimum cash balance 50,000
Stock of Raw Materials (4 weeks)
52,000 x 400 x (4/52) 16,00,000
Stock of work-in-progress (2 weeks)
8,00,000
Raw material 52,000 x 400 x

Direct labour (50% completion)
1,50,000
52,000 x 150 x
Overheads (50% completion)
3,00,000 12,50,000
52,000 x 300 x
Stock of Finished goods (4 weeks)
34,00,000
52,000 x 850 x
Amount blocked in Debtors at cost (8
weeks)
68,00,000
52,000 x 850 x
Total Current Assets 1,31,00,000
Less: Current Liabilities:
Creditors for raw materials (4 weeks)
16,00,000
52,00,000 x 400 x
Net Working Capital Required 1,15,00,000
Illustration 6: Texas Manufacturing Company Ltd. is to start
production on 1st January, 1995. The prime cost of a unit is expected to be
Rs.40 out of which Rs.16 is for materials and Rs.24 for labour. In addition,
variable expenses per unit are expected to be Rs.8 and fixed expenses per
month Rs.30,000. Payment for materials is to be made in the month
following the purchases. One-third of sales will be for cash and the rest on
credit for settlement in the following month. Expenses are payable in the
month in which they are incurred. The selling price is fixed at Rs.80 per
unit. The number of units manufactured and sold are expected to be as
under:
January
900
February
1,200
March
1,800
April
2,100
May
2,100
June
2,400
Draw up a statement showing requirements of working capital from month
to month, ignoring the question of stocks.
Solution:
Statement Showing Requirement of Working Capital
January February March Rs. April Rs. May Rs. June Rs.
Rs. Rs.
Payments:
Materials - 14,400 19,200 28,800 33,600 33,600
Wages 21,600 28,800 43,200 50,400 50,400 57,600
Fixed 30,000 30,000 30,000 30,000 30,000 30,000
Expenses
Variable 7,200 9,600 14,400 16,800 16,800 19,200
Expenses
58,800 82,800 1,06,800 1,26,000 1,30,800 1,40,400
Receipts:
Cash Sales 24,000 32,000 48,000 56,000 56,000 64,000
Debtors - 48,000 64,000 96,000 1,12,000 1,12,000
24,000 80,000 1,12,000 1,52,000 1,68,000 1,76,000
Working 34,800 2,800 - - - -
Capital
Required
Payments-
Receipts)
Surplus - - 5,200 26,000 37,200 35,600
Cumulative 34,800 37,600 32,400 6,400 - -
Requirement
s of Working
Capital
Surplus - - - - 30,800 66,400
Working
Capital
Working Notes:
(i) As payment for material is made in the month following the
purchase, there is no payment for material in January. In February,
material payment is calculated as 900 x 16 = Rs.14,400 and in the
same manner for other months.
(ii) Cash sales are calculated as:
For January 900 x 80 x 1/3 = Rs.24,000 and in the same manner for
other months.
(iii) Receipts from debtors are calculated as:
For Jan. – Nil because cash from debtors is collected in the month
following the sales.
For Feb. – 900 x 80 x 2/3 = Rs.48,000
For March – 12002 x 80 x 2/3 = Rs.64,000, and so on.
MANAGEMENT OF CASH
MANAGEMENT OF CASH
Smriti Chawla

University of Delhi
Delhi
CHAPTER OBJECTIVES
 Introduction
 Nature of Cash
 Motives for holding Cash
 Cash Management
 Managing Cash Flows
o Methods of accelerating Cash Inflows
o Methods of Slowing Cash Outflows
 Determining Optimum Cash Balance

 Baumol’s Model
 Miller-Orr Model
 Investment of Surplus Funds
 Illustrations
 Lets Sum Up
 Questions
Introduction
Cash is one of the current assets of a business. It is needed at all times

to keep the business going. A business concern should always keep sufficient
cash for meeting its obligations. Any shortage of cash will hamper the
operations of a concern and any excess of it will be unproductive. Cash is
the most unproductive of all the assets. While fixed asses like machinery,
plant, etc. and current assets such as inventory will help the business in
increasing its earning capacity, cash in hand will not add anything to the
concern. It is in this context that cash management has assumed much
importance.
Nature of Cash
For some persons, cash means only money in the form of currency
(cash in hand). For other persons, cash means both cash in hand and cash at
bank. Some even include near cash assets in it. They take marketable
securities too as part of cash. These are the securities which can easily be
converted into cash.
Cash itself does not produce good or services. It is used as a medium

to acquire other assets. It is the other assets which are used in
manufacturing goods or providing services. The idle cash can be deposited in
bank to earn interest.
A business has to keep required cash for meeting various needs. The
assets acquired by cash again help the business in producing cash. The goods
manufactured of services produced are sold to acquire cash. A firm will have
to maintain a critical level of cash. If at a time it does not have sufficient
cash with it, it will have to borrow from the market for reaching the
required level.
There remains a gap between cash inflows and cash outflows.

Sometimes cash receipts are more than the payments or it may be vice-
versa at another time. A financial manager tries to synchronize the cash
inflow and cash outflows.
Motives for Holding Cash

The firm’s needs for cash may be attributed to the following needs:
Transactions motive, Precautionary motive and Speculative motive. These
motives are discussed as follows:
1. Transaction Motive: A firm needs cash for making transacions in

the day-to-day operations. The cash is needed to make purchases, pay
expenses, taxes, dividend, etc. The cash needs arise due to the fact that
there is no complete synchronization between cash receipts and payments.
Sometimes cash receipts exceed cash payments or vice-versa. The
transaction needs of cash can be anticipated because the expected
payments in near future can be estimated. The receipts in future may also
be anticipated but the things do not happen as desired. If more cash is
needed for payments than receipts, it may be raised through bank
overdraft. On the other hand if there are more cash receipts than payments,
it may be spent on marketable securities.
2. Precautionary Motive: A firm is required to keep cash for meeting

various contingencies. Though cash inflows and cash outflows are
anticipated but there may be variations in these estimates. For example a
debtor who was to pay after 7 days may inform of his inability to pay; on the
other hand a supplier who used to give credit for 15 days may not have the
stock to supply or he may not be in a position to give credit at present. In
these situations cash receipts will be less then expected and cash payments
will be more as purchases may have to be made for cash instead of credit.
Such contingencies often arise in a business. A firm should keep some cash
for such contingencies or it should be in a position to raise finances at a
short period.
3. Speculative Motive: The speculative motive relates to holding of

cash for investing in profitable opportunities as and when they arise. Such
opportunities do not come in a regular manner. These opportunities cannot
be scientifically predicted but only conjectures can be made about their
occurrence. The price of shares and securities may be low at a time with an
expectation that these will go up shortly. Such opportunities can be availed
of if a firm has cash balance with it.
Cash Management
Cash management has assumed importance because it is the most

significant of all the current assets. It is required to meet business
obligations and it is unproductive when not used.
Cash management deals with the following:
(i) Cash inflows and outflows
(ii) Cash flows within the firm
(iii) Cash balances held by the firm at a point of time.
Cash Management needs strategies to deal with various facets of cash.

Following are some of its facets.
(a) Cash Planning: Cash planning is a technique to plan and control the
use of cash. A projected cash flow statement may be prepared, based on
the present business operations and anticipated future activities. The cash
inflows from various sources may be anticipated and cash outflows will
determine the possible uses of cash.
(b) Cash Forecasts and Budgeting: A cash budget is the most important
device for the control of receipts and payments of cash. A cash budget is an
estimate of cash receipts and disbursements during a future period of time.
It is an analysis of flow of cash in a business over a future, short or long
period of time. It is a forecast of expected cash intake and outlay.
The short-term forecasts can be made with the help of cash flow
projections. The finance manager will make estimates of likely receipts in
the near future and the expected disbursements in that period. Though it is
not possible to make exact forecasts even then estimates of cash flow will
enable the planners to make arrangement for cash needs. A financial
manager should keep in mind the sources from where he will meet short-
term needs. He should also plan for productive use of surplus cash for short
periods.
The long-term cash forecasts are also essential for proper cash
planning. These estimates may be for three, four, five or more years. Long-
term forecasts indicate company’s future financial needs for working
capital, capital projects, etc.
Both short term and long term cash forecasts may be made with help
of following methods.
(a) Receipts and Disbursements method
(b) Adjusted net income method
Receipts and Disbursements method

In this method the receipt and payment of cash are estimated. The
cash receipts may be from cash sales, collections from debtors, sale of fixed
assets, receipts of dividend or other income of all the items; it is difficult to
forecast the sales. The sales may be on cash as well as credit basis. Cash
sales will bring receipts at the time of sales while credit sale will bring cash
later on. The collections from debtors will depend upon the credit policy of
the firm. Any fluctuation in sales will disturb the receipts of cash. Payments
may be made for cash purchases, to creditors for goods, purchase of fixed
assets etc.
The receipts and disbursements are to be equalled over a short as well

as long periods. Any shortfall in receipts will have to be met from banks or
other sources. Similarly, surplus cash may be invested in risk free
marketable securities. It may be easy to make estimates for payments but
cash receipts may not be accurately made.
Adjusted Net Income Method
This method may also be known as sources and uses approach. It

generally has three sections: sources of cash, uses of cash and adjusted cash
balance. The adjusted net income method helps in projecting the company’s
need for cash at some future date and to see whether the company will be
able to generate sufficient cash. If not, then it will have to decide about
borrowing or issuing shares etc. in preparing its statement the items like net
income, depreciation, dividends, taxes etc. can easily be determined from
company’s annual operating budget. The estimation of working capital
movement becomes difficult because items like receivables and inventories
are influenced by factors such as fluctuations in raw material costs,
changing demand for company’s products. This method helps in keeping
control on working capital and anticipating financial requirements.
Managing Cash Flows
After estimating the cash flows, efforts should be made to adhere to

the estimates or receipts and payments of cash. Cash management will be
successful only if cash collections are accelerated and cash disbursements,
as far as possible, are delayed. The following methods of cash management
will help:
Methods of Accelerating Cash Inflows

1. Prompt Payment by Customers: In order to accelerate cash inflows,
the collections from customers should be prompt. This will be possible
by prompt billing. The customers should be promptly informed about
the amount payable and the time by which it should be paid. Another
method for prompting customers to pay earlier is to allow them cash
discount.
2. Quick Conversion of Payment into Cash: Cash inflows can be
accelerated by improving the cash collecting process. Once the
customer writes a cheque in favour of the concern the collection can
be quickened by its early collection. There is a time gap between the
cheque sent by the customer and the amount collected against it. This
is due to many factors, (i) mailing time, i.e. time taken by post office
for transferring cheque from customer to the firm, referred to as
postal float; (ii) time taken in processing the cheque within the
organization and sending it to bank for collection, it is called lethargy
and (iii) collection time within the bank, i.e. time taken by the bank
in collecting the payment from the customer’s bank, called bank
float. The postal float, lethargy and bank float are collectively
referred to as deposit float. The term deposit float refers to cheques
written buy customers but the amount not yet usable by the firm.
3. Decentralised Collections: A big firm operating over wide
geographical area can accelerate collections by using the system of
decentralised collections. A number of collecting centres are opened
in different areas instead of collecting receipts at one place. The idea
of opening different collecting centres is to reduce the mailing time
for customer’s dispatch of cheque and its receipt in the firm and then
reducing the time in collecting these cheques.
4. Lock Box System: Lock box system is another technique of reducing
mailing, processing and collecting time. Under this system the firm
selects some collecting centres at different places. The places are
selected on the basis of number of consumers and the remittances to
be received from a particular place.
Methods of Slowing Cash Outflows
A company can keep cash by effectively controlling disbursements.

The objective of controlling cash outflows is slow down the payments as far
as possible. Following methods can be used to delay disbursements:
1. Paying on Last Date: The disbursements can be delayed on making
payments on the last due date only. It is credit is for 10 days then payment
should be made on 10th day only. It can help in using the money for short
periods and the firm can make use of cash discount also.
2. Payments through Drafts: A company can delay payments by issuing

drafts to the suppliers instead of giving cheques. When a cheque is issued
then the company will have to keep a balance in its account so that the
cheque is paid whenever it comes. On the other hand a draft is payable only
on presentation to the issuer. The receiver will give the draft to its bank for
presenting it to the buyer’s bank. It takes a number of days before it is
actually paid. The company can economise large resources by using this
method.
3. Adjusting Payroll Funds: Some economy can be exercised on payroll

funds also. It can be done by reducing the frequency of payments. If the
payments are made weekly then this period can be extended to a month.
Secondly, finance manager can plan the issuing of salary cheques and their
disbursements. If the cheques are issued on Saturday then only a few
cheque may be presented for payment, even on Monday all cheques may not
be presented.
4. Centralisation of Payments: The payments should be centralised

and payments should be made through drafts or cheques. When cheques are
issued from the main office then it will take time for the cheques to be
cleared through post. The benefit of cheque collecting time is availed.
5. Inter-bank Transfer: An efficient use of cash is also possible by

inter-bank transfers. If the company has accounts with more than one bank
then amounts can be transferred to the bank where disbursements are to be
made. It will help in avoiding excess amount in one bank.
6. Making use of Float: Float is a difference between the balance

shown in company’s cash book (Bank column) and balance in passbook of the
bank. Whenever a cheque is issued, the balance at bank in cashbook is
reduced. The party to whom the cheque is issued may not present it for
payment immediately. If the party is at some other station then cheque will
come through post and it may take a number of days before it is presented.
Until the time; the cheques are not presented to bank for payment there
will be a balance in the bank. The company can make use of this float if it is
able to estimate it correctly.
Determining Optimum Cash Balance
A firm has to maintain a minimum amount of cash for settling the dues
in time. The cash is needed to purchase raw materials, pay creditors, day-
to-day expenses, dividend etc.
An appropriate amount of cash balance to be maintained should be

determined on the basis of past experience and future expectations. If a
firm maintains less cash balance then its liquidity position will be weak. If
higher cash balance is maintained then an opportunity to earn is lost. Thus,
a firm should maintain an optimum cash balance, neither a small nor a large
cash balance.
There are basically two approaches to determine an optimal cash

balance, namely, (i) Minimising Cost Models and (ii) Preparing Cash Budget.
Cash budget is the most important tool in cash management.
Cash Budget
A cash budget is an estimate of cash receipts and disbursements of

cash during a future period of time. In the words of soloman Ezra, a cash
budget is “an analysis of flow of cash in a business over a future, short or
long period of time. It is a forecast of expected cash intake and outlay.” It is
a device to plan and control the use of cash. Thus a firm by preparing a cash
budget can plan the use of excess cash and make arrangements for the
necessary cash as and when required.
The cash receipts from various sources are anticipated. The estimated
cash collections for sales, debts, bills receivable, interests, dividends and
other incomes and sale of investments and other assets will be taken into
account. The amounts to be spent on purchase of materials, payment to
creditors and meeting various other revenue and capital expenditure needs
should be considered. Cash forecasts will include all possible sources from
which cash will be received and the channels in which payments are to be
made so that a consolidated cash position is determined.
Baumol’s Model
William J. Baumol has suggested a model for determining the optimum

balance of cash based upon carrying and transaction costs of cash. The
carrying cost refers to the cost of the holding cash i.e. interest; and
transaction cost refers to the cost involved in getting the marketable
securities converted into cash, the algebraic representation of the model is:
where, C = Optimum cash balance
A = Annual (or monthly) cash disbursements)
F = Fixed cost per transaction
O = Opportunity cost of cash

Limitations of Model:
1. The model assumes a constant rate of use of cash. This is hypothetical

assumption. Generally the cash outflows in any firm are not regular
and hence this model may not give correct results.
2. The transaction cost will also be difficult to be measured since these
depend upon the type of investment as well as the maturity period.
Miller-Orr Model
The Miller–Orr model argues that changes in cash balance over a given
period are random in size as well as in direction. The cash balance of a firm
may fluctuate irregularly over a period of time. The model assumes (i) out
of the two assets i.e. cash and marketable securities, the latter has a
marginal yield, and (ii) transfer of cash to marketable securities and vice
versa is possible without any delay but of course of at some cost.
The model has specified two control limits for cash balance. An upper
limit, H, beyond which cash balance need not be allowed to go and a lower
limit, L, below which the cash level is not allowed to reduce. The cash
balance should be allowed to move within these limits. If the cash level
reaches the upper control limit, H, then at this point, apart of the cash
should be invested in marketable securities in such a way that the cash
balance comes down to a predetermined level called return level, R, If the
cash balance reaches the lower level, L then sufficient marketable securities
should be sold to realize cash so that cash balance is restored to the return
level, R. No transaction between cash and marketable securities is
undertaken so long as the cash balance is between the two limits of H and L.
The Miller–Orr model has superiority over the Baumol’s model. The latter
assumes constant need and constant rate of use of funds, the Miller-Orr
model, on the other hand is more realistic and maintains that the actual
cash balance may fluctuate between higher and the lower limits. The model
may be defined as:
Z = (3TV/4i)1/3
Where, T = Transaction cost of conversion
V = Variance of daily cash flows
i = Daily % interest rate on investments.
Investment of Surplus Funds
There are, sometimes surplus funds with the companies which are
required after sometime. These funds can be employed in liquid and risk
free securities to earn some income. There are number of avenues where
these funds can be invested. The selection of securities or method of
investment is very important. Some of these methods are discussed
herewith:
Treasury Bills : The treasury bills or T-Bills are the bills issued by the
Reserve Bank of India for different maturity periods. These bills are highly
safe investment an are easily marketable. These treasury bills usually have a
vary low level of yield and that too in the form of difference purchase price
and selling price as there is no interest payable on these bills.
Bank Deposits: All the commercial banks are offerings short term
deposits schemes at varying rate of interest depending upon the deposit
period. A firm having excess cash can make deposit for even short period of
few days only. These deposits provide full safety, facility of pre-mature
retirement and a comfortable return.
Inter-Corporate Deposits: A firm having excess cash can make deposit
with other firms also. When company makes a deposits with another
company, such deposit is known as inter corporate deposits. These deposits
are usually for a period of three months to one year. Higher rate of interest
is an important characteristic of these deposits.
Bill Discounting: A firm having excess cash can also discount the bills
of other firms in the same way as the commercial banks do. On the bill
maturity date, the firm will get the money. However, the bill discounting as
a marketable securities is subject to 2 constraints (i) the safety of this
investment depends upon the credit rating of the acceptor of the bill, and
(ii) usually the pre mature retirement of bills is not available.
Illustration 1: From the following forecast of income and expenditure,
prepare cash budget for the months January to April, 1995.
Months Sales Purchases Wages Manufac- Adminis Selling
ring trative Expenses

expenses expenses
1994
Nov 30,000 15,000 3,000
Dec 35,000 20,000 3,200
1995
1,150 1,060
Jan 25,000 15,000 2,500 500
Feb 30,000 20,000 3,000

1,225 1,040
March 35,000 22,500 2,400 550
April 40,000 25,000 2,600
990 1,100
600
1,050 1,150
620
1,100 1,220
570
1,200 1,180
710
Additional information is as follows: -
1. The customers are allowed a credit period of 2 months.

2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on 15 th January
for Rs. 5,000; a Building has been purchased on 1 st March and the
payments are to be made in monthly instalments of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on Ist January, 1995 is Rs. 15,000.
Solution:
Details January February March April
Receipts
Opening Balance of 15,000 18,985 28,795 30,975

cash
Cash realized from

debtors 30,000 35,000 25,000 30,000
Payments
Payments to
customers
15,000 20,000 15,000 20,000
Wages
Manufacturing
expenses
3200 2500 3000 2400
Administrative
expenses 1225 990 1050 1100
Selling expenses
Payment of 1040 1100 1150 1220

dividend
Purchase of plant
560 600 620 570
Instalment of
building plant ------ ------ ------ 10,000
Total Payments 5000 ----- ------ ------
Closing Balance ----- ---- 2,000 2,000
26,015 25,190 22,820 37,290
18,985 28,795 30,975 23,685
Illustration 2: ABC Co. wishes to arrange overdraft facilities with its

bankers during the period April to June, 1995 when it will be manufacturing
mostly for stock. Prepare a cash budget for the above period from the
following data, indicating the extent of the bank facilities the company will
require at the end of each month:
(a) 1995 Sales Purchases

Wages
Rs. Rs.
Rs.
February 1,80,000 1,24,800
12,000
March 1,92,00 1,44,000

14,000
April 1,08,000 2,43,000

11,000
May 1,74,000 2,46,000

10,000
June 1,26,000 2,68,000

15,000
(c) 50 per cent of credit sales are realised in the month following the
sales and remaining 50 per cent in the second month following.
Creditors are paid in the month following the month of purchase.
(d) Cash at bank on 1.4.1995 (estimated) Rs.25000
Solution:
Receipts April May June
Opening Balance 25,000 53000 (-) 51000
Sales 90,000 96,000 54000
Amount received from 96,000 54,000 87000

sales
Total Receipts
2,11,000 2,03,000 90000
Payments
Purchase
1,44,000 2,43,000 246000
Wages
14,000 11,000 10000
Total Payments
1,58,000 2,54,000 256000
Closing Balance (a-b) 53,000 (-)51,000 (-)1,66,000
Lets Sum Up
 Cash Management refers to management of ash and bank balance or in
a broader sense it is the management of cash inflows and outflows.
 Every firm must have minimum cash. There may be different motives
for holding cash. These may be Transactionary motive, Precautionary
motive or Speculative motive for holding cash.
 The objectives of cash management may be defined as meeting the
cash outflows and minimizing the cost of cash balance.
 Cash budget is the most important technique for planning the cash
movement. It is a summary of cash inflows and outflows during
particular period. In cash budget all expected receipts and payments
are noted to find out the cash shortage or surplus during that period.
 Optimum level of cash balance is the balance which firm should have
in order to minimize the cost of maintaining cash. Baumol’s model
gives optimum cash balance which aims at minimizing the total cost of
maintaining cash. The Miller – Orr model says that a firm should
maintain its cash balance within a range of lower and higher limit.
QUESTIONS
1 What are objectives of cash management?
2 Write short notes on:
(a) Lock box system
(b) Paying the Float
3 Explain the Baumol’s model of cash management?
4 Discuss the Miller – Orr model for determining the cash balance for the
firm?
5 “Cash budget is an appropriate technique of cash management” Explain.
What are the different methods of preparing the cash budget?
RECEIVABLES MANAGEMENT
RECEIVABLES MANAGEMENT
Smriti Chawla
University of Delhi
Delhi
CHAPTER OBJECTIVES
 Introduction
 Meaning of Receivables
 Costs of Maintaining Receivables
 Factors influencing the size of receivables
 Meaning and Objectives of Receivable Management
 Dimensions of Receivable Management
 Illustrations
 Lets Sum Up
 Questions
Introduction
A sound managerial control requires proper management of liquid

assets and inventory. These assets are a part of working capital of the
business. An efficient use of financial resources is necessary to avoid
financial distress. Receivables result from credit sales. A concern is required
to allow credit sales in order to expand its sales volume. It is not always
possible to sell goods on cash basis only. Sometimes, other concerns in that
line might have established a practice of selling goods on credit basis. Under
these circumstances, it is not possible to avoid credit sales without
adversely affecting sales. The increase in sales is also essential to increase
profitability. After a certain level of sales the increase in sales will not
proportionately increase production costs. The increase in sales will bring in
more profits.
Thus, receivables constitute a significant portion of current assets of

a firm. But, for investment in receivables, a firm has to incur certain costs.
Further, there is a risk of bad debts also. It is, therefore, very necessary to
have a proper control and management of receivables.
Meaning of Receivables
Receivables represent amounts owed to the firm as a result of sale

of goods or services in the ordinary course of business. These are claims of
the firm against its customers and form part of its current assets.
Receivables are also known as accounts receivables, trade receivables,
customer receivables or book debts. The receivables are carried for the
customers. The period of credit and extent of receivables depends upon the
credit policy followed by the firm. The purpose of maintaining or investing
in receivables is to meet competition, and to increase the sales and profits.
Costs of Maintaining Receivables
The allowing of credit to customers means giving funds for the

customer’s use. The concern incurs the following cost on maintaining
receivables:
(1) Cost of Financing Receivables: When goods and services are

provided on credit then concern’s capital is allowed to be used by the
customers. The receivables are financed from the funds supplied by
shareholders for long term financing and through retained earnings. The
concern incurs some cost for colleting funds which finance receivables.
(2) Cost of Collection: A proper collection of receivables is
essential for receivables management. The customers who do not pay the
money during a stipulated credit period are sent reminders for early
payments. Some persons may have to be sent for collection these amounts.
All these costs are known as collection costs which a concern is generally
required to incur.
(3) Bad Debts : Some customers may fail to pay the amounts due
towards them. The amounts which the customers fail to pay are known as
bad debts. Though a concern may be able to reduced bad debts through
efficient collection machinery but one cannot altogether rule out this cost.
Factors Influencing the Size of Receivables
Besides sales, a number of other factors also influence the size of

receivables. The following factors directly and indirectly affect the size of
receivables.
(1) Size of Credit Sales: The volume of credit sales is the first factor
which increases or decreases the size of receivables. If a concern sells only
on cash basis as in the case of Bata Shoe Company, then there will be no
receivables. The higher the part of credit sales out of total sales, figures of
receivables will also be more or vice versa.
(2) Credit Policies: A firm with conservative credit policy will have a
low size of receivables while a firm with liberal credit policy will be
increasing this figure. If collections are prompt then even if credit is
liberally extended the size of receivables will remain under control. In case
receivables remain outstanding for a longer period, there is always a
possibility of bad debts.
(3) Terms of Trade: The size of receivables also depends upon the
terms of trade. The period of credit allowed and rates of discount given are
linked with receivables. If credit period allowed is more then receivables
will also be more. Sometimes trade policies of competitors have to be
followed otherwise it becomes difficult to expand the sales.
(4) Expansion Plans: When a concern wants to expand its activities, it

will have to enter new markets. To attract customers, it will give incentives
in the form of credit facilities. The period of credit can be reduced when
the firm is able to get permanent customers. In the early stages of
expansion more credit becomes essential and size of receivables will be
more.
(5) Relation with Profits: The credit policy is followed with a view to
increase sales. When sales increase beyond a certain level the additional
costs incurred are less than the increase in revenues. It will be beneficial to
increase sales beyond the point because it will bring more profits. The
increase in profits will be followed by an increase in the size of receivables
or vice-versa.
(6) Credit Collection Efforts: The collection of credit should be

streamlined. The customers should be sent periodical reminders if they fail
to pay in time. On the other hand, if adequate attention is not paid towards
credit collection then the concern can land itself in a serious financial
problem. An efficient credit collection machinery will reduce the size of
receivables.
(7) Habits of Customers: The paying habits of customers also have

bearing on the size of receivables. The customers may be in the habit of
delaying payments even though they are financially sound. The concern
should remain in touch with such customers and should make them realise
the urgency of their needs.
Meaning and Objectives of Receivables Management
Receivables management is the process of making decisions relating to

investment in trade debtors. We have already stated that certain
investment in receivables is necessary to increase the sales and the profits
of a firm. But at the same time investment in this asset involves cost
considerations also. Further, there is always a risk of bad debts too. Thus,
the objective of receivables management is to take a sound decision as
regards investment in debtors. In the words of Bolton, S.E., the objectives
of receivables management is “to promote sales and profits until that point
is reached where the return on investment in further funding of receivables
is less than the cost of funds raised to finance that additional credit.”
Dimensions of Receivables Management
Receivables management involves the careful consideration of the following

aspects:
1. Forming of credit policy.

2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt a

credit policy. A credit policy is related to decisions such as credit standards,
length of credit period, cash discount and discount period, etc.
(a) Quality of Trade Accounts of Credit Standards: The volume of

sales will be influenced by the credit policy of a concern. By liberalising
credit policy the volume of sales can be increased resulting into increased
profits. The increased volume of sales is associated with certain risks too. It
will result in enhanced costs and risks of bad debts and delayed receipts.
The increase in number of customers will increase the clerical wok of
maintaining the additional accounts and collecting of information about the
credit worthiness of customers. There may be more bad debt losses due to
extension of credit to less worthy customers. These customers may also take
more time than normally allowed in making the payments resulting into
tying up of additional capital in receivables. On the other hand, extending
credit to only credit worthy customers will save costs like bad debt losses,
collection costs, investigation costs, etc. The restriction of credit to such
customers only will certainly reduce sales volume, thus resulting in reduced
profits.
A finance manager has to match the increased revenue with

additional costs. The credit should be liberalised only to the level where
incremental revenue matches the additional costs. The quality of trade
accounts should be decided so that credit facilities are extended only upto
that level. The optimum level of investment in receivables should be where
there is a trade off between the costs and profitability. On the other hand,
a tight credit policy increases the liquidity of the firm. On the other hand, a
tight credit policy increases the liquidity of the firm. Thus, optimum level
of investment in receivables is achieved at a point where there is a trade off
between cost, profitability and liquidity as depicted below:
(b) Length of Credit Period: Credit terms or length of credit period
means the period allowed to the customers for making the payment. The
customers paying well in time may also be allowed certain cash discount. A
concern fixes its own terms of credit depending upon its customers and the
volume of sales. The competitive pressure from other firms compels to
follow similar credit terms, otherwise customers may feel inclined to
purchase from a firm which allows more days for paying credit purchases.
Sometimes more credit time is allowed to increase sales to existing
customers and also to attract new customers. The length of credit period
and quantum of discount allowed determine the magnitude of investment in
receivables.
(c) Cash Discount: Cash discount is allowed to expedite the collection

of receivables. The concern will be able to use the additional funds received
from expedited collections due to cash discount. The discount allowed
involves cost. The discount should be allowed only if its cost is less than the
earnings from additional funds. If the funds cannot be profitably employed
then discount should not be allowed.
(d) Discount Period: The collection of receivables is influenced by the

period allowed for availing the discount. The additional period allowed for
this facility may prompt some more customers to avail discount and make
payments. This will mean additional funds released from receivables which
may be alternatively used. At the same time the extending of discount
period will result in late collection of funds because those who were getting
discount and making payments as per earlier schedule will also delay their
payments.
2. Executing Credit Policy
After formulating the credit policy, its proper execution is very

important. The evaluation of credit applications and finding out the credit
worthiness of customers should be undertaken.
(a) Collecting Credit information: The first step in implementing

credit policy will be to gather credit information about the customers. This
information should be adequate enough so that proper analysis about the
financial position of the customers is possible. This type of investigation can
be undertaken only upto a certain limit because it will involve cost.
The sources from which credit information will be available should be

ascertained. The information may be available from financial statements,
credit rating agencies, reports from banks, firm’s records etc. Financial
reports of the customer for a number of years will be helpful in determining
the financial position and profitability position. The balance sheet will help
in finding out the short term and long term position of the concern. The
income statements will show the profitability position of concern. The
liquidity position and current assets movement will help in finding out the
current financial position. A proper analysis of financial statements will be
helpful in determining the credit worthiness of customers. There are credit
rating agencies which can supply information about various concerns. These
agencies regularly collect information about business units from various
sources and keep this information upto date. The information is kept in
confidence and may be used when required.
Credit information may be available with banks too. The banks have
their credit departments to analyse the financial position of a customer.
In case of old customers, business own records may help to know their
credit worthiness. The frequency of payments, cash discounts availed,
interest paid on over due payments etc. may help to form an opinion about
the quality of credit.
(b) Credit Analysis: After gathering the required information, the

finance manager should analyse it to find out the credit worthiness of
potential customers and also to see whether they satisfy the standards of
the concern or not. The credit analysis will determine the degree of risk
associated with the account, the capacity of the customer borrow and his
ability and willingness to pay.
(c) Credit Decision: After analysing the credit worthiness of the

customer, the finance manager has to take a decision whether the credit is
to be extended and if yes then upto what level. He will match the
creditworthiness of the customer with the credit standards of the company.
If customer’s creditworthiness is above the credit standards then there is no
problem in taking a decision. It is only in the marginal case that such
decisions are difficult to be made. In such cases the benefit of extending the
credit should be compared to the likely bad debt losses and then decision
should be taken. In case the customers are below the company credit
standards then they should not be outrightly refused. Rather they should be
offered some alternative facilities. A customer may be offered to pay on
delivery of goods, invoices may be sent through bank. Such a course help in
retaining the customers at present and their dealings may help in reviewing
their requests at a later date.
(d) Financing Investments in Receivables and Factoring: Accounts

receivables block a part of working capital. Efforts should be made that
funds are not tied up in receivables for longer periods. The finance manager
should make efforts to get receivables financed so that working capital
needs are met in time. The quality of receivables will determine the amount
of loan. The banks will accept receivable of dependable parties only.
Another method of getting funds against receivables is their outright sale to
the bank. The bank will credit the amount to the party after deducting
discount and will collect the money from the customers later. Here too, the
bank will insist on quality receivables only. Besides banks, there may be
other agencies which can buy receivables and pay cash for them. This
facility is known as factoring. The factoring may be with or without
recourse. It is without recourse then any bad debt loss is taken up by the
factor but if it is with recourse then bad debts losses will be recovered from
the seller.
Factoring is collection and finance service designed to improve he cash

flow position of the sellers by converting sales invoices into ready cash. The
procedure of factoring can be explained as follows:
1. Under an agreement between the selling firm and factor firm, the
latter makes an appraisal of the credit worthiness of potential
customers and may also set the credit limit and term of credit for
different customers.
2. The sales documents will contain the instructions to make payment
directly to factor who is responsible for collection.
3. When the payment is received by the factor on the due date the
factor shall deduct its fees, charges etc and credit the balance to the
firm’s accounts.
4. In some cases, if agreed the factor firm may also provide advance
finance to selling firm for which it may charge from selling firm. In a
way this tantamount to bill discounting by the factor firm. However
factoring is something more than mere bill discounting, as the former
includes analysis of the credit worthiness of the customer also. The
factor may pay whole or a substantial portion of sales vale to the
selling firm immediately on sales being effected. The balance if any,
may be paid on normal due date.
Benefits and Cost of Factoring

A firm availing factoring services may have the following benefits:
§ Better Cash Flows
§ Better Assets Management
§ Better Working Capital Management
§ Better Administration
§ Better Evaluation
§ Better Risk Management
However, the factoring involves some monetary and non-monetary costs as

follows:
Monetary Costs
a) The factor firm charges substantial fees and commission for
collection of receivables. These charges sometimes may be too
much in view of amount involved.
b) The advance fiancé provided by factor firm would be available
at a higher interest costs than usual rate of interest.
Non-Monetary Costs
a) The factor firm doing the evaluation of credit worthiness of the
customer will be primarily concerned with the minimization of risk of
delays and defaults. In the process it may over look sales growth
aspect.
b) A factor is in fact a third party to the customer who may not feel
comfortable while dealing with it.
c) The factoring of receivables may be considered as a symptom of
financial weakness.
Factoring in India is of recent origin. In order to study the feasibility of

factoring services in India, the Reserve Bank of India constituted a study
group for examining the introduction of factoring services, which submitted
its report in 1988.On the basis of the recommendations of this study group
the RBI has come out with specific guidelines permitting a banks to start
factoring in India through their subsidiaries. For this country has been
divided into four zones. In India the factoring is still not very common. The
first factor i.e. The SBI Factor and Commercial Services Limited started
working in April 1991. The guidelines for regulation of a factoring are as
follows:
(1) A factor firm requires an approval from Reserve Bank of India.
(2) A factor firm may undertake factoring business or other
incidental activities.
(3) A factor firm shall not engage in financing of other firms or
firms engaged in factoring.
3. Formulating and Executing Collection Policy
The collection o f amounts due to the customers is very important.

The collection policy the termed as strict and lenient. A strict policy of
collection will involve more efforts on collection. Such a policy has both
positive and negative effects. This policy will enable early collection of dues
and will reduce bad debt losses. The money collected will be used for other
purposes and the profits of the concern will go up. On the other hand a
rigorous collection policy will involve increased collection costs. It may also
reduce the volume of sales. A lenient policy may increase the debt
collection period and more bad debt losses. A customer not clearing the
dues for long may not repeat his order because he will have to pay earlier
dues first, thus causing.
The objective is to collect the dues and not to annoy the customer.
The steps should be like (i) sending a reminder for payments (ii) Personal
request through telephone etc. (iii) Personal visits to the customers (iv)
Taking help of collecting agencies and lastly (v) Taking legal action. The last
step should be taken only after exhausting all other means because it will
have a bad impact on relations with customers.
Illustration 1: A company has prepared the following projections for a year
Sales 21000 units
Selling Price per unit Rs.40
Variable Costs per unit Rs.25
Total Costs per unit Rs.35
Credit period allowed One month
The company proposes to increase the credit period allowed to its

customers from one month to two months .It is envisaged that the change in
policy as above will increase the sales by 8%. The company desires a return
of 25% on its investment. You are required to examine and advise whether
the proposed credit policy should be implemented or not?
Solution:
Particulars Present Proposed Incremental

Sales (units) 21000 22680 1680
Contribution per unit Rs.15 Rs.15 Rs.15
Total Contribution Rs.3,15,000 Rs.3,40,000 Rs.25,200
Variable cost @ Rs.25 5,25,000 5,67,000 42,000
Fixed Cost 2,10,000 2,10,000 ------
7,35,000 7,77,000 42,000
Total Cost 1 month 2 month -----
Rs.61250 Rs.1,29,500 Rs.68,250
Credit period
Average debtors at cost
Incremental Return = Increased Contribution/Extra Funds
Blockage *100
= Rs.25,200/Rs.68,250*100
=36.92%
Illustration 2: ABC & Company is making sales of Rs.16,00,000 and it extends a credit of 90 days to its
customers. However, in order to overcome the financial difficulties, it is considering to change the credit
policy. The proposed terms of credit and expected sales are given hereunder:
Policy Terms Sales
I 75 days Rs.15,00,000
II 60 days Rs. 14,50,000

III 45 days Rs 14,25,000
IV 30 days Rs 13,50,000
V 15 days
Rs.13,00,000
The firm has variable cost of 80% and fixed cost of Rs.1,00,000. The cost of
capital is 15%. Evaluate different policies and which policy should be
adopted?
Solution:
figures in Rs.
Particular Present I II III IV V
s
Sales 16,00,000 15,00,000 14,50,000 14,25,000 13,50,000 13,00,000
-- Variable 12,80,000 12,00,000 11,60,000 11,40,000 10,80,000 10,40,000

cost
-- Fixed
Cost 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Profit (A)
Total Cost 2,20,000 2,00,000 1,90,000 1,85,000 1,70,000 1,60,000
Average 13,80,000 13,00,000 12,60,000 12,40,000 11,80,000 11,40,000

Receivable
(at cost) 3,45,000 2,70,833 2,10,000 1,55,000 98,333 47,500
(Cost¸360x
credit
period
Cost of
debtors @
15% (B) 51,750 40,625 31,500 23,250 14,750 7,125
Net profit
(A – B)
1,68,250 1,59,350 1,58,500 1,61,750 1,55,250 1,52,875
Illustration3: A trader whose current sales are Rs.15 lakhs per annum and average collection
period is 30 days wants to pursue a more liberal credit policy to improve sales. A study made by
consultant firm reveals the following information.
Credit Policy increase in collection period
Increase in sales
A 15 days
Rs.60,000
B 30 days
90,000
C 45 days
1,50,000
D 60 days
1,80,000
E 90 days
2,00,000
The selling price per unit is Rs.5. Average Cost per unit is Rs.4 and variable
cost per unit I Rs.2.75 paise per unit. The required rate of return on
additional investments is 20 percent Assume 360 days a year and also
assume that there are no bad debts. Which of the above policies would you
recommend for adoption.
Solution:
Particular Present A B C D E
s
Credit 30 days 45 days 60 days 75 days 90 days 120 days
period
No. of units
@ Rs.5 3,12,000 3,18,000 3,30,000 3,36,000 3,40,000
3,00,000
Sales
Variable
cost@ 2.75
15,60,000 15,90,000 16,50,000 16,80,000 17,00,000

Fixed Cost
Total Cost
8,58,000 8,74,500 9,07,500 9,24,000 9,35,000
15,00,000
Profit (A)
3,75,000 3,75,000 3,75,000 3,75,000 3,75,000
12,33,000 12,49,500 12,82,500 12,99,000 13,10,000

Average
debtors(at
cost)
8,25,000
3,27,000 3,40,500 3,67,500 3,81,000 3,90,000

cost¸360x
credit
period
Cost of 3,75,000 1,54,125 2,08,250 2,67,188 3,24,750 4,36,667

investment
@ 20% (B)
Net Profit 12,00,000

(A-B)
3,00,000 30,825 41,650 53,437 64,950 87,333
1,00,000 2,96,175 2,98,850 3,14,063 3,16,050 3,02,667
20,000
2,80,000
Lets Sum Up
 The receivables emerge when goods are sold on credit and the
payments are deferred by the customers. So, every firm should have a
well-defined credit policy.
 The receivables management refers to managing the receivables in the
light of costs and benefit associated with a particular credit policy.
 Receivables management involves the careful consideration of the
following aspects: Forming of credit policy, Executing the credit
policy, Formulating and executing collection policy.
 The credit policy deals with the setting of credit standards and credit
terms relating to discount and credit period.
 The credit evaluation includes the steps required for collection and
analysis of information regarding the credit worthiness of the
customer.
QUESTIONS
1. What do you understand by Receivables Management? Discuss the

factors which influence the size of receivables?
2. What should be the considerations in forming a credit policy?
3. “Receivables forecasting is important for the proper management of
receivables forecasting.” Explain.
4. Discuss the various aspects or dimensions of receivable management?
5. Write short note on Factoring.
INVENTORY MANAGEMENT
INVENTORY MANAGEMENT
Smriti Chawla
University of Delhi
Delhi
CHAPTER OBJECTIVES
 Introduction
 Meaning and nature of inventory
 Purpose/Benefits of Holding Inventory
 Risks/Costs of Holding inventory
 Inventory Management
 Objects of Inventory Management
 Tools and Techniques of Inventory Management
 Risks in Inventory Management
 Lets Sum Up
 Questions
Introduction
Every enterprise needs inventory for smooth running of its activities. It

serves as a link between production and distribution processes. There is,
generally, a time lag between the recognition of need and its fulfilment.
The greater the time – lag, the higher the requirements for inventory.
The investment in inventories constitutes the most significant part of

current assets/working capital in most of the undertakings. Thus, it is very
essential to have proper control and management of inventories. The
purpose of inventory management is to ensure availability of materials in
sufficient quantity as and when required and also to minimise investment in
inventories.
Meaning and Nature of inventory
In accounting language it may mean stock of finished goods only. In a

manufacturing concern, it may include raw materials, work in process and
stores, etc. Inventory includes the following things:
(a) Raw Material: Raw material form a major input into the
organisation. They are required to carry out production activities
uninterruptedly. The quantity of raw materials required will be determined
by the rate of consumption and the time required for replenishing the
supplies. The factors like the availability of raw materials and government
regulations etc. too affect the stock of raw materials.
(b) Work in Progress: The work-in-progress is that stage of stocks

which are in between raw materials and finished goods. The raw materials
enter the process of manufacture but they are yet to attain a final shape of
finished goods. The quantum of work in progress depends upon the time
taken in the manufacturing process. The greater the time taken in
manufacturing, the more will be the amount of work in progress.
(c) Consumables: These are the materials which are needed to

smoothen the process of production. These materials do not directly enter
production but they act as catalysts, etc. Consumables may be classified
according to their consumption and criticality.
(d) Finished goods: These are the goods which are ready for the
consumers. The stock of finished goods provides a buffer between
production and market. The purpose of maintaining inventory is to ensure
proper supply of goods to customers.
(e) Spares: Spares also form a part of inventory. The consumption

pattern of raw materials, consumables, finished goods are different from
that of spares. The stocking policies of spares are different from industry to
industry. Some industries like transport will require more spares than the
other concerns. The costly spare parts like engines, maintenance spares etc.
are not discarded after use, rather they are kept in ready position for
further use.
Purpose/Benefits of Holding Inventors
There are three main purposes or motives of holding inventories:

(i) The Transaction Motive which facilitates continuous production
and timely execution of sales orders.
(ii) The Precautionary Motive which necessitates the holding of
inventories for meeting the unpredictable changes in demand and
supplies of materials.
(iii) The Speculative Motive which induces to keep inventories for
taking advantage of price fluctuations, saving in re-ordering costs
and quantity discounts, etc.
Risk and Costs of Holding Inventors
The holding of inventories involves blocking of a firm’s funds and

incurrence of capital and other costs. It also exposes the firm to certain
risks. The various costs and risks involved in holding inventories are as
below:
(i) Capital costs: Maintaining of inventories results in blocking
of the firm’s financial resources. The firm has, therefore, to
arrange for additional funds to meet the cost of inventories. The
funds may be arranged from own resources or from outsiders. But
in both cases, the firm incurs a cost. In the former case, there is an
opportunity cost of investment while in later case the firm has to
pay interest to outsiders.
(ii) Cost of Ordering: The costs of ordering include the cost of
acquisition of inventories. It is the cost of preparation and
execution of an order, including cost of paper work and
communicating with supplier. There is always minimum cot involve
whenever an order for replenishment of good is placed. The total
annual cost of ordering is equal to cost per order multiplied by the
number of order placed in a year.
(iii) Cost of Stock-outs: A stock out is a situation when the firm
is not having units of an item in store but there is demand for that
either from the customers or the production department. The stock
out refer to demand for an item whose inventory level is reduced
to zero and insufficient level. There is always a cost of stock out in
the sense that the firm faces a situation of lost sales or back
orders. Stock out are quite often expensive.
(iv) Storage and Handling Costs. Holding of inventories also
involves costs on storage as well as handling of materials. The
storage costs include the rental of the godown, insurance charge
etc.
(v) Risk of Price Decline. There is always a risk of reduction in
the prices of inventories by the suppliers in holding inventories.
This may be due to increased market supplies, competition or
general depression in the market.
(vi) Risk of Obsolescence. The inventories may become obsolete
due to improved technology, changes in requirements, change in
customer’s tastes etc.
(vii) Risk Deterioration in Quality: The quality of the materials
may also deteriorate while the inventories are kept in stores.
Inventory Management
It is necessary for every management to give proper attention to

inventory management. A proper planning of purchasing, handling storing
and accounting should form a part of inventory management. An efficient
system of inventory management will determine (a) what to purchase (b)
how much to purchase (c) from where to purchase (d) where to store, etc.
There are conflicting interests of different departmental heads over

the issue of inventory. The finance manager will try to invest less in
inventory because for him it is an idle investment, whereas production
manager will emphasise to acquire more and more inventory as he does not
want any interruption in production due to shortage of inventory. The
purpose of inventory management is to keep the stocks in such a way that
neither there is over-stocking nor under-stocking. The over-stocking will
mean reduction of liquidity and starving of other production processes;
under-stocking, on the other hand, will result in stoppage of work. The
investments in inventory should be kept in reasonable limits.
Objects of Inventory Management
The main objectives of inventory management are operational and

financial. The operational objectives mean that the materials and spares
should be available in sufficient quantity so that work is not disrupted for
want of inventory. The financial objective means that investments in
inventories should not remain idle and minimum working capital should be
locked in it. The following are the objectives of inventory management:
(1) To ensure continuous supply of materials spares and finished goods
so that production should not suffer at any time and the customers
demand should also be met.
(2) To avoid both over-stocking and under-stocking of inventory.
(3) To keep material cost under control so that they contribute in
reducing cost of production and overall costs.
(4) To minimise losses through deterioration, pilferage, wastages and
damages.
(5) To ensure perpetual inventory control so that materials shown in
stock ledgers should be actually lying in the stores.
(6) To ensure right quality goods at reasonable prices.
(7) To maintain investments in inventories at the optimum level as
required by the operational and sales activities.
(8) To eliminate duplication in ordering or replenishing stocks. This is
possible with help of centralising purchases.
(9) To facilitate furnishing of data for short term and long term planning
and control of inventory.
(10) To design proper organisation of inventory. A clear cut accountability
should be fixed at various levels of management.
Tools and Techniques of inventory Management
Effective Inventory management requires an effective control system for

inventories. A proper inventory control not only helps in solving the acute
problem of liquidity but also increases profits and causes substantial
reduction in the working capital of the concern. The following are the
important tools and techniques of inventory management and control:
1. Determination of Stock Levels.

2. Determination of Safety Stocks.
3. Determination of Economic Order Quantity
4. A.B.C. Analysis
5. VED Analysis
6. Inventory Turnover Ratios
7. Aging Schedule of Inventories
8. Just in Time Inventory
1. Determination of Stock Levels
Carrying of too much and too little of inventories is detrimental to the

firm. If the inventory level is too little, the firm will face frequent stock-
outs involving heavy ordering cost and if the inventory level is too high it
will be unnecessary tie-up of capital. Therefore, an efficient inventory
management requires that a firm should maintain an optimum level of
inventory where inventory costs are the minimum and at the same time
there is not stock-out which may result in loss of sale or stoppage of
production. Various stock levels are discussed as such.
(a) Minimum Level: This represents the quantity which must be
maintained in hand at all times. If stocks are less than the minimum
level then the work will stop due to shortage of materials. Following
factors are taken into account while fixing minimum stock level:
Lead Time: A purchasing firm requires some time to process the order
and time is also required by supplying firm to execute the order. The time
taken in processing the order and then executing it is known as lead time.
Rate of Consumption: It is the average consumption of materials in the

factory. The rate of consumption will be decided on the basis pas
experiences and production plans.
Nature of Material: The nature of material also affects the minimum level.
If material is required only against special orders of customer then minimum
stock will not be required for such materials.
Minimum stock level = Re-ordering level-(Normal consumption

x Normal Re-order period).
(b) Re-ordering Level: When the quantity of materials reaches at a certain

figure then fresh order is sent to get materials again. The order is sent
before the materials reach minimum stock level. Reordering level is fixed
between minimum and maximum level. The rate of consumption, number of
days required to replenish the stock and maximum quantity of material
required on any day are taken into account while fixing reordering level.
Re-ordering Level = Maximum Consumption x Maximum Re-order
period.
(c) Maximum Level: It is the quantity of materials beyond which a firm

should not exceed its stocks. If the quantity exceeds maximum level limit
then it will be overstocking. A firm should avoid overstocking because it will
result in high material costs.
Maximum Stock Level = Re-ordering Level+ Re-ordering Quantity

-(Minimum Consumption x Minimum Re-ordering
period).
(d) Danger Level: It is the level beyond which materials should not fall in
any case. If danger level arises then immediate steps should be taken to
replenish the stock even if more cost is incurred in arranging the materials.
If materials are not arranged immediately there is possibility of stoppage of
work.
Danger Level = Average Consumption x Maximum reorder period
for emergency purchases.
(e) Average Stock Level
The average stock level is calculated as such:
Average Stock level = Minimum Stock Level +½ of re-order

quantity
2. Determination of Safety Stocks
Safety stock is a buffer to meet some unanticipated increase in usage.

It fluctuates over a period of time. The demand for materials may fluctuate
and delivery of inventory may also be delayed and in such a situation the
firm can face a problem of stock-out. The stock-out can prove costly by
affecting the smooth working of the concern. In order to protect against the
stock out arising out of usage fluctuations, firms usually maintain some
margin of safety or safety stocks. Two costs are involved in the
determination of this stock i.e. opportunity cost of stock-outs and the
carrying costs. The stock out of raw materials cause production disruption
resulting in higher cost of production. Similarly, the stock out of finished
goods result into failure of firm in competition, as firm cannot provide
proper customer service. If a firm maintains low level of safety frequent
stock out will occur resulting in large opportunity coast. On the other hand
larger quantity of safety stock involves higher carrying costs.
3. Economic Order Quantity (EOQ)
A decision about how much to order has great significance in inventory

management. The quantity to be purchased should neither be small nor big
because costs of buying and carrying materials are very high. Economic
order quantity is the size of the lot to be purchased which is economically
viable. This is the quantity of materials which can be purchased at minimum
costs. Generally, economic order quantity is the point at which inventory
carrying costs are equal to order costs. In determining economic order
quantity it is assumed that cost of a managing inventory is made of solely of
two parts i.e. ordering costs and carrying costs.
(A) Ordering Costs: These are costs that are associated with the
purchasing or ordering of materials. These costs include:
(1) Inspection costs of incoming materials.
(2) Cost of stationery, typing, postage, telephone charges etc.
(3) Expenses incurred on transportation of goods purchased.
These costs are also know as buying costs and will arise only when some
purchases are made.
(B) Carrying Costs: These are costs for holding the inventories. These
costs will not be incurred if inventories are not carried. These costs include:
(1) The cost of capital invested in inventories. An interest will be paid
on the amount of capital locked up in inventories.
(2) Cost of storage which could have been used for other purposes.
(3) Insurance Cost
(4) Cost of spoilage in handling of materials
Assumptions of EOQ: While calculating EOQ the following assumptions are

made.
1. The supply of goods is satisfactory. The goods can be purchased
whenever these are needed.
2. The quality to be purchased by the concern is certain.
3. The prices of goods are stable. It results to stabilise carrying
costs.
Economic order quantity can be calculated with the help of the following
formula:
where, A = Annual consumption in rupees.
S = Cost of placing an order.
I = Inventory carrying costs of one unit.
Illustration 1: The finance department of a Corporation provides the

following information:
(i) The carrying costs per unit of inventory are Rs. 10
(ii) The fixed costs per order are Rs. 20]
(iii) The number of units required is 30,000 per year.
Determine the economic order quantity (EOQ) total number of orders in a

year and the time gap between orders.
Solution: The economic order quantity may be found as follow
A = 30,000
S = Rs.20
I = Rs.10
Now, EOQ = ( 2 x 30,000x 20) ¸ 10 )1/2 = 346 units
So, the EOQ is 346 units and the number of orders in a year would be
30,000/346 = 86.7 or 87 orders. The time gap between two orders would be
365/87 = 4.2 or 4 days.
4. A-B-C Analysis
Under A-B-C analysis, the materials are divided into three categories
viz, A, B and C. Past experience has shown that almost 10 per cent of the
items contribute to 70 percent of value of consumption and this category is
called ‘A’ Category. About 20 per cent of value of consumption and this
category is called ‘A’ Category. About 20 per cent of the items contribute
about 20 per cent of value of consumption and this is known as category ‘B’
materials. Category ‘C’ covers about 70 per cent of items of materials which
contribute only 10 per cent of value of consumption. There may be some
variation in different organisations and an adjustment can be made in these
percentages.
The information is shown in the following diagram:

Class No. of Items (%) Value of Items (%)
A 10 70
B 20 20
C 70 10
A-B-C analysis helps to concentrate more efforts on category A since
greatest monetary advantage will come by controlling these items. An
attention should be paid in estimating requirements, purchasing,
maintaining safety stocks and properly storing of ‘A’ category materials.
These items are kept under a constant review so that substantial material
cost may be controlled. The control of ‘C’ items may be relaxed and these
stocks may be purchased for the year. A little more attention should be
given towards ‘B’ category items and their purchase should be undertaken a
quarterly or half-yearly intervals.
5. VED Analysis
The VED analysis is used generally for spare parts. The requirements
and urgency of spare parts is different from that of materials. A-B-C analysis
may not be properly used for spare parts. Spare parts are classified as Vital
(V), Essential (E) and Desirable (D) The vital spares are a must for running
the concern smoothly and these must be stored adequately. The non-
availability of vital spares will cause havoc in the concern. The E type of
spares are also necessary but their stocks may be kept at low figures. The
stocking of D type of spares may be avoided at times. If the lead time of
these spares is less, then stocking of these spares can be avoided.
6. Inventory Turnover Ratios
Inventory turnover ratios are calculated to indicate whether

inventories have been used efficiently or not. The purpose is to ensure the
blocking of only required minimum funds in inventory. The Inventory
Turnover Ratio also known as stock velocity is normally calculated as
sales/average inventory or cost of goods sold/average inventory cost.
Inventory Turnover Ratio =
and, Inventory Conversion Period =
7. Aging Schedule of Inventories
Classification of inventories according to the period (age) of their

holding also helps in identifying slow moving inventories thereby helping in
effective control and management of inventories. The following table show
aging of inventories of a firm.
AGING SCHEDULE OF INVENTORIES

Item Age Date of Acquisition Amount %age to
Name/Code Classification (Rs.) total
011 0-15 days June 25,1996 30,000 15
002 16-30 days June 10,1996 60,000 30
003 31-45 days May 20,1996 50,000 25
004 46-60 days May 5,1996 40,000 20
005 61 and above April 12,1996 20,000 10

2,00,000 100
9. Just in Time Inventory (JIT)
JIT is a modern approach to inventory management and goal is essentially

to minimize such inventories and thereby maximizing the turnover. In JIT,
affirm keeps only enough inventory on hand to meet immediate production
needs. The JIT system reduces inventory carrying costs by requiring that the
raw materials are procured just in time to be placed into production.
Additionally, the work in process inventory is minimized by eliminating the
inventory buffers between different production departments. If JIT is to be
implemented successfully there must be high degree of coordination and
cooperation between the suppliers and manufacturers and among different
production centers.
Risk in Inventory Management

The main risk in inventory management is that market value of inventory
may fall below what firm paid for it, thereby causing inventory losses. The
sources of market value of risk depend on type of inventory. Purchased
inventory of manufactured goods is subject to losses due to changes in
technology. Such changes may sharply reduced final prices of goods when
they are sold or may even make the goods unsaleable. There are also
substantial risks in inventories of goods dependent on current styles. The
ready-made industry is particularly susceptible to risk of changing consumer
tastes. Agricultural commodities are a type of inventory subject to risks due
to unpredictable changes in production and demand.
Moreover, all inventories are exposed to losses due to spoilage,
shrinkage, theft or other risks of this sort. Insurance is available to cover
many of these risks and if purchased is one of the costs of holding inventory.
Hence, the financial manager must be aware of the degree of risk involve
infirm investment in inventories. The manager must take those risks into
account in evaluating the appropriate level of investment.
Lets Sum Up
§ Inventory includes and refers to raw material, work in progress and
finished goods. Inventory management refers to management of level of
these components.
§ The inventory management involves a trade off between costs and
benefits of inventory. In a systematic approach to inventory
management, a financial manager has to identify (i) the items that are
more important than others and (ii) the size of each order for different
items.
§ Two important techniques of deal with the inventory management are
ABC Analysis and The Economic Order Quantity (EOQ) model.
§ The EOQ model attempts to find out the number of units to be ordered
every time in order to minimize the total cost of ordering and carrying
the inventory.
QUESTIONS
1 Write short notes on:
(a) ABC Analysis of inventory control
(b) Economic order quantity
2 Define safety stock. How is it determined? What is the role of
safety stock in inventory management?
3. What is the need for holding inventory? Why inventory
management is important?
4. Explain briefly techniques of inventory management.

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o CAPITAL STRUCTURAL MANAGEMENT OR PLANNING THE CAPITAL

o FINANCING DECISION – LEVERAGE ANALYSIS

o DIVIDEND POLICY : DETERMINANTS AND CONSTRAINS

o DIVIDEND POLICY IN PRACTICE

o WORKING CAPITAL: ESTIMATION AND CALCULATION

Contains five parts...

3. CAPITAL STRUCTURAL MANAGEMENT OR PLANNING THE CAPITAL STRUCTURE

4. FINANCING DECISION: EBIT –EPS ANALYSIS

5. FINANCING DECISION – LEVERAGE ANALYSIS

Shri Ram College of Commerce

 Understand the Meaning, Concept and

Cost of Preference Capital

Cost of Retained Earnings

Meaning, Concept and Definition

The cost of capital of a firm is the minimum rate of return expected

According to Solomon Ezra Cost of capital is the minimum required

(i) Cost of capital is not a cost as such. In fact, it is the rate of

(ii) It is the minimum rate of return. Cost of capital of a firm is

(iii) It comprises of three components. As there is always some

(b) the premium for business risk; and

(c) the premium for financial risk on account of pattern of

Symbolically cost of capital may be represented as:

ro=Normal rate of return at zero risk level

b=Premium for business risk.

f=Premium for financial risk.

Significance of the Cost of Capital

(1) As an Acceptance Criterion in Capital Budgeting: Capital budgeting

(2) As a Determinant of Capital Mix in Capital Structure Decisions:

(3) As a basis for evaluating the Financial Performance: The concept of

where, Io, is the net cash inflow at zero point of time,

Ot is the outflow of cash in period 1, 2 and n.

k is the explicit cost of capital.

Determination of Cost of Capital

Problems in determining Cost of Capital

1. Conceptual controversies regarding the relationship between

2. Problems in computation of cost of equity: The computation of

3. Problems in computation of cost of retained earnings: It is

4. Problems in assigning weights: For determining the weighted

Computation of each specific source of finance, viz, debt, preference

where, Kdb = Before tax cost of debt

In case the debt is raised at premium or discount, we should consider

(ii) Kdb = (where, NP = Net Proceeds)

Further, when debt is used as a source of finance, the firm saves a

(iii) Kda = Kdb (1-t) =

Cost of Redeemable Debt

Usually, the debt is issued to be redeemed after a certain period during

(iv) Before-tax cost of debt

N = Number of years in which debt is to be redeemed

(v) After tax cost of debt, Kda = Kdb (1-t)

Illustration1: A Company issues shares of Rs.10,00,000, 10%

(NP=Rs. 10,00,000-50,000 (discount) – 30,000 cost of floatation)

After tax cost of debt, Kda = Kdb (1-0.5)

= 12.09 (1-0.5) = 6.04%

Cost of Debt Redeemable at Premium

Sometimes debentures are to be redeemed at a premium; i.e at more

(i) Before tax cost of debt,

n = Number of years in which debt is to be redeemed

RV= Redeemable value of debt

(ii) After-tax cost of debt,

Kda= Kdb (1-t)

Illustration2: A 5-year Rs.100 debenture of a firm can be sold for a